Review – The Panic Of 1819

The Panic of 1819: Reactions and Policies

by Murray Rothbard, published 1962, 2007

Please note, this book is also available as a free PDF on the website, which is how I read it [PDF]


Rothbard’s “The Panic of 1819” is a lot of things, but the thing it is most is yet another reminder of the old dictum “Plus ca change, plus c’est la meme chose”. Contained in this approximately 250-page reporting of the causes, consequences and social responses to the Panic of 1819 are the same behaviors and political programs that could be found in today’s headlines about corrupt Chinese banking practices, Chicago-school monetarism and Keynesian pump priming, including early recognition that attempts to kickstart “idle resources” logically implies a totalitarian command economy where the government manages all resources (and all people) at all times.

It’s all here, and more. There is nothing new under the sun.

How the business cycle gets started

Early on page 16 the reader is entreated to an excerpt from private correspondence between Pennsylvania politician Condy Raguet and European economist Richard Cantillon in which Raguet tries to clear Cantillon’s confusion as to how fractional reserve banking manages to operate to the point of a catastrophic bubble instead of wobbling and crashing under its own confusing weight:

You state in your letter that you find it difficult to comprehend, why person who had a right to demand coin from the Banks in payment of their notes, so long forebore to exercise it. This no doubt appears paradoxical to one who resides in a country where an act of parliament was necessary to protect a bank, but the difficulty is easily solved. The whole of our population are either stockholders of banks or in debt to them. It is not the interest of the first to press the banks and the rest are afraid. This is the whole secret. An independent man, who was neither a stockholder or debtor, who would have ventured to compel the banks to do justice, would have been persecuted as an enemy of society.

Today’s full reserve Austrian economists, caught between clueless and complacent bank executives, a massively indebted “ownership society” public, Keynesian and monetarist adherents and “free banking” friends who are anything but, simply has no place to turn for safety. He defaults to “enemy of society” status in the ensuing confusion though he seeks only to point out the folly of these fractional reserve systems which inevitably injure all in tying their fates by one string.

The Panic of 1819 followed the War of 1812. During the war, imports and exports came to a halt due to the sea being a battleground and many products which would’ve been imported were kept in their home (overseas) markets to furnish the war effort. As a result, the young States United of America saw the development and growth of domestic manufactures and exportable industries. However, when the war ended and international trade resumed, many domestic manufacturers found they weren’t actually competitive facing world markets (this makes sense because if they had been they probably would’ve developed before the war, not during it in a period of “isolationism”). This created a nascent strain of “protectionist” thinking and monied interests who saw a benefit to adding tariffs on imported products.

The end of the war and the resumption of trade saw a banking boom (fractional reserve) which finally ended in 1819 with the panic. From about 1819-1823 the country was in and out of what could be termed depressed economic conditions. In many ways the early country’s experience mirrored the present day experience from 2008-2009 onward, especially the contentious economic and political debates about how to respond.

Something I found fascinating was what happened to various “macro” economic metrics during the Panic (what we’d call a crash):

The credit contraction also caused public land sales to drop sharply, falling from $13.6 million in 1818 to $1.7 million in 1820, and to $1.3 million in 1821. Added to a quickened general desire for a cash position, it also led to high interest rates and common complaint about the scarcity of loanable funds.

That last bit is especially fascinating to me. I don’t know what the state of federal funded debt was in this time period as Rothbard doesn’t really go into the concept or existence of a “risk free rate” but it is interesting to see “deflation” leading to HIGHER rather than LOWER interest rates. In today’s topsy turvy world, low rates are supposed to be the result of the flight to safety during a depression while high rates are supposed to herald an economic recovery. However, it seems it was just the opposite in 1819.

I found myself charmed by the ability of so many in 1819 to see what was the cause of the bubble and the collapse, even politicians. For example, in an address supporting a “relief bill”, Illinois Senator Ninian Edwards observed:

The debtors, like the rest of the country, had been infatuated by the short-lived, “artificial and fictitious prosperity.” They thought that the prosperity would be permanent. Lured by the cheap money of the banks, people were tempted to engage in a “multitude of the wildest projects and most visionary speculations,” as in the case of the Mississippi and South Sea bubbles of previous centuries.

I enjoyed learning that even medical analogies to describe the cause and effect of monetary expansion and collapse were popular in 1819. One government committee, the Hopkinson Committee, arguing against “debt relief” legislation, noted:

palliatives which may suspend the pain for a season, but do not remove the disease, are not restoratives of health; it is worse than useless to lessen the present pressure by means which will finally plunge us deeper into distress.

I thought that pain pill and hangover analogies were something recent and peculiar to adherents of the Austrian school but critics knew of these rhetorical flourishes even two hundred years ago, at least!

On the topic of “flight to safety”, I did make note of one paragraph which seemed to suggest that while interest rates on bank debt and other commercial lending may have risen, interest rates fell dramatically on tax-backed (ie, “guaranteed”) government issues, for example:

“A Pennsylvanian” pointed to United States and City of Philadelphia 6 percent bonds being currently at 3 percent about par– indicating a great deal of idle capital waiting for return of public confidence before being applied to the relief of commerce and manufacturing. Thus, in the process of criticizing debtors’ relief legislation, the “Pennsylvanian” was led beyond a general reference to the importance “confidence” to an unusually extensive analysis of the problems of investment, idle capital, and the rate of interest.

This theme of “idle capital” was remarked on more than once in the text and by various parties with differing viewpoints. This is a particular fetish of Keynesians and monetarists who cite the existence of “idle capital” as an excuse for government to raise public spending to “put it to work.” It is fascinating to see these early Americans predicted Keynesianism by almost 150 years!

Another thing I found remarkable was the prevalence of either state-owned banks (federal, with the Bank of the United States, or individual states) or strong political pushes to establish these banks in response to the ensuing depression and the stress this created on the banking system. In other words, nationalization of the banking industry as a political prop to collapsing FRB institutions is nothing new:

The Alabama experience highlights the two basic measures for monetary expansion advocated or effected in the states: (1) measures to bolster the acceptance of private bank notes, where the banks had suspended specie payment and where the notes were tending to depreciate; and (2) creation of state-owned banks to issue inconvertible paper notes on a large scale. Of course, the very fact of permitting non-specie paying banks to continue in operation, was a tremendous aid to the banks.

People refer to the United States economy and monetary system at various points in time being “free market”, and while it’s true that tax rates and business regulations were generally less cumbersome near the nation’s founding than today, it is also true that there has been a virulent strain(s) of interventionist thinking and policy-making from very early on. It wasn’t until 1971 with Richard Nixon’s closing of the gold window that the US currency finally went fully inconvertible, and yet already in 1820 (if not earlier), people were calling for inconvertible paper currencies issued by state-owned banks. Some free market!

The whole episode seems to beg a question that, sadly, Rothbard did not explicitly address or explore, namely, Why did banks need to be chartered by the government in the first place? Although there were calls during the response to the economic crisis for various forms of occupational licensing and business regulation (aimed at stemming the flood of superior imports damaging local industries), the reality is that any other business but banking, such as butchering, baking, sawmilling, leather tanning, import/export, etc., did not require special permission granted by a session of the local legislature, state or federal. Why was banking different, requiring an act of congress to get the enterprise going?

Besides the fact that many such banks seemed to be public-private partnerships which included state “capital” injected into them, the only answer I have managed to come up with so far that makes any sense is that the banks were all set up on a fractional reserve basis, and a blessing by the government served to either 1.) grant legitimacy to an illegitimate institution or 2.) create the pretense and wishful thinking of providing some kind of “legal oversight” to what everyone at the outset understood to be an essentially criminal organization operating with a special legal privilege or 3.) both.

Because every bank had to be chartered, when the FRB system inevitably hit a bump in the road as it did in 1819 and many banks wished to suspend redeemability of their bank notes to stem outflows of specie, their status as creatures of the public legal mechanism meant they could run to the legislature for permission to violate their own contracts– and they almost always got the permission granted. Now, for example, if angry pitchfork-wielding townsfolk show up to break into the vault, take their gold and lynch the bankers, the Sheriff might step in with his posse to make sure everyone remembered their role.

Keynesians and monetarists and Chinese bankers

Continuing the theme of “everything new is old”, I was struck by commentary from a Pennsylvanian congressman named Henry Jarrett suggesting that government relief money might serve to prime the pump of the economy:

An inconsiderable sum of money, for which the most ample security could be given, being loaned to a single individual in a neighborhood, by passing in quick succession, would pay perhaps a hundred debts.

Kind of sounds like George W. Bush urging Americans to go shopping after 9/11, in order to get confidence in the economy back. It’s a crass Keynesian tactic inspired by a confused understanding of the relationship between production, consumption and the role of money in the economy.

It was also interesting to see how many people back then could sense there was a problem with the way the banking system operated, but were confused into thinking banking in and of itself was illegitimate, rather than simply the practice of issuing a greater supply of banknotes than the amount of specie held in reserve. Consider a campaign circular for a candidate for Congress from mid-Tennessee, who said:

banking in all its forms, in every disguise is a rank fraud upon the laboring and industrious part of society; it is in truth a scheme, whereby in a silent and secret manner, to make idleness productive and filch from industry, the hard produce of its earnings

If you substitute “banking in all its forms” with “fractional reserve banking”, you’ve got a pretty accurate description of the nature of the problem.

