David Friedman’s The Machinery Of Freedom, Illustrated

 

 

David Friedman narrates an illustrated look at the world of the private property society, where law and security are provided by voluntary contract and the legal system is pluralistic with trends/incentives toward monolithic standards in areas of major social importance. The source of the material is his book, The Machinery of Freedom.

Do You Know What The NSA’s True Purpose Is?

A friend sent me a chilling article from Wired magazine about a new, gargantuan spy center being built by the NSA in Utah. The article started with this short background on the genesis, and current evolution, of the NSA:

For the NSA, overflowing with tens of billions of dollars in post-9/11 budget awards, the cryptanalysis breakthrough came at a time of explosive growth, in size as well as in power. Established as an arm of the Department of Defense following Pearl Harbor, with the primary purpose of preventing another surprise assault, the NSA suffered a series of humiliations in the post-Cold War years. Caught off guard by an escalating series of terrorist attacks—the first World Trade Center bombing, the blowing up of US embassies in East Africa, the attack on the USS Cole in Yemen, and finally the devastation of 9/11—some began questioning the agency’s very reason for being. In response, the NSA has quietly been reborn. And while there is little indication that its actual effectiveness has improved—after all, despite numerous pieces of evidence and intelligence-gathering opportunities, it missed the near-disastrous attempted attacks by the underwear bomber on a flight to Detroit in 2009 and by the car bomber in Times Square in 2010—there is no doubt that it has transformed itself into the largest, most covert, and potentially most intrusive intelligence agency ever created.

I want to channel G Edward Griffin a little bit here. Griffin is the author of The Creature From Jekyll Island, and in this book he put forth the notion that if the results of a policy consistently and widely diverge over time from the stated intentions, one has a sound basis upon which to question the stated intentions of the policy being observed.

In “Creature”, Griffin was discussing the Federal Reserve System and its “dual mandate”– to maintain stable prices and low unemployment. Of course, the Fed has never managed to achieve either one of its objectives since it was founded, leading a skeptical observer to wonder if the Fed was perpetually failing at its stated objective, or consistently succeeding on an unstated one.

Proponents of the NSA will argue that there are many successes we might never know about due to matters of secrecy. We can’t critically examine the veracity of these arguments because we’re not deemed worthy of the trust necessary to obtain the information required to evaluate these claims, so they must be ignored.

What we are sure of, as the paragraph above points out, is that there have been numerous “surprise assaults” that the NSA has done nothing to stop.

And yet, it only grows larger.

Maybe the NSA is succeeding wildly at its true purpose despite appearing to fail at its stated purpose. The construction of this massive, $2 billion facility in Utah is alarming.

But we should be even more alarmed that we do not know what is the true purpose of this multi-billion dollar agency.

Thoughts On Mergers, Acquisitions And Conglomeration From Rothbard And Buffett

In reading David Merkel’s third posting on Warren Buffett’s latest shareholder letter, I came across the following:

it should be no surprise that as BRK grew, given Buffett’s desire for owning as much of great businesses as he could, that BRK became a conglomerate, albeit one dominated by its leading insurance businesses.

David’s making a particular point using the language of “conglomerate” in a specific way– the idea of a company operating in multiple industries, none of which are necessarily related or complimentary to the other businesses in the portfolio. He’s observing Buffett’s behavior from the standpoint of acquisitions and trying to arrive at a meaningful interpretation of why and how Buffett has acquired as he has, resulting in his business representing a conglomerate.

It’s a worthwhile consideration but I want to try standing Merkel’s perspective on its proverbial head with the help of my friend Murray Rothbard, and see if some new insights aren’t arrived at. This is from chapter ten of his opus, Man, Economy and State, discussing “Cartels, Mergers and Corporations“:

What happens when a partnership or corporation is formed? Individuals agree to pool their assets into a central management, this central direction to set the policies for the owners and to allocate the monetary gains among them. In both cases, the pool­ing, lines of authority, and allocation of monetary gain take place according to rules agreed upon by all from the beginning. There is therefore no essential difference between a cartel and an or­dinary corporation or partnership.

Before you start getting upset (you who are having your worldview challenged here), read on:

Yet clearly the only difference between a merger and the original forming of a single corporation is that the merger pools existing capital ­goods assets, while the original birth of a corporation pools money assets. It is clear that, economically, there is little difference be­tween the two. A merger is the action of individuals with a certain quantity of already produced capital goods, adjusting themselves to their present and expected future conditions by cooperative pooling of assets.

