Leithner Letter Nos. 48-49
26 December, 2003 - 26 January 2004

Most people get interested in stocks when everybody else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.

Warren E. Buffett
Newsweek (1 April 1985)

You do things when the opportunities come along. I’ve had periods in my life when I’ve had a bundle of ideas come along, and I’ve had long dry spells. If I get an idea next week, I’ll do something. If not, I won’t do a damn thing.

Warren E. Buffett
USA Today (9 August 1989)

There is more respect to be won in the opinion of this world by a resolute and courageous liquidation of unsound positions than by the most stubborn pursuit of extravagant and unpromising objectives.

George F. Kennan
Statement to the Committee on Foreign Relations, US Senate
Supplemental Foreign Assistance Fiscal Year 1966 – Vietnam

There is simply no avoiding the conclusion that the human race is mad. There are scarcely any human beings who do not have some lunatic beliefs or other to which they attach great importance. People are mostly sane enough, of course, in the affairs of common life: the getting of food, shelter and so on. But the moment they attempt any depth or generality of thought, they go mad almost infallibly.

David Stove
Against the Idols of the Age (1999)

The end of one calendar year and the beginning of the next is an appropriate time to reflect upon the outgoing year’s events, twists and turns, triumphs, trials and tribulations. It is also a time to place them into a broader context, consider their causes and consequences, learn one’s lessons and set one’s course for the new year. Stephen Roach encapsulated 2003 in a report dated 11 July and entitled “Been There, Done That.” Roach is sceptical about the conventional wisdom that the sharp rally of stock prices since March means “the long nightmare is over” and a “full-blown cyclical recovery” has begun.

In the words of Alan Abelson (Barron’s 14 July), Roach “is one of our favourite Street seers, not least, we confess, because these days he agrees with us on the economy and the market (maybe that should make us both nervous). Truth is, Steve’s a particularly acute weigher and sifter of what’s happening (he’s Morgan Stanley’s global economic guru, but we won’t hold that against him and trust you won’t either).” Abelson continued: “to Steve, [current conditions boil] down to what he calls ‘a classic policy bet.’ And he’s pretty certain it’s destined to prove a bad bet. ... The mistake [that the bullish contingent] makes, Steve argues, is that they assume the [present] business-cycle climate is normal. He’s convinced ‘it’s anything but.’ Instead, he, as we do, believes the economy is firmly in the grip of a ‘unique post-bubble’ business cycle, where standard [policies] are largely dysfunctional – having been all but neutralised by the excesses of the past eight years.” In his own words, Roach is “beginning to worry that since the current rally has now distinguished itself from the previous false starts, market spin is starting to take over in driving perceptions of underlying economic activity.” And that, he notes, is exactly what happened during the late 1990s – a time “when the bubble gave rise to a constant stream of ‘new wave’ interpretations of the New Economy.” Roach concludes that “this is all starting to have an eerie sense of déjà vu.”

In many countries, then, including Australia, Britain, Canada and (especially) the U.S., the boom of the late 1990s sowed the seeds of its own bust. Australia’s boom ended in 2000 (see Letters 12-13) and signs of bust gathered pace throughout 2001 (Letters 24-25). In the second half of 2001, throughout 2002 and into 2003, the Commonwealth Government and Reserve Bank of Australia moved heaven and earth in an effort to counteract the bust. These efforts, i.e., profligate fiscal and monetary policies, have cost much, achieved little of enduring value and may create difficulties in the future (Letter 30). To deny and attenuate a bust, in short, is to mute and delay a genuine recovery. Jim Puplava seems to agree. Well worth reading is his recent and three-part overview of American financial markets and general economic conditions (many of whose points apply, to greater or lesser degrees of approximation, to Australia):

  1. The ‘OK’ [unless something happens] Economy (5 September)
  2. The ‘OK’ [but fictional] Economy (12 September)
  3. The ‘OK’ [unbalanced and at risk] Economy (3 October)

A major theme of Puplava’s series is that mainstream statistics routinely conflate two distinct – and indeed, diametrically opposed – phenomena. The first is “healthy economic growth” and the second is “consumption that has been financed by credit rather than savings.” Under present conditions, it therefore seems to me that mainstream data tend to overestimate prosperity (see also Statistics: A Vehicle for Collectivist Mischief by John Wenders, Escaping from Depression by Martin Hutchinson and The Bubble Deflates by Jeremy Grantham). The Reserve Bank of Australia (5 November) puts this point rather diffidently. “Credit outstanding is rising at around 14 per cent per year, and at over 20 per cent to households. That is a much faster rate of growth than can be expected to be consistent with economic stability over the longer run. The strength of demand for credit increases the danger associated with delaying a tightening of policy that is called for on general macroeconomics grounds. Short periods of rapid credit growth have not typically been a major concern for monetary policy, but this growth has been sustained for some time and at present shows no sign of abating.”