It’s also worth quoting at length the argument of “An Anti-Bullionist”, who thought that the economic crisis of 1819 was caused by specie money specifically, rather than abuse of specie money via fractional reserves. In its place he sought to create a fully inconvertible paper currency issued by the government which would of course be “well regulated” and serve to protect the economy from the inevitable deflationary death spiral of the specie system he believed he was witnessing. Shades of later monetarist thinking abound:

His goal was stability in the value of money; he pointed out that specie currency was subject to fluctuation, just as was paper. Moreover, fluctuations in the value of specie could not be regulated; they were dependent on export, real wages, product of mines, and world demand. An inconvertible paper, however, could be efficiently regulated by the government to maintain its uniformity. “Anti-Bullionist” proceeded to argue that the value of money should be constant and provide a stable standard for contracts. It is questionable, however, how much he wished to avoid excessive issue, since he also specifically called a depreciating currency a stimulus to industry, while identifying an appreciating currency with scarcity of money and stagnation of industry. One of the particularly desired effects of an increased money supply was to lower the rate of interest, estimated by the writer as currently 10 percent. A lowering would greatly increase wealth and prosperity. If his plan were not adopted, the writer could only see a future of ever-greater contractions by the banking system and ever-deeper distress.

Even chartalists will be happy to see that early proponents of the “American System” of nationalist public-private industry were representing their views in the debates of the early 1820s, for example:

Law pointed to the great amount of internal improvements that could be effected with the new money. He decried the slow process of accumulating money for investment out of profits. After all, the benefit was derived simply from the money, so what difference would the origin of the money make? And it would be easy for the government to provide the money, because the government “gives internal exchangeable value to anything it prefers.”

Why even have a private industry? Or money, for that matter?

Luckily, advocates of laissez-faire existed in this time period, too, and they were not silent. Commenting on one proposal to deal with “idle capital” by Matthew Carey, the “Friends of Natural Rights” wrote:

The people of the United States being in a very unenlightened condition, very indolent and much disposed to waste their labor and their capital… the welfare of the community requires that all goods, wares, merchandise and estates… should be granted to the government in fee simple, forever… and should be placed under the management of the Board of Trustees, to be styled the Patrons of Industry. The said Board should thereupon guarantee to the people of the United States that thenceforth neither the capital nor labor of this nation should remain for a moment idle.


It is a vulgar notion that the property which a citizen possesses, actually belongs to him; for he is a mere tenant, laborer or agent of the government, to whom all the property in the nation legitimately belongs. The government may therefore manage this property according to its own fancy, and shift capitalists and laborers from one employment to another.

Finally, I don’t seem to have made a good note of the specific passage that caught my attention in this regard but I chuckled when reading the description of the operations of the average bank before collapse. These bankers would set up a new bank and pay only a fraction of capital with specie, the rest would be constituted by additional promissory notes from other banking institutions (which were themselves fractional). The bankers would pay themselves dividends, in specie, while the bank operated, and issue themselves and their friends enormous loans with which they’d purchase real goods and services, all while the real specie capital of their bank depleted. When crisis hit and they could not redeem their depositors’ money, they’d get legal permission to suspend redemption, ask for infusions of new capital from state authorities and/or set up a brand new bank whose purpose was to steady the previous institution. Ultimately, the bank would collapse and this too would work in their interest because they’d already hauled off the specie via dividends to themselves, and many of them were debtors of the bank who now had loans due in a worthless currency that was easy to obtain.

It reminded me a lot of the present Chinese state capitalist model.


“The Panic of 1819” is not light reading and for some readers it may not even be interesting reading. It depends a lot on how fascinating you find in depth examinations of “minor” historical economic events.

But that doesn’t mean it isn’t surprising, well-written (for all the facts and data, Rothbard still manages to weave together a narrative that helps the reader appreciate the nuances of the various factions and viewpoints of the time) and at times, depressingly relevant. People who care about economic and financial history and unique, formative episodes in the early history of this country, will find a lot of insights and curiosities in this work. I strongly recommend it.

The Rape of Russia

During the 1990s, the countries of the former Soviet Union had a unique historical opportunity to move toward a competitive market economy based on private property rights. After decades of “experimenting” with various degrees of totalitarian socialism, this privatization moment would allow hundreds of millions of people to leap ahead in their standards of living and personal well being while fundamentally transforming their political and social relationships. Instead of an economic “miracle”, the privatization era was characterized by a new structure of cronyism wherein the formerly nationalized wealth of the Soviet Union came to be controlled by a small group of “oligarchs” and the people of the various countries were essentially politically repressed. The worst part is that this economic and political travesty took place with direct involvement by various Western and US-backed institutions and individuals, such as members of an elite advisory team from Harvard University. Below are several resources exploring the theory and experience of privatization in Russia and other former communist nations.

How Harvard Lost Russia [PDF]

We learn about the exploitation of the Russian privatization by members of the Harvard Institute for International Development. We learn a couple of interesting facts about the period: the HIID advisors were not doling out pure, fundamental free market theory about how to create a competitive market economy but instead helped to build a “managed” system directly modeled on the US and other crony systems; and, many of the advisors involved in the HIID project made direct investments in industries they were advising, for personal benefit, in direct contradiction to their employment contracts and the laws of the US and Russia at the time (ie, corruption). Deeply involved in the scandal and a close friend of many of the advisors directly involved, the infamous Larry Summers does not come out looking so good.

Two money quotes:

Judge Woodlock found that, while running the Harvard Institute for International Development’s advisory program in Russia in the early 1990s, Harvard economics professor Shleifer and attorney Ha had conspired to defraud the US government, engaged in self-dealing and violated conflict-of-interest regulations.


Harvard University was in a unique position to exert a powerful influence. Post-Soviet Russia turned to the West for help in rebuilding its economy and filling the vacuum left by communism’s fall. In running Harvard’s Russia Project, Andrei Shleifer and Jonathan Hay had an opportunity to preach the importance of integrity, transparency and fairness in shaping a business culture, to work to enshrine those values in the country’s legal and financial infrastructure. Instead, their personal dealings sent a very different message.

This is a horrible tragedy for post-communist European societies, US and Russian foreign relations and for governance and culture in our own society as Shleifer paid a settlement but received no formal judicial sanction and maintained his tenure and social standing at Harvard and in the wider American economic community after playing the role of a miscreant carpetbagger.

Testimony of Anne Williamson Before the Committee on Banking and Financial Services of the United States House of Representatives, September 21, 1999

Anne Williamson explores “the question of the many billions in capital that fled Russia to Western shores via the Bank of New York and other Western banks.” Claiming that “property is the poor man’s ticket into the game of wealth creation” (a sentiment echoed in Hernando de Soto’s The Mystery of Capital) because “the rich… have their money and their friends to protect their holdings, while the poor must rely upon the law alone,” Williamson observes that Russian economist Larisa Piasheva, building on the theory of Austrian school economist Wilhelm Ropke, had designed a “cold turkey” privatization policy which would’ve invited direct foreign investment in Russia; instead, the Harvard cabal and other Western reformers created a weak, US taxpayer-supported voucher system that relied on Western bank lending and led to widescale corruption.

She makes the further claim that “Communism had evaporated by late 1987, the year in which the Russian people were allowed to hold convertible foreign currencies.” She condemns the entire, Western-organized privatization program as a sham and part of a known political formula:

Sell assistance programs on an alleged “free market” and “humanitarian” basis by awarding government grants to those academics who can be relied upon to supply the intellectual camouflage politicians and journalists then repeat ad nauseum to a distracted public, move the IMF and the World Bank to target, induce target to raise taxes, fine tune target’s central banking operations, encourage borrowing and debt creation through the target’s government and its national banks, allowing IMF lending to pay yields if necessary; induce target to privatize national property while building a flimsy, artificial “infrastructure” for an equities market good enough to attract high risk foreign investors. Once the target nation’s government flounders, step back and watch speculators assert discipline through a run on the target’s currency. The subsequent devaluation delivers, in turn, a flood of cheap imports to American manufacturers and producers.

The finishing touch on the swindle is to confiscate more money from G-7 citizens (the lion’s share from Americans) to pay for what is said to be an “essential” IMF bailout; thereby allowing Uncle Sam’s IMF minions to entrench themselves more deeply in the target government’s. Taxes are raised, the population struggles beneath indebtedness, government funding demands and the inevitable domestic inflation and devaluation delivers. Western neo-colonialists then bully the target over its rapidly compounding debt in order to extract yet more property. Once successful, the world’s insiders then turn around and deliver cheap shares from privatizations and initial public offerings into the maw of U.S. mutual funds and portfolio investors. US taxpayers get hit coming (foreign aid) and going (bailouts) and innocent foreigners’ property is finagled away either from, or on account of, inattentive and corrupt leaderships. The big winners are the world’s increasingly corrupt and cozy governing class, international bureaucracies and global banks.

We would be wise to remember her coronation of currency speculators as “the last disciplinarians in the world’s financial system.

Stanley Fischer’s role in piratizing Russia’s wealth

Reminding us of the dictum that “bad men need nothing more to compass their ends, than that good men should look on and do nothing”, Steve Sailer observes that during the Russian privatization,

Fischer was there at the creation. He had numerous chances to speak out publicly about what was going horribly wrong in a Russia that looked to him and his friends for advice.

When a person observes evil and does not speak out, particularly when he shares proximity to it, we have to question whether he is competent to recognize what he is looking at and whether he might be compromised in being a participant in it in some way.

Stanley Fischer is now the vice chairman of the US Federal Reserve System. He wields incredible power and influence over the US monetary system and economy, not to mention the world’s. The Sailer article explores his questionable judgment of the facts-on-the-ground in Russia, which he had a hand in, and his ethics in seeming to overlook the blatant corruption. The article helps us to remember that politicians of the present have a past, and that past is rarely flattering and seems to be easily forgotten. It also reiterates the theme that a golden opportunity to move Russia and other post-communist countries toward true free market thinking was squandered.

