Review – More Money Than God

More Money Than God: Hedge Funds And The Making Of A New Elite

by Sebastian Mallaby, published 2010

A veritable pantheon of masters of the universe

Mallaby’s book is not just an attempt at explaining and defending the beginning, rise and modern state of the hedge fund industry (the US-focused part of it, anyway), but is also a compendium of all of the hedge fund world’s “Greatest Hits.” If you’re looking for information on what hedge funds are, where they come from, what they attempt to do, why they’re called what they are and how they should be regulated (SURPRISE! Mallaby initially revels in the success “unregulated” funds have had and feints as if he’s going to suggest they not be regulated but, it being a CFR book and he being a captured sycophant, he does an about-face right at the last second and ends up suggesting, well, umm, maybe SOME of the hedge funds SHOULD be regulated, after all) this is a decent place to start.

And if you want to gag and gog and salivate and hard-to-fathom paydays and multiple standard deviations away from norm profits, there are many here.

But that wasn’t my real interest in reading the book. I read it because I wanted to get some summary profiles of some of the most well known hedgies of our time — the Soroses and Tudor Joneses and such — and understand what their basic strategies were, where their capital came from, how it grew and ultimately, how they ended up. Not, “What’s a hedge fund?” but “What is this hedge fund?” As a result, the rest of this review will be a collection of profile notes on all the BSDs covered by the book.

Alfred Winslow Jones – “Big Daddy”

  • started out as a political leftist in Europe, may have been involved in U.S. intelligence operations
  • 1949, launches first hedge fund with $60,000 from four friends and $40,000 from his own savings
  • By 1968, cumulative returns were 5,000%, rivaling Warren Buffett
  • Jones, like predecessors, was levered and his strategy was obsessed with balancing volatilities, alpha (stock-picking returns) and beta (passive market exposure)
  • Jones pioneered the 20% performance fee, an idea he derived from Phoenician merchants who kept one fifth of the profits of successful voyages; no mgmt fee
  • Jones attempted market timing as a strategy, losing money in 1953, 1956 and 1957 on bad market calls; similarly, he never turned a profit following charts even though his fund’s strategy was premised on chartism
  • Jones true break through was harvesting ideas through a network of stock brokers and other researchers, paying for successful ideas and thereby incentivizing those who had an edge to bring him their best investments
  • Jones had information asymetry in an era when the investment course at Harvard was called “Darkness at Noon” (lights were off and everyone slept through the class) and investors waited for filings to arrive in the mail rather than walk down the street to the exchange and get them when they were fresh

Michael Steinhardt – “The Block Trader”

  • Background: between end of 1968 and September 30, 1970, the 28 largest hedge funds lost 2/3 of their capital; January 1970, approx. 150 hedge funds, down from 200-500 one year earlier; crash of 1973-74 wiped out most of the remainders
  • Steinhardt, a former broker, launches his fund in 1967, gained 12% and 28% net of fees in 1973, 74
  • One of Steinhardt’s traders, Cilluffo, who possessed a superstitious eating habit (refused to change what he ate for lunch when the firm was making money), came up with the idea of tracking monetary data, giving them an informational edge in an era where most of those in the trade had grown up with inflation never being higher than 2% which meant they ignored monetary statistics
  • One of Steinhardt’s other edges was providing liquidity to distressed institutional sellers; until the 1960s, stock market was dominated by individual investors but the 1960s saw the rise of institutional money managers; Steinhardt could make a quick decision on a large trade to assist an institution in a pinch, and then turn around and resell their position at a premium
  • Steinhardt’s block trading benefited from “network effects” as the more liquidity he provided, the more he came to be trusted as a reliable liquidity provider, creating a barrier to entry for his strategy
  • Steinhardt also received material non-public information: “I was being told things that other accounts were not being told.”
  • In December 1993, Steinhardt made $100M in one day, “I can’t believe I’m making this much money and I’m sitting on the beach” to which his lieutenants replied “Michael, this is how things are meant to be” (delusional)
  • As the Fed lowered rates in the early 90s, Steinhardt became a “shadowbank”, borrowing short and lending long like a bank
  • Steinhardt’s fund charged 1% mgmt fee and 20% performance fee
  • Anecdote: in the bloodbath of Japan and Canada currency markets in the early 90s, the Canadian CB’s traders called Steinhardt to check on his trading (why do private traders have communications with public institutions like CBs?)

Paul Samuelson & Commodities Corporation – “Fiendish Hypocrite Jackass” (my label)

  • Paul Samuelson is one of history’s great hypocrites, in 1974 he wrote, “Most portfolio decision makers should go out of business– take up plumbing, teach Greek, or help produce the annual GNP by serving corporate executives. Even if this advice to drop dead is good advice, it obviously is not counsel that will be eagerly followed.”
  • Meanwhile, in 1970 he had become the founding backer of Commodities Corporation and also investing in Warren Buffett; he funded his investment in part with money from his Nobel Prize awarded in the same year
  • Samuelson paid $125,000 for his stake; total start-up capital was $2.5M
  • Management of fund resembled AW Jones– each trader was treated as an independent profit center and was allocated capital based on previous performance
  • Part of their strategy was built on investor psychology: “People form opinions at their own pace and in their own way”; complete rejection of EMH, of which Samuelson was publicly an adherent
  • Capital eventually swelled to $30M through a strategy of primarily trend-surfing on different commodity prices; in 1980 profits were $42M so that even net of $13M in trader bonuses the firm outearned 58 of the Fortune 500
  • Trader Bruce Kovner on informational asymetries from chart reading: “If a market is behaving normally, ticking up and down within a narrow band, a sudden breakout in the absence of any discernible reason is an opportunity to jump: it means that some insider somewhere knows information that the market has yet to understand, and if you follow that insider you will get in there before the information becomes public”

George Soros – “The Alchemist”