Leithner & Co.’s attitude for 2004 is therefore sceptical and its plans remain cautious. More specifically, they remain based upon four unconventional premises. The first is that the excesses of the late 1990s remain imperfectly recognised and incompletely purged – and therefore that the prices of most financial assets are prohibitively high. The second is that government intervention in response to the bust has impeded rather than facilitated proper recovery. The third, a consequence of the first and second, is that Australia’s debt-propelled “recovery” has masked rather than counteracted the bust; and the fourth is that the underlying bust, given the country’s heavy reliance upon artificially low rates of interest and foreigners’ savings, may yet be sharp.

It is important to recognise, however, that the dour possibilities nominated for 2003 in Letters 36-37 have not eventuated. Fortunately, these unfashionable sentiments did not dampen Leithner & Co.’s results for the year. Instead of relying upon others’ forecasts, an investment program was devised that remained viable under very different (and quickly-changing) conditions. In absolute terms and relative to others – and bearing in mind that Leithner & Co. does not count unrealised capital gains towards its results – this program generated reasonable returns on equity in the January to June half and excellent ROE in the July to December half.

Another Year of Ignoring Mr Buffett

In 1956, Benjamin Graham retired and his investment company, Graham-Newman Corp., disbanded and distributed its assets among its investors. At its farewell dinner one investor lamented that “Graham-Newman can’t continue because the only guy they have to run it is this kid named Warren Buffett. And who’d want to ride with him?”

In 1969, Buffett liquidated most of the portfolio of Buffett Partnership Ltd and referred many of his investors to a disciple of Graham, William Ruane, who had worked with Buffett at Graham-Newman. Buffett said that he would invest much of his own money in municipal bonds and wrote an insightful letter (which repays reading and is reprinted in John Train’s The Money Masters, HarperBusiness, 1980, ISBN: 0887306381) that justified that decision. Buffet sold all but two of the partnership’s investments (both of which it controlled). One was a struggling manufacturer of textiles based at New Bedford, Massachusetts. Buffett’s investors could take either of these companies’ shares or an equivalent amount of cash. Buffett would take shares and thereby become Berkshire Hathaway’s biggest shareholder. As one of his oldest, most ardent and therefore wealthiest investors tartly summarised the situation, “that’s all anybody had to hear if they had any brains” (Roger Lowenstein, Buffett: The Making of an American Capitalist, Doubleday, 1996, ISBN: 0385484917).

In 1956 one could plausibly overlook and discount the formidably intelligent, earnest and energetic but as yet unknown young Buffett. Since the 1970s, however, his results have been sufficiently widely recognised so that only egomaniacs or morons (or both) ignore his views. Alas, in 2003 – and hardly for the first time – it seemed that few market participants were prepared to restrain their favourable opinions of themselves, study Buffett’s principles and emulate his behaviour. In Berkshire’s 2003 Annual Report, released on 8 March, Mr Buffett stated that “we [are doing] little in equities. [Vice Chairman] Charlie [Munger] and I are increasingly comfortable with our holdings in Berkshire’s major [holdings] because most of them have increased their earnings while their valuations have decreased. But we are not inclined to add to them. Though these enterprises have good prospects, we don’t yet believe their shares are undervalued.”

Mr Buffett continued: “in our view, the same conclusion fits stocks generally. Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us. That dismal fact is testimony to the insanity of valuations reached during The Great Bubble. Unfortunately, the hangover may prove to be proportional to the binge. The aversion to equities that Charlie and I exhibit today is far from congenital. We love owning common stocks – if they can be purchased at attractive prices. In my 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again. Unless, however, we see a very high probability of [earning] at least 10% pretax returns (which translate to 6% to 7% after corporate tax), we will sit on the sidelines. With short-term money returning less than 1% after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity.” (Whitney Tilson’s summary of and detailed notes taken at Berkshire’s AGM on 3 May 2003 remain well worth perusing.)

More recently, according to Barron’s (27 October), “the world’s most successful investor doesn’t see a lot that appeals to him right now. A patient Warren Buffett ... is sitting on an enormous cash hoard ... [and is] ... awaiting investment opportunities in the stock and bond markets.” On the stock market, Mr Buffett said, “we’re not finding anything [and] we’ve got more cash than ideas. The question is whether that will prevail for an unduly long time.” Similarly, on the junk bond market “we don’t see anything attractive.” Barron’s added that Buffett is “optimistic” that good opportunities will eventually arise; that Berkshire’s cash hoard grew from $10 billion at the end of 2002 to over $24 billion on 30 June (and to $27 billion of cash and cash-equivalents on 30 September, according to The Wall Street Journal on 7 November); and that in the past Berkshire has endured and ultimately benefited from fallow periods.

A Year of Much Pointless Activity

“If there’s nothing smart to do,” Mr Buffett said at Berkshire’s 2003 AGM, “cash is the default action.” Patience, preparation and a hefty cache of cash, in other words, are often the most sensible orders of the day. It follows that if prices are too high and quality insufficiently appealing, then the frequent buying and rapid selling that is the hallmark of most market participants is a pointless and ultimately damaging exercise.