George Reisman’s Capitalism (PDF), pg. 290, “From Socialism to Capitalism: How to Privatize Communist Countries”

So, if corrupt self-dealing and crony managed economies are not the solution for privatizing former socialist regimes, how could it or should it be done? Luckily, there are real free market thinkers who have thought of possible solutions for reform. An extended section from George Reisman’s Capitalism lays out one such approach in detail. I have decided to quote it at length:

The advantages of private ownership of the means of production are so overwhelming that it is actually of secondary importance precisely who the initial private owners are and how their ownership is established. Whatever the specific method or methods of establishing private ownership of the means of production, the institution will function to the benefit of everyone—owners of the means of production and nonowners of the means of production alike. It will do so, however, only to the degree that the individual private owners possess full and secure rights of ownership.

The security of property rights means that the owners must be secure both against the possibility of any form of new confiscation by the state and against successful challenge to their ownership by other private individuals claiming to be the rightful owners. To understand the necessity of the security of property rights, the reader should imagine how his behavior would be affected if he were contemplating buying a home that he could not be certain would be his for very long. He would not be prepared to pay very much for it, and, after he bought it, he would not be prepared to put very much into it. Indeed, his incentive would probably be to let the house run down and even to sell off such things as the appliances for the sake of obtaining cash or other assets that would be more securely his. Without the security of property rights, the situation of all would-be owners of factories, farms, mines, and stores in the present-day socialist countries must be exactly the same. Such owners would be in essentially the same position as the state employees described earlier who were supposed to act as capitalists under “market socialism.” The absolute security of the owners’ property rights is essential if people are to be willing to pay proper prices for the various properties and then to stay on and improve them rather than milk them for whatever they can.

An essential aspect of the rights of ownership is the right freely to buy and sell property. This aspect of property rights is especially important in the transition from socialism to capitalism. The combinations of assets of the various enterprises of socialism and thus the combinations of assets of the enterprises that will initially exist under capitalism will almost certainly need radical change. It will be essential for the market to have the freedom literally to redefine all enterprises by changing the combinations of their assets. This means, there must be the freedom both to break up existing enterprises by selling off their assets in the manner of “corporate raiders” and to combine their assets through such devices as mergers and acquisitions.

As I say, these freedoms are essential. For a major foundation of the efficiency of capitalism—ironically, increasingly overlooked in the supposedly capitalist United States—is the ability to create business firms that possess the right combinations of assets. This ability is essential if firms are to be able to produce the right products by the most efficient methods. It must be present at all times, if the economic system is to be able to adjust to changing conditions. It is acutely necessary in the context of putting right the combinations of assets that a socialist government is likely to have thought appropriate for the various enterprises. It would be essential not only for such things as combining manufacturers with the right parts makers, and retail outlets with the appropriate warehouse facilities, but also for changing the uses made of all kinds of existing factories and land sites.

Nothing less than a radical overhaul of the entire apparatus of production inherited from socialism will be necessary if the economic system is to become efficient. Many factories will have to be closed and such of their assets as are still useable, devoted to production in different locations. Most other factories will have to undergo major changes in what they produce and the methods by which they produce. The output of innumerable factories will have to go to different users. The use that is made of innumerable land sites will have to change. All of this requires the freedom to buy and sell and to breakup and combine the assets of firms.

Along the same lines, the market would need the absolute freedom to hire and fire the managers of enterprises. This freedom too is necessary at all times and acutely necessary in the conditions of a transition from socialism to capitalism. Any managers inherited from socialism are likely to need replacement. Many of the initial managers under capitalism will also need replacement. To be effective, the transition from socialism to capitalism will need to be followed by a fall into obscurity of numerous former top managers and rise from obscurity of numerous new managers. Nothing must be allowed to impede the business takeovers and buyouts that are an essential part of this process.

In addition, of course, there must be the absolute freedom to hire and fire ordinary workers. Socialism is characterized by a massive misallocation of labor, just as it is characterized by massive misallocation of capital. This too must be put right if production is to become efficient.

A vital aspect of the transition from socialism to capitalism, that is implicit in all that has just been said and is clearly called for by the nature of capitalism, is the freedom of every enterprise to enter into the industry of every other enterprise, and, of course, the freedom of everybody to form new enterprises. In other words, the full freedom of competition must exist.

In the light of these requirements, the specific methods of establishing private ownership of the means of production can now be considered.

The simplest and most obvious method is that wherever former owners of property or their descendants are still alive, the properties should be returned to those from whom they were stolen, or to their descendants.

In Eastern Europe, this method is somewhat complicated by the fact that many of the private property owners who were dispossessed by the Communists were themselves beneficiaries of expropriations carried out not long before by the Nazis. Here the solution clearly is to return the properties to the earlier owners dispossessed by the Nazis, or to the descendants of those owners.

To the difficulty of settling claims as between two or more private claimants is added the fact that the method of returning property to former owners becomes less and less adequate, the longer is the period of time during which socialism has existed and the more ruthless were the means employed to establish socialism in the first place. This is because it becomes correspondingly more difficult to locate specific individuals with valid claims to ownership. (In many cases, everyone with a valid claim may simply have been murdered.) The major part of the problem, however, is the fact that as time has passed, numerous new plants and machines have been constructed, which no one can now claim on the basis of property rights existing before the establishment of socialism. These observations are particularly applicable to the former Soviet Union, where socialism existed for over seventy years and where over twenty million people were murdered by the Communist regime. The mass murders committed by the Nazis may pose a similar problem to the location of heirs.

In view of these facts, I propose three methods of privatization. First, as far as possible, property should be returned to those from whom it was stolen, or to their descendants. Second, in the case of agricultural land where it is not possible to locate former owners or their descendants, the land should be made the individual private property of those who now work it. That is, all the collective farms and state farms should be broken up into separate, individual private farms. Formulas could be devised allowing for differences in the amount of land individuals received based on differences in the time they had been compelled to work the land. Those who had suffered such forced labor for a longer period, would receive more of the land than those who had suffered it for a shorter period. Individuals who would otherwise receive parcels of land too small to farm might simply receive cash.

Third, in the case of all other property—factories, mines, shops, and so forth—the appropriate principle would be to place the assets on the open market for competitive bidding. Foreigners should be actively encouraged to participate in this bidding and, indeed, the bidding should be carried on in Western currencies and in gold. Foreigners should have the same full rights of ownership as citizens: they should be allowed to buy and sell property of all kinds, to form companies, and to remit dividend and interest payments to their own countries to whatever extent they wish.

Active foreign participation in the bidding creates the possibility of the average citizen of the socialist countries deriving an important immediate benefit from privatization. Namely, as the proceeds from the sale of assets came in, each individual citizen could receive his individual share of the proceeds—that is, the proceeds of the government’s sales could be divided up among the citizens. Thus, during the period of liquidation of state assets, the average citizen could receive one or more checks payable in Western currencies. He could use the proceeds to buy essential consumers’ goods that could be imported from the outside world because the means would be present to pay for those imports. This would help to tide him over during the difficult period of transition during which his country’s economic system was being reorganized and he was unemployed or not in a position to earn a significant amount by working. In this way, for the first and only time—in the process of its liquidation—collective ownership of the means of production would turn out to provide some actual benefit to the citizens: in the moment of its being liquidated for Western cash, it would enable them to obtain something of value to their lives.

It should be observed, incidentally, that the benefit to the average citizen would be the greater, the greater was the prospective security of property. Because to the extent that newly acquired property rights were expected to be upheld, the higher would be the prices that foreigners would be prepared to pay for the assets being offered for sale, and thus the greater would be the proceeds accruing to the average citizen of the formerly socialist country. Economic morality would be rewarded. (The ability of foreigners freely to remit dividends and interest payments is an important aspect of this morality and also an important foundation of the foreigners’ willingness to bid up the prices of the assets offered for sale, and thus of the ability of the average citizen of the formerly socialist country immediately to benefit from privatization.)

[…] Once the transition to capitalism was accomplished and the average citizen of the formerly socialist country was in a position to begin saving and investing on a significant scale, not only would he begin to accumulate capital within his own country, but the capital market of the entire world would be open to him, and he could invest abroad just as others had invested in his country. This is an aspect of what can be called capitalist internationalism.

In order to secure the best prices for assets being sold off, a corps of professional auctioneers and brokers should be employed, who would receive a commission based on a percentage of the sales proceeds.

The principle of distributing the proceeds from the sale of assets equally among the citizens could be modified to give greater compensation to victims of labor camps and survivors of those who have been murdered by the Communist regime. However, the primary compensation for such crimes should probably be left until after the transition to capitalism has been completed and it is thus possible to provide more substantial compensation.

There are, of course, other possible methods of establishing private property. One would be simply to make the various existing enterprises the private property of their present managements. Another would be to turn the various enterprises over to their present employees. Obviously, the two methods could be combined, with the present managers receiving a certain percentage of the ownership and the present employees a further percentage. To some extent, these methods are actually in use.

If, following the establishment of private property in these ways, there really was security of property and full rights to buy and sell assets and shares, to hire and fire managers and workers, and to compete in all branches of industry, these methods would ultimately be effective in establishing private ownership of the means of production. As time went on, all the necessary changes could take place, including changes in ownership, which would be effected by the market, and an efficient economic system would emerge. However, the appropriation of enterprises by their Communist-appointed managers will necessarily carry with it the taint of the old regime and all of its injustices, and is likely also to be accompanied by a continued large-scale ability to use political pull, based on previously established relationships with government officials. Thus, private ownership of the means of production begun in this way will be tainted by injustice, past and present, and by corresponding inefficiency. This would be a legitimate source of resentment and would constitute a potential threat to the continuation of such ownership.

