Leithner Letter No. 55
26 July, 2004

The issue is whether this process has gone too far – that is, whether investors are failing to take adequate account of the risks. ... Forming such a judgment requires a view on the level of asset prices that would be ‘appropriate’ given economic fundamentals. Unfortunately, economists are not very good at this – but neither is anyone else, including Wall Street analysts.

Donald Kohn, Board of Governors, U.S. Federal Reserve
Monetary Policy and Imbalances (6 April 2004)

We have, I believe, a reasonably good understanding of why Americans have been able to incur significant increases in debt and yet [avoid] the disruptions so often observed as a consequence. ... Our meagre domestic savings, and those attracted from abroad, are being very effectively invested in domestic capital assets. The efficiency of our capital stock has been an important offset to what, by any standard, has been an exceptionally low domestic saving rate in the United States. Although saving is a necessary condition for financing the capital investment required to engender productivity, it is not a sufficient condition. ... It is thus difficult to judge how significant a problem our relatively low gross domestic saving rate is to the future growth of an efficient capital stock. The high productivity growth rate of the past decade does not suggest a problem. But our success in attracting savings from abroad may be masking the full effect of deficient domestic saving.

Alan Greenspan, Board of Governors, U.S. Federal Reserve
Globalisation and Innovation (6 May 2004)

It’s too bad that Hayek’s The Pure Theory of Capital is no longer being read and that nobody tries now to work on it. The relation of money capital to pure capital has still to be [elaborated]. It’s terribly important ... but what some people did with the monetary approach was to concoct some terribly – well, how should I say?–esoteric formulations, which are quite unhelpful.

Fritz Machlup
The Austrian Economics Newsletter (1980)

Leithner & Co. Pty Ltd is a private investment 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 arrival of 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 under principles, revisit these principles, learn one’s lessons and adjust one’s sails for the next twelve months.

One Man’s Consensus, Another’s Imbalance

Optimism – one is tempted to say exuberance – increasingly prevailed among virtually all Australian market participants during 2003-2004. Indeed, recent surveys indicate that spirits have seldom been higher. The Weekend Australian (6-7 March) trumpeted that “Australian business never had it so good” and The Australian Financial Review simultaneously applauded the country’s “miracle economy.” Similar sentiments are appearing on the other side of the Pacific. According to The AFR (11 May), “there is no stopping the U.S. economy. ... The overwhelming consensus among market economists is that the U.S. is in the midst of a sustainable, solid economic recovery.” The chief economist at a major institutional investor told The Wall Street Journal (13 May) “the economic outlook looks excellent. What we’re going to have is solid growth ... with subdued inflation and improved corporate profits. But along with that we are getting a rise in interest rates because it is no longer appropriate to have as accommodative a monetary policy as we have had.”

More than 61% of the professional investors responding to Barron’s most recent (3 May) Big Money Poll regard themselves as either bullish or very bullish about the prospects for the U.S. economy and stocks through the end of the calendar year (26.7% are neutral, 12.0% are bearish and 0.0% are very bearish). The bulls’ ranks have thinned slightly since the northern autumn (see Barron’s 27 October 2003), but their lofty expectations have endured. Bulls expect that the Dow Jones Industrial Average will reach 11,042 and the S&P 500 1212 by the end of calendar 2004. The bears (whose number, Barron’s notes, has sagged to an historic low) expect the Dow to drop to 9,436 and the S&P to 1,017.

It is always instructive to think for oneself and to investigate alternatives; and emotional detachment and intellectual independence can be most profitable when the crowd queues ever more confidently on one side of a debate. Alan Wood, it seems to me, was and is far closer to the mark. He wrote a year ago in The Weekend Australian (24-25 May 2003) “the critical issue for the world economy and investors [including Australian investors] over the next few years is how and how quickly the United States works off the major imbalances in its economy – low savings, high public and private debt, a large external deficit, massive foreign borrowing and an overvalued stock market and currency.”