Yet in financial markets and most walks of life, this is an age that demands “commitment” and “proactivity.” Faced with a perceived problem, someone must act immediately. Decisive engagement, it is commonly assumed, demonstrates purpose, concern, energy and courage. Today’s injunction is “don’t just stand there – do something!” Accordingly, to believe that there is usually much to be said for caution, deliberation and inaction (“don’t just do something – stand there!”) is to belong to a small and reprobate minority. But the case for prudence and inertness was not always suspect: indeed, a policy of calculated idleness once commanded widespread assent. Sir Robert Walpole, Britain’s first prime minister (1721-1742), famously let sleeping dogs lie. So too, for the most part, did Canada’s first prime minister (Sir John A. Macdonald, 1867-1873, 1878-1891). Similarly, Charles Maurice de Talleyrand-Perigord, the foreign minister of France during the late 18th and early 19th centuries, offered what is perhaps the wisest advice ever given to practitioners of foreign policy. He counselled “above all, gentlemen, not the slightest zeal” and practised an admirable distaste for pointless and destructive busyness.

The 20th century provides an overwhelming mountain of evidence that Talleyrand’s advice, presently ignored and derided, is eminently wise. Consider how the hyperactive Anthony Eden created the débâcle at Suez; how the frenetic Nikita Khrushchev’s desire in the Cuban missile crisis to upset the balance of terror pushed the world to the brink of nuclear war; and how the arrogant interventionist policies of the Ivy League’s best and brightest (few of whom, apart from Daniel Ellsberg, deigned to subject themselves to the same military dangers they inflicted upon others) set in train millions of Vietnamese, 55,000 American and 500 Australian deaths. Today we must endure Tony Blair’s incessant jetting around the world to no purpose other than impassioned hand-wringing. But in investing as well as diplomacy, constant and frenetic activity can have lasting and damaging consequences. It is therefore sobering to reflect that inspiration in financial markets presently seems to be drawn much more from Blair’s bustling and emotional “commitment” than from Tallyrand’s serene and logical detachment.

There is much to be said, then, for a calm attitude and disinterested policy (which is not the same as an uninterested approach). This does not imply that decisive action is never justified. Of course it is – but only on those infrequent occasions when the right conditions are present: when you have a clear sense of what you want; when you have established that what you want is available; and when you are sure that the opportunity cost of what you desire will not negate more important objectives. It is imperative, therefore, to look back for perspective, ahead for opportunity and in both directions with caution and a healthy dose of scepticism. When conditions are right, but not before, is the time to act decisively. At Berkshire’s 2003 AGM, according to Homespun Words of Wisdom, Mr Buffett said that “really outstanding investment opportunities are rare enough that you should really have a go at it when it comes around, and put a [significant] portion of your wealth into it. I’ve said in the past you should think of investment as though you have a punch card with 20 holes in it. You have to think really hard about each one, and in fact 20 is way more than you need to do extremely well as an investor.” Mr Munger hastened to add “this idea has zero currency in academic circles. Investment managers don’t feel they will make enough money this way. It’s so foreign to them.”

An Important Safety Tip

Unlike most market participants, value investors ignore both “market experts” and their predictions about the level of or movements in overall financial markets, prices of individual securities, etc. “The further one gets away from Wall Street,” Ben Graham reflected, “the more scepticism one will find about the pretensions of stock-market forecasting or timing. ... In our experience and observation, extending over 50 years, we have not known a single person who has consistently or lastingly made money by ‘following the market.’ We do not hesitate to declare that this approach is as fallacious as it is popular.” Mr Buffett has added that “forecasts may tell you a great deal about the forecaster; [but] they tell you nothing about the future.”

Similarly, although they strive to comprehend the principles of economics and to structure their investments so that they conform to these principles, value investors pay little attention to forecasts about the level and direction of interest rates, the exchange rate of the $A vis-à-vis other currencies, unemployment and so on. This is because economists’ ability to forecast these things is at best tenuous. In Mr Buffett’s words, “if Fed Chairman Alan Greenspan were to whisper to me what his monetary policy was going to be over the next two years, it wouldn’t change one thing I do.”

Paul Ormerod, author of The Death of Economics (John Wiley & Sons, 1997, ISBN: 0471180009), would likely applaud these sentiments. He says that economists should halt their pretence that they know more than they do. Ormerod visited Canberra in order to deliver the Chris Higgins Memorial Lecture on 29 September, and in that lecture he made three important points. First, economists’ forecasts are generally useless. Ormerod, whose talk was sponsored by the Commonwealth’s macroeconomics forecasting arm, the Treasury, said “some economic forecasters may believe they can make consistently accurate predictions, but no one else does ... [and] economic forecasters aren’t getting any better.” Further, investment and retail bank economists, “most with fat salaries and plush offices, were just part of their companies’ marketing teams” and their work was “a complete waste of time.”

Ormerod, once a senior economic forecaster at Britain’s National Institute of Social and Economic Research, offered an explanation of economists’ inability to forecast with any useful degree of accuracy. His second point was that the data and econometric models used to make forecasts contain very little genuine information about economic conditions and behaviour. Indicators such as retail trade data and capital expenditure numbers, for example, contain both “signal” and “noise.” “Signal is the bit that contains genuine information, and noise is, well, noise. ... There is a tiny bit of signal, but the data [are] otherwise indistinguishable from a random series.” Finally, Ormerod criticised the hubris of the world’s governments. He said they falsely believe that their interference with business cycles does more good than harm. “Governments suffer from the illusion of control. In the last 50 years governments [have had] a much bigger role in the economy and in society ... than [they did] in the previous 50 years, yet economic and social problems remain.”