Turning the ownership of each establishment over to the workers of that establishment would at best arbitrarily favor some workers over others. Those workers who happened to work in highly capital-intensive industries, such as electric-power production or steel making, would obtain ownership of far more capital than workers who happened to work in less capital-intensive industries, such as clothing factories and restaurants. The same point would apply within each industry, insofar as some plants were more modern and efficient than others. It is very pertinent, of course, that as the result of socialism’s protracted gross inefficiencies, the value of many factories and other productive establishments would turn out to be altogether nonexistent.

The problem of workers benefitting or failing to benefit by virtue of the accidental circumstances of where they worked would also exist in agriculture. The workers of collective farms with abundant, rich soil would receive more than the workers of collective farms with relatively meager, poor soil. In agriculture, however, apart from the return of former owners or their descendants, there does not appear to be an alternative to the workers’ coming to own the land. Of course, the workers on the relatively poorer lands could be given the option of sharing in the proceeds of the sale of other assets rather than accept land they had been forced to work.

To the extent that workplaces do become the property of the workers employed in them, it must be stressed that it is vital that the workers of each plant be free both to sell their ownership shares while keeping their jobs and to leave their jobs while keeping their shares. In this case, ownership and employment would eventually become almost entirely separate, as under capitalism. The ability to hold ownership and employment separately is essential for the free movement of capital and labor between industries. In its absence, workers would be reluctant to leave their employment, because they would then lose their capital, and they would be afraid to admit new workers into their firm or industry, because they would then have to correspondingly dilute their ownership. There would be no possibility of transferring capital from one industry to another, since the workers of the industry from which the capital came would simply lose it. Furthermore, the rapid separation of ownership and employment is necessary to overcome a bias that might otherwise exist against improvements in efficiency if workers as owners were in a position to reject improvements that might cost them their jobs.

Thus, at its worst, turning ownership over to the workers could mean a state of affairs in which the movement of labor and capital between the various branches of industry was made impossible. In addition, it could mean a situation in which the workers of each industry, by virtue of their possession of a monopoly on employment in their industry, were in a position to practice extortion on the rest of the economic system as the price of providing their services. Obviously, these are conditions which should be avoided at all costs.49

Provided that the essential requirements of security of property, the separation of employment and ownership, and the unrestricted freedoms to buy and sell, hire and fire, and compete, are observed, what remains is to accomplish the transition to private ownership as quickly as possible. Reasonable but strict time limits must be set for the location of former owners or their heirs, and it must be firmly established that thereafter no new claims will be heard on their account. This is an essential part of establishing the security of property. All of the assets in the hands of the state must likewise be disposed of within a strict time limit, so that no one in the market need labor under any uncertainty about what properties will be available and when and thus what plans he can and cannot make. This is essential to making the economic system as efficient as possible as soon as possible.

In the absence of the establishment of private ownership of the means of production, all other reform is meaningless. [emphasis added] For example, decontrolling prices without first establishing private ownership of the means of production and its corollary the freedom of competition, simply means giving arbitrary, monopolistic power to lesser government officials in charge of individual industries and enterprises. It is comparable to giving the postmaster general or the local postmaster the right to set postal rates. Without private ownership of the means of production, there can be no market economy or free market. Divorced from private ownership of the means of production, such notions are a contradiction in terms. Nor, of course, can there be lasting or meaningful reform in the political realm.


These articles are shared as evidence of several ideas:

  • Free markets haven’t been tried, not in Russia, not in the US
  • “Free markets” are a convenient and distracting cover term for what is actually corrupt crony systems because it confuses people who understand the value of free markets and it distracts those who hate them
  • “Economists” are often not economists but political agents, and many of them have flawed ethical frameworks
  • Harvard as an institution, specifically, has a record of questionable ethics with regards to the HIID’s involvement in the privatization of Russia
  • Modern US-Russian relations are a lot more complicated than Good, Liberty-Loving America vs. the Former Red Menace
  • Larry Summers is corrupt
  • Stanley Fischer is corrupt
  • The truth is complicated and unpopular and those who are scandalized by it have a strong incentive to cover it up, ignore it or forget about it

Recession Risk, The Ultimate Risk Paradigm Of Modern Business Operations

The business cycle rotates periodically between boom and bust. This is one of the inevitable consequences of centrally planning the economy’s interest rates and forcing them below their market equilibrium levels. Because it is inevitable, it is “predictable” and thus every business person must conduct their affairs in light of the fact that at some point in the future they will be faced with a recession. The key measure of risk for a business person operating in a central bank-managed economy, then, is “How will I feel when the recession comes?”

If a recession poses no risk to the financial structure of his holdings and he is positioned in his operations to weather a storm, he may be termed “low risk.” If instead a recession represents an existential threat and/or the potential for severe hardship for his operations, he may be termed “high risk.”

As an ideal, a sufficiently low risk operator should eagerly anticipate a recession as it will represent a cheap buying opportunity during which he will consolidate the failing enterprises of his competitors, scooping up their assets at bargain prices and thereby leap ahead of them without the use of leverage or cheap competitive tactics. Conversely, a sufficiently high risk operator will find the economic Sword of Damocles plunging through his neck in a recession, permanently severing the connection between himself and his former assets. How then to manage financial and operational risk so that continued growth can occur in a manner that is sustainable in all possible economic environments?

In terms of financial risk, we could sort our assets in two ways, by asset quality and by financing quality. The asset with the highest asset quality is the one which has the largest earnings yield relative to its current value. The asset with the highest financing quality is the one which is cheapest to own (ie, annual interest cost).

Practically speaking, sorting assets by asset quality and financing quality and then selling low quality assets and paying down outstanding debt would move an organization toward a more favorable balance between asset quality and finance quality, with an emphasis on equity in the balance sheet. The capital that is freed up in the process is now available to purchase a higher quality asset in the future.

In a recession, the cash flows from low quality assets dwindle while the finance charges on debt remain fixed; not only does such a mixture create a problem in a recession but it falsifies the true “free cash” position of the company in a boom because, to operate prudently, extra cash must be maintained on the balance sheet to offset the risk this low quality asset and debt represent should a recession appear.

The insistence on focusing on the management of financial risk first offers us clues as to a sound growth strategy overall. To be successful and sustainable through all potential economic conditions, growth must be purposeful and planned and should only occur when three conditions are met: there is abundant free cash on the balance sheet, the organization has people “on the bench” and ready for new opportunities and a good buying opportunity (represented by a fair or discount to fair value price) presents itself.

A debt-laden balance sheet is not cash rich because the cash which may be present is actually encumbered by the debt as an offset in a recessionary environment. When we are talking about a cash rich balance sheet, we’re by implication talking about an unlevered balance sheet. Otherwise, the cash is not “free” but rather is “phantom” cash– it will disappear the moment adverse economic conditions present themselves.

The organizational bench condition may be harder to evaluate objectively, but there is a decent rule of thumb. When people in each position in the organization are sufficiently organized to handle their own responsibilities with time to spare, there is organizational bandwidth to spend on promotions and new responsibilities, such as management of newly acquired assets. In contrast, when people in relatively higher positions within the organizational hierarchy are spending their time doing the work of people relatively lower in the organizational hierarchy, it indicates that there is a shortage of quality personnel to fill all positions and that those personnel available are necessarily being “mismanaged” with regards to how they are spending their time as a result.

Further, it implies the risk that growth in such a state might further dilute and weaken the culture and management control of both legacy assets and those newly acquired. This is a risky situation in which every incremental growth opportunity ends up weakening the organization as a whole and creating hardships to come in the next recession. If it’s hard to find good people, inside the organization or without, and there is a general attitude of complacency about what could go wrong in a recession, it is a strong indicator that underperforming assets should be sold and the balance sheet delevered to reduce organizational risk in the event of a recession.

Growth should be fun, exciting and profitable. If it’s creating headaches operationally, or nightmares financially, it should be avoided. You shouldn’t own or acquire assets you don’t love owning. Perhaps the best rule of thumb overall is to ask oneself, “Does owning this asset bring us joy?” If yes, look for opportunities to buy more. If no, sell, sell, sell!

Ultimately, there are three ways to get rich: randomly, with dumb luck and unpredictable market euphoria for the product or service offered (billion-dollar tech startups); quickly, with a lot of leverage, a lot of luck in terms of market cycles and a lot of risk that you could lose it all with poor timing (private equity roll-up); and slowly, with a lot of cash, a lot of patience and a lot less risk while taking advantage of the misery of others during inevitable downward cycles in the economy.

If you were fearful in the last economic cycle, it suggests your financial and organizational structures were not as conservative as you might have believed. It may be an ideal, but it’s one worth reaching for: a recession represents a golden buying opportunity for a cash rich organization to leap ahead of the competition and continue its story of sustainable growth and success.

What Education, At What Cost?

In “The Big Uneasy“, the New Yorker explores what some students are taking away from their liberal-arts educations:

If you are a white male student, the thought goes, you cannot know what it means to be, say, a Latina; the social and the institutional worlds respond differently to her, and a hundred aggressions, large and small, are baked into the system. You can make yourself her ally, though—deferring to her experience, learning from her accounts, and supporting her struggles. You can reach for unity in difference.

It also profiles some of the students who are learning these important concepts:

Eosphoros is a trans man. He was educated in Mexico, walks with crutches, and suffers from A.D.H.D. and bipolar disorder. (He’d lately been on suicide watch.) He has cut off contact with his mother, and he supports himself with jobs at the library and the development office. He said, “I’m kind of about as much of a diversity checklist as you can get while still technically being a white man.”