Wood is not alone. William L. Anderson also noted a year ago in Recovery or Boomlet? “an economic recovery occurs when consumers and investors begin to direct investments into sustainable lines of production. A recovery can only happen after the malinvestments that accumulated during the previous boom are substantially liquidated.” Alas, since 2000 governments have moved heaven and earth in order to soften and corrupt the bust. Anderson therefore warned “this is not a recovery but simply an unsustainable mini-boom that makes the long-term picture even worse.” Albeit for different reasons, Stephen Roach (“The Long Road” 14 May) agrees: “I continue to believe that the rebalancing of a lopsided, U.S.-centric global economy will be the big macro call over the next three to five years. ... The evidence suggests that the process has barely begun.” Roach concludes “until the adjustment process enters [a] more fundamental phase, I believe any recovery in the world economy can only be tenuous at best. It’s likely to be a long and arduous journey on the road to global rebalancing.”

The ultimate causes of these economic and financial imbalances are the ideas and policies that became and have remained orthodox since the 1930s. Their proximate causes include the mindset that inflated The Great Bubble of the 1990s. If so, then an investor’s plans for the future depend heavily upon his assessment of the past; and a misdiagnosis of that past is likely to lead to an even more error-ridden prognosis of the future.

For several years, my appraisal of recent history has been severe and my assessment of the road ahead has been correspondingly cautious. Letter 24-25 (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 and signs of bust gathered pace in 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, 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. Leithner & Co. will [therefore] be in no hurry to sing ‘Happy Days Are Here Again.’”

In mid-2002 (see Letter 30) and again mid-2003 (Letter 42) this cheerless assessment remained unrevised and unrepentant. And in at least one respect it has been vindicated. Scepticism and caution have not crimped Leithner & Co.’s fortunes. Quite the contrary: they have helped it to generate quite reasonable (both relative to others and in an absolute sense) results since its inception in 1999; and notwithstanding the Company’s hefty cash weighting and conservative tallying (unrealised capital gains, for example, are not counted towards its results), doubt and prudence have enabled it to extend these reasonable results into the 2003-2004 financial year. But this good fortune should not obscure the fact that for the last several years it has generally been difficult to locate quality investments at sensible prices. Interestingly, Warren Buffett seems to concur. In Berkshire Hathaway’s 2003 Annual Report, posted on the Internet on 6 March 2004, Mr Buffett stated that he has “found it hard to find significantly undervalued stocks” and suggested more generally that the prices of both stocks and bonds are forbiddingly dear. If prices fell to attractive levels then he would buy aggressively. Berkshire certainly has the means to do so: during 2003 its holdings of cash and cash equivalents trebled to $US31.3 billion – an amount equivalent to 40.3% of its shareholders’ equity of $US77.6 billion. Mr Buffett acknowledged that Berkshire’s capital is presently underutilised and that the interest the company earns from its mammoth hoard of cash is “pathetically low.”

Mr Buffett added “we are neither enthusiastic nor negative about the portfolio we hold. We own pieces of excellent businesses – all of which had good gains in intrinsic value last year – but their current prices reflect their excellence. The unpleasant corollary to this conclusion is that I made a big mistake in not selling several of our larger holdings during The Great Bubble. If these stocks are fully priced now, you may wonder what I was thinking four years ago when their intrinsic value was lower and their prices far higher. So do I.” Finally, “when we can’t find anything exciting in which to invest, our ‘default’ position is U.S. Treasuries. No matter how low the yields on these instruments go, we never ‘reach’ for a little more income by dropping our credit standards or by extending maturities. [Berkshire’s Vice Chairman] Charlie [Munger] and I detest taking even small risks unless we feel we are being adequately compensated for doing so. About as far as we will go down that path is to occasionally eat cottage cheese a day after the expiration date on the carton.” (The notes taken by Whitney Tilson at Berkshire’s and Wesco Financial Corp.’s recent – 1 and 5 May respectively – AGMs are well worth perusing.)