A Year of Ignoring Economic History

Ormerod’s final point is much more important than it might appear at first glance. “When President George W. Bush took office in January 2001,” notes H.A. Scott Trask in an excellent article entitled Reflation in American History, “the Dow had been in decline for a year, the other markets since March. Within a month, the economy officially fell into recession. Bush responded with a mix of Keynes (tax cuts and higher government spending) and Friedman (cutting interest rates and pumping up the money supply). During that year, the Fed cut the federal funds rate 475 basis points, to 1.75%, and poured liquidity into the system by open market operations. The same remedy was applied, but with ever stronger doses, in 2002 and 2003. Despite this heady dose of inflation, as well as persistent efforts to ‘talk up’ the economy, the recession persisted into 2002 and the stock market continued to fall. The bust remained a bust, and no amount of money magic could restart the boom.”

Trask notes something that very few market participants observed during 2003. “We have seen it all before ... American governments have [long] tried and failed to restart business expansions by reflation. That is, they have tried to revive an inflation-driven economic boom that has stalled or collapsed by pumping new money into the system. In other words, they have tried reflating as the cure for the evils introduced by inflating. They have not yet succeeded in skipping over the inevitable contraction of the business cycle, but they have succeeded in worsening its severity and length and delaying sound recovery.”

William Graham Sumner, a perceptive student of American business cycles whom Trask cites, observed in 1896 that “for three hundred years our history has been marked by the alternations of ‘prosperity’ and ‘distress’ which are produced by the booms and their collapses. When the collapse comes, the people who are left long on goods and land always make a great outcry and start a political agitation. Their favourite device always is to try to inflate the currency and raise prices again until they can unload. ... [But] no scheme which has ever been devised by them has ever made a collapsed boom go up again.” Sumner identified why all of these efforts had failed: “the most far-reaching vice in all these [inflationist] schemes was that they led the people to believe that the methods of a ‘boom’ could be successfully employed in the place of the methods of thrift.” Then and now, in other words, inflationists claim falsely that a recovery necessitates no need to save, liquidate and retrench. Instead, they assure us, the government need only print large amounts of money, lavish much of it upon itself and favoured groups and lend the remainder at sub-market rates.

Trask also notes that one of the most powerful, persistent and pernicious of historical myths is that the Great Depression of the 1930s resulted from laissez-faire policies (see also Jim Powell, FDR’s Folly: How Roosevelt and His New Deal Prolonged the Great Depression, Crown Forum, 2003, ISBN: 0761501657; Murray Rothbard, America’s Great Depression, Ludwig von Mises Institute, 1963, 2000, ISBN: 0945466056; Gene Smiley, Rethinking the Great Depression: A New View of Its Causes and Consequences, and Ivan R. Dee, 2002, ISBN: 1566634725. In Modern Times: A History of the World from the 1920s to the Year 2000, Orion, 1992, ASIN: 1857990250), Paul Johnson identified a corollary of this myth: that President Herbert Hoover, “because of his ideological attachment to laissez-faire, refused to use government money to reflate the economy and so prolonged and deepened the Depression.” Yet as Trask and a host of others have demonstrated, Hoover held no such principles. Indeed, Hoover did exactly those things that the myth falsely states he did not do. Hoover was a corporatist, an inflationist and a statist who tried to enact every interventionist policy that he and his advisers could devise (see also Letter 39). And the evidence is mounting that his and FDR’s actions made things much worse rather than better.

During the 19th century, business contractions lasted fewer than four years and were not plagued by the sustained levels of unemployment and drops in industrial production that marked the 1930s. Slumps were accompanied by sharp reductions of bank deposits, bank notes, wages and prices – i.e., by deflation. During the slump, marginal and bankrupt firms, farms and banks failed in large numbers, banks called loans and the extension of new credit virtually ceased. At the same time, however (and precisely because the structure of production readjusted rapidly), after a short but sharp slump economic conditions revived. To be sure, times often remained difficult for several years; but equally clearly, people who sought work could find it with relatively little trouble, and surviving businesses and farms could borrow at rates of interest that reflected the supply of savings and capital goods. The bust, in essence, was a painful but salutary and restorative redirection of capital and labour from unprofitable pursuits towards more profitable ones.

Why, then, did the Great Depression last so much longer and was so much more severe than previous depressions? Because Hoover’s and Roosevelt’s proto-Keynesian fiscal and inflationary monetary policies depressed interest rates, maintained wage levels and thereby encouraged uneconomical activities to proliferate. These policies prevented deflation and thus delayed and enfeebled the robust liquidations and readjustments that a sound recovery required. As Trask notes and myth strives mightily to deny, a plethora of writers and economists at the time recognised that nothing good would stem from these policies. In August 1930, for example, Benjamin Anderson of Chase National Bank warned that the “depression has been prolonged and not alleviated by delay in making necessary readjustments.” And in 1933, Seymour Harris lamented that Hoover’s policies had “retarded the process of liquidation ... [and thereby] ... accentuated the depression” (see Benjamin Anderson, Economics and the Public Welfare: A Financial and Economic History of the United States, 1914-1946, Liberty Classics, 1949, 1979, ISBN: 0913966681).