  • Soros had an investment theory called “reflexivity”: that a trend could feedback into itself and magnify until it became unavoidable, usually ending in a crash of some sort
  • Soros launched his fund in 1973, his motto was “Invest first, investigate later”
  • Soros quotes: “I stood back and looked at myself with awe: I saw a perfectly honed machine”; “I fancied myself as some kind of god or an economic reformer like Keynes”
  • Soros was superstitious, he often suffered from back pains and would “defer to these physical signs and sell out his positions”
  • Soros believed in generalism: know a little about a lot of things so you could spot places where big waves were coming
  • Soros had a “a web of political contacts in Washington, Tokyo and Europe”
  • Soros hired the technical trader Stan Druckenmiller, who sometimes read charts and “sensed a panic rising in his gut”
  • As Soros’s fund increased in size he found it harder and harder to jump in and out of positions without moving the markets against himself
  • Soros rejected EMH, which had not coincidentally developed in the 1950s and 1960s in “the most stable enclaves within the most stable country in the most stable era in memory”
  • Soros was deeply connected to CB policy makers– he had a one on one with Bundesbank president Schlesinger in 1992 following a speech he gave in Basel which informed Quantum fund’s Deutschemark trade
  • “Soros was known as the only private citizen to have his own foreign policy”; Soros once off-handedly offered Druckenmiller a conversation with Kissinger who, he claimed, “does know things”
  • Soros hired Arminio Fraga, former deputy governor of Brazil’s central bank, to run one of his funds; Fraga milked connections to other CB officials around the world to find trade ideas, including the number two official at the IMF, Stanley Fischer, and a high-ranking official at the central bank of Hong Kong
  • Soros was a regular attendee at meetings of the World Bank and IMF
  • Soros met Indonesian finance minister Mar’ie Muhammed at the New York Plaza hotel during the Indonesian financial crisis
  • Soros traveled to South Korea in 1998 as the guest of president-elect Kim Dae-jung
  • In June 1997, Soros received a “secret request” for emergency funding from the Russian government, which resulted in him lending the Russian government several hundred million dollars
  • Soros also had the ear of David Lipton, the top international man at the US Treasury, and Larry Summers, number 2 at the Treasury, and Robert Rubin, the Treasury secretary, as well as Mitch McConnell, a Republican Senator

Julian Robertson – “Top Cat”

  • Managed a portfolio of money managers, “Tigers”
  • Used fundamental and value analysis
  • Once made a mental note to never buy the stock of an executive’s company after watching him nudge a ball into a better position on the golf green
  • Robertson was obsessed with relative performance to Soros’s Quantum Fund
  • Called charts “hocus-pocus, mumbo-jumbo bullshit”
  • Robertson didn’t like hedging, “Why, that just means that if I’m right I’m going to make less money”
  • High turnover amongst analysts, many fired within a year of hiring
  • Tiger started with $8.5M in 1980
  • A 1998 “powwow” for Tiger advisers saw Margaret Thatcher and US Senator Bob Dole in attendance
  • Tiger assets peaked in August 1998 at $21B and dropped to $9.5B a year later, $5B of which was due to redemptions (Robertson refused to invest in the tech bubble)

Paul Tudor Jones – “Rock-And-Roll Cowboy”

  • Jones started out as a commodity trader on the floor of the New York Cotton Exchange; started Tudor Investment Corporation in 1983, in part with an investment of $35,000 from Commodities Corporation
  • “He approached trading as a game of psychology and high-speed bluff”
  • Superstition: “These tennis shoes, the future of this country hangs on them. They’ve been good for a point rally in bonds and about a thirty-dollar rally in stocks every time I put them on.”
  • Jones was a notorious chart reader and built up his theory of the 1987 crash by lining up recent market charts with the 1929 chart until the lines approximately fit
  • Jones was interested in Kondratiev wave theory and Elliott wave theory
  • “When you take an initial position, you have no idea if you are right”but rather you “write a script for the market” and then if the market plays out according to your script you know you’re on the right track
  • Jones made $80-100M for Tudor Investment Corp on Black Monday; “The Big Three” (Soros, Steinhardt and Robinson) all lost heavily in the crash
  • Jones, like Steinhardt, focused on “institutional distortions” where the person on the other side of the trade was a forced seller due to institutional constraints
  • Jones once became the catalyst for his own “script” with an oil trade where he pushed other traders around until they panicked and played out just as he had predicted
  • PTJ never claimed to understand the fundamental value of anything he traded
  • PTJ hired Sushil Wadhwani in 1995, a professor of economics and statistics at the LSE and a monetary policy committee member at the Bank of England
  • PTJ’s emerging market funds lost 2/3rd of their value in the aftermath of the Lehman collapse

Stanley Druckenmiller – “The Linebacker” (my title)

  • Druckenmiller joined Soros in 1988; while Soros enjoyed philosophy, Druckenmiller enjoyed the Steelers
  • He began as an equity analyst at Pittsburgh National Bank but due to his rapid rise through the ranks he was “prevented from mastering the tools most stock experts take for granted” (in other words, he managed to get promoted despite himself, oddly)
  • Survived crash of 1987 and made money in the days afterward
  • Under Druckenmiller, Quantum AUM leaped from $1.8B to $5B to $8.3B by the end of 1993
  • Druckenmiller stayed in touch with company executives
  • Druckenmiller relied on Robert Johnson, a currency expert at Bankers Trust, whose wife was an official at the New York Fed, for currency trade ideas; Johnson himself had once worked on the Senate banking committee and he was connected to the staff director of House Financial Services Committee member Henry Gonzalez
  • Druckenmiller was also friends with David Smick, a financial consultant with a relationship with Eddie George, the number 2 at the Bank of England during Soros and Druckenmiller’s famous shorting of the pound
  • Druckenmiller first avoided the Dot Com Bubble, then jumped aboard at the last minute, investing in “all this radioactive shit that I don’t know how to spell”; he kept jumping in and out until the bubble popped and he was left with egg on his face, ironic because part of his motivation in joining in was to avoid losing face; Druckenmiller had been under a lot of stress and Mallaby speculates that “Druckenmiller had only been able to free himself by blowing up the fund”

David Swensen & Tom Steyer – “The Yale Men”

  • Swensen is celebrated for generating $7.8B of the $14B Yale endowment fund
  • Steyer and his Farallon fund were products of Robert Rubin’s arbitrage group at Goldman Sachs; coincidence that Rubin proteges rose to prominence during the time Rubin was in the Clinton administration playing the role of Treasury secretary?
  • Between 1990 and 1997 there was not a single month in which Steyer’s fund lost money (miraculous)
  • Farallon somehow got access to a government contact in Indonesia who advised Bank Central Asia would be reprivatized soon and Farallon might be able to bid for it
  • Some rumors claimed Farallon was a front for the US government, or a Trojan horse for Liem Sioe Liong (a disgraced Indonesian business man); it is curious that Yale is connected to the CIA, Farrallon is connected to Yale

Jim Simons & Renaissance Capital – “The Codebreakers”

