Leithner Letter No. 30
26 June 2002

cession is a dirty word, and that’s understandable. But recessions are necessary. People have to sleep, and businesses and households have to rebuild their liquidity. What the Fed is doing now it was doing in the 1970s. It’s trying to paper over a recession.

James Grant
Grant’s Interest Rate Observer (15 March 1991)

So the U.S. economy will recover soon? Really? It has a massive current account deficit and equally huge household debt, both of which are still rising, record corporate debt, negative private sector saving and an overvalued dollar. All the elements of an overblown economy are still there, unremedied by recession, which seems to indicate that the U.S. hasn’t had its recession yet.

Recessions wind back debt and rebuild savings – that’s what they’re all about. Debt is still climbing in the U.S. and savings are still negative. The U.S. will have a recovery in due course, but not until after it has had its recession, and that hasn’t happened yet. No pain, no gain.

Tyler Kelly, Bribie Island, Queensland
The Australian Financial Review (8 February 2002)

Leithner & Co. Pty Ltd is a private company that adheres strictly to the Graham-and-Buffett “value” approach to investment. Its goal is its method: to undertake investment operations which are based upon thorough research and cautious assumptions; to provide reasonable safety of principal and offer an adequate return; and to inform shareholders regularly, fully and in plain language about these investment operations. Like most Australian corporations, its financial year begins on 1 July and ends on 30 June. The winter is therefore an appropriate time to conduct two exercises. The first is to contemplate the twists and turns, triumphs, trials and tribulations of the financial year coming to a close; and the second is to subsume these events within broader principles, revisit these principles, learn one’s lessons and adjust one’s sails for the next twelve months.

Letter 24-25, dated 26 December 2001-26 January 2002, stated that “in many countries, including Australia, Britain, Canada and (especially) the U.S., the boom of the late 1990s sowed the seeds of bust. Australia’s boom ended in 2000 (see Letters 11-12) and signs of bust gathered pace throughout 2001. ... [Our] plans for 2002 are based on the premise that many of the excesses of the 1990s remain unrecognised and therefore unpurged, and that the bust may be extended and sharp.”

Underscoring its dour tone, the Letter 24-25 also stated that a “renewed misallocation of resources ... may manifest itself in 2002 through a ‘recovery.’ Whatever the euphoria it incites in financial circles, such a recovery neither causes economic growth nor creates wealth. Rather, it misdirects Australia’s small and eroding pool of funding and thereby weakens the potential for longer term and sustainable prosperity. During 2002, then, Leithner & Co. will be in no hurry to sing ‘Happy Days Are Here Again.’”

Six months later, this cautious and cheerless assessment is unrevised, unrepentant – and possibly vindicated (“Stock Slump Is Casting Doubt On Slight Economic Recovery: ‘Double Dip’ Recession Worries Some; Others See Adjustment From ’90s Bubble” The Wall Street Journal 10 June). Yet far from crimping our fortunes, this severe and disbelieving stance has helped us to achieve our most adequate results (in absolute terms and relative to others) since inception.

The Consequences of 1.75% and 4.25%

Underlying and encompassing the myriad events of the 2001-2002 financial year is a single, overarching, venerable and seemingly forgotten principle. Interest rates, when not manipulated by a central bank, are determined by individuals’ time horizons (or “time preference”) and the rate of return on investment tends to equal the rate of time preference. In the absence of interference, in other words, interest rates efficiently co-ordinate the actions of – and convey accurate signals to – borrowers and lenders. Under these conditions, to use the apt phrase of Roger Garrison (Time and Money: The Marcroeconomics of Capital Structure, Routledge, 2000, ISBN: 0415079829), interest rates “tell the truth about time” (see also Steven Horwitz, Microfoundations and Macroeconomics: An Austrian Perspective, Routledge, 2001, ISBN: 0415197627).

Conversely, interest rates fixed by central banks not only tend to deviate from the truth about time and money (i.e., the natural rate of interest): in retrospect it is clear that at critical junctures subsidised bank rates have unintentionally but nonetheless repeatedly imparted damaging falsehoods about these phenomena. As James Grant has noted (The Trouble With Prosperity: The Loss of Fear, the Rise of Speculation and the Risk to American Savings, Random House, 1996, ISBN: 0812924398), the sin of central bankers is not just that they create credit backed by thin air rather than hard savings. More fundamental is their pretence to knowledge. They pretend to know what no single person or small group of people, no matter how diligent and intelligent, can possibly know: the appropriate rate of interest at which credit (in the form of bank reserves) should be lent and borrowed.

