Review – Family Fortunes

Family Fortunes: How to Build Family Wealth and Hold on to It for 100 Years

by Bill Bonner, Will Bonner, published 2012

What kind of habits and modes of thought separate Old Money families from everyone else? How do you build a family fortune? How do you get a family to work together toward a single purpose as the “core” is continually invaded by new spouses and children? How do you invest your prodigious wealth at high rates of return? How do you hold on to your family fortune for 100 years? Why does 100 years seem like a long time when it’s really only 3-4 generations of people?

Frustratingly (maddeningly?), the answer most often given in this book to questions like these is, “We don’t know, but here’s our guess.”

What I didn’t get from this book, then, were many specific, useful ideas for implementing with my own family enterprise– or family-as-enterprise. What I did get, and what will be the focus of this review, are a lot of questions, principles to ponder, and general strategic problems in need of robust solutions. This is not a how-to manual for putting together the essential structure of long-lived family institutions such as tax and estate planning, family organization and branding, household management.

Most people will not have a family fortune to contend with. It is not something that can be acquired through a known formula, but rather it is the outcome of an entrepreneurial process that is, epistemologically speaking, random. Just as one can not predictably create a family fortune, one can not predictably control the size or scope of the family fortune, within certain bounds. In other words, your family may have the good fortune to stumble upon a business opportunity with a significant market capitalization. That’s the first hurdle, and there’s no formula for getting there. Then, that fortune might turn out to be worth $50M, $100M, or $5B. That’s another hurdle, and there’s no formula. Failing to seize every opportunity you are presented with might limit your total fortune, and being eager and observant for those opportunities might extend the limit. But there is no recipe for turning something that is worth $50M into $5B unless it was the kind of opportunity that can scale that big in the first place.

Some market opportunities are worth a lot to one person who owns them (“he made a fortune!”), but they’re still not worth a lot to the market or economy as a whole (limited scale). This is an important point because of the gilded cage nature of family fortunes– once you have one, you’re kind of stuck with it, but it’s really tempting to think you have a lot more control over it than you do, or that it’s a lot more durable than it might be.

Imagine you’re the guy with the $50M fortune. You’re pretty happy with your luck, assuming everything else is right in your life, but you’re aware of people with $5B fortunes. If you can generate a $50M fortune, why can’t you generate a $5B fortune? Are those people smarter? Better connected? More productive? What’s the difference?

Luck, and leverage, but using leverage without blowing up is really just a residue of luck.

So you’ve got this $50M fortune. What can you do with it? If you have it invested in the business that created it, you enjoy a nice income stream from it each year (maybe that’s worth $2.5M, maybe it’s worth $5M if you’re really lucky) and you reinvest where and when you can. If your business doesn’t scale easily though, you can’t put it back in and make more. You’re stuck at $50M. What if you take the $50M out by selling the business? Now you have $50M in cash with no annual return and an investment problem. Where are you going to put $50M to work such that you can, say, spend $5M per year and still have $50M left over to do it again next year? Know any hot stocks? You didn’t make your fortune in investing the first time around, what makes you think you’re going to make it there the second time around just because you have $50M now? (Note: you are statistically and logically unlikely to achieve this outcome if you so desire it.) Know any good businesses for sale? Oh, that’s right, you just sold one!

That’s the gilded cage. You’re stuck with a $50M fortune. It’s a nice problem to have, but it’s still a problem. And nothing changes at scale besides the difficulty of the problem. It isn’t easier but actually harder to achieve yield at higher increments of invested capital due to the economic phenomenon of diminishing marginal returns (if this were not the case, you could infinitely scale things by always adding more resources to every project; DMR ensures that the more you add over time, the less incremental gain you get to the point that you get no return or a negative return, ie, waste). If you had $5B, you’d have even fewer places to put it and you’d have given up an even rarer business opportunity in selling.

Unless your business value is about to become permanently impaired and you can see the writing on the wall when no one else can — technological change, regulatory change, some kind of disastrous political or economic event — your business will never be as valuable to you on the market as it is under your ownership, assuming you’re a competent operator. I’m not going to explore what you do if you’re incompetent because that’s a special case, although it follows the same general logic and leads to the same general investment problems.