  • Between the end of 1989 and 2006, the flagship Medallion fund returned 39% per annum on average (the fund was named in honor of the medals Simons and James Ax had won for their work in geometry and number theory– named in honor of an honor, in other words)
  • Jim Simons had worked at the Pentagon’s secretive Institute for Defense Analyses (another possible US intelligence operative turned hedgie?)
  • Simons strategy was a computer-managed trend following system which had to be continually reconfigured due to “Commodities Corporation wannabes” crowding the trades by trending the trends
  • Simons looked to hire people who “would approach the markets as a mathematical puzzle, unconnected to the flesh and blood and bricks and mortar of a real economy” (this is distinctly different than the Graham/Buffett approach, and one wonders how this activity is actually economically valuable in a free market)
  • “The signals that we have been trading without interruption for fifteen years make no sense. Otherwise someone else would have found them.”
  • Renaissance treated employee NDAs like a wing of the CIA– anyone who joined could never work elsewhere in the financial industry afterward, and for this reason they specifically avoided hiring from Wall St in the first place; they were required to invest a fifth of their pay in the Medallion Fund and was locked up as bail payment for four years after they departed (money hostage)

David Shaw & D.E. Shaw

  • Began trading in 1988, the same year as the Medallion fund
  • Shaw was originally hired by MoStan in 1986 into their Analytical Proprietary Trading unit which aimed at beating Steinhardt at his block-trading game using predictive computer technology
  • In 1994, Shaw’s 135-member firm accounted for 5% of the daily turnover on the NYSE
  • Jeff Bezos, of Amazon, was originally a DE Shaw employee
  • The strategy was heavily reliant on pair-trade “arbitrage”, looking for securities in similar industries which were temporarily misaligned in price/multiple
  • Circle of competence: in 1995 the firm launched the ISP Juno Online, as well as FarSight, an online bank and brokerage venture

Ken Griffin & Citadel

  • Created in 1990, grew to $15B AUM and 1400 employees by 2008
  • Griffin’s goal was to develop an investment bank model that could compete with traditional, regulated ibanks, but which was actually a hedge fund
  • Flagship funds were down 55% at the end of 2008, losing $9B (the equivalent of two LTCMs)

John Paulson

  • Paulson graduated from HBS in 1980 and went to work for Bear Stearns; he launched his hedge fund in 1994 with initial capital of $2M which grew to $600M by 2003; by 2005 he was managing $4B
  • Paulson’s main strategy was capital-structure arbitrage
  • He looked for “capitalism’s weak spot”, the thing that would blow up the loudest and fastest if the economy slowed even a little; cyclical industries, too much debt, debt sliced into senior and junior tranches, risk concentrated
  • Paulson spent $2M on research related to the US mortgage industry, assembling a proprietary database of mortgage figures and statistics
  • Many of Paulson’s investors doubted him and threatened to pull capital in 2006
  • Paulson enlarged his bets against the mortgage market through derivative swaps on the ABX (a new mortgage index) and eventually acquired over $7.2B worth of swaps; a 1% decline in the ABX earned Paulson a $250M profit, in a single morning he once netted $1.25B
  • By 2007, he was up 700% net of fees, $15B in profits and made himself $3-4B

Conclusion

I’m actually even more bored with this book having finished typing out my notes than I was when I finished the book the first time I read it. The book actually has some great quotes in it, from the insane delusions of grandeur of government officials and central bank functionaries, to wild facts and figures about the statistical trends of the hedge fund and financial industries over the last 60 years. I am too exhausted to go back and type some of it out right here even though I kind of wish I had some of the info here even without an idea of what I’d use it for anytime soon.

My biggest takeaway from MMTG is that most of these masters of the universe have such huge paydays because they use leverage, not necessarily because they’re really good at what they do. Many of their strategies actually involve teasing out extremely small anomalies between asset prices which aren’t meaningful without leverage. And they’re almost uniformly without a meaningful and logically consistent understanding of what risk is– though many are skeptics of EMH, they seem to all see risk as volatility because volatility implies margin calls for levered traders.

There were so many displays of childish superstition. Many of these guys are chart readers. The government intelligence backgrounds of many was creepy. And it was amazing how many relied on informational asymmetries which are 100% illegal for the average investor. These people really travel in an elite, secretive world where everyone is scratching each other’s backs. How many one on one conversations have you had with central bank presidents? How many trips to foreign countries have you been on where you were the invited guest of the head dignitary of the country? Are you starting to put the picture together like I am?

Overall, it seems so arbitrary. The best word that comes to mind to describe these titans and their success is– “marginalism”. We have lived in an inflationary economy for the last 60+ years and these players all seem to excel in such an environment. But inflationism promotes marginalism; the widespread malinvestment of perpetual inflation confuses people looking to engage in real, productive economic activity, and paper shuffling necessarily becomes a high value business.

The author himself is incredibly ignorant of economic fundamentals and the role monetary intervention plays in the economy. All of the various crises these hedgies profited from seem to come out of nowhere according to his narrative. The incredible growth in volumes of money managed by the hedge fund industry over time goes without notice, as if it was just a simple, unexceptional fact of life. Shouldn’t that be interesting? WHY ARE THERE HUNDREDS OF FIRMS MANAGING TENS OF BILLIONS OF DOLLARS EACH? Where did all this money come from?!

That makes the book pretty worthless as it’s key.

One thing that does strike me is that many of the most successful, most levered trades of Soros, Druckenmiller and others were related to currencies. These guys are all Keynesians but they probably don’t fully believe their own economic theories. However, they do understand them well enough to make huge plays against the dope money managers who DO put all their credence into what they learned at university. I should think an Austrian econ-informed large cap macro fund would have quite a time of it playing against not only the dopes, but the Soroses of the world– they’ll get their final comeuppance as this system of artificial fiat exchange finally unwinds over the next decade.

And, little surprise, the guy with the nearly perfect trading record for almost a decade (Farrallon) was involved in arbitrage trades.

Trend following is for slaves. It may have proven to be a profitable strategy (with gobs of leverage) for the contemporary crop of hedgies but I feel fairly confident in saying most of these guys will get hauled out behind the woodshed in due time if they keep it up, to the extent their strategies truly are reliant on mystic chart reading and nothing more.

Bon voyage!