The greater the departure of subsidised from natural rates of interest, the more egregious the misinformation transmitted to borrowers and lenders. From this perspective, the lowest and most artificial rates of interest in a generation are no cause for celebration. Quite the contrary: it is likely that they have induced further “malinvestments” in addition to those undertaken during the mania of the late 1990s.

If so, then in the 2002-2003 financial year the unpalatable consequences of 1.75% (in America) and 4.25% (in Australia) may begin to dawn upon yet another class of speculators-who-thought-they-were-investors. Under these circumstances the anguish of debtors, hand wringing of politicians and babble of analysts will fill the air; and vast volumes of verbal fog will distract attention from the causes of the distemper. It is therefore important to bear in mind that increases of artificially-low, bank-imposed interest rates do not cause problems; rather, they reveal them. Increases of artificially-low rates, in other words, are the consequences of patterns of error set in train by central banks and committed by speculators-who-thought-they-were-investors.

An Incomplete Correspondence of Excess and Retrenchment

One of the most pervasive sets of events of the 2001-2002 financial year was a hand-me-down from previous financial years. Despite the “tech wrecks” of 2000 and 2001, many of the media, technology, telecommunications and other malinvestments of the 1990s remain incompletely liquidated. “Clusters of error,” as Murray Rothbard called them and whose realisation defines the bust which is caused by the boom, continue to percolate to the surface.

Consider the number and extent of the corporate errors (together with the shameful paucity of executive apologies, resignations and sackings) that have recently been confessed (“Firms That Lived By the Deal Are Now Sinking By the Dozen”, The Wall Street Journal 6 June). Most notably, AOL Time Warner, the world’s biggest media company, conceded in April that it paid a modest $US54 billion ($A96 billion) too much for its epochal betrothal of old and new technologies. Plus ça change. Like all other aspects of business, corporate mergers and acquisitions are inherently risky propositions. The stark truth is that many and perhaps most fail to achieve what their highly-remunerated creators confidently claim that they will achieve. Disturbingly, corporate deal makers are seldom in doubt and often in error. In Warren Buffett’s words: ‘the sad fact is that most major acquisitions display an egregious imbalance: they are a bonanza for the shareholders of the acquiree; they increase the income and status of the acquirer’s management; and they are a honeypot for the investment bankers and other professionals on both sides. But, alas, they usually reduce the wealth of the acquirer’s shareholders, often to a substantial extent.”

This write-down of AOL Time Warner’s balance sheet constitutes the biggest single loss in American corporate history. Much smaller in relative terms, but still colossal in absolute terms and just as painful to their shareholders, are the losses confessed by Qwest ($20-30 billion), WorldCom ($10-20 billion), NorTel ($12.3 billion) and Lucent ($8 billion) in the fourth quarter of 2001 and the first and second quarters of 2002. For those 350 or so American companies whose managerial débâcles First Call has been able to quantify, write-offs will total roughly $US48.5 billion; adding AOL Time Warner and the aforementioned “major players” to the pyre will, according to The Australian Financial Review (26 April), “probably push the final figure into hundreds of billions of dollars.”

The craze of the late 1990s was largely but not exclusively a new economy (as James Grant has noted, this label is no longer dignified with upper-case script) phenomenon. Accordingly, attention has been diverted from a closely related, equally significant but perhaps even more insidious development: in a significant number of companies shareholders’ equity – a company’s assets less its liabilities – is shrinking dramatically. AOL Time Warner’s write-down, for example, comprised no less than 36% of its equity. Equivalent or even more severe (in percentage terms) haircuts have been fashioned recently by the executives of Clear Channel Communications (56%), General Motors (32%), Gemstar TV Guide (68%) and AETNA (30%).

At the 2002 AGM of Wesco Financial Services Charles Munger identified an important and hitherto anonymous contributor to these repeated catastrophes. “There’s a lot wrong [with American universities]. I’d remove three-quarters of the faculty – everything but the hard sciences. But nobody’s going to do that, so we’ll have to live with the defects. It’s amazing how wrongheaded [the teaching is]. There is fatal disconnectedness. You have these squirrelly people in each department who don’t see the big picture.”