The epistemology of this paradigm appears to be relativism, which is to say that it is a subscription to denial of a universal human reason. It’s hard to understand what the point of attending an institution of learning is if it has nothing to teach you because your personal experience is the only truth to know.

It’s also hard to accept that this paradigm is representative of a universal truth and thus part of an enlightened human knowledge, not just because that would be a contradiction in terms according to the paradigm itself, but because so many of the correspondents seem to suffer from a multiplicity of dysfunctions.

It seems many of today’s students really need help sorting out their personal problems, not “access to higher education.” When they arrive at even the most accommodating, out-there institutions like Oberlin and find the curriculum is not about them but about something else, they develop severe inferiority complexes that result in frustrated, emotional outbursts.

But, imagining for just a moment that the common mainstream trope that “access to higher education” really is a missing social panacea, are these the students such supporters have in mind and are these the ideas they think are important that they receive as part of their program?

“Students believe that their gender, their ethnicity, their race, whatever, gives them a sort of privileged knowledge—a community-based knowledge—that other groups don’t have,” O’Leary went on.


“People are so amazed that other people could have a different opinion from them that they don’t want to hear it.”

What is the value “to society” in these factionalizing lessons, and are they really worth borrowing money, in many cases, to have them taught?

Doing The Hugh Hendry

Below is some commentary from Hugh Hendry I found in an editorial I since can not access as I don’t have a login. But I thought it was interesting when I first read it awhile back and I still think it’s interesting now. I meant to post it earlier. Rectifying my mistake:

For the moment, let us forget the chances of a hard landing in China. Forget the drama of Europe’s circus of politically inspired economic incompetency. Forget that the good news of the US economy’s succession of positive economic surprises is really bad news as fixed income managers have sold copious amounts of too cheap volatility and because it has made equity investors turn bullish, sending stock market volatility back to 2007 levels. This is dangerous. Improved US data may represent a classic short-term cyclical upturn amid a profound global deleveraging cycle.

Such moves have been commonplace for the past three years and have yet to prove a harbinger of any structural upswing. I worry that the pathological course of the last several years will see volatility rise sharply once again. Even so, there exists, in terms of my parochial world of hedge fund investing, a bigger issue.

I fear that my no longer small community has been compromised. Last year was generally very tough for long/short strategies and I commiserate with all concerned. But last year world class funds lost more than 15 per cent in just two months. Today they are celebrated again for making double digit returns in the last quarter even though they still languish below high water marks and their reputation for risk management, at least to those clients who have poured over their copious due diligence statements, has been sorely compromised.

You can probably live with that if you are a pension scheme or a large, sophisticated fund-of-fund because you have a global macro sub-sector that can benefit from short-term shifts in volatility. But the unfortunate thing is that this group exercised its stop losses somewhere between the great stock market rallies of 2009 and 2010. That is to say, they honoured the pact they had with clients. They adhered to the terms of their risk budget: they lost money and they reduced their positions. I fear that owing to this nasty experience the financial world is in danger of harvesting a monoculture of fund returns that could prove less than robust should the global economy suffer another deflationary reversal.

To my mind the situation has parallels with the plight of the banana. Today the world eats predominately just one type of banana, the Cavendish, but it is being wiped out by a blight known as Tropical Race 4, which encourages the plant to kill itself. Scientists refer to it as programmed death cell destruction. In stressful situations bananas fortify themselves by dropping leaves, killing off weaker cells so that stronger ones may live to fight anew. They operate a stop-loss system.

But modern mass production of single type bananas has replaced jungle diversity with commercial monocultural fields that provide more hosts to harbour the blight. The economy keeps producing stressful volatility events. Good managers keep shedding risk and monetising losses and are duly fired, leaving us with a monoculture of brazen managers who will never stop loss because they are convinced central banks will print more money.

Diversification has proven the most robust survival mechanism against failures of judgment by any one society, hedge fund manager or style. But what if we are now a single global hedge fund community afraid to take stop losses and convinced of an inflationary outcome to be all short US Treasuries and long real assets?

This is pertinent as I have always been fascinated by that second rout in US Treasuries in 1984, long after the inflation of the 1970s was met head on by Paul Volcker’s monetary vice and a deep recession. How could 10-year Treasury yields have soared back to 14 per cent and how could so many investment veterans have been convinced that a second even more virulent inflation wave was to hit the global economy?

Psychologists tell us the explanation is embedded deep in the mind. They refer to the “availability heuristic”. Goaded by the proximity to the last dramatic event, investors overreacted to the news that the US economy was pulling out of recession in 1984. They saw high inflation where there was none.

With this in mind, I would contend that it may take several more years before the threat of debt and deflation can be successfully exorcised from investors’ minds, even if the global economy were not set on such a perilous course. Such is the potency and memory of 2008’s crash that anything remotely challenging to the economic consensus could be met by a sudden and severe reappraisal to the downside.

Should such an event send 30-year Treasury yields back to their 2008 low of 2.5 per cent, we believe enlightened investors might better be served by thinking the opposite. Only then might it prove rewarding to short the government bond market and embrace what may turn out to be a much promised once in a lifetime buying opportunity for risk assets.


The Student Loan Scam

I saw this story on “What Student Loans Are Really Spent On” at ZeroHedge:

Robert Thomas Price Jr. borrowed about $105,000 for his tuition at Harrisburg Area Community College from 2005 and 2007, federal authorities say. It doesn’t cost anywhere near that much to study at HACC, though.
So Price, 45, of Newport, is facing federal student loan fraud and mail fraud charges.

A U.S. Middle District Court indictment alleges that Price spent much of the loan money on crack cocaine, cars, motorcycles, jewelry, tattoos and video games.

U.S. Attorney Peter J. Smith said today that Price secured about $92,000 in private student loans and around $13,000 in federal PELL grants and Stafford loans. Price was aided in the alleged scam by his ex-wife, a former HACC employee who is not charged or named in the case, Smith said.

Granted, this is anecdotal– one hapless fraud a pattern does not make.

But the fact that it even happened highlights a couple things of import in my mind:

  1. This guy was in his late 30s when he committed this fraud; I bet the average person would be surprised to know what the demographic profile is of the average student loanee, my guess is it is not a starry-eyed, hard-working, bright-but-unresourced 18yo kid just looking to make it in this cold, harsh world
  2. If it happened once, it’s possible it’s happened more than once; how much of the $1T+ in outstanding student loan debt is being spent in frivolous or fraudulent ways? Reminds me of David Einhorn’s book on a SBA loan-backed fraud he shorted and exposed. Fraudsters flock to government handout programs like flies to dung because the government has less of an incentive to catch and punish them given it doesn’t cost them anything but bad press if it takes place, there are always more taxpayers to steal from if fraudsters take a piece of the pie
  3. Student loans are leverage, and they are leverage used to engage in consumption; these kids with student debt don’t suddenly become ascetic monks while they scrupulously work toward their degree and eventually paying off their debt… they continue to live and spend like the college kids they are, just with someone else’s money

To the last point, I chuckled at this response from a friend to whom I sent the ZeroHedge article:

Oh yeah, big time. One of my really good friends that I’ve known since senior year HS, who has never really been a big spender or a big earner, is now a third (or fourth?) year medical student, and he is really living the life of the young adult…through loans. He has a loft in downtown [city withheld], has a HUGE flat-screen tv, bought a new car a couple years ago, and adopted a dog (granted, [name withheld] the dog is super sweet). I seriously doubt he 1) had all that money laying around before, and 2) would spend his own money like that. I’m 99.9% sure it’s all loans because he’s never spent money like this, even when he had a serious gf in college whom he loved and wanted to marry.

I think this article really connects with the last one you sent about vomitus whores. Student loans are essentially enabling all that behavior. Here’s some money, go to “school,” attend some BS classes and write some BS essays, then go drink with this free money. Or perhaps you can go buy a new fancy, shiny thing to show off so that girls will want to sleep with you. *sarcastic thumbs up

I certainly think there is some causation-via-correlation here, though how much exactly is uncertain. Young people are pretty stupid, levered or not. I mean, look at how they vote! What dopes! It’s like they get off on being debt slaves or something.

Anyway, that link in the quote is worth checking out. It’s a riotously funny post from today by Kid Dynamite on the shocking idiocy of the modern American collegiate zeitgeist. Brings new meaning to the term “idiot savant.”

Are Cash-Flush Corporate Balance Sheets Hiding Stagnating Operating Efficiencies?

In an article entitled “Too Much of a Good Thing” from, we learn that American businesses have become less efficient with their use of working capital over the last year:

Days working capital (DWC) — the number of days it takes to convert working capital into revenue — did decrease marginally in 2011, from 37.7 days to 37 days. But REL downplays the improvement, attributing it in part to the companies’ 13% average revenue growth. “To have a 1.9% decrease is a positive, but not by a lot,” says Prathima Iddamsetty, senior manager of operations, research, and marketing at REL, a working capital consultancy.

Cash on hand across the group of surveyed companies, dubbed the REL U.S. 1,000, increased by $60.3 billion in 2011, helped in part by companies taking advantage of low interest rates to issue more debt, up by a record $233 billion year-over-year. Those companies now have a staggering $910 billion in excess working capital, including $425 billion in inventory, according to REL. “Way too much cash is being left on the table and not being put toward growth objectives,” says Iddamsetty.

But why does it matter?

Indeed, cash is still king for the REL U.S. 1,000. This is clearly evidenced by the $60 billion increase in cash on hand and the $233 billion increase in debt in 2011. Over a three-year period, cash on hand was $277 billion and accumulated debt $268 billion.