I think what this means is that the primary challenge for a family with a fortune in terms of managing their business is to be sensitive to the innovation required over time to maintain the economic value of the assets, to manage the capital structure of their business intelligently (ie, not too much debt) so they don’t lose control because of the volatility of the business cycle, and to build cash up and keep their eyes peeled for a truly unique investment opportunity, the kind that made the first family fortune possible. That means it’s more important to avoid doing the wrong things than it is to try to be finding the right things to do. It also means it requires great patience. If we’re talking about building multi-generational wealth, patience is implied in the premise, but it’s still worth repeating. Bonner emphasizes this frequently– find ways to let time work for you, not against you. He believes luck, advantages and businesses all tend to grow over time so the idea is to set things up so those advantages will accumulate in your favor.

Smart investing is not the way to build a fortune. Some people will build a fortune building an investment business (ie, a wealth manager), but it will not be the investing itself that makes them rich but the operational leverage they gain through their fee structure. Because Bonner is a skeptic of “investing” as a tool for wealth building, he would land squarely on my side of the skeptic’s divide about the value public capital markets play in economic growth. Why should a person find it necessary or valuable to contribute capital to a company building things in other people’s towns instead of investing in opportunities in their own town, right “down the street”? Profit signals and differing equity returns will attract capital from disparate areas and thereby indicate relative value across an economy, but I am skeptical that this process and the capital markets in general would be as big a part of the economy overall as they are presently if we were in anything more closely approximating free market conditions without crony capitalist interventions.

So, you may get lucky and find yourself with a fortune, small or large, from a family business. If you do, hold on to it, appreciate it, care for it, tend to it responsibly and hope you or one of your descendants has an opportunity to take another swing at an uncertain point in the future. But don’t try to force it, and don’t think there’s anything you can do to greatly enhance your opportunity beyond what it is. And understand that it will never be as valuable to you as a pile of cash as it is invested in your business.

The other big topic in the book is building the institutional framework of a long-lived family that can participate in this family business over the generations and can also be “true” to the family culture and values. Family planning is an idea that attracts me, and I have spent considerable time on my own with the concept of creating a family brand (what the ancients’ termed a coat of arms) to identify the family and its enterprises.

The trouble I have with family planning is the same trouble I have with all planning, particularly that of the central variety– what if the individual members of your family don’t really find value in your plan? Obviously, raising them with certain values and viewpoints creates a better chance for a kind of coalescing around this identity and direction. But is that how I want to raise my children, by telling them what is important? I think they can figure that kind of stuff out on their own, just as I did. Hopefully I can lead by example, and provide a demonstration of the virtue of the family virtue. But I think a potentially frustrating consequence of putting this emphasis on building multi-generational institutions together is you might find out your family just doesn’t see the use in them. That’s kind of worse case, though, and doesn’t necessarily argue against the project in general.

Yet, what if you’re successful at this? Building a business and building wealth is a coordination problem resolved by growing trust. Who can you trust more than members of your own family? Creating a family organization based on shared values and common identity and linking that organization to a business entity could allow for a uniquely successful competitive strategy and management continuity over a significantly longer timeline than the average public or private competitor– in other words, huge competitive advantages over time. Simultaneously, this arrangement could solve one of the common problems of families and their constituent members, that being how each as an individual and the family as a whole can achieve security, success and satisfaction with one’s productive efforts and life. As I’ve argued in the past, I believe the family is the best institution for accomplishing this task and it is certainly far superior to the currently dominant model of public corporations (for-profit and nation-states/institutional gangsterism).

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Review – Invisible Wealth

Invisible Wealth: The Hidden Story of How Markets Work

by Arnold Kling, Nick Schulz, published 2011

Recently I found myself rooting around the in archives of sites like Let A Thousand Nations Bloom and Distributed Republic and I selected a few recommended titles about the frontier of economics, politics and soft institutions (culture, legal norms, etc.) looking for answers to these questions mentioned in an earlier post:

  • Why do political borders and different legal systems seem to have such disparate impacts on economic development?
  • Which follows which, the culture/political system or the economy?
  • How sound is the idea of “competition amongst governments” and why don’t we see more countries’ policies moving toward a “developed” mean?