More Ignorance of Economic History

Why on earth should the arcane and forgotten details of economic history concern today’s investors? It is not just that people who are ignorant of history are typically condemned to repeat it; those who repeat history are usually determined to ignore it. To deny the damage wrought by the policies of the 1930s, in other words, is to be oblivious to the damage wrought by analogous policies today. Trask concludes “it is too early to see the full consequences of the Bush-Greenspan reflation, but if the past is any guide we can expect the next decade to more resemble the 1970s than the 1990s.”

Murray Rothbard once said “it is no crime to be ignorant of economics, which is, after all, a specialised discipline and one that most people consider to be a ‘dismal science.’ But it is totally irresponsible to have a loud and vociferous opinion on economic subjects while remaining in this state of ignorance.” Conrad Black, the Anglo-Canadian media magnate who by his own admission is a forthright and vociferous person (A Life in Progress, Random House Australia, 1993, ISBN: 0091828651), recently advanced frank, enthusiastic – and demonstrably incorrect – claims about the Great Depression (“Capitalism’s Saviour,” The Wall Street Journal 29 October). Black defended the myth that President Roosevelt’s interventionist policies saved America and American capitalism. According to Black, Roosevelt “swiftly revived the American banking system;” his scheme to increase farm income by reducing production in exchange for subsidies “was a success;” and “in economic policy terms ... he produced a smorgasbord of measures, kept those that worked [and] made fairly steady progress through the 1930s.”

But as John P. Cochrane shows, Black tilts the scale heavily in FDR’s favour by making unemployment appear worse than it was at the beginning of his tenure and better than it was towards the end of the 1930s. As Cochrane also notes, Black conveniently overlooks the disastrous middle of Roosevelt’s tenure. Christopher Westley observed in The Roosevelt Nobody Knows that “by the midpoint of FDR’s second term [i.e., in 1937-38, the so-called “depression with the Depression”] the failure of New Deal policies was evident to all but the truly delusional. The unemployment rate again reached levels associated with the hated Hoover, while the public’s tolerance of the pretentious New Dealers and their endless attempts to control the economy waned.” The authors of A New Economic View of American History: from Colonial Times to 1940 (W.W. Norton, 1994, ASIN: 0393036227) conclude from their analyses that “a glance at almost any of the statistical data covering the period, such as unemployment, GNP, the money supply or prices, shows that no matter how kindly disposed one is to Roosevelt’s policies, recovery did not come with the New Deal.”

Today’s investors should acquire a passing acquaintance with this literature because the policies that many ardently believe revived Anglo-American countries during the 1930s – and which are presently in vogue among many American “conservatives” – actually generated more harm than good. (Scratch an American conservative Republican today and you typically encounter someone who wants to preserve FDR’s socialism at home and extend his militarism abroad.) Most foreboding of all, Robert Higgs (Crisis and Leviathan: Critical Episodes in the Growth of American Government, Oxford University Press, 1989, ISBN: 019505900X) shows that governments “rescued” their subjects from the frying pan 1930s by plunging them into the fire of world war (see also Thomas Fleming, The New Dealers’ War: FDR and the War Within World War II, Basic Books, 2001, ISBN: 0465024653). Cochrane concludes: “as to crisis management, these policies represent classic mismanagement – and not, as presented by Black, a ‘huge success.’”

An Appeal for Evidence-Based Government

This point leads to another consequence of the defiance of logic, denial of evidence and ignorance of history. Will Rogers, the American humorist and common man’s philosopher, once said “America has a great habit of always talking about protecting American interests in some foreign country. Protect them here at home. There is more American interest right here than anywhere.” If only its – and other countries’ – politicians would heed his advice. Alas, during 2003 major politicians in America, Australia and Britain (then-Congressman Ron Paul was a stalwartly honourable exception to this dismal rule) indulged themselves in jingoism and military adventurism (see also Letter 38). According to The Guardian (29 October), as many as 15,000 Iraqis – perhaps 4,300 of them civilian non-combatants – were killed in the first days of the Anglo-American invasion and occupation of that unhappy country; and Veterans for Common Sense has documented the sufferings and betrayals borne recently by American military personnel and their families (see also Casualties in Iraq).

“Take nothing on its looks; take everything on evidence” wrote Charles Dickens in Great Expectations. “There’s no better rule.” Alas, most of today’s politicians strenuously disagree. “Simply stated, there is no doubt that Saddam Hussein now has weapons of mass destruction” said Dick Cheney on 26 August 2002. On 4 February 2003 John Howard spoke not of suspicions or reasonable conjectures but “unqualified knowledge.” “The Australian Government”, he assured his compatriots, “knows that Iraq still has chemical and biological weapons, and that Iraq wants to develop nuclear weapons.” George W. Bush added on 30 May that “we found the weapons of mass destruction. We found biological laboratories. You remember when Colin Powell stood up in front of the world, and he said Iraq has got laboratories, mobile labs to build biological weapons. They’re illegal. They’re against the United Nations resolutions, and we’ve so far discovered two. And we’ll find more weapons as time goes on. But for those who say we haven’t found the banned manufacturing devices or banned weapons, they’re wrong, we found them.” And in June, Tony Blair reaffirmed that he “believed” that his claims about Iraq’s weapons had been “established beyond doubt.” His initial response to the inability to find these weapons was that he “strongly believed” that they would eventually be uncovered. He then amended his position into a strong belief that weapons programs would be revealed.