Notes – Gary North On Inflation, Deflation And Japan

The following notes cover Austrian economist Gary North’s views on the chances of inflation and deflation in the US and Japanese monetary systems, derived from a 5-part article series on the subject found at LewRockwell.com:

Why Deflation Is Not Inevitable (Sadly), Part 1: John Exeter’s Mistake

  • Fed will attempt to stabilize money supply before hyperinflation; “mass inflation, yes; hyperinflation, no. Then deflation.”
  • Deflation will not take place unless the CB stops making new money
  • When prices fall, you are richer, but you pay no income tax on your profits (deflation is good)
  • Not-money: if you pay a commission to exchange, the asset is not truly liquid
  • Gold is a mass inflation hedge, not a deflation hedge
  • According to Exter/deflationists, gold is supposedly both an inflation hedge and a deflation hedge– the only asset possessing this virtue
  • We have never been able to test Exter’s theory of gold as a hedge against price deflation because there has never been a single year in which CPI has fallen (Q: what did gold price of Yen do in 2009 Japanese CPI decrease?)
  • Consumer price indexes should be based upon goods and services that are rapidly consumed; not price of homes and other prices of “markets for dreams”
  • Central banks inflate, they do not deflate
  • “When housing is bought on the basis of ‘I’ll get rich,’ the market begins to resemble a stock market. When it is bought on the basis of ‘I can live here for what I can rent,’ it is more like the toilet paper market”
  • The skyrocketing price of housing under Greenspan was not reflected in the CPI; the collapsing price of housing under Bernanke was not reflected in the CPI
  • Consumer prices did not fall during the 2008-09 crisis because the money supply did not fall; if the money supply shrinks, there will be price deflation; watch the monetary statistics

Why Deflation Is Not Inevitable (Sadly), Part 2: The Deflationists’ Myth of Japan

  • The money supply shrank in the US 1930-33 (Q: Why did the Fed allow money supply to shrink? Does this weaken North’s argument that the Fed will always inflate rather than deflate going forward?)
  • The US and Japan had similar CB policies until late 2008, when the Fed “went berserk”
  • Japan’s M2 was mildly inflationary from 1992-2009; CPI was slightly deflationary over the same period of time but never worse than 1% in any 12mo period; prices rose 2% 1997 and 2008
  • There has been no systemic price deflation in Japan
  • Japan is more Chicago School than Austrian
  • Statistical conclusions about Japan:
    • CPI in Japan fell little 1992-2009, no more than 1% per annum
    • BoJ did not inflate the currency to overcome systemic price deflation, because it didn’t exist
    • Collapse of Japanese RE prices did not affect CPI
    • Collapse of Japanese stock market prices did not affect CPI

Why Deflation Is Not Inevitable (Sadly), Part 3: Why Currency Withdrawals Don’t Matter

  • The Japanese economy is starting to become price competitive; this will have ramifications higher up the corporate command chain
  • Estimates of US currency held outside the United States range from 50-70%
  • Rise of credit transactions such as credit cards have minimized the role paper currency plays in everyday transactions
  • Currency withdrawals from the banking system which are not later redeposited are deflationary due to the reserve ratio mechanism
  • Monetary deflation can occur as a result of deliberate Fed policy:
    • increase legal reserve requirement
    • sell assets
    • allow bank collapse to occur by not funding FDIC with new money to offset withdrawals

Why Deflation Is Not Inevitable (Sadly), Part 4: High Bid Wins

  • All economics systems are governed by principles of:
    • supply and demand
    • high bid wins
  • The increase in the Fed’s balance sheet (monetary base) has been offset by increase in excess reserves held at banks; thus, no price increases
  • Deflationists’ claim: “Commercial banks will not start lending until the recovery is clear. The recovery is a myth. So, banks will not start lending, no matter what the FED does. The largest banks remain over-leveraged. They will not be able to find borrowers at any rate of interest, so the capital markets will collapse (except gold), and then consumer prices will fall.”
  • North’s response: “the largest banks are making money hand over fist. It is the local banks that are failing. The FED has done what it was set up to do in 1913: protect the largest banks.”
  • Inflationists’ claim: “Commercial banks will start lending when the recovery is clear. The FED will probably not contract the monetary base all the way back to August 2008, because this would bring on another crisis comparable to September 2008. The FED will not risk bankrupting the still highly leveraged megabanks. It will therefore not fully offset the decrease in excess reserves. It will not “wind down” all the way, if at all. Bernanke fears 1930—33 more than anything else. So, the money supply will rise. Prices will follow.”
  • “The increase in excess reserves has been voluntary. The bankers are afraid to lend, even to the U.S. Treasury.” (Q: Why are bankers afraid to lend, even to the Treasury?)
  • “The FED is in complete control over excess reserves. It pays banks a pittance to maintain these reserves. It is legally authorized to impose fees.”
  • Why the Fed maintains its current policy:
    • doesn’t have to sell assets
    • doesn’t have to face rising long-term interest rates due to expanding money supply
    • doesn’t have to worry about collapsing housing market as interest rates go to 25-40%
    • doesn’t face a corporate bond market collapse
  • Monitoring money supply changes is key to predicting consumer price increases

Why Deflation Is Not Inevitable (Sadly), Part 5: Conclusion

  • J Irving Weiss and his son Martin, recommended 100% T-Bills since 1967; it takes $6400 to buy what $1000 bought in 1967
  • Deflationists confuse asset prices with consumer prices
  • Deflationists believe low interest rates lead to debt build up but lower ones won’t stabilize; cost of capital can fall to zero and no one will borrow
  • This is John Maynard Keynes theory, who therefore recommended the government should borrow and spend to avoid this fate
  • There is not a shortage of borrowers today, corporate bond rates are around 6%, not 0%, implying there are people looking to borrow at positive rates of interest
  • Capital markets — markets for dreams, priced accordingly
  • Consumer prices rise comparably to increases in M1 in the US and M2 in Japan
  • Deflationists confuse money (in a bank account) with dreams (imputed asset prices in capital markets)
  • At the supermarket, prices are slowly rising in the US and slowly falling in Japan

Notes – Dying Of Money

Dying of Money

by Jens O. Parsson, published 1974, 2011

The collapse of a monetary regime

The following note outline was rescued from my personal document archive. The outline consists of a summary of Jen O. Parsson’s classic tale of monetary woe, Dying Of Money. Parrson catalogued two mass inflation events in modern Western history– the German post-war hyperinflation and the US monetary boom of the 1960s and 70s which culminated in the abrogation of the gold-exchange mechanism by Nixon in 1971; both are instructive for different reasons.