Given the Graham-and-Buffett principles of investment that guide it, Leithner & Co. retains its part-ownership of a swag of businesses; continues to search assiduously for additional quality assets at sensible prices; and during the past year has been very sceptical about the rosy lenses through which most market participants have viewed economic and financial developments in Australia. It is therefore cautious about prospects for 2004-2005 and is hoarding a hefty cache of cash as a buffer against others’ excesses. “The fact that people will be full of greed, fear or folly is predictable,” said Mr Buffett in 1985. “The sequence is not.” Thus, “when much of the rest of the investing world, burdened by debt, encounters some crisis forcing a panic, we are standing there with no debt and a loaded gun of cash ready to bag rare and fast-moving elephants.” Armed with plenty of ammunition and Mr Buffett’s insight, we therefore await with equanimity Mr Market’s next descent into despondency.

Sean Corrigan wrote in Six Myths of the Crash that “the most striking feature of the typical economic discussion is the persistent state of denial. ... Also notable is the unthinking promulgation of a species of economic fallacies which, though long since discredited, keep springing up like weeds to choke our reasoning about where we might go from here and, therefore, of how we should be preparing to act.” These six myths are:

Myth #1 : “the consumer” comprises two-thirds of “the economy”;

Myth #2 : central banks’ policy of hyper-low interest rates and easy credit creates and maintains prosperity, and promotes recovery from a “slowdown”;

Myth #3 : spending by individuals and governments promotes prosperity and recovery;

Myth #4 : dividends are outré and capital gains are king;

Myth #5 : the U.S. recently faced the risk of deflation;

Myth #6 : the prices of stocks always rise. Hence the bull market will resume this quarter – and if it doesn’t then it certainly will in the next quarter or the one after that.

Anglo-Saxons’ Cheery Consumption of Capital

These and other fallacies (see also Letter 51, Letter 52 and Letter 53) are encouraging something – the consumption of capital – that is rarely mentioned because it is neither widely recognised nor well understood. The contemporary mainstream fixates upon short-term consumption and the classical economists focused upon long-term growth. Austrian School economists, on the other hand, direct their attention towards the “real coupling” (as Roger Garrison has called it) of the two, i.e., the trade-off between consumption today and possibly greater consumption in the future.

This coupling requires capital and its comprehension necessitates a coherent theory of capital. If labour and nature’s endowment are regarded as original means of production, and if consumer goods are the ultimate end towards which production is directed, then capital links original means and ultimate ends. A drastically oversimplified example: to produce motor cars one requires car parts, machinery and labour; to construct car parts one requires metal, plastic, machinery and labour; to produce metal one requires ore, machinery and labour; and to extract ore one requires labour and machinery. In order to comprehend these production processes’ technical aspects one consults engineering and management science; and to understand their economic characteristics one refers to economic science and capital theory (see also Letter 41).

In an interview in the Austrian Economics Newsletter, Professor Garrison noted that John Maynard Keynes “threw capital theory out of macroeconomics. ... He was proud to have found a way to break macro loose from all the thorny issues of capital theory.” So too “those trained in the Chicago tradition. They all learnt ... that they didn’t have to pay attention to capital and so they ignored it. They have always considered it irrelevant to macroeconomics. ... When [Milton] Friedman launched the counter-revolution against Keynes, one point he never attacked was the throwing of capital out of macro.”