But no matter: on 18 July Mr Blair told the U.S. Congress that “history will forgive” the Anglo-American invasion of Iraq even if it transpires that Saddam Hussein posed no threat to neighbouring and more distant lands. Blair affirmed with “every fibre of instinct” that the March invasion was justified. But he also raised the possibility that WMDs may never be found in Iraq. Hence his conflation of separate issues and dissemination of fog: “can we be sure that terrorism and weapons of mass destruction will join together? Let us say one thing. If we are wrong, we will have destroyed a threat that, at its least, is responsible for inhuman carnage and suffering. That is something I am confident history will forgive. ... But if our critics are wrong, if we are right – as I believe with every fibre of instinct and conviction I have that we are – and we do not act, then we will have hesitated in face of this menace, when we should have given leadership. That is something history will not forgive.”

It is important in this matter to draw a distinction between politicians and bureaucrats. According to Case for War Confected (originally published in The Independent/UK 9 November), “an unprecedented array of US intelligence professionals, diplomats and former Pentagon officials have gone on record to lambaste the Bush administration for its distortion of the case for war against Iraq. In their view, the very foundations of intelligence gathering have been damaged in ways that could take years, even decades, to repair.” The Enlightenment bequeathed the idea that if we wish to make sense of the physical world then it is better to use reasoning and evidence (and tests thereof) rather than blind faith. But this is not how Messrs. Blair and Bush – or, come to think of it, Osama bin Laden – see things. To politicians such as Mr Blair, says Brian Toohey (The Weekend Australian Financial Review on 26-27 July), “the Enlightenment never happened. .... Mr Blair is a throwback to the medieval era. For Blair, it is enough for something to be right if he believes it. ... Blair is the pre-eminent exponent of a pre-Enlightenment form of politics in which the facts count for little. Although he lacks Blair’s flashing-eyed fervour, Bush is not far behind.”

These statements of major Anglo-American politicians, and the thinking that underlies them, hold two fundamental but unrecognised lessons for investors. First, the evidence (“intelligence”) upon which momentous decisions are often based is typically imperfect and incomplete – and perhaps biased or simply incorrect. Further, the secret nature of “intelligence” and “inside information” invites decision-makers to misinterpret and misuse it. “The beauty of intelligence as grist for [the Liberal-National] coalition’s information and public diplomacy campaign,” said The Weekend Australian Financial Review (8-9 November), “was that because of its secret, unverifiable nature, its value at any given moment was whatever governments chose to put on it – and no one could contradict them. Before the war, intelligence material was the trump card in governments’ hands, unbeatable because (unlike, say, economic data or legal opinion) no one else could assess it.”

Rumour, unverified and unverifiable (“inside”) information, then, is not a precious commodity: it is dangerous stuff that can explode in its user’s hands. Investors should recall that when he was asked why he works in Omaha rather than New York (i.e., half a continent from the epicentre of the financial rumour mill), Mr Buffett replied “with enough inside information and a million dollars you can go broke in a year.” Analogously, Charley Reese (Don’t Trust Government) recounts an off-the-record interview conducted years ago with the man who prepared the president’s daily intelligence briefing. “He explained in detail how it’s prepared. This was during the first Bush presidency, after the first Gulf War. The current president’s father had used as an excuse to rush American troops to Saudi Arabia the idea that the Iraqi forces in Kuwait were about to invade the kingdom. So I asked the guy, who had talked about his access to all the latest satellite imagery, ‘Did you at any time see any evidence that Iraqi troops were massing for an invasion of Saudi Arabia?’‘Off the record?’ he said as a reminder.

‘Off the record,’ I replied.

‘No,’ he said.

“So, 13 years later, you can know that two President Bushes have led this country into war in the Persian Gulf on false pretences. It’s no wonder the White House loves secrecy so much. The wonder is that the American people are so tolerant” (see also Lying in State) by Butler Shaffer.

A second important lesson for investors relates to the political “insiders” who, it seems, interpreted “inside” information about Iraq so erroneously. Before the invasion, their egos did not allow them to disclose to their publics that their “intelligence” (i.e., both their information and the brains that interpreted it) was imperfect; today, their egos do not permit them to admit that either their information or their interpretation (or both) was faulty; and their egos throughout this sorry episode have encouraged them to ridicule and denounce doubters and dissenters. During 2003, in other words, political élites in Australia, Britain and the U.S. succumbed holus-bolus to ‘The Institutional Imperative’ and their capacity to measure and conduct risk management was exposed as risible.