But using debt instead of efficient working capital management to get more cash into the bank account “comes with a long-term cost: eventually they will have to pay [the debt] down,” points out Ginsberg. “They’ll also have to generate a return on their existing assets that exceeds the interest rate, which is not what we’re seeing.”

It’s better to tap working capital as a funding source for long-term growth strategies, says Ginsberg. REL Consulting cites top performers in a broad range of industries, leveraging working capital to open up new businesses in emerging markets with growing consumer demand, for instance.

“Top performers have very tight manufacturing timetables and inventory management practices, in addition to strict collections and payment systems that are standardized across all locations,” says Michael K. Rellihan, an associate principal at REL. “The cash they generate from this high level of working capital efficiency is then applied to the growth agenda. Long-term, the result is a powerful benefit to the bottom line.”

“Only process improvements will provide sustainable cash flow benefits,” adds REL’s Sparks. “This requires working more closely with customers, getting better information to suppliers, and improving demand forecasting. You need to have an underlying process in place to manage working capital on a day-to-day basis; if not, it will be difficult to sustain.”

In other words, the growth in corporate debt and the resulting excess cash on the balance sheet gives the illusion of financial and business health in the short-term, when in the long-term these companies still must find ways to improve operating efficiencies and thereby generate profit. Ironically, even as the cost of debt in a zero-interest rate policy environment falls, this is getting harder and harder to do because there are fewer and fewer genuine opportunities to drive real growth and expand the top line while maintaining operating efficiency. It makes you wonder how much of this working capital problem is a symptom of our ZIRP-economy.

There was also a helpful chart showing the state of working capital efficiency by industry that can give you a quick high-level look at winners and losers in terms of working capital management.

A Record Of Some Misgivings

I’ve had a little back and forth with some other value investors recently on my concerns about some of DreamWorks Animation’s outstanding corporate governance and capital allocation issues. I figured it was probably time to put pen to paper and formally record some of these thoughts.

Capital mis-allocation

To start, I want to mention the capital allocation issues. Over the last four years (2008-2011), DWA generated approximately $508M in operating cash flow, or about $127M/yr. In that same period, DWA invested $217M in their business, or about $54M/yr, while it bought back $389M, or about $97M/yr, worth of stock and finally they retired $73M worth of debt, which occurred in one year (2009) and represented the last of their LT debt on the books at that time.

As you can quickly surmise, there was only $291M of FCF or about $73M/yr over that period to support $462M in buybacks and debt paydown, a deficit of $171M which appears to have been financed by drawing down cash on the balance sheet and potentially leaning on the revolving credit facility as well.

I see a couple problems here:

  1. This is a growth company but the company will not be able to finance its growth ambitions on its own now because it has used a ton of its own financial resources buying back stock, which means it’ll have to either issue substantial new equity at low prices or take on more debt to finance its future growth
  2. The buybacks occurred at a range of prices and therefore market valuations of the company, with many of them clustered at the high end of that range, implying the company is not good at determining its own value and buying back only when the company is on sale

The first issue concerns me especially so given the nature of DreamWorks Animation’s business– in the end, it is highly speculative and could easily fail, meaning the most appropriate financing type is equity, not debt. Debt is more appropriate for a low-risk, predictable, consistent enterprise (such as financing a real estate venture). Equity provides the kind of flexibility and endurance one needs to weather the potential storms in a business like DWA’s.

But by using up much of its cash, DWA has put itself in the position where it will have to either dilute existing shareholders at potentially disadvantageous prices, or else it’ll have to raise debt which I believe adds substantial extra risk because of the way it mismatches with their business fundamentals.

The second issue concerns me because I think it directly explains a lot of the apparent value destruction that has occurred at DWA over the last 4 years as communicated by the fluctuating market capitalization and I think it sets a precedent that is in the long-run bad for minority shareholders, not good, as people of the “buybacks are good no matter what” school of thought seem to believe.

In 2008, the peak price of DWA was $32/share and with 91M FDSO at the time, that amounted to a market cap of $2.9B. In early 2010, the company climbed to an all-time peak price of nearly $43.50/share and with 87M FDSO that amounted to a market cap of nearly $3.8B. The shares now linger back below their 2009 low of $18.56/share and very close to the all-time low of $16.52/share reached in January of 2012, trading around $17/share for a total market cap of about $1.43B.

Slice it how you like it but according to the market the company has conservatively destroyed almost $1.5B of value in that time and I’d say that’s primarily due to spending $460M on buybacks and debt reduction that could’ve been spent on growing the business or waiting for opportunities to grow the business. If you add that capital back into the business you’d get a market cap closer to $2B right now.

Most of the buybacks occurred near the $30/share range with relatively little of the buybacks occurring near the lows of around $17/share. This kind of capital allocation “discipline” can not be put to bed by arguing that “share buybacks are good if they happen at all”– the latter price represents a 50% discount to the former (or the former a nearly 100% premium to the latter, depending on how you want to look at it)! Are we supposed to be comforted by the fact that DWA’s management and board seem to think the company is cheap anywhere between $3B and $1.5B in market cap?

That isn’t a reasonable way to manage capital. You’ll never catch Warren Buffett making that kind of argument and I highly doubt you’d have much money to manage on your own if you adhered to that philosophy for long.

One of the replies I got back from another investor (see below) on this was that “what’s done is done.” That is an unacceptable response. What’s done is not done because it could very easily happen again and it is more than likely to do so given that the pattern set, the discipline demonstrated so far, is that the management and board of DWA is incompetent when it comes to allocating capital to share buybacks. This is a red flag and a way they could continue to destroy whatever value they create through their growth strategy in the future.

Golden parachutes for the pilot and the flight crew, but not the passengers

At the behest of another money manager with a value-based approach I had been communicating with, I decided to review the Form DEF-14A filed 4/11/12 for DWA. I had (admittedly) skim-read the thing when first performing due diligence several months ago, but I had not read it line-by-line as he had urged me to do, more on that fact in a bit.

As I read through it, I noticed a few things.

For one, I noticed that FRMO-owned companies own 9,614,089 shares or 13.1% outstanding, ostensibly for their ETF products. I am impressed with the strategic thinking of this organization and for the purposes of their own business they seem to be great capital allocators (of course, I have no idea at what prices they accumulated their position). But then it dawned on me that most of their products are passively-managed index ETFs and that took the wind out of my sails. I’m not necessarily under the impression at this point that they hold a stake because they think it’s a great buy, but just because it fits some strategy or theme for one of their proprietary indexes. So, that’s about 13% of the company potentially owned by “dumb money” in this case.

Then I noticed that the company utilizes Exequity and Frederic W. Cook & Co., compensation consultants, to determine executive pay. I’m working on a “digest” post of articles I’ve been reading about corporate governance and activism over at a now-defunct website nominally belonging to Carl Icahn (man, that guy seems a bit ADD at times the way he starts and stops investments, grass roots activism platforms, etc.) and I came across this post on compensation consultants which really set off alarm bells for me.

Think about it for a second– the managers are using company money, which belongs to shareholders, to hire consultants (multiples in this case) who charge millions of dollars and spend hundreds of hours trying to outdo each other in justifying outlandish executive compensation packages. In other words, they use your money to figure out how much they should pay themselves at your expense. It’s kind of like gilt-edged unionism for corporate executives. Why the hell is this such a mystery? Why do you need consultants to figure stuff like this out for you?

This is a corporate governance red flag– this is not treating minority shareholders like equal partners but rather treating them like the sucker at the table. After all, Katzenberg owns about 15% of the company and because of the dual class share structure (another red flag, by the way), effectively controls the company himself which makes him an owner-operator (to be fair, a good thing)… you think he can’t figure out how much to pay his other executives in terms of what’s good for K-man and what’s not?


Then I get to the actual executive compensation itself. Katzenberg is now paid a $1 annual salary, choosing to receive most of his compensation via stock options and other perks. Other executives are compensated quite generously and compensation has been growing. The value of options grants is $17M annually, or over 1% of market cap each year. Long-term incentive compensation is worth another $9.2M. Combined, that is $26M or almost 2% of the company’s market cap for a handful of top execs and board members.

Other things of note:

  • Lew Coleman, president and CFO, recently exchanged higher annual cash salary structure in return for decreased long-term incentive awards, does this show lack of faith in the long-term value of the company?
  • Ann Daly, the COO, has part of her compensation tied to performance of the company’s stock price, which is an idiotic practice given that it incentivizes her to manipulate the company’s operations to game short-term numbers meanwhile the company’s management has no direct control, in the long-run, over what the investing public thinks of the value of the company (yes, their actions will translate into better or worse valuations but in the end it’s like tying someone’s compensation to the weather)
  • Overall, tons of golden parachutes for just about everyone in the case of a change of control or a termination with or without cause, which are more blatant red flags and give minority shareholders an unfair shake

Then there’s the income tax savings-sharing agreement with Paul Allen, a former shareholder and financial enabler of the company which the proxy explains constitutes “substantial” payments to Mr. Allen over time (this fact being confirmed by the multi-hundred million dollar payable on the balance sheet). To put it simply, I don’t get this or how it works and so far no one has been able to explain it to me. It could be harmless, it could be disastrously unfair to minority shareholder. I really have no clue, it’s beyond my accounting and income tax liability knowledge.

My overall impressions were thus: it takes 66 pages to explain/justify DWA’s compensation practices and related-party special transactions. The company hires compensation and other consultants with shareholder money to determine what management should be paid. And shares are locked up and all change of control decisions will be made by Katzenberg. This company gets maybe a C in terms of corporate governance, which is average in relative terms but sucks in my absolute opinion.