Contemporary mainstream macroeconomics is thus labour- and consumption-based; that is, it focuses upon (and its policy prescriptions give a privileged position to) employment and consumer expenditure. It virtually ignores – and its resultant policies tend to trivialise and even denigrate – savings, capital and investment. (The “investment” promoted by politicians and lobbyists is actually a plea for subsidised consumption by favoured groups.) Professor Friedman’s oft-quoted remark “we’re all Keynesians now” meant that a framework based upon employment and consumption underlies both his and Keynes’s economics. In sharp contrast, capital lies at the core of modern Austrian macroeconomics (see in particular Roger Garrison, Time and Money: The Macroeconomics of Capital Structure, Routledge, 2001, ISBN: 0415079829; Steven Horwitz, Microfoundations and Macroeconomics: An Austrian Perspective, Routledge, 2000, ISBN: 0415197627; and Peter Lewin, Capital in Disequilibrium: The Role of Capital in a Changing World, Routledge, 1999, ISBN: 0415147069).

The mainstream, then, tends to trivialise or ignore capital. It is therefore refreshing that four recent articles written by Paul Kasriel of Northern Trust provide important insights into the contemporary consumption of capital. (The Reserve Bank occasionally publishes indirect insights into the health or otherwise of capital in Australia. See, for example, its Statement on Monetary Policy dated 7 May). Kasriel refers to the U.S. but raises points that also apply, to greater or lesser extents, to other Anglo-Saxon countries.

In the most recent article, Businesses Save So That Households and Governments Can Spend (5 March), Kasriel shows that saving by American businesses presently stands at a record high. Alas, businesses are re-investing relatively little (roughly 50% – the smallest percentage since the Second World War) of their undistributed profits. Total domestic savings have also fallen sharply. Indeed, relative to income they are currently lower than at any time since the Great Depression.

Combined (i.e., personal and government sector) savings have also tumbled. Not only have they fallen to zero: for the first time since the Second World War they are negative. Hence “dissaving” and the consumption of capital are presently widespread. According to Kasriel, “record federal budget deficits and households continuing to party like it’s 1999 – that is, saving very little – is what has put combined personal and government savings below zero. Throughout most of the post-war era, the sum of personal and government net savings was higher than business saving. The implication of this is that the household and government sectors were curbing their enthusiasm for current spending so that businesses could build up their capital stock – the true source of wealth and future rising standards of living. But not now.”

Like most goods and services, savings need not derive from domestic sources. As Tennessee Williams might have put it, they can also come from the kindness of strangers. During the nineteenth century, for example, British savings underwrote much of the accumulation of capital in Argentina, Australia, Canada and the U.S.; and during the past twenty years foreigners have been increasingly – to the point where today they are extraordinarily – kind to Americans. Kasriel notes that foreign savings in the U.S. are close cousins of that country’s trade deficit: as domestic savings have sunk to record lows, foreigners’ savings destined for the U.S. have levitated to unprecedented highs.

It is amusing to hear that many Americans regard Britons and Australians as their strongest friends and supporters (and vice versa). But military bonhomie and economic reality are two very different things. Very few realise that these days Anglo-Saxons’ best friends by far are savers in China, Japan and Taiwan (and to some extent France and Germany). These thrifty foreigners – or, to be more precise, their central banks – are financing contemporary Anglo-Americans’ appetite not for capital but for consumer goods such ever-bigger and luxurious houses and motor cars and longer and more lavish and exotic overseas holidays. In military and diplomatic terms they are not members of the “coalition of the willing.” But in an economic sense they are the most eager of all: they are underwriting Anglo-Saxons’ welfare states at home and military adventures abroad.

Kasriel observed that, like Australians, Americans “have been basically throwing a big party with the capital that the rest of the world has been advancing us.” Probably without understanding what they are doing – flying in the face of the juvenile (“bring’em on”) jingoism rampant in a country in which the stars and stripes seems to adorn every other residence – Americans have been reducing the extent to which they are (re)investing in America. This consumption of capital does nothing to increase the likelihood that they will continue to enjoy the growth and prosperity to which many believe that they are entitled. Kasriel adds that the recent surge of productivity in the U.S. – which according to many, including Mr Greenspan, can offset its low savings – is much more apparent than real. Productivity has been rising not because workers are becoming more productive but because during the past few years less productive workers have been pruned from the workforce.