I think this can be taken a step further, even, by saying that mergers don’t actually exist, there are only acquisitions. The reason I say this is because after every merger, “of equals” or otherwise, someone is left with de facto, if not technical or legal, control over the combined entity.

When two public corporations “merge”, the minority capital owners can de-merge (or escape acquisition) by liquidating their shares in the market. Their financial capital is freed to be placed elsewhere but their physical assets (the property of the merged corporation) remain. In this sense, clearly what has occurred is an acquisition of real capital goods, not a “merger”.

Does this logic apply to liquid investment partnerships, such as hedge funds, as well? By my definition, a hedge fund is not a “merger” (temporary, at that) because mergers don’t exist… it’s an acquisition by the portfolio manager. But there is no physical capital involved at this level, it is all liquid financial assets which represent claims to real, physical capital. And if the “merged” partner decides to de-merge, the portfolio manager has to sell a corresponding number of securities and financial assets to liquidate him, the control of which he does not hold onto going forward, unlike the corporation in which investors are made liquid not by the corporation but by outside investors.

I’ll have to think about that one a bit more. In the meantime, I’ve got another Rothbard quote on the subject, from the same chapter:

a merger and the original forma­tion of a corporation do not, as we have seen, essentially differ. The former is an adaptation of the size and number of firms in an industry to new conditions or is the correction of a previous error in forecasting. The latter is a de novo attempt to adapt to present and future market conditions.

Why mention this? What does any of this have to do with David Merkel’s article, Buffett and corporate conglomeration?

Merkel notes that Buffett has talked a lot about acquisitions over the years for a good reason: all investors are acquirers. Great investors are great acquirers (and tend to be extremely acquisitive, as well as extremely conscious of their status as acquirers). Buffett, as arguably the greatest investor of all time, is also one of the greatest acquirers of all time.

Many people talk about the investment process as one of efficiently and profitably allocating capital, and they talk of Buffett as an especially talented capital allocator. Few of these people realize how close they are to the profound, in this sense. Acquisitions and mergers are part of the capital allocation process. Acquisitions decide who will make future capital allocations with regards to a current pool of capital as well as its anticipated future capital yield.

Before Buffett was the head of a big time corporate conglomerate, he was a small investor. But even then, he was still an acquirer and involved in constant corporate acquisition, just like you, me and anyone else who makes small investments periodically. Every time we purchase a security, even if it is a fractional interest in an enterprise, we are acquiring that real capital and adding it to our own enterprise, corporate or otherwise. We are expanding our own personal domain as it pertains to the total pool of capital in the economy (local, national, global) and simultaneously someone else is either transferring their domain or relinquishing it in favor of consumption.

The corporate conglomeration is the natural, logical outcome of a track record of successful, long-term serial acquisitiveness, aka “investing”. In fact, it would be extremely odd to find a successful investor who hadn’t assembled a conglomerate. No, it would be impossible!

“What about a Buffett-contemporary like Walter Schloss?” you might be asking. He didn’t assemble a corporate conglomerate.

True, Schloss did not possess the precise econo-legal structure of the corporate holding company that Buffett did. But he was still a conglomerator– he acquired small pieces of many different businesses and essentially pooled their assets under his control.

Even a person who has concentrated their investing into ONE firm over their entire career is essentially an acquirer and a conglomerater, assuming this firm grows profitably. Through profitable growth, the firm generates retained earnings which are essentially internal corporate savings that the firm can use to ACQUIRE new capital goods and assets. Cornelius Vanderbilt, the steamboat and railroad magnate of the 1800s, is a good example of this. Even though he did not acquire a number of other firms, he acquired additional assets such as steamships, railroad cars, raillines, etc., from suppliers and thereby put these capital goods under his direct control. John D. Rockefeller is an extreme example of the acquisitional behavior of an investor-entrepreneur– he acquired into his oil empire not only oil equipment and oil reserves but entire capital good suppliers related to his business, such as railroads, warehouses and service stations.

Returning to Buffett, as Merkel says:

Once BRK got big, that meant becoming a conglomerate, albeit a special one, was the logical outcome.  And I could be wrong, but that is the final corporate form for BRK.  There may come a day in a post-Buffett era when it may do many things, such as spin off companies, or centralize functions.

I don’t think conglomeration had anything to do with hitting a size threshold. I think it is related to Buffett’s long-term success as a capital allocator, which is dependent upon his ability to acquire the right assets over time. I think Merkel is correct that this will be the final corporate form of BRK.