Invisible Wealth proved helpful in thinking more deeply about the first two questions, but it really didn’t offer any insights on the third question. The book is a mixture of introductory lessons on concepts from “Economics 2.0” intermixed with interviews from numerous academic economists who have done research in the field of the interplay between economic development and social institutions. The strongest parts of the book are the interviews with the economists. The introductory lessons suffer from too many mixed metaphors (hardware/software layer, Malthusian meadow/food court, innovation as the heart of the economy) and the insistence on delineating economic ideas as part of 1.0 or 2.0 thinking seems contrived and forced, not only because there is no existing group of economic thinkers who so identify themselves as adhering to one system of ideas or the other, but also because there is an entire school of thought, the Austrian school of economics, which recognized the importance of both 1.0 and 2.0 concepts and successfully integrated them decades ago, but which gets no spotlight aside from the consistent mentions amongst the interviews of the importance of the work of FA Hayek as an exemplar.

Briefly, Economics 1.0 is supposedly Classical Economics, which sees all economic issues in terms of the three basic inputs of land (original, unprocessed resources), labor (the effort and ingenuity of human beings interacting with those resources) and capital (the factors of production generated by mixing land and labor for future production). E1.0 is obsessed with equilibrium and static economic models, which are amenable to mathematical and statistical analysis. In contrast, Economics 2.0 acknowledges the important role of entrepreneurs in managing change and dynamism in the economy. Sadly, the authors neglect the ultra-important dimension of TIME and the role this plays in production and the coordinating activities of entrepreneurs… which is why the Austrian school again seems incredibly advanced compared to this offering and might be categorized as Economics 3.0. But even ignoring time, E2.0 is a big advance on E1.0 in acknowledging change as not only a real phenomenon of economic systems that is neglected by E1.0, but also the central element of economic development and growth. For development to take place, change must occur, and for change to occur, there must be actors with an interest and incentive in causing the change.

This shifts the analysis from studying the mineral resources or accumulated capital of a community, to studying the existence and behavior of entrepreneurs as innovators improving economic outcomes for everyone. The question begged then is, “Why do some economies have a lot of entrepreneurs, or very talented ones, while others have none or poor ones (or corrupt ones who get wealthy making people worse off)?” And for an answer to that question, one must explore the role of institutions.

With institutions, whether we’re talking E2.0 or E3.0, it’s clear that the science is still developing on which institutions are important for development, what role they play and how they can be successfully built (a significant meta-problem, because often there is feedback between a poor economy and difficulty building strong institutions and so on). There are also so many potential institutions to consider that the analysis can quickly get complicated, for example:

  • Property rights (how to define, how to enforce, what can/can’t be owned and by whom)
  • Legal norms (ie, tendency to rule a certain way in a certain type of case)
  • Legislation (ie, “the law” that will be enforced, including civil, criminal and regulatory policies)
  • “Culture” (accepted behaviors, social expectations, traditions, ideals, even aesthetics)
  • History (this is an odd one because it is so intangible and uncontrollable, but the history that each community comes from has a real effect on shaping other institutions and thus economic outcomes)
  • IQ (more on summary findings from Hive Mind below)
  • Religion
  • The family

I think this is why the interview portions of the book really shine. It is here that we get a lot of competing theories of development and which institutional factors are most important and why. They not only highlight how unsettled this part of economic or social science is, but also they provide outstanding examples of how critical each of these factors can be. And there is a clear distribution of insight and intelligence demonstrated by these interviews as well– while almost all of the interviewees have earned numerous awards and accolades, including Noble Prizes, for their economic work, several stand out as innovative giants while others seem to trade in the same, tired old statist fallacies of yore. What follows are some of the quotes I thought were most fascinating.

Robert Fogel

RF emphasized the role of technology in development, because as he says, “technological advance is the basis for all economic growth.”