Generalising his point, Mr Munger continued: “this doesn’t just happen in academia. Companies can get balkanised. Look at what happened at Arthur Andersen and Enron. They weren’t all bad people, but their cultures were dysfunctional. It’s easy to create such a culture, in which you have good people but terrible results. Many areas of government are dysfunctional. Universities are complicit. They don’t feel guilty about the product they’re producing. ... We have the best universities in the world. They are strong in the hard sciences, but if you go to business, law, sociology. ... ”

“Deflation” and the Supply Hangover of the Noughties

The mania of the 1990s also distracted attention from development whose presence was felt increasingly, and sometimes forcibly, in Australia during the 2001-2002 financial year. For a decade or more, thanks in no small part to artificially-low interest rates (remember that cash rates in America fell to 3% in the early 1990s) and the consequent orgy of malinvestment in particular higher-order goods, more and sometimes vastly more of some primary resources, and of not a few secondary ones, has been supplied than has been demanded. (This cause of this phenomenon can by no means be laid exclusively at the door of central banks: the collapse of Soviet Communism and the consequent large-scale export of minerals and oil from ex-Soviet republics, together with the vast increase of China’s manufacturing abilities and the explosion of its foreign trade, have done much to increase the supply of many primary and secondary goods. So too has the torrent of subsidies from the world’s two most important bastions of Soviet-style agriculture: Brussels and Washington. In Western countries, increases in the productivity of various links of the structure of production may also have played a modest role).

This surplus of supply relative to demand has caused the prices of many goods and services to stagnate – and in many instances to decrease. Hence one of the defining delusions of our age: we live in an era of high inflation whose major consequences – pervasive malinvestment in many capital goods, consequent oversupply of many higher-order goods and stagnation of many prices – is not only ubiquitously and erroneously hailed as “low inflation;” to the extent that the prices of oversupplied goods and services fall, the consequences of high inflation are mistakenly dubbed “deflation.”

Accordingly, if the predominant condition of many industries around the world is glut; if glut compresses profit margins and earnings and thereby discourages efficient capital investment; and if governments seek to attenuate the downward leg of the business cycle and thereby to constrain the ability of busts to liquidate poor businesses, reallocate their assets to better ones and thus rebuild profit margins; then the predominant response of many companies in these industries is simultaneously to consolidate and cut costs.

Governments thus face increasingly clamorous commands to allow cartels to (re)develop so that margins and market shares can be fattened and labour and other costs pruned; large mining companies are merging and aggressively acquiring other mines in the hope that the supply of minerals and the costs of production can thereby be curbed; and perhaps most notably, a mammoth imbalance of supply vis-à-vis demand in telecommunications and IT (the epicentres of the mania of the late 1990s) will require several more years of retrenchments, liquidations and reconfigurations in order to return to some semblance of balance.

If this interpretation corresponds even roughly to reality, then neither demand nor capital investment (both of which are constrained by various but usually large loads of debt) will rise sustainably; accordingly, unless prices fall corporations and individuals cannot absorb the present excesses of supply. If demand will be subdued, in other words, then supply must adjust. In aviation, to give one extreme, the period of adjustment was drastically compressed by the attacks on 11 September into an unprecedented demand-side shock (and then aborted by mammoth handouts from governments). At the other extreme, the adjustment in IT and telecommunications has been and may well continue to be far more extended and even more painful.

Bust Denied Is Recovery Delayed

Booms can be artificially generated, market prices can for a time be suspended and rational calculation temporarily impeded. But as time passes the cumulatively pernicious consequences of erroneous and irrational calculations become ever more apparent; and to the extent that central banks, commercial banks and governments allow them to become apparent contemporaneously rather than retrospectively, or are unable to prevent their appearance, a necessary and salutary process, i.e., a bust, purges the excesses and absurdities of the artificial boom. Unfortunately, during the 2001-2002 financial year it became clear that America’s and Australia’s busts have been tentative and woefully incomplete. Indeed, over the past year governments and central banks – cheered to the rooftops by most economists, journalists and market participants – have moved heaven and earth in order to abort any restorative purging and to maintain and indeed extend the boom’s misallocations and excesses.

Each country’s present administration is the most profligate in its history. Well before 11 September the U.S. Government commenced its biggest spending spree since the 1960s. The domestic welfare budget has expanded by almost twice as much in the first two years of President Bush’s administration ($96 billion) as during Bill Clinton’s first six years in office ($51 billion). More generally, federal discretionary spending has grown by 41% and non-military expenditure by 35% since 1998. According to The Wall Street Journal (16 May), “although many economists portray this surge in expenditure as a stimulus to growth, the opposite is true. The runaway federal budget, which is up nearly $300 billion in just the last two years, and the parallel hike in taxes and debt needed to finance this spending binge, is America’s single most ominous domestic economic danger sign.”