Given this deceleration and in some instances absolute reduction of investment, and bearing in mind that capital depreciates over time in various ways and at varying rates, it follows that a greater percentage of this reduced investment must be allocated to the replacement of depleted or obsolete capital – leaving ever less to add to the capital stock. And so it appears: in 2002, GDP net of depreciation was the smallest percentage of GDP since records began in 1929. Not even during the Great Depression, in other words, did Americans eat their seed corn as voraciously as they do now.

According to Kasriel, the rest of the world currently supplies to the U.S. an average of approximately US$1.5 billion a day. “Given that we are throwing a party with these proceeds rather than investing for our future growth, our foreign benefactors are likely to start wondering how we will be able to pay them interest and dividends on a timely basis in the years ahead. In fact, it looks as though that already is starting to happen among private foreign investors. ... Although foreign private demand for US$-denominated assets may be waning, it has not yet collapsed. But as we keep partying on, using foreign capital to finance our purchases of more SUVs, McMansions and government entitlement programs, it could dawn on more foreign investors that we might intend to pay our interest and dividends in [freshly-printed] greenbacks. In other words, we might attempt to service our debt with US$ of declining purchasing power. If (when?) this realisation comes to pass, U.S. inflation would move higher, bond yields rise and the Fed be forced to raise the funds rate more aggressively than otherwise. In an economy as highly leveraged as that of the U.S., this would not be a pretty picture.”

Recovery? Surely You Mean Deterioration

In Begging the Chairman’s Pardon – Household Balance Sheets Are Improving? (17 July 2003) Kasriel shifted the focus more explicitly upon households’ financial position (see also Households: Another Quarter Older and Deeper in Debt, 6 June 2003). He concluded “it would be a stretch to say that the prospects for a resumption of strong economic growth have been enhanced by steps taken in the household sector over the past couple of years.” Why? One reason is that is ratio of debt to assets reached a record (post-Second World War) high in the first quarter of 2003. In past recessions this ratio decreased and remained stable for several quarters thereafter. “That is, recessions typically are periods when households actually do repair their balance sheets. But not so in the most recent recession.” Similarly, in a typical recession households borrow less relative to their personal disposable income. But not in the most recent recession: the ratio of borrowing to income hit a post-war high in late 2002 and has not fallen since.

It is true that households have replaced relatively expensive debt with cheaper obligations. Historically low rates of interest have indeed reduced the financial pressure upon households; but their insatiable appetite for new borrowing has largely offset the chimerical effect of artificially low rates. It is also true that despite the massive amount of equity extracted from homes, the absolute dollar amount of equity has continued to rise (albeit very slowly). But equity expressed as a percentage of homes’ inflated market price has fallen – you guessed it, to a post-war low. In these respects American households, like their Australian counterparts, are more leveraged now than they have been at any time in the past sixty years. This leverage, even assuming that developments during the next several decades will be benign, does not augur well for homeowners’ ability to accumulate capital (see also Letter 45).

Kasriel draws attention to another critical point: only a small amount (approximately 15%) of the recent increase in household net worth has derived from savings. Unrealised capital gains, i.e., increased market prices of household assets, particularly houses, has accounted for the bulk of the remainder. “So, household net worth is rising because of Fed-induced asset appreciation rather than old-fashioned thrift. Sound familiar? In sum, households have not meaningfully repaired their balance sheets since the onset of the last recession. Households are not [as Mr Greenspan has contended] ‘better positioned than they were earlier to boost outlays as their wariness about the economic environment abates.’ If anything, they are more poorly positioned to do so. ... Unless household debt-to-asset ratios and debt-service burdens are significantly reduced, then a rise in interest rates will greatly limit households’ ability to take on more debt in order to step up their spending. Credit card delinquency and mortgage foreclosure rates are at record highs in this environment of very low interest rates. What will happen to household creditworthiness if rates were to rise?” Perhaps we will soon see.