One measure of economic development he suggested was looking at life expectancy. A rising life expectancy implies that people are able to produce sufficient resources to protect themselves from basic environmental and health risks. However, in looking at the historical data, there is an interesting trend in early industrial European societies by which rural populations maintained higher life expectancies than urban dwellers until around the turn of the 20th century. He blamed this on changes in technology, because

when you walked around in New York City, you were breathing pulverized horse manure, a much worse pollutant than the exhaust of automobiles

That idea grabbed me, both because it is vivid and disgusting, but also because it highlights that economic development is fraught with risk and even though the “ultimate” destination of economic development might be a less toxic technology like automobiles, the “path” along the way might include way points with more toxic technology (pathogen-laden pulverized horse manure) which is worse for health outcomes than taking your chances with subsistence-level existence in the countryside. A question I had which wasn’t explored in the discussion is why a.) city municipal services failed to keep the volumes of horse manure out of the streets as part of a sanitation program or b.) why market entrepreneurs didn’t collect and sell this “fertilizer” back to the countryside? It could be a technological problem within a technological problem.

Fogel also emphasized that the rate of technological change appears to be increasing in industrial economies:

it took four thousand years to go from the invention of the plow to figuring out how to hitch a plow up to a horse… it took 65 years to go from the first flight in a heavier-than-air machine to landing a man on the moon

Now, the example is cherry-picked and there are probably still a lot of technologies we’re using that are 10,000 years old (for example, if we ever primarily grow crops indoors, one could say “It took us 10,000 years to go from growing crops outdoors, to figuring out how to grow them indoors”, which seems like a really long time to figure out what will at that point be a best practice idea) but it still has impact.

He also mentioned the importance of economic development for the well-being of the aged:

you need to have a successful and rapidly growing economy in order for standards of living for the elderly to improve

I think this is true because the savings of the elderly need to earn an increasing return in real terms for their standard of living to improve without being forced to consume their capital, which puts a fixed timeline on their survival once they run out of capital entirely. And the only way their savings can earn a greater real return over time is if the entire economic pie is growing. It’s an interesting example of the connection between economic growth and and humane conditions.

Robert Solow

RS highlighted the complexity of the problem of solving poverty in poor countries:

Without appropriate institutional infrastructure, without the right local incentives, without complementary human capital, aid and investment will be wasted… poor countries are not only poor in capital, they are poor in the factors that make for “total factor productivity”

This is a direct application of E2.0 thinking contrasted with E1.0 thinking. The E1.0 aid crowd believes that if you just redistribute enough of the world’s wealth to the poor countries, they’ll be able to escape poverty. But RS emphasizes that they’re not just poor in terms of resources but also in terms of institutions which allow them to manage and develop resources. If this is true (and I think it is), it certainly gives one pause before hitting the “Donate to Charity”-button.

Paul Romer

PR focused on changes in technological systems and the economic impact that comes from replacing an old technology with a new one:

We didn’t get that much more light by producing hundreds of thousands of candles per person, but by switching from candles to gas

He also discussed the way technological development may improve our capacity to make further discoveries,

it may be inherent in the process of discovery that the more we learn the faster we can learn

and the impact that improvements in institutional technology have allowed us to harness those discoveries with greater efficiency:

the modern university and research system was designed not to create property rights but to lead to the rapid dispersal of new information; academics were rewarded based on the priority with which they disclosed information, so that the first person to disclose gets all the professional credit for discovering something new

[…]

what we’ve done is created better institutions over time, so that we now exploit the opportunities for discovery much more effectively than we used to

The most important insight from his interview was that growth requires change, and change creates “winners” and “losers”, and it’s easy for the losers to become a special interest group and lobby the government to arrest the change:

everyone wants growth but nobody wants change, and you’ve got to have both or you’ve got to have neither… change accompanies growth… when you have change, there will inevitably be winners and losers… we can’t let a small group of losers — either absolute losers or relative losers — stop the process of growth that will benefit most people going forward

Incidentally, this is why countries pursuing socialist policies stagnate. Socialism is a policy that preserves the status quo and tries to equalize outcomes that are created by change. Inevitably, equalizing outcomes ends up stopping the change itself and thus stagnation sets in.

Joel Mokyr

JM was actually one of my favorite interviews, so I will quote him extensively.