Dying Of Money

  1. Prologue: The German Inflation of 1914-1923
    1. The Ascent
      1. “Disastrous prosperity”
        1. old mark had been worth 23 US cents; written off at 1T old marks to one new mark at end of inflation
        2. all the marks in the world in summer of 1922 (190 billion) were not enough to buy a newspaper or tram ticket in November 1923
        3. first 90% of Reichsmark’s real value had been lost before the middle of 1922
        4. inflation cycle: gestation of 8 years, collapse of 1 year
      2. The beginning
        1. summer of 1914, Germany leaves gold standard, runs up debt, prints money in anticipation of WWI
        2. war financed through issuance of new debt (war loans) paid for with newly printed currency
        3. domestic prices slightly more than doubled by the end of the war in 1918, even though money supply increased more than 9x
        4. 1919, Germany sees violent price increases of 17x prewar level
        5. other nations, including WWI victors, stop spending and suffer recession 1920-1921; Germany continues printing and experiences a boom while prices stabilize for fifteen months between 1920 and 1921, money supply doubles again
      3. Benefits of the inflationary boom
        1. Exports thriving
        2. Hordes of foreign tourists
        3. New fortunes minted overnight
        4. Berlin becomes one of the brightest capitals in the world
        5. Great mansions of the new rich in abundance
        6. City life took on a wanton, careless manner
        7. Frugality absent as no one took time to search for real value
      4. Losers of the inflationary boom
        1. Crime rate soared
        2. Unionized workers kept up with inflation while non-unionized fell behind
        3. Salaried and white-color workers lose purchasing power even as unemployment virtually disappears
        4. Total production rose
      5. Paradoxical wealth and poverty
        1. much employment in “spurious and unproductive” pursuits
        2. paperwork and paperworkers abounded
        3. government employment grew, heavy restraints against layoffs and discharges kept redundant employees on payroll
        4. incessant labor disputes and collective bargaining consumed time and effort
        5. business failures and bankruptcies were few
        6. almost any kind of business could make money
      6. Speculative fever
        1. speculation became one of the largest activities
        2. fever to buy and sell paper titles to wealth was enormous
        3. volumes on Berlin Bourse were so high that, even with bloated back-office staff, Bourse was closed several days a week to work off the backlog
        4. capital goods and industrial construction industry experience a boom, many new factories built all while neighboring countries continued using old equipment
        5. M&A, takeovers and proxy fights in vogue
        6. massive conglomerations of non-integrated businesses took place; these businesses and the “kings of inflation” disappeared after the collapse
    2. The Descent
      1. Price increases catch-up with money printing
        1. From July 1921, prices double in next four months and increase 10x through summer of 1922
        2. consumers put on “buyer’s strikes” that are fruitless
        3. interest rates soar as lenders attempt to anticipate inflation
        4. businessmen transact in gold or constant-value clauses or foreign currency
        5. government’s budget deficits close to balance; nonetheless, government is only able to refinance existing debt through money printing
      2. Final moments
        1. July 1922, prices rise 10x in four months, 200x in 11 months
        2. near end in 1923, prices nearly quadrupling each week
        3. prices raced so far ahead of printing that the total real value of all Reichsmarks in the world was smaller than ever
      3. The end of the inflation
        1. August 1923, government of Wilhelm Cuno falls; October 1923, Gustav Streseman made chancellor, given dictatorial powers, hires Dr. Hjalmar Schacht as commissioner of new Rentenmark (“investment mark”)
        2. Rentenmark placed in circulation beside mark with the avowal that Rentenmark’s would not be inflated
        3. Germans believed it, and Rentenmarks supply was held constant
        4. November 15, 1923: final exchange rate, 1T mark: 1 Rentenmark
        5. Government budget balanced by finance minister Dr. Hans Luther
      4. The fallout of the collapse
        1. Schacht orders end of credit from Reichsbank April 7, 1924; credit squeeze ensues; price increases halt
        2. Savings destroyed
        3. Inflationary boom businesses go bankrupt
        4. Credit nearly impossible to get
        5. Unemployment temporarily skyrockets
        6. Govt spending slashed, govt workers dismissed, taxes raised
        7. Working hours increase, wages cut
        8. Millions of voters join Communist and Nazi parties in the “inflation Reichstag” of May 1924
      5. Economic recovery
        1. New elections in December 1924 erase extremist party gains
        2. business recovery based upon foreign loans due to German credit tightening; world depression of 1929 knocks debtor Germany down
    3. Gains and Losses
      1. Debtors: winners
        1. every contract or debt fixed in marks was paid off in worthless marks
        2. Germany’s total prewar mortgage indebtedness, equal to 40 billion marks or 1/6th of total German wealth, worth less than one American cent after the inflation
        3. Savers and owners of mark wealth (bank accounts, savings, insurance, bonds, notes) lose out big
        4. those who borrowed up until the last minute to buy assets turned out to be winners
      2. German Govt: winner
        1. Largest debtor
        2. Entirely relieved of crushing war debt, representing cost of war, reconstruction, reparations and deficit-financed boom
        3. beware being a creditor when the government is a huge debtor
      3. Farmers: winners
        1. always had food
        2. farms were constant values
        3. mortgages were forgiven outright
      4. Foreign owners of marks and other losers
        1. Germany made a profit of 15 billion gold marks, or 40% of annual national product, on sale of paper marks to foreigners, after deduction of reparation payments
        2. Trustees, forced by law to own fixed obligations, lost
        3. Wealthy Germans invested in marks lost
        4. Great charitable institutions wiped out
        5. Banks and insurance companies were weakened but not destroyed (they are both lenders and borrowers)
        6. Sound business survived, but in a weakened state, boom businesses wiped out
      5. Industrial stocks
        1. height of the boom, astronomical P/E ratios
        2. dividends cancelled
        3. stock prices increase 4x from February 1920-November 1921
        4. Stock market crash of December 1, 1921, in the middle of inflation
          1. prices fell by 25% and hovered for 6 mos while other prices were soaring
        5. real value of stocks decline because their prices lagged behind the price of tangible goods
          1. Entire stock of Mercedes-Benz valued at price of 327 cars
        6. near end of 1923, stocks skyrocket again as investors realize that stocks have value even when bonds do not and have a claim to underlying real value
    4. Roots of the inflation
      1. Prices contained by faith
        1. Germans and foreign investors, until 1922 and the brink of collapse, absorbed the Reichsmark
        2. faith was in the idea that an economic giant like Germany could not fail
        3. willingness to save marks kept them from being dumped immediately back into the markets
        4. realization that Germany would not back the money was the moment the dam let loose
      2. Balance of payments
        1. More cheap Reichs flowed out than hard money came in
        2. This despite constantly rising exports and constantly falling imports
        3. payment deficit actually muted price increases by keeping Reichs outside of German markets
        4. Reversal of payments deficits marked the proximity of the end
        5. in collapsing stages, Germany ran a huge payments surplus
      3. Foreign exchange rate
        1. unlike era after WWII, free and uncontrolled “float” of forex