Political “leaders,” then, routinely make dreadful mistakes that cost countless dollars and sometimes many lives. But they cannot bring themselves to state the obvious. They fuse their ambition and an imaginary “public interest,” surround themselves with sycophants and seldom personally experience the disastrous results of what they wreak upon others (read Glendon Schubert’s The Public Interest: A Critique of the Theory of a Political Concept, The Free Press, 1960, and never again will you encounter this utterly vacuous phrase without laughing). In contrast to politics – which is based upon lies, equivocations, wishful thinking and evasions of responsibility – good economics seeks clear laws, valid cause-effect relationships and reliable evidence. In his excellent new book (Applied Economics: Thinking Beyond Stage One, Basic Books, 2003, ISBN: 0465081436) Thomas Sowell observes that politicians usually draw their lavish taxpayer-financed pensions before the invidious consequences of their actions come home to roost.

Hence taxes are economically harmful but politically advantageous. Sowell shows, for example, that during the past four decades New York City has suffered a succession of mayors whose tax rises have driven two-thirds of Fortune 500 corporate headquarters out of the city. Similarly, government-run medical industries mean higher costs, longer waits and less time with doctors; anti-discrimination laws destroy jobs for minorities; state insurance laws subsidise car crashes; ”defence” spending means aggression abroad and less liberty at home, and on and on ad infinitum.

Reichsmarshal Hermann Göring has shed disturbing light upon the political tricks that frighten people into the false belief they need more laws, services and protection. During the Nuremburg War Crimes Trial, Göring mused to an interviewer “why, of course, the people don’t want war. Why would some poor slob on a farm want to risk his life in a war when the best that he can get out of it is to come back to his farm in one piece? Naturally, the common people don’t want war; neither in Russia nor in England nor in America, nor for that matter in Germany. That is understood. But, after all, it is the leaders of the country who determine the policy and it is always a simple matter to drag the people along, whether it is a democracy or a fascist dictatorship or a Parliament or a Communist dictatorship.”

“There is one difference,” his interviewer interjected. “In a democracy the people have some say in the matter through their elected representatives, and in the United States only Congress can declare wars.” Göring was unimpressed. “Oh, that is all well and good, but, voice or no voice, the people can always be brought to the bidding of the leaders. That is easy. All you have to do is tell them they are being attacked and denounce the pacifists for lack of patriotism and exposing the country to danger. It works the same way in any country” (see Gustave Gilbert, Nuremberg Diary, DaCapo Press, 1995, ISBN: 0306806614; see also Hans-Herman Hoppe, Democracy, The God That Failed: The Economics and Politics of Monarchy, Democracy and Natural Order, Transaction Publishers, 2002, ISBN: 0765800888).

The Year They Nationalised Grief

For decades, Australian politicians were content to limit their predations to the expropriation of Australians’ property. In recent decades they extended their reach to the subsidisation of joy; and in 2003 they stooped to the nationalisation of grief. Geoffrey Barker, in an outstanding op-ed article (“Playing at Patriot Games,” The Australian Financial Review 20 October), wrote that “the demands of Australian patriotism are becoming too onerous. Loyal Australians are now expected, on demand, to join uncritically in simultaneous shows of mass grief and triumphant nationalism. Those who are uneasy about emotion-charged spectacles, who cannot ‘feel’ deeply enough to ‘become involved’ or who find them banal and undignified, are seen as uncaring or cynical towards their fellow Australians and their country.”

Barker says that this phenomenon has been accentuated by the co-incidence of three recent events: the ceremonies commemorating the first anniversary of the Bali bombing; the commencement of the Rugby World Cup; and Matthew Hayden’s record 380-run innings in test cricket. According to Barker, “the Bali and rugby ceremonies reflected the extremes of mass grief and nationalist glory. Both were produced show-biz events, contrived to elicit mass emotional responses and to leave no room for individual scepticism or reserve. Both were profoundly manipulative.”

It was once enough for an Australian to love his sunburnt country, its surf (and volunteer SLSCs), footy (and amateur RFCs), unpretentious people and uncomplicated lifestyle. But no longer: “in a potentially sinister evolution, bloated and seemingly interminable spectacles of grief and glory have become authoritarian politics continued by other means. ... And the unspoken subtext is always the same: here in our grief, here in our athletic (or military) triumph, we stand united. One nation. One people. Opposition or even scepticism is unseemly and unpatriotic, an affront to Team Australia.” Barker concludes perceptively that “in these circumstances, the true patriot is not he or she who joins in the wails and the whoopee. The true patriot is the dissenter who dares to question the creation and manipulation of mass politically correct opinion” (see also What’s So Special About Those Killed by Hijackers on September 11, 2001? by Robert Higgs).

A Fair Dinkum Patriotic Australian

David Stove (1927-1994), a philosopher at the University of Sydney, was a true (and hence reviled by a few and unsung and even unknown to most of his countrymen) Australian patriot. According to Scott Campbell, “the greatest philosopher of the twentieth century may not have been Wittgenstein, or Russell, or Quine (and he certainly wasn’t Heidegger), but he may have been a somewhat obscure and conservative Australian named David Stove. If he wasn’t the greatest philosopher of the century, Stove was certainly the funniest and most dazzling defender of common sense to be numbered among the ranks of last century’s thinkers.” Another admirer, Michael Levin, added “reading Stove is like watching Fred Astaire dance. You don’t wish you were Fred Astaire; you are just glad to have been around to see him in action.”