In general, I am concerned about my own ability to understand the accounting behind the company’s compensation practices. And this dovetails with my lingering concern that neither I nor anyone else seems to be able to confidently and accurately model just how much cash specific or even any single movie title in DWA’s library generates for the company at different points over its life.

Bringing it full circle

A few days ago I posted a video interview of Rahul Saraogi, a value investor operating in India, along with my notes of the interview. I found the interview surprisingly impactful (I’ve been watching other interviews from the Manual of Ideas folks and unfortunately none of them have come anywhere close in terms of profundity) and the item that stuck out the most from the whole thing was Saraogi’s comments on the importance of corporate governance and capital allocation for the long-term investment results of minority shareholders.

To reiterate, according to Saraogi good corporate governance means dominant shareholders who treat the minority shareholders like equal partners, who do not treat the company like a personal piggy bank or a tool for furthering their own personal agendas at others’ expense. He says good corporate governance is binary– it either exists or it doesn’t, there are no shades of grey here. The issues I’ve cited above make it clear that DWA does not have good corporate governance practices. The fact that the Form 14A discloses the fact that both David Geffen and Jeffery Katzenberg are essentially using the company resources to the tune of over $2M per year to subsidize their ownership and maintenance of private aircraft is another good example– it is one thing to have the company reimburse them for expenses occurred in doing business but it is quite obvious from the way this agreement is structured that the company is basically paying for the major costs of ownership while they are deriving the personal benefits and exercising discretion as owners in name and title.

Similarly, capital allocation is critical in Saraogi’s mind and many companies and their management don’t get it– they either don’t understand it’s importance or how to do it, or they don’t care because they’re rich enough. I think a little bit of both is operating here. Certainly Jeffery Katzenberg is “rich enough” at this point. He’s worth several hundred million dollars at least, he has the company paying for his private aircraft and other perks and he has even said in interviews I’ve read that he’s got all the money he could need or want at this point and continues to work out of passion and interest. Normally that’s a good thing but in this respect it’s a bad thing because a person who operates as an artist rather than a businessman probably doesn’t care what their ROC looks like as long as they get to put their name on the castles they build.

And people who get capital allocation don’t pay prices that range nearly 100% in value for shares they purchase, unless of course they’re absolutely convinced the intrinsic value still far exceeds such prices. I note here that while there is no evidence from the company that this isn’t the case, there’s similarly no evidence that there is, and I don’t think faith is a good basis on which to form a valuation. As an aside, none of the grade-A elite Wall St analysts on the earnings calls ever ask about this, and my e-mail to DWA’s IR on this topic and numerous others went completely unanswered, which is another embarrassing black mark for the company in terms of corporate governance.

Other voices in the wild

For those who are interested, there are now two recent write-ups on DWA over at Whopper Investments, the first on the value case for DWA and the second analyzing the company’s potential takeover value when compared to Disney’s acquisition of Pixar in 2004.

I really enjoy Whopper’s blog for the most part but I consider these two posts to be some of his weaker analytical contributions to date (which should be obvious from my remarks in the comments section of each, 1 and 2) and if anything that makes me even more queasy with this one– he mimicked a lot of my own unimpressive reasons for investing and I don’t generally find the sound of my own voice that soothing in cases like these, and he seemed unable to answer some of my deeper concerns, which could be evidence of his own shortcomings as an analyst or it could be evidence that these are questions with unsatisfactory answers by and large (I prefer to believe the latter at this point).

In a nutshell, at this point my major concern is that, even if the company successfully executes on its grand growth strategy it might not mean as much for minority shareholders as we might like due to outstanding corporate governance and capital allocation concerns. I seriously wonder if I and many other value investors like me are not blinding themselves to these “binary” concerns because the potential home-run hit possibility of getting in near all-time lows on “the next Disney” is just too exciting to resist.

Whatever I do, I’ve now written this post and put it in the public domain so I won’t be able to excuse myself later on by claiming I hadn’t thought about these issues.

Notes – Distressed Debt Analysis

Distressed Debt Investing: Strategies For Speculative Investors

by Stephen G. Moyer, published 2004

Distressed debt: a true contrarian investment strategy

The following note outline was rescued from my personal document archive. The outline consists of a summary of Stephen G. Moyer’s integral handbook on distressed debt dynamics, Distressed Debt Analysis. The notes currently cover chapters 1-4. They are incomplete at present. I will likely not revise these notes and instead plan to release a new series of notes on this book in the future when I re-read it.