        2. German mark almost always falling and almost always had a lower forex value than its purchasing power within Germany
        3. Thus, forex rate proved a quicker and more sensitive measure of inflation than internal prices
        4. German exports were abnormally competitive on world markets due to forex vs. internal purchasing power discrepancies
        5. Germany lost 10 billion gold marks, or 25% of a year’s national product, on underpriced exports due to inflation
    5. The Great Prosperity of 1920-1921
      1. March 1920-December 1921
        1. prices stable
        2. businesses and stock market booming
        3. exchange rate of mark against $ and other currencies rose for a time, was momentarily strongest in the world
        4. ROW enduring severe recession; Germany envy of the world
      2. Reign of finance minister Matthias Erzberger, June 1919
        1. Raised taxes on capital; real tax yield of 1920 highest of any year from beginning of war to end of inflation
        2. tight money induced for an extended period in late 1919; only time money supply stopped rising for more than a month or so
        3. March 1920, price level was 17x prices of 1914, roughly equal to increases in money supply, new equilibrium reached
        4. Price increases halted for nearly a year, real burden of war debt had been cut by 5/6ths as a result of price increases of 1919
        5. March 12, 1920, Erzeberger exits govt, disgraced after a libel suit, and his pro-inflationary rivals take over
        6. March 1920 is the month prices stop rising, but with Erzeberger’s exit, the boom prosperity begins
          1. prices remain passive
          2. exchange value of Reichsmark rises
          3. stock market rises 3x before crashing in December 1921
          4. Reichsbank doubles over next year into summer of 1921 when price increases catch up
    6. The Lessons
      1. Unrealized depreciation
        1. built upon faith in the German economy to recover
        2. built upon faith in German government to make good on debts
      2. Booms
        1. built upon increasing rates of inflation
      3. Hitler and extremists thrive in wild, inflationary conditions
        1. Hitler’s putsch was in the last and worst month of the inflation
        2. totally eclipsed when economic conditions improved
        3. took power through elections during another economic period of trouble
        4. middle class voters wiped out in the inflation moved to the extremes in polling, bolstering Hitler and others
  2. ACT ONE: The Rise of the great American Inflation
    1. The War
      1. Dollar lost 70% of its value from 1939-1973, prices rose 3.5x
      2. Seven years of WWII, Federal debt increased to $269B
        1. 1/4th greater than the annual gross product of the country at that time
        2. money supply grew by 3.5x between 1939 and 1947
        3. June of 1946, prices had increased by less than half from 1939
          1. price controls
          2. new money was absorbed by the issuance of war debt rather than bidding for consumer goods
          3. many saved money during the war for “safety” rather than spent it
          4. low money velocity resulted
        4. real value of dollar at the end of the war was 2/3rd what it had been at start of war
        5. government stopped inflating, allowed price increases to reach new equilibrium
      3. Prices controls end 1946
        1. prices double from levels in 1939 in two years
      4. Money supply held stable 1947-1950; prices remain stable as well
        1. economic recession 1949
      5. Comparisons: German war inflation vs. US war inflation
        1. American war debt of $269B, about 1.25x annual national product; Germany 153B marks, about 1.5x annual national product
        2. American monetary inflation, 3.5x; German 25x
        3. American price inflation 2x; German 17x
        4. Ratio of monetary to price increases about the same, 60%
    2. Grappling with Stability
      1. Korean War, 1950
        1. Federal budget did not run a deficit fighting the war
        2. money supply increases by 16%; prices increased 13%
      2. Eisenhower administration
        1. money supply increased 1% per year on average from 1953-1962; wholesale prices never varied +/-1% from 1958-1964
        2. “monetary oscillations”
          1. 1953-1954, money growth <1%, recession
          2. 1954-1956, money growth 3.9%pa, boom and price inflation
          3. 1957, money supply contracts, followed by recession
          4. 1958-1959, inflation
          5. 1959-1960, contraction
          6. 1961, inflation
          7. 1962, contraction
    3. The Great Prosperity of 1962-1968
      1. intense monetary inflation beginning 1962
        1. 4.6% per annum for 43 months (through April 1966)
        2. 7.2% per annum for 27 months (January 1967-April 1969)
        3. total inflation over seven years was 38%, interrupted only by the 9month period of no expansion in 1966, accompanied by stock market collapse and economic recession by no effect on prices
        4. combined with an investment tax credit of 7% for businesses to spend on new capital assets, leading to exaggerated investment boom
        5. prices did not keep up, leading to “unrealized price inflation”, despite rising at nearly 5% per annum for the seven year period
    4. The Inflationary Syndrome
      1. economic effects from 1962-1968
        1. gross national product increased $360B, or 7% per annum, compared to 4.8% per annum during Eisenhower years of 1955-1960
        2. unemployment continually decreased
        3. stock market was almost constantly rising for more than 6 years
      2. speculative effects
        1. high stock market volumes, huge capital gains appreciation, large paper profit generation
        2. conglomeration and merger of big business
        3. most wage growth in the speculative class of paper-pushers
        4. overinvestment in capital goods
        5. IBM, Xerox (back-office service/goods companies) were the investment darlings of the era
        6. overproduction and stimulation of the growth of educational and legal industries
      3. foreign exchange and the balance of international payments
        1. current account deficits are a symptom of inflation
          1. when there is excess money in one country it flows out to other countries
          2. the currency in the inflationary country is overpriced relative to world markets, so it goes out and buys imports
        2. current account deficits reduce price inflation in the inflationary country because the currency bids up prices in foreign rather than domestic markets
        3. dollars held by foreigners returning to the US at the point that the current account turns to a surplus, would result in price inflation in the US
  3. INTERLUDE: The General Theory of Inflation
    1. Prices
      1. prices in aggregate are determined by total amount of money availble for spending in a given period of time, in relation to total supply of all values available for purchase with money in that period of time
      2. money supply defined as that which people use to buy things of value with, but which is not a thing of value itself (dollars, coins, checking account deposits)
      3. money available per unit of time, aka money velocity, also a factor, but it is hard to measure or determine
      4. price level = money quantity x money velocity / supply of all real values
      5. this is the quantity theory of money
    2. Real Values
      1. in an inflation, there are many “spurious values” which disguise and conceal the inflation of prices of real values
      2. real wealth consists of land, resources, productive plant, durable goods and people
      3. paper wealth is not real wealth; money wealth is debt, including money contracts such as bonds, mortgages, debentures, notes, loans, deposits, life insurance and pension obligations
      4. debt does not represent the direct ownership of any real assets but rather subdivision of interests in real assets with the direct owners of the assets
        1. for ex, a man is not part of the total supply of real capital as he can not be bought and sold
        2. however, if this man borrows money, he subdivides ownership of his future productive power and adds himself to the supply of capital assets