Stove’s literary executor summarised Stove’s many dislikes. “The list of what he attacked was a long one, and included, but was certainly not limited to, Arts Faculties, big books, contraception, Darwinism, feminism, Freud, the idea of progress, leftish views of all kinds, Marx ... metaphysics, modern architecture and art, philosophical idealism, [Sir Karl] Popper, semiotics, Stravinsky and Sweden. ... Also, anything beginning with ‘soc’ (even Socrates got a serve or two).”

The executor continued: “there is something to offend nearly everyone in Stove’s essays. One can imagine the reaction of his colleagues at the University of Sydney when, in 1986, he published A Farewell to Arts: Marxism, Semiotics, and Feminism. This bombshell begins: ‘The Faculty of Arts at the University of Sydney is a disaster-area, and not of the merely passive kind, like a bombed building, or an area that has been flooded. It is the active kind, like a badly-leaking nuclear reactor, or an outbreak of foot-and-mouth disease in cattle.’ Stove went on to quote from, and ridicule, the work of several of his colleagues. He cheerfully identified one egregious offender by name, concluding that, intellectually, ‘the sum of Marxism, semiotics and feminism is 0 + 0 + 0 = 0.’ It was around that time that university administrators spoke of bringing nebulous ‘disciplinary proceedings’ against Stove.”

David Stove’s attraction to the value investor is twofold. The first is his preparedness to accept denigration and obscurity as the price of unstinting adherence to worthy principles. According to Campbell, “although there are some who feel that Stove’s work should be removed from libraries, there are a few others who feel that [he] should be accorded the status of national treasure. That will probably never happen, though, and not just because he is so spectacularly out of fashion. He is just too contrary, too sarcastic and too good at going in for the kill to become beloved by large numbers of Australians. He could not suffer fools gladly. Neither was he a follower of party lines.”

Secondly, what preoccupied Stove was reasoning – and, in particular, the ways people commit errors of reasoning. A staunch defender of good old fashioned common sense, Stove demonstrated how the thought of great (or at least highly regarded) intellects could go spectacularly wrong – and how the unheralded common man and a tireless adherence to common sense could get it right. Applied to finance and investing, Stove showed that élite and institutional “smart money” can actually be breathtakingly stupid. As Roger Kimball, editor of a summary collection of Stove’s writings (Against the Idols of the Age, Transaction Publishers, 1999, ISBN: 0765800004) says, his “first allegiance was always to the best argument, whoever propounded it.” It is a great pity that Stove is not here today to deflate economic and market forecasters, speculators, politicians and other pretentious and dangerous Australians.

Approaching 2004: Times Change But Principles Don’t

On three occasions during the 2002-2003 financial year, employees of three investment institutions (each of which, interestingly, had a minus sign in front of its results in 2001-2002 and again in 2002-2003) expressed incredulity at Leithner & Co.’s cautious and contrarian stance and heavy weighting towards cash-equivalents. They counselled that cash be reduced to “industry benchmarks” and requested that I justify such an unconventional allocation.

I replied with a point made by Charles Munger, Chairman of Wesco Financial Corp. (a subsidiary of Berkshire Hathaway Inc), at Wesco’s 1993 AGM. Asked why Berkshire did not write a volume of insurance policies commensurate with its size, Mr Munger replied “people are always saying to Berkshire, ‘gee, why don’t you write a lot more volume in relation to capital? Everyone else is doing it. The rating agencies say that you can write twice as much in annual volume as you have in capital.’ And they look at our $US10 billion in insurance capital and say, ‘that’s $20 billion a year. What are you doing writing only $1 billion?’ But then ... somebody else comes in and asks ‘why did everybody get killed last year but you?’ Maybe the questions are related.” The point, then, is not to do business: it is to do sensible and profitable business. After I related this anecdote, each of the three stared uncomprehendingly at me and repeated their mantra that Leithner & Co.’s holding of “dry powder” is much too high.

According to H.L. Mencken, “men become civilised, not in proportion to their willingness to believe but in proportion to their readiness to doubt.” Mencken’s Razor thus excises from civilisation most of today’s market participants and politicians: but perhaps it spares some investors, capitalists and businesspeople. Value investors, as custodians of capital, kick the tyres, look under the bonnet and make cautious bids. They strive at all times and on the basis of cautious assessments, in other words, to buy 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; and because the Company is a net saver (and therefore a net purchaser), my preference for 2004 is that the quality of the businesses we own (or seek to own) improves but that the prices at which we are able to buy them falls. In Mr Buffett’s words, ”only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.” Don’t ask me to forecast, but do ask in a year’s time whether 2004 was a good year for purchasers.

Leithner & Co., like many of the inhabitants of Terra Australis, takes a break during the latter half of December and the first fortnight of January. Best wishes for a pleasant summer and Christmas holiday, happy New Year, easygoing Australia Day and healthy and prosperous 2004.

Chris Leithner


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