First, he talked about the reasons why humanity has gotten increasingly technologically advanced over time:

inventions are made when there is a minimum epistemic base… you cannot build a nuclear reactor by accident… but you can invent aspirin quite serendipitously, without having the faintest clue about how it works

[…]

We invent something, and sometimes we know a little bit about how it works, sometimes we know nothing, sometimes we know quite a bit, but in all cases, as we use it more, the epistemic base gets wider.

This technological advancement requires time, and a bit of luck, because

the only way we can think about technology is in evolutionary terms… a kind of science that makes no predictions

That’s also a really interesting idea because some economists have claimed that “science is prediction” and thus any economics which does not concern itself with empiricism and making valid predictions is not scientific. But here we have two examples (evolution, and technology) of sciences where prediction is not possible. Does that mean they are not scientific?

Later, JM goes into an explanation of the way changing technology led to economic development, and the way economic development impacted institutions and social ideas, and then the way this fed back into attempts to limit technological development and, by extension, economic development:

If you look at Europe in 1650 or 1700, what you see is a very sophisticated set of economies. They have just basically finished exploring the rest of the world, and there has been great deal of commerce and trade — joint stock companies are emerging, insurance is emerging. This is a fairly sophisticated commercial economy. The problem is, there are lots of special interests trying to get exclusionary arrangements that are good for them but bad for the economy. This is a system in which property rights are well defined and enforced, as Douglass North loves to say, but also rather distortive in the sense that you have lots of exclusionary arrangements. In other words, for the economy to function well, you don’t just need good property rights, you also need what we could call, somewhat vaguely, “economic freedoms.” You need labor mobility; you need to get rid of guilds; you need to get rid of monopolies, both local and global; you need to get rid of all kind of regulations; and above all, you need free trade. And if you don’t have that, you’re going to end up in a society that will not be able to grow.

Nowadays we have a different term for this. We call it corruption. We always say, look at countries like Russia or the Central Asian nations — these countries will never have good economies because they are corrupt. But corruption is really just a special form of what we call, in economic jargon, “rent-seeking.” I argue in my book that one of the things that happens in eighteenth-century Europe is a reaction against what we today would call rent-seeking, and that this, to a great extent, is what the Enlightenment was all about. The Enlightenment wasn’t just about freedom of religion and democracy. It wasn’t to be about democracy at all, but never mind that. It was about freedom of religion, tolerance, human rights– it was about all of those things. But it was also a reaction against mercantilism, and you find that attitude in certain people who were very important in the Enlightenment. Above all, of course, the great Adam Smith.

[…]

when you look at the few places in Europe where the Enlightenment either didn’t penetrate or was fought back by existing interests, those are exactly the countries that failed economically [Spain, Russia]

This is definitely a different take on the Enlightenment than I have come across before, but it makes a lot of sense to me and seems to do a good job of integrating economic, technological and political phenomena of the time period!

nobody has held technological leadership for a very long time… technology creates vested interests, and these vested interests have a stake in trying to stop new technologies from kicking them out in the same way that they kicked out the previous generation

That is the feedback loop mentioned earlier, and why the Enlightenment might have been a reaction against a vested interest reaction.

Cardwell’s Law: the more open the world is, the more free trade, the more ideas and people can move from one country to another, the less likely it is that technological progress will come to an end

This idea gives hope that there is a case for rational optimism assuming liberal social institutions around the world.

if you change the institutions but don’t change the culture, you’re not going to change the institutions

[…]

the degree to which we hold fast to the wisdom of earlier generations is an incredibly important element in how innovative a society is, because if you think about it, every act of invention is an act of rebellion

This suggests that “conservativism” as a social policy might lead to stunted economic development, depending upon when marks the beginning of what traditions and systems one is trying to conserve. It also highlights the problem that RS mentioned, namely, that there is complex interactivity between social institutions which enable economic growth and it’s possible that a “backwards” culture could interfere with or limit the effectiveness of “progressive” social institutions as a whole, so it’s not as simple as, say, invading a country and giving them a modern political constitution (ignoring the obviously negative social impact of a war!)

And this might seem like a throwaway quote, but I thought it was interesting:

Over most of history people have not voted their pocketbooks — Marxists included.

Thankfully! Because if they did, or do, then it will be truly hopeless to expect any kind of reform ideology to take place in the face of billions of people who could “vote their pocketbook” and keep instituting handout systems that impoverish everyone.