And, I think Merkel is onto something when he says there could come a day when BRK spins off companies or otherwise transforms itself, particularly in the post-Buffett era. As we learned in our reading of Value: The Four Cornerstones of Corporate Finance, a particular asset will have numerous “best owners” over its entire lifetime. Looking at a collection of assets in the form of a contiguous business, this business will have numerous “best owners” over time, as well. From start-up, to growth, to maturity and eventually decline, ownership of the business will naturally transfer to those who are best positioned to maximize value (that is, future cash flows) from the business in its present form and at that particular stage of its lifecycle. The general trend is increasing acquisition of assets until the terminal point is reached at which point assets are divested and spun-off as the business declines and ultimately fails or disappears via merger/acquisition into the total control of another enterprise.

Merkel makes an important observation about the above-average ownership period of the average Buffett investment:

BRK is the acquirer of choice for those that want to cash out, but don’t want the unique character of their organizations to change, which Buffett points at in the present Shareholders’ Letter as a unique competitive advantage.

Buffett finds himself to be the “best owner” of various assets he has acquired for periods that seem much longer than most others because he has determined that committing himself to this role gives him a competitive advantage in convincing the previous owners to allow him to acquire the assets in the first place. Although Buffett as a capital allocator (acquirer) may have no particular advantage in managing businesses and assets involved in any particular late-phase lifecycle such as maturity and decline, by creating a credible belief that Buffett will preserve a business he aims to acquire, he is granted opportunities to acquire that might not exist for anybody else due to non-financial (such as emotional or prestige) reasons.

So far, this strategy has proven to be a good one, and a unique one for the most part. But it remains to be seen how this strategy will hold up when Buffett himself is no longer around, and many more of his businesses have entered the maturity/decline phases. After all, Buffett eventually sold off his textile mills, albeit for pennies on the dollar, though, it could be argued, not before extracting from them substantial free cash flows he was able to allocate into better businesses.

As investors, we’re all in the acquisition game. Like Buffett, whether we’re buying public or private companies, whole businesses or tiny slivers, we’re constantly acquiring (and sometimes divesting) pools of real capital.

How does acknowledging this fact change your perspective, and your behavior?

Post-script

There is nothing inherently efficient about the corporate conglomeration as an entrepreneurial structure. In fact, the conglomerate form (in the more traditional sense in which Merkel uses it) is generally found to be less efficient because it causes management to make decisions about business activities it may have substantially less expertise in, while simultaneously dividing total management attention and thereby causing distractions.

Frankly, there is no reason why a company like BRK, which owns candy confectioners, insurance companies and railroads, should necessarily have any special ability to compound wealth merely because of the corporate combination of these assets and businesses. If it were true that the corporate conglomeration was inherently more efficient and profitable, this business form would be vastly more prevalent than it currently is, if not entirely dominant.

The reality, however, is that most conglomerates are not specially profitable. They are not specially efficient. They suffer from bureaucratic operation, distracted management and huge internal calculational problems as they grow in size.

In that sense, Buffett (and Munger, to some extent) is the unique competitive advantage that BRK as a corporate conglomerate is blessed with. And it is for this reason that I believe the death of Buffett will be devastating to BRK’s market value and will most likely result in massive divestitures and the eventual break-up of the entity.

One final note, which I couldn’t help but to mention: the totalitarian state is the penultimate corporate conglomeration. And it suffers mightily as an economic entity, as a result.

Buffett: Inflation Is Just A Tax, So Why Expect Economic Miracles?

Since the global economic crisis began in 2007, many observers and commentators of economic and financial events alike have suggested that inflation (a little, some, a lot) is part of the solution to our troubles. From Ben Bernanke to Joseph Stiglitz, from Paul Krugman to Jeremy Siegel, it seems like everyone’s got something good to say about inflation and its miraculous economic benefits.

But what has Warren Buffett, the “greatest investor of all time” and, by correlation, one of the greatest businessmen and economic actors of all time, had to say about inflation?

The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5 percent inflation. Either way, she is “taxed” in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120 percent income tax, but doesn’t seem to notice that 6 percent inflation is the economic equivalent.

If my inflation assumption is close to correct, disappointing results will occur not because the market falls, but in spite of the fact that the market rises. At around 920 early last month, the Dow was up fifty-five points from where it was ten years ago. But adjusted for inflation, the Dow is down almost 345 points – from 865 to 520. And about half of the earnings of the Dow had to be withheld from their owners and reinvested in order to achieve even that result.