        3. if he borrowed from a bank which borrowed from a depositor, further subdivision has occurred
        4. government debt represents a “lien” on the part of the productivity of all citizens
      5. this multiplication and stratification of paper wealth can be increased to many times the size of the real existing wealth
      6. paper wealth structure is all built on faith– issuance of new paper wealth does not result in an increase in real values by itself
    3. Government Debt
      1. issuance of government debt increases supply of paper wealth, meaning it is price deflationary
      2. when Fed wants to tighten money, sells govt debt into market, reducing prices
      3. large issues of government debt could not be marketed without a large increase in the supply of money because they’d drive interest rates upward– precisely what govts don’t want; therefore, they’re almost always accompanied by money printing
      4. government surplus is price inflationary; if it is used to pay down debt, it reduces the supply of outstanding values and raises prices
      5. when faith in government debt fails, price inflationary effects will be amplified
    4. Interest
      1. lenders accepted negative real rates only because they didn’t realize what they were doing
      2. “the announced intention of Keynesian economics was to effect [the holder of money’s] extinction”
      3. the rich tend to be net debtors in an inflation
      4. inflation is paid for by the lower classes and the creditors
      5. an attack on interest results in a flight from debt to equity, from money wealth to equity/real values
    5. The Economics of Disaster
      1. occurs when the holders of money wealth revolt
      2. duller the holders of money are, the longer price inflation can be kept at bay by govt, though the greater will be the eventual breaking of the price dam
      3. desertion of money resembles a panic, sudden and unexpected
      4. people’s ability to discern real and spurious values suddenly becomes acute
      5. people flee paper assets and goods and services for known value like food and land
      6. no government causes collapse, “when at least it sees the choice, it has no choice”
  4. THE LAST ACTS: The American Prognosis
    1. Act Two, Scene One: President Nixon Begins
  1. Treasury reduces expenditures and attempts to balance budget, July 1969- June 1970
  2. Fed drops inflation rate in May of 1969 from 8%, 1yr later approx 3.8%
  3. Stock market prices fall by 14% within two months of May 1969, another year later down 31 percent; interest rates rise into spring 1970 credit crunch
  4. Approaching two year mark to next election, government begins pumping money again
    1. August 1970, budget deficit plunges to new peacetime lows
    2. money inflation of 6.5%
    3. interest rates plunge, stock market soars
  • Act Two, Scene Two: Price Controls and Other Follies
    1. worst inflation since the end of WW2 and before 1967
    2. economic boom into Nixon’s re-election in 1972
    3. boom quickly wears off
      1. stock market falls
      2. interest rates rise to surpass peaks of 1970
      3. price inflation worse than ever, around 4%
      4. cheap dollar floods world markets
    4. Nixon announces Phase I of price controls, August 15, 1971
      1. detaches dollar from gold
      2. 10% import surcharge
      3. excise taxes on automobiles removed
      4. wage and price controls
  • Self-Defense
    1. No sure safety, safety will change fluidly through an inflation
    2. Best hope is to lose as little as possible
    3. fixed money wealth/debt is the absolute worst investment in an inflation
    4. foreign money can be safe refuge only if the foreign government inflates less wildly than the domestic government
    5. the author shits on gold, but with no reason other than an arbitrary one because he is a Keynesian– gold may be overvalued during and even before and inflation but so long as people continue to think it is money, it can hold some value
    6. real estate provides a shelter for REAL value (usability/livability/productivity of land) but could be harmed in terms of investment value in an inflation
      1. real estate held in high esteem by inflationary prosperity (luxury dwellings, overblown commercial developments) may lose more real value than other investments as they started out overpriced in the inflation
    7. farmland is a special category of real estate
      1. produces what people must have, inflation or no
      2. farmers thrive and farmland excels in dying throes of every inflation
      3. less prosperous in early stages of an inflation
    8. hoarding of useful goods is a possibility, but has large storage, distribution and opportunity costs prior to an inflation
  • Self-Defense Continued: The Stock Market
    1. stock shares are pieces of paper, but they are claims on real assets and real wealth
    2. stock market is incredibly liquid
    3. common stocks provide returns in first madness of an inflation, then fall into disrepute in middle stages of an inflation
    4. a booming stock market is not necessarily part of an economically healthy nation
      1. the opposite is truer: booming stock market is a signal of inflation
      2. falling stock market is a sign of returning to reality
    5. the stock market as a whole rises due to inflation and nothing more
    6. the stock market declines on a weakening of inflation
    7. general business conditions and price inflation operate on a lag; when money is first printed it has nowhere to “work” and goes into investment markets
      1. markets rise while business is still bad
      2. later, as money moves out of the market and into businesses, the market falls
      3. when business is worst, stock markets rise; when business is best, stock markets fall
      4. rising stock market signals nothing but fresh money inflation– it is the earliest and most sensitive signal
    8. stocks bought at any price above their real-value bottom are not a hedge against loss but a guaranteed loss
    9. conversely, stocks bought at real-value bottoms have a good chance of holding their values through an inflation
    10. American stock market’s deflated bottom in 1970 was 43% higher than deflated bottom in 1962, just as money supply in 1970 was about 43% higher than in 1962
    11. as other prices outpace stock market rises (or even stock market decreases), fear can take over that the businesses will not be worth anything; but faith will pay off with real value nearly the same at the end of an inflation
    12. stock markets can enjoy inflated gains if there are laws in place forbidding the inflationary money to bid up prices elsewhere or in foreign markets
    13. the stock market represents real value, but not every stock does
    14. inflationary times tend to reward the most valueless stocks; use a “post-inflationary eye” to have a look around at what might actually survive the inflation in terms of real value
    15. “Attempting to make profits from the stock market, or even to make sense of it, without completely understanding the universal determinant of inflation was like being at sea among uncharted rocks and shoals without so much as a tide table.”
  • A World of Nations
    1. Virtually all of the entire growth of Federal debt after 1967, $55B, was involuntarily financed and acquired by foreigners
    2. by 1973, foreigners’ holdings of liquid dollar debt had risen to $90B from $31B in 1966
    3. America exported inflation; other nations imported it– this is the balance of payments deficit
    4. natural consequence of an inflation, surplus money must flow outward looking for “cheap” items to buy abroad
    5. 100% beneficial to the deficit country
      1. import real value from abroad while exporting worthless paper
      2. price inflation domestically is partially contained
    6. central bankers began a game of printing up new local currency to exchange with the inflowing dollars, sending the dollars back to the US where they would be recycled and re-exported
    7. exchange rates operate on a time lag
      1. first, the internal price level is too low, so the new currency flows out to the rest of the world
      2. then, the internal price level rises, drawing in currency from the rest of the world
    8. the best defense against another country’s inflation, is inflation