Distressed Debt Analysis

  1. Chapter 1 – Introduction
    1. What is “distressed debt”
      1. Some define based off of credit ratings, which lacks rigor because:
        1. credit ratings lag fundamental credit developments
        2. credit ratings essentially only handicap the risk of default, they say nothing of whether the price is appropriate for the risk
      2. Martin Fridson advocates defining debt as distressed when it trades with a yield to maturity greater than 1000 basis points more than the comparable underlying treasury security
      3. Moyer suggests the following:
        1. equity value is diminimus (eg, under $1/share)
        2. all or some portion of unsecured debt trading at a market discount of more than 40%
        3. this pattern implies a balance sheet restructuring, resulting in creditors owning a significant portion of equity, or else a sale of assets and subsequent liquidation
    2. Distressed debt investing is not for everybody
      1. significant risk of loss
      2. often an informational advantage for professional participants
      3. markets are often illiquid, significantly increasing transaction costs
      4. average trading size is sufficiently large to rule out the average investor
    3. Potential restructuring events introduce significant levels of complexity
      1. Will restructuring occur within or outside of a bankruptcy context?
      2. What is the risk of a loss of economic value due to loss of key customers, suppliers or employees?
      3. How much economic value might be gained via bankruptcy?
      4. If balance sheet is restructured, what will new components look like and who will win and lose?
      5. What are the tax consequences?
      6. Any investors with “controlling” stake allowing them to unfairly influence the process at the expense of others?
    4. Common considerations of a distressed investment:
      1. What is the cause of distress?
      2. How will the distress be resolved?
      3. What are the implications of that resolution on the value of the business or particular securities?
      4. What actions on the part of bondholders are being assumed to realize a particular outcome?
      5. Will the price of the instrument in question go up or will it be exchanged into other securities requiring a new analysis?
  2. Chapter 2 – The Distress Debt Investing Opportunity
    1. investment grade bonds
      1. BBB or higher – investment grade
      2. lower than BBB – speculative grade
      3. fallen angel – a company that goes from investment grade to speculative grade
      4. bonds that go from BBB to BB or lower may result in forced selling for fund managers who by law must hold BBB or higher, creating an opportunity for distressed debt investors
      5. alternately, fallen angels may force speculative grade fund managers into “forced buying” when they are added to an index, creating another opportunity
        1. economic performance- economic softness generally gives rise to falling revenues and cash flows, putting many companies into distressed situations
        2. relative quantity of low-rated bonds
          1. low-rated bonds tend to default more often
          2. downgrades and new issuance can increase the number of low-rated bonds
        3. capital markets liquidity- highly leveraged companies are often more dependent on capital markets for on-going financing
          1. the appearance of a recession can restrain a levered companies ability to float more debt
          2. general risk aversion or investor disinterest with the junk bond market can increase financing challenges for companies
          3. a bear market in stocks can shut off another source of funding for these companies
        1. equal access to information
          1. hundreds of high-yield issuers have no analyst coverage
          2. many transactions are done OTC
          3. many high-yield issuers have no public equity and thus do not fill out SEC reports
          4. when companies file for bankruptcy, they often delay or totally fail to file SEC reports
          5. two levels of information in bankruptcy proceedings: restricted nonpublic info; publicly available info
          6. the seller of heavily discounted bonds may know something you do not
        2. rational behavior- absence of “free will”, “coerced” sales:
          1. sales by banks to maintain portfolio quality standards often not based on “fair value”
          2. institutional investors may have earnings goals and sell an asset for less than they deem it is worth but still more than its carrying cost, satisfying the goal
          3. high yield, open ended mutual fund managers may be forced to liquidate holdings to meet investor demands for redemption following a swift change in sentiment about their asset class
        3. low transaction costs
          1. settlement fee, including commission to broker- generally nominal, but indeed higher than large-cap equity or other mainstream transactions
          2. “unwind” fee, represents bid-ask spread in the market
            1. this fee can often be a point or more
            2. on highly speculative bonds it can often consist of several % of the total value of the trade
            3. this reduces potential liquidity and volume of exchange in the markets
  3. Chapter 3 – Conceptual Overview of Financial Distress and the Restructuring Process
    1. the value of assets is typically uncertain and subjective
    2. EMT theory suggests the market can be relied upon to accurately asses the value of assets and thus one can infer the value of a firm’s securities
    3. in reality, the market makes dramatic reassessments of securities, positive and negative, often with very few fundamental changes in the business
    4. declines in asset value can be handled fairly flexibly when the capital structure is composed of equity; when the capital structure is composed of large amounts of debt this becomes tricky (due to debt covenants)
    5. two solutions
      1. increase the value of the company (unlikely possibility or management would’ve done it)
      2. resize the capital structure
    6. resizing is accomplished via the restructuring process, a combined legal and financial operation
  4. Chapter 4 – Legal OverView of Distressed Debt Restructurings
      1. The Financial Effects of an Out-of-Court Restructuring
        1. Firm and its most significant creditors negotiate a change in the terms of obligations or a voluntary exchange of financial interests
        2. debt for equity or reduced debt for new debt and equity are typical arrangements
        3. the post-reorganization capital structure is fairly “arbitrary”; the company may eventually flourish under a number of different capital structures
        4. because it is not handled in court, this settlement can not change or negate the interest of other claimants not participating in the restructuring
        5. the restructuring can involve payments of cash instead of exchanges of securities
      2. The Out-of-Court Restructuring Process
        1. Parties Involved
          1. With bank debt, the negotiating agent is usually self-evident and is often a previously chosen “agent” of a loan syndicate specified in the loan agreement
          2. With bonds, typically represented by a small group of significant bondholders who form an informal bondholder committee, in practice >=25% of all bonds
          3. There are often agendas involved; commonly people are united around the cause of achieving the most economic value from their claims as possible, but opportunists might see a way to cheaply “acquire” equity which might be profitable in the future
          4. The view of the “job” of forming a bondholder committee is subjective; a hedge fund may see it as an intended part of the investment; a mutual fund or insurance company might consider it to be an embarrassing but necessary evil
          5. The bondholder committee has no legal authority to bind either member or nonmember bondholders
        2. Strategic Considerations in Participating on the Bondholder Committee
          1. If the objective is to invest so as to participate in the bondholder committee, one must be prepared to accumulate a significant quantity of the bonds
          2. an investor may be forced to sign a “confi” (confidentiality agreement); the investor gains the best material information available but must make disclosures of possession of such information (but not the info itself) when trading, which could make trading more difficult
          3. restriction begins at the receipt of material non-public info and ends when the information becomes non-material or is publicly disclosed via an 8-K, 10-Q or 10-K
          4. counter-parties which have become restricted must execute a “big-boy letter”
            1. an acknowledgement by the nonrestricted party that they are aware the counter-party has material non-public info
            2. a waiver of claims the nonrestricted party might otherwise have under securities law
            3. typically executed by a broker-dealer to maintain anonymity
        3. Beginning the Process
          1. when the debt is bank debt, usually begins because the borrower is in or approaching technical default of some provision of the loan
          2. when the debt is bonds and there is no or little bank debt, an investment bank or other restructuring specialist is often hired on retainer for advice
          3. if out-of-court looks like an option, the firm can
            1. invite creditors to organize a bondholders committee
            2. propose a restructuring without prior consultation
        4. Implementing the Restructuring
          1. with bank debt, usually involves an amendment to the loan agreement
          2. with bonds and a bondholder committee, usually a relatively simple private exchange
        5. Feasibility: The Holdout Problem
          1. those not participating in the restructuring may be better off than those who do, but if nobody participates, all will be worse off
          2. with too many holdouts, the company’s only option is bankruptcy, which often just adds legal costs and reduces everyone’s final recovery
          3. holdouts may be managed via:
            1. moral sanction– the distressed debt market is small and the big players are well known so most deals happen within a context of familiarity and consideration for the future of relationships
            2. coercive structural devices– use of tender offers to strip out covenants on the holdouts, forcing them to participate
      1. Intro
        1. it is hardly ever a surprise when a firm files for bankruptcy
          1. market prices have typically adjusted prior to the filing to represent the fear and uncertainty
        2. many firms send signals and warnings to the market before doing so
          1. distressed debt situations are often illiquid and you can not wait for the “bottom” to accumulate a position
        3. some or all of the creditors will usually incur some financial loss
        4. the key is not to buy at the bottom but to buy for less than things are worth
      2. Declaring Bankruptcy
        1. begins with a petition filed at a bankruptcy court, filed by the debtor and known as a “voluntary petition”
        2. in a few cases, three or more creditors may have grounds for filing an “involuntary petition”
        3. Chapter 11 contemplates allowing the existing management to reorganize the debtor as a going concern
        4. Chapter 7 anticipates that a court-appointed trustee will supervise the liquidation of the debtor’s assets
        5. Jurisdiction of Filing
          1. if a prepackaged plan has been put together, a jurisdiction with a reputation for expediting the process may be chosen
          2. if management anticipates a fight with creditors, it might choose a more “debtor” or “home-town” friendly jurisdiction
          3. DDI need to consider the relative level of bankruptcy planning that has occurred or may be possible, the probable jurisdiction of filing and what this implies for the timing of the resolution and the potential effect on the treatment of various claims
        6. Timing of Filing
          1. debtor will typically choose to file before it is in material breach of an agreement, which would allow creditors to make an involuntary filing
          2. the debtor will often try to conserve or charge up liquidity prior to the filing by stretching payment to vendors and creditors and utilizing revolving lines of credit
          3. everything that occurs before filing is considered “prepetition” and everything afterward is “postpetition”, which are senior to “prepetition” claims
          4. when the management of the debtor continues to operate the business postpetition, it does so as fiduciary of the creditors, known as “debtor in possession”
            1. tasked with managing day-to-day operation of biz
            2. anything outside the scope of ordinary business, such as sale of a major asset, requires approval of the bankruptcy court
          5. chapter 11, creation of “official committee of unsecured creditors”
            1. appointed by U.S. Trustee under the Bankruptcy Code
            2. supposed to consist of the seven largest creditors willing to serve
          6. equity holders are allowed to participate in the process and vote on acceptance of the plan for reorganization in certain cases
      3. The Goal: The Plan of Reorganization
        1. Intro
          1. plan of reorganization is a legal document that discusses what will happen to the debtor, its assets and all constituent liabilities, including equity interests, upon the debtor’s exit from bankruptcy
          2. confirmation of the plan is a pivotal legal event which instantaneously alters, with significant uncompensated loss in most cases, preexisting legal relationships such as lending agreements, leases and other contracts
        2. The Role of Exclusivity and Prefiling Coordination
          1. in cases of significant cooperation, management and creditors may work out a tentative plan and have it readied for a vote before the bankruptcy petition, called “prenegotiated” chapter 11 filing
          2. opposite end of the spectrum, an abrupt filing or one lacking consensus is called “free-fall” chapter 11
            1. often a warning sign that the bankruptcy process may be especially lengthy (1-3yrs) and expensive
            2. may signal the reorganization will involve a change of management, introducing a new element of risk
        3. Content and Structure of the Plan
          1. identifies claimants and assigns them to classes for purposes of voting and priority
          2. class usually determined by commonality of interest
          3. similarity involves similar priority against the debtor
          4. provides for what, if anything, each class will receive in the reorganization
          5. all claims grouped within a class must be treated similarly
      4. Operating Under Chapter 11
        1. Stabilizing Operations
          1. automatic stay freezes all creditors in their prepetition state
          2. grants debtor some “breathing room” and financial flexibility
          3. debtor-in-possession allows a super-priority interest against assets to be granted to postpetition lenders
          4. rollup, conversion of a prepetition claim into a postpetition claim through an offer to become a DIP lender
          5. critical vendor motion occurs when the bankruptcy court allows the debtor to pay critical vendors to allow for the continuance of business
          6. KERP, key employee retention plans are often negotiated
        2. Developing a Going-Forward Business Plan
          1. downsizing the labor force, closing unprofitable facilities, selling noncore lines of business or assets and renegotiating various contracts are typical
          2. making a new acquisition is not common although not technically prevented by the law
        3. Determining the Assets and Liabilities
          1. assets
            1. voidable preferences are transactions and distributions that occurred before bankruptcy filing which need to be unwound
            2. fraudulent conveyance, occurs when a debtor did not receive fair value in the transaction in question and at the time or as a result of the transaction was insolvent
            3. debtor may be seeking assets through ongoing legal actions and complaints
          2. liabilities
            1. executory contract rejection and expunging of unexpired leases
        4. Determining the Valuation and the New Capital Structure
          1. “best interests test”, no creditor should come out with less in a reorganization than they would under a liquidation
      5. Voting on and Confirming a Plan of Reorganization
        1. a solicitation package is approved by the creditors and then sent to all holders of impaired claims and interests
        2. for acceptance, 50% in number of claims representing 66 ⅔% of the amount must vote in favor
      6. Summary
        1. chapter 11 is the result of a failure to reach a consensual restructuring
        2. bankruptcy proceedings are complicated and involve substantial negotiation and gamesmanship
        3. the DDI must gain an appreciation for the other participants and their leverage
        4. secured claims will have greater assurance of recovery but lower return potential
  5. Chapter 5 – Overview of the Valuation Process

Gary North: If You Wouldn’t Buy A Company With Multiple Bankruptcies In Its Past, Don’t Buy Government Bonds

Having a historical perspective can open your eyes to risks and trends. According to Gary North on government bonds:

Today, governments issue bonds. They have been doing this in the West for three centuries. They have been defaulting on these bonds ever since, just as they have been doing on all other forms of debt since at least the fourth century B.C. The rate of defaults has escalated over the last two centuries.

Have you ever stopped to think about that? That the formal issuance of government bonds in the “West” is a practice which is only 300 years old? And that over that entire period, the rate of default has been rising?

In the grand scheme of things, government bonds are equivalent to a recent IPO with a pro-forma operating history of consistent unprofitability.

Why do governments issue bonds?

The ability of the government to extract wealth from rich people through taxation has always been limited. Rich people know how to hide their money. They know how to get it out of the country, and they know how to get it into markets that are less easily taxed.

So, politicians learned half a millennium ago to get their hands on rich people’s money before rich people started hiding their money. They did this by promising to pay a rate of interest on the money. Government bonds are ways of extracting money in advance, especially from rich people, which politicians would have preferred to tax directly, but which they did not tax directly because they knew that rich people would hide the money.

The whole point of the bond market is to enable the government to expand its operations beyond what would be possible by collecting taxes today. Politicians are able to get more money to expand operations today, because they promise to repay lenders a specific rate of interest. But, of course, this does not promise that the government will not repay with debased money.

The specific risk of government defaulting on debt while you own it changes over time.

The risk of government defaulting on debt is constant throughout time and is always guaranteed.

It’s worth reading the whole thing.