In the next ten years, the Dow would be doubled just by a combination of the 12 percent equity coupon, a 40 percent payout ratio, and the present 110 percent ratio of market to book value. And with 7 percent inflation, investors who sold at 1800 would still be considerably worse off than they are today after paying their capital-gains taxes.

I can almost hear the reaction of some investors to these downbeat thoughts. It will be to assume that, whatever the difficulties presented by the new investment era, they will somehow contrive to turn in superior results for themselves. Their success is most unlikely. And, in aggregate, of course, impossible. If you feel you can dance in and out of securities in a way that defeats the inflation tax, I would like to be your broker – but not your partner.

According to Warren Buffett and the simple arithmetic he shares, inflation is a tax. If inflation is a tax, it follows that it can not produce economic growth and miracles. Taxes represent confiscation of real wealth by taxing authorities, at which point that wealth is consumed as government authorities do not earn a profit on their expenditures and therefore these expenditures can not be looked at as productive.

Are higher taxes good for stock prices in the long run?

No. Higher taxes reduce the value of discounted future cash flows of any given asset and thereby reduce their present, capital value. Inflation is bad for stock prices (denominated in real terms) over time.

If inflation is a tax and taxes are not beneficial to economic growth, how does Buffett suggest American corporations can increase their returns on equity over time?

Corporate America cannot increase earnings by desire or decree. To raise that return on equity, corporations would need at least one of the following: (1) an increase in turnover, i.e., in the ratio between sales and total assets employed in the business; (2) cheaper leverage; (3) more leverage; (4) lower income taxes; (5) wider operating margins on sales.

Inflation, and taxation generally, do nothing to increase sales turnover, they do not make leverage cheaper, they do not create more leverage, they do not lower income taxes (obviously!) and they do not create wider operating margins on sales. Inflation/taxation are not a quick fix for an ailing economy according to Buffett!

To reiterate:

We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.

If inflation doesn’t help Warren Buffett earn higher returns on equity (that is, greater equity claims to real production on existing assets), what chance does anyone else have for benefitting from inflation in this way?

And again, if Buffett hadn’t been clear before:

As we said last year, Berkshire has no corporate solution to the problem. (We’ll say it again next year, too.) Inflation does not improve our return on equity.

Higher return on equity means more real value produced from the same base of assets.

And the taxation effect of inflation is so nefarious, it even extends to “tax-exempt” institutions, as Buffett explains:

At 7 percent inflation and, say, overall investment returns of 8 percent, these institutions, which believe they are tax-exempt, are in fact paying “income taxes” of 871⁄2 percent.

Everyone is caught in the net of inflation-taxation, even the so-called tax-exempt.

If inflation is a tax, and inflation, like other forms of taxation, consumes real wealth and depletes capital, and society doesn’t benefit from this, then who benefits? Who is consuming all of that capital?

The answer must be the individuals who stand outside of society and prey on its productive efforts, that is, the institution of government:

Investors in American corporations already own what might be thought of as a Class D stock. The class A, B and C stocks are represented by the income-tax claims of the federal, state, and municipal governments. It is true that these “investors” have no claim on the corporation’s assets; however, they get a major share of the earnings, including earnings generated by the equity buildup resulting from retention of part of the earnings owned by the Class D shareholders

You’ve heard it from the “greatest investor of all time”, Warren Buffett– inflation is a tax, it consumes real wealth and accumulated capital, it forces many corporations (and therefore, the people who work for them and own them) to run vigorously just to stand in place, and it places the equity of the country in a subordinate role to local, state and federal government.

Inflation is bad for the economy as it consumes the real returns of everyone’s productive efforts, sometimes so much that nothing is left over and in fact previous savings must be consumed, as well. Therefore, inflation is bad for your investments and bad for real returns in the stock market over time.

As Warren Buffett once said,

external conditions affecting the stability of currency may very well be the most important factor in determining whether there are any real rewards from your investment in Berkshire Hathaway.

And Berkshire Hathaway is no different from any other business, in that sense.

Frank Shostak: Is Krugman Joking? Liquidity Traps Are Impossible

The Mises Institute’s Frank Shostak is out with another simple-yet-edifying piece on the “liquidity debate”, that is, is the US facing a liquidity or solvency crisis? Shostak argues that liquidity traps are impossible.

Shostak ranks with Gary North as one of the most accomplished observers of economic events through an Austrian lens, in my opinion. Here’s the salient snippet, though I recommend reading the whole piece:

To suggest then that people could have an unlimited demand for money (hoarding money) that supposedly leads to a liquidity trap, as popular thinking has it, would imply that no one would be exchanging goods.