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.

Wall Street Mesmerized, Perplexed By “400% Man”, But Why?

Two separate friends sent me links to an investor profile in SmartMoney magazine entitled “The 400% Man“, about a college dropout in Salt Lake City who appears to have made a killing over the last ten years following the principles of value investing.

Allan Mecham, had been posting mind-bogglingly high returns for a decade at a tiny private-investment fund called Arlington Value Management, and the Wall Streeters were considering jumping on board. For nearly two hours, they peppered him with questions. Where did he get his business background? I read a lot, he replied. Did he have an MBA? No. I dropped out of college. Did he have a clever computer model or algorithm? No, he replied. I don’t use spreadsheets much. Could the group look at some of his investment analyses? I don’t have any of those either, he said. It’s all in my head. The investors were baffled. Well, could he at least tell them where he thought the stock market was headed? “I don’t know,” Mecham replied.

When the meeting broke up, “most people left the room mystified,” says Brendan O’Brien, a New York City money manager who was there. “They were expecting to see this very sharp-dressed, fast-talking guy. They were saying, I don’t get it, I don’t understand why he wouldn’t have a view on the market, because money managers get paid to have a view on the market.” Mecham has faced this kind of befuddlement before — which is one reason he meets only rarely with potential investors. It’s tough to sell his product to an industry that’s used to something very different. After all, according to their rules, he shouldn’t even be in the business to begin with.

The fact that people were mystified by this young man’s performance should be embarrassing to Wall Street. And, not to rain on Mecham’s parade, but it really doesn’t speak to the greatness of Mecham so much as it speaks to the “mysticism” of Wall Street.

Benjamin Graham’s lessons on value investing have been available to the general public for over 70 years. Graham’s greatest disciple, Warren Buffett, is also the greatest investor of all time and one of the wealthiest individuals in the world. The story of his success has been told in countless biographies (of which little old me has managed to read two), all of which make it abundantly clear that Buffett’s time at an Ivy League graduate program likely had little to do with his destiny in the financial world. In fact, the man has railed against the Wall Street paradigm for decades himself and has explained to anyone who will listen — and they are legion! — why you can’t make money playing Wall Street’s game.

So, why is this all such a big surprise to these people?

It’s a big surprise because Wall Street isn’t broken. Wall Street is a mystical financial priesthood, just as the Federal Reserve and other central banks infesting the globe are mystical monetary priesthoods.

Wall Street doesn’t “get” value investing and is “surprised” to learn of its existence, and successful practitioners, because if Wall Street ever acknowledged that such a school of thinking existed, they’d be admitting their own inefficacy and the whole jig would be up. This is just the same as how the members of the Fed remain ignorant of the teachings of Austrian economics– to acknowledge and seek to understand them would be the beginning of the end of their nefarious charade.

The Wall Street business model is a volume-based, sales operation. It isn’t any different from television sales, automobile sales, pharmaceutical sales or insurance sales in terms of mechanics and objectives. All that’s different is the sales people are better “educated”, wear fancier clothes and work out of taller, shinier buildings. It’s a fee-based business, and the fees are generated by controlling assets and repeatedly churning them– the more you manage and the more often you turn it over, the more fees you generate and the richer you get.

Because Wall Street lives off of hyperactivity, the philosophy of patient inactivity (Buffet’s “waiting for a fat pitch”) and concentrated portfolios is, literally, blasphemous. Under such a model, your only chance at earning a return for your services is… to generate real returns for your clients! With the Wall Street model, you can get rich even as you lose your clients money. In fact, if you’re a brokerage or investment bank, you might even be able to accelerate the pace at which you enrich yourself as your client loses simply by trading more losing positions more often!

This is not an indictment of capitalism, free markets or financial exchanges, all of which are socio-economic goods with real value. This is an indictment of the Wall Street money management paradigm in relation to the tenets of value investing, a paradigm which doesn’t “work” at generating real returns for investors because it can’t– it wasn’t designed to do that!

Again, to draw comparisons to the Federal Reserve and the nature of central banking, the Fed can’t “fight inflation” and “lower unemployment” because that is not what the Fed was designed to do. The Federal Reserve CREATES inflation by issuing new fiduciary media into the economy and, with the assistance of the fractional reserve banking system, expanding the monetary base. It does this because the purpose of the Federal Reserve is to provide an alternative, “silent” tax system for the political class while easing the built-in, we-all-fall-down tensions within the fractional reserve banking system, which is the whole reason such a system requires a “lender of last resort.”

Wall Street, as a moniker for the fee-based, AUM-central “financial services” industry, delivers precisely what it was designed to deliver– lucrative pay plans and an unearned sense of superiority compared to everyone else in the economy for the specially-entitled club members and graduates of the connected institutions who populate it. It, like the banking industry and the global central bank system, operates via the herd mentality simply because those who thieve together, hang together. If you want to avoid hanging together, you must be committed to thieving together.

Defining risk as volatility, as Wall Street does, practically ensures that you’ll repeatedly expose your clients to real risk (that is, the risk of permanent capital loss) while naively trying to juggle the impossible task of managing ex post facto-determined volatility risk. Operating off of an asset accumulation/inventory churn model guarantees that your incentive structure will never be aligned with your clients, no matter how well-intentioned you might be. Government coercion in the form of mutual fund industry regulation and others provides the necessary legal muscle to prevent anyone who can think for themselves from attempting to do so.

Mecham’s closing comment is prescient:

Where does Arlington head next? Mecham says he won’t compromise his strategy to play the Wall Street game. That leaves Ben Raybould battling to market a fund, and a manager, that many other money managers can’t even understand. Mecham is bemused that so many people expect him to hold a broad basket of stocks and follow a benchmark, such as the S&P 500. “It’s laughable to think that in this competitive world, you’re going to find brilliant ideas every day,” he says. “The world’s just not set up that way.”

Exactly. And Wall Street will never manage to successfully manage risk and generate real returns for its clients– it’s just not set up that way.

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

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

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

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

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

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

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

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

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

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

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

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

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

To reiterate:

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

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

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

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

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

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

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

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

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

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

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

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

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

As Warren Buffett once said,

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

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

Thorsten Polleit: Deflation Will Not Be Tolerated

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

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

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

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

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

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

Interestingly, Polleit agrees:

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

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

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

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

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