William Easterly

WE focused on the appropriateness of specific institutions to solving specific problems, namely, the planner-mentality to solving poverty. He looks at poverty as a circumstance created by a lack of innovation, and he identifies planning as a practice which is antithetical to innovation. Thus, planning can not solve poverty:

Planners think that the end of poverty requires a comprehensive, administrative solution. They’re trying to do something that’s a lot like central planning in the old, Soviet-style economies, in the context of poverty reduction.

[…]

It’s as if central planning has been totally, mercifully extinguished everywhere else except [in the areas with] the world’s desperate, poorest people, who can least afford such a dysfunctional solution to their problems — [areas] where it would be much better to imitate the mentality of free markets, which are all about giving financial incentives and motivating people to meet consumer needs.

[…]

corporate planning is just about scaling up a solution after you find something that works… you can’t use planning to find what works

William Lewis

WL, like JM, emphasizes the way that institutions can be used to enable and unleash innovative forces, or to restrict and restrain them. He also talks about attitudes of people in the industrialized West who are trying to create panacea solutions for people in poor countries:

Just because people are not educated does not mean that they are incapable, which is a mistake educated people in the West often make.

He points out that if the opposite were true, poverty would be a necessary part of the social landscape for much of the world for at least the next 50 years while several generations of people are being educated. But this wasn’t the pattern of development in the industrial countries before they obtained their industrial development and he doesn’t think it’s a good assumption for the remaining non-industrial countries as well.

No producer – no producer – has ever asked for more competition. So these domestic producers are really the secret enemies of globalization and they are exerting a lot of influence against it.

There’s that feedback loop! And it gives us an insight into the truth of protectionist policies, which don’t enable development but rather enable special interest groups to profit patriotically.

[Gordon] Wood showed that at the time of the Revolution, consumerism exploded in the United States. And consumerism was associated with fundamental notions of individual rights. Prior to that, at least in the feudal societies of Europe, consumption was viewed as a luxury to which only the land-owning class was entitled.

I’ve got a Gordon Wood book on my stack right now so I am excited to explore this idea further, this is another example of integrating economic and political ideas holistically and applying them to the analysis of a historical period to yield an interesting result.

And of course, the way you make a plan happen is by having a plan for production, not for consumption. There is no way you can plan or affect the individual choices that people make as individuals when they buy things, but you certainly can affect strongly what they have to buy through production planning. So this whole producer orientation was aided and abetted in modern times by the planning idea. It’s easy to see where the idea came from in feudal times– basically, the landowners and the people who owned the capital could control what happens. They were the only ones who had the ability to do anything. This whole battle for individual rights, for the political philosophies based on individual rights, and for what immediately comes from those political philosophies — namely, the idea of consumer rights — has expanded around the world to a relatively small degree.

Earlier I had mentioned [amazon text=Hive Mind&asin=0804785961]. Here are some “institutional” effects of High IQ societies, according to the author.

High IQ:

  1. Correlated with higher savings, which means more capital which raises the productivity of all labor
  2. Correlated with more cooperation, which means less corrupt government and more productive businesses
  3. Correlated with social market orientation, a form of social organization key to widespread prosperity
  4. Better at using “weakest link” team-based technology

So one challenging idea from Invisible Wealth and some of these interviews is that poor countries, in so far as they demonstrate low average IQs, as well, may have a more difficult time creating the institutional arrangements necessary to allow for sustained economic development. That has many ramifications for social policy if it’s true!

I noticed also that this idea about the importance of institutions is exactly what Hernando de Soto was discussing in his The Mystery of Capital, which I read last year. His approach was to emphasize property rights and formal versus informal economies. His argument was that poor countries tend to have major urban areas centered around the political capital where the elites in power and their cronies have the benefit of property rights enforcement and thus are able to build and accumulate capital, whereas the squatters and poor folk in the outlying communities not only have no property rights but are actively prevented from developing them or having them recognized by the formal legal system. The result is an estimate of trillions of dollars of capital “frozen” in informal structures which limit their exchangeability and thus their value, usefulness and ability to be improved or accumulated over time.