Similarly, Australia’s Liberal-National coalition boasts its conservative pedigree but spends as if there will be no tomorrow. The key phrases are “big spending, big taxing. That is the Howard-Costello government in a nutshell. The size of government in Australia has surged under the six-year stewardship of the Howard Government to the point where overall government spending and taxing have reached record levels as a share of GDP. ... But it is not just the size of government that is a concern. It is also troubling that the mix of the massive spending spree is generally poorly directed” (The Australian Financial Review 13 May).

According to a former senior Treasury official (The AFR 12 December 2001), the Commonwealth has hitherto “preached prudence even though it has balanced its own accounts by raiding ours. ... In a recession the automatic stabilisers will push the Budget further into deficit. Any more discretionary spending and we will start to rebuild the public debt mountain we have so painfully paid off.” Peter Walsh (Confessions of a Failed Finance Minister, Random House Australia, 1995, ISBN: 0091829992), unheralded pillar of what was arguably the best (i.e., least worst) Commonwealth government: your country once again needs you. Lord Mayor Jim Soorley: Brisbane, Queensland and the country as a whole continue to need you.

Governments can grow only if they capture or co-opt resources owned by individuals, and individuals grow richer not by spending more but by accumulating more (and more productive) capital goods. In Canberra, the Treasurer and a phalanx of analysts and commentators are pointing towards “business investment” as a bulwark of prosperity in coming months and years. According to The Australian (16 May), Mr Costello “is pinning his hopes for continued strong economic growth on business investment and has singled out nine diverse projects as examples of the bullish investment climate.”

Two equivocations lurk in this statement. First, lost in the excitement is the fundamental distinction between investment and consumption; second, also obscured is the dependence of the “investment”, much of which is actually consumption, upon government subsidies. It follows that a significant amount of today’s “business investment” is actually disguised and possibly misdirected government expenditure.

The $1.3 billion Adelaide to Darwin rail project, for example, a boondoggle no previous Commonwealth government has been willing to underwrite, has received $200 million of direct support from Canberra and more from South Australia; Rio Tinto’s $1.5 billion aluminium refinery in central Queensland has received a $137 million interest-free loan from the Commonwealth and $150 million from the Queensland Government; Australian Magnesium Corp.’s $1.3 billion plant, also in central Queensland, has secured at least $250 million of government loan guarantees; the Commonwealth will extend $356 million of support to the $1.5 billion Western Sydney Orbital Road, and on and on. From these equivocations spring misconceptions and malinvestments. A typical example (The Australian 16 May): “Mr Costello said the $300 million redevelopment of the Melbourne Cricket Ground, which will be given $90 million by the Federal Government, would help drive growth.”

It is worth noting, whilst reflecting upon the state of contemporary public finance and the thinking that presently underlies it, not only that little of value has been learnt in recent decades: even worse, much of great value bequeathed to us by our forebears has been unlearnt and consigned to the dustbin. According to John Stuart Mill (Essays On Some Unsettled Questions of Political Economy, 1844), “the utility of a large government expenditure for the purpose of encouraging industry is no longer maintained. Taxes are not now esteemed to be like the dews of heaven, which return in prolific showers. It is no longer supposed that you benefit the producer by taking his money, provided that you give it to him again in exchange for his goods. There is nothing [to commend the doctrine] that the more you take from the pockets of the people to spend on your own pleasures, the richer they grow; that the man who steals money out of a shop, provided that he expends it all again at the same shop, is a public benefactor to the tradesman whom he robs; and that the same operation, repeated sufficiently often, would make the tradesman a fortune.”

John Quiggin (The Australian Financial Review 6 June) summarises the present situation: “… fiscal and monetary stimulus is a drug that must be used with care if habituation and addiction are to be avoided. If a temporary recovery is used as a reason for dodging necessary reforms, it may do more harm than good in the long run. Japan provides a cautionary example, [and there] is little sign that the need for reform in the U.S. has been recognised. ... The longer the necessary adjustments ... are delayed, the greater will be the eventual pain.”

Soft Expectations and Hard Experiences

During the latter half of the 2001-2002 financial year, economists’ and analysts’ soft expectations and capitalists’ hard experiences told ever more divergent stories. This disjuncture hints that the market prices of equity and debt remain greater, and in some instances much greater, than their intrinsic value. In America, according toThe Wall Street Journal (26 January), “based on stock valuations, expectations for a rebound in corporate profits this year are pumped up like they are on steroids, with the price-to-earnings ratios for S&P 500 companies almost two times the average. ... But wait a minute! Corporate executives, an often optimistic bunch, aren’t seeing a silver lining in the theories of economists, who are predicting an impending turnaround in the economy. ... In the hundreds of earnings reports that hit the market last week, there was little chest-thumping from corporate leaders about the outlook for profits.”