Obviously, this is not a realistic proposition, given the fact that people require goods to support their lives and well-being. (Please note: people demand money not to accumulate indefinitely but to employ in exchange at some more or less definite point in the future).

Being the medium of exchange, money can only assist in exchanging the goods of one producer for the goods of another producer. The state of the demand for money cannot alter the amount of goods produced, that is, it cannot alter the so-called real economic growth. Likewise a change in the supply of money doesn’t have any power to grow the real economy.

Contrary to popular thinking we suggest that a liquidity trap does not emerge in response to consumers’ massive increases in the demand for money but comes as a result of very loose monetary policies, which inflict severe damage to the pool of real savings.

Thorsten Polleit: Deflation Will Not Be Tolerated

Over at the Mises Blog, Frankfurt-based business professor Thorsten Polleit explains the deflationary forces active in the banking system following the 2008 crisis:

In “fighting” the credit crisis, the US Federal Reserve increased US banks’ (excess) reserves drastically as from late summer 2008. As banks did not use these funds (in full) to produce additional credit and fiat-money balances, however, the credit and money multipliers really collapsed.

The collapse of the multipliers conveys an important message: commercial banks are no longer willing or in a position to produce additional credit and fiat money in a way they did in the precrisis period.

This finding can be explained by three factors. First, banks’ equity capital has become scarce due to losses (such as, for instance, write-offs and creditor defaults) incurred in the crisis.

Second, banks are no longer willing to keep high credit risks on their balance sheets. And third, banks’ stock valuations have become fairly depressed, making raising additional equity a costly undertaking for the owners of the banks (in terms of the dilution effect).

The bold part in effect represents Mike Shedlock’s argument for why we will see sustained deflation due to economic forces. He insists that the only way mass inflation or hyperinflation could occur is if the political forces in society decide to create it.

Interestingly, Polleit agrees:

The political incentive structure, combined with the antideflation economic mindset, really pave the way for implementing a policy of counteracting any shrinking of the fiat-money supply with all instruments available.

And the shrinking of the fiat-money supply can be prevented, by all means. For in a fiat-money regime the central bank can increase the money supply at any one time in any amount deemed politically desirable.

Even in the case in which the commercial banking sector keeps refraining from lending to the private sector and government, the central bank can increase the money supply through various measures.

Polleit says mass inflation can be produced by a central bank policy of quantitative easing (direct monetization of existing and newly issued government debt) and that in fact this is the policy choice already being observed with regards to the actions of the Federal Reserve and European Central Bank.

Deflation will be incredibly painful for the political and financial classes. But mass inflation is not necessarily a policy that will delight them either. On each side lies disaster and it’s hard to make the case that any particular disaster is more preferential than the other from the perspective of the political and financial interests. And surely, the absolute size of the problem and the precariousness of the perch currently enjoyed seems to dictate that an attempt at finding an “easy middle” ground will fail this time around.

A Future Full of Urban Gulches

Zach Caceres over at Let A Thousand Nations Bloom has penned a rebuttal to a critic, called “In Defense of Urban Life“:

Urban life brings people together for mutual aid, and it opens wealth-generating possibilities for specialization and trade. It can integrate otherwise contentious groups, and it melds culture together to bring about beautiful new hybrids of music and art. We shouldn’t write off cities because of a romanticized ideal of the pastoral.

Indeed. There’s more and it’s a good, brief apologia for the urban environment versus the un-urban (suburbia, rural, pastoral, wilderness) in terms of satisfying human needs and lifestyle preferences. He touched on it briefly but I believe it bears further emphasizing, much of the problems his critic and those like him cite about urban environments are caused by central planning and non-market regulation.

Pollution, economic exploitation, environmental degradation and destruction (a poorly defined term for an ill-premised concept, but even accepted at its face in this situation it makes some sense), resource “overuse”, all of these problems are caused by undefined or poorly defined property rights and arbitrary interference and dictates from governments and other political, non-market institutions.

The solution to society’s economic ills are free markets. And the solution to society’s habitat ills are free cities. More of the current paradigm of Ponzi city construction based upon uneconomic, unproductive government infrastructure, city service and land-use planning will surely doom us all. But free cities, organized voluntarily by the participants and outcomes of local and international free markets, are just as surely the salvation, offering nearly limitless density, technological innovation, economic opportunity and variety in lifestyle.

Imagine the high rise urban wonderland of New York City meeting the honesty, productivity and heroic excellence of Galt’s Gulch.

That’s the way forward.