Alan Wood (The Australian 22 January) put this disparity into a particularly insightful perspective: “the economists forecasting this recovery are the same ones who failed to see the recession coming and failed to understand the nature and extent of the bubble that preceded it. Stock markets are still overvalued and the impact of the bursting bubble is still working its way through corporate America. The extraordinary case of the collapse of Enron raises the prospect that many more cases of bubble accountancy will be flushed out, with a corresponding effect on corporate and bank balance sheets, of the sort we saw in Australia in the late ’80s and early ’90s.”

Mr Wood continues: “if this proves to be the case, the extent of stock market overvaluation will increase as the earnings side of projected earnings ratios deflates. Further falls in share prices will have an effect on household balance sheets and spending and U.S. recovery will prove both feeble and drawn out.”

Mr Wood concludes that “there is probably not much more that Greenspan can do about these risks via monetary policy, even if he cuts rates further. If there are grounds for labelling this the Greenspan recession, it is not because of his failure to cut interest rates far enough or fast enough. If he has made a mistake it is his failure to burst the asset price bubble earlier, when he correctly recognised it in December 1996 as irrational exuberance. Instead he became the leading promoter of the new economy. ...”

Regression to the Mean

The last of the most noteworthy sets of events of the 2001-2002 financial year was also a hand-me-down from previous financial years. In Alan Sloan’s words (“Get Used to It: The Wall Street Party Is Over”, The Washington Post 4 June), “sorry to be a party pooper, but the bull market that defined a generation and linked Main Street and Wall Street more intimately than ever is over, and it won’t be back for years and years – maybe not in our lifetimes. ... The 30 percent S&P decline and the 70 percent Nasdaq decline from their peaks in March 2000 are a return to reality, not a passing hangover that will vanish tomorrow night when the party resumes.”

This latter point alludes to something that is presently discombobulating many market participants. In the words of Barrie Dunstan (The Weekend Australian Financial Review, 4-5 May), “what is happening is probably a drawn-out phase during which overpriced stocks of all types are coming back to earth. ... Forget about projections of economic growth in the United States or elsewhere. Stock markets at the moment aren’t about business prospects; they’re about the excessive valuations investors have been placing on shares. These valuations went far too high until early 2000. Now they are in the process of adjusting in what the experts call ‘reversion to the mean.’”

If so, and if (say) the DJIA reverts to its average rate of levitation of 8.4% per annum during the past fifty years, then it would either tumble to 7,250 by the end of 2002 (an implied and garishly unfashionable haircut of minus 28% from its level at the beginning of the year) or post zero gains for the next 4.5 years. According to Robert Fuller, cited by Dunstan, “you won’t hear much about reversion to the mean from investment managers – one never does when they are on the wrong side of it – but the process is one of the most logical and predictable long-term cyclical developments in markets.”

It is also imperfectly understood. According to Edward Kerschner of UBS Warburg, described by USA Today (2 January 2002) as “Wall Street’s leading cheerleader” and “the most optimistic forecaster” of 2002 (at the beginning of 2001 he predicted that the S&P 500 would rise by 29% during the year, versus its actual decline of 13%, and at the beginning of 2002 he forecast that it would rise 37% and end the year at 1,570), the notion of reversion to the mean is naïve. To demonstrate his point he pokes fun at himself: “my average body weight in my life is [72 kilograms]. I’m not going back there!” Alas, and seemingly unbeknownst to Kerschner, reversion to the mean is a group phenomenon that refers to an inverse correlation among roughly normally distributed observations that are drawn from a non-random sample and made repeatedly over time. An individual’s body weight does not have these attributes; but a large body of evidence indicates that the prices and results of financial market transactions do.

Value investors, as custodians of capital, seek at all times to buy quality assets at reasonable or bargain prices. Leithner & Co. therefore likes gloom, doom, pessimism and despondency – not for their own sake but because they help to make good businesses available at good prices. Accordingly, and for the reasons outlined in this Letter, the strong disbelief which have served us very well since 2000, will remain undiminished during 2002-2003.

At the same time, however, reasonable investment opportunities appeared sporadically during the 2001-2002 financial year and underwrote our results for the year. The hope is that similar or better opportunities will appear in 2002-2003; and the test is whether the decisions taken in response to any such opportunities will produce reasonable results.

Chris Leithner


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