Kasriel concludes in Businesses Save So That Households and Governments Can Spend that “U.S. businesses, along with the rest of the world, are saving so that U.S. households can spend more on SUVs and McMansions and U.S. government units can spend more on whatever governments spend on. That’s terrific for now. But will these SUVs, McMansions and government spending programs allow [America] to grow faster in the future? If not, will we not have to suffer more of a decline in our future (or our children’s future) standard of living when we have to service our foreign debt, or maybe even have to pay down some principal? One last question: why are businesses willing to forgo investment spending so that households and governments can spend more? Could it be that the expected return on business capital is very low as a result of the massive ‘malinvestment’ of the late 1990s? What does that say about the health of the U.S. economy?”

Fritz Machlup and the Consumption of Capital

Fritz Machlup (1902-1983) was well-placed to answer questions such as these. Born at Wiener Neustadt, Austria, where his father owned a manufacturing business, he entered the University of Vienna in 1920 and studied under Friedrich von Wieser and Ludwig von Mises. Machlup became a partner in an Austrian manufacturer in 1922 and helped to form a Hungarian concern in 1923. He also served as the treasurer and secretary of the Austrian Economic Society; participated in Mises’ famous seminar in Vienna; migrated to the U.S. and taught at a variety of universities; and was President of the Southern Economic Association, Vice-President and President of the American Economic Association and President of the International Economic Association (see also Breadth and Depth in Economics: Fritz Machlup, The Man and His Ideas, ed. by Jacob S. Dreyer, Lexington Books, 1978, ISBN: 0669014303).

Machlup’s many publications include The Stock Market, Credit and Capital Formation (see also How to Think About Losses). On the basis of his business experience and Austrian School training, Machlup was well placed to shed light upon the consumption of capital. A good example is an address he delivered to the American Statistical Society in 1934 and published under the title The Consumption of Capital in Austria. In that article, which acknowledged that von Mises was the first to identify the phenomenon, Machlup examined factors that might induce entrepreneurs to consume the funds that would normally be allocated to the replacement or expansion of inventory, plant and equipment. His “discussion of capital consumption and economic decline was provoked by the course of events observed in Austria during the [First World] War, the post-war inflation and the years of social reform.” Alas, it is so relevant that it might have been written yesterday.

Miscalculation Due to a Rising Price Level

Attention stock market and real estate speculators: “profits due to an increasing price level are only fictitious profits. If they are consumed, capital is consumed.” Machlup showed that inflation (in the proper sense of the term) in Austria induced entrepreneurs to calculate replacement reserves incorrectly and thereby to consume fixed capital. He also showed how inflation and consumption depletes working capital. As an example, consider a commodity speculator who buys 1,000 kilos of copper. As its price rises he sells it at a considerable nominal profit. He consumes half of the proceeds and uses the rest to buy (say) 800 kilos of copper. Prices continue to rise, the dealer continues to sell at a large nominal profit, spends half the proceeds and reinvests the remainder in progressively fewer kilos of copper. It is likely, given the inflation, that in nominal terms the speculator’s money capital will eventually grow to a multiple of his initial outlay; in real terms, however (as measured by the decreasing purchasing power of his money, either for copper or consumer goods), he has progressively consumed his capital.

Overtaxation of Incomes

To tax incomes at higher and higher rates, as has been the habit of Western governments since the 1930s (today’s “conservative” coalition government at Canberra, for example, is the highest taxing and spending in Australian history), is to encourage the owners of capital to consume capital. Austrian governments between 1913 and 1930 set a woeful example. In response, “if a capitalist’s income is too heavily taxed, he does not always cut down his expenditures accordingly but rather nibbles on his capital. High income taxes are seldom a transfer of consumers’ purchasing power from the rich to the public, but more often a conversion into consumption of funds which otherwise would be saved [or reinvested], and which are therefore disinvested capital.”

Overtaxation of Production 

Machlup notes that “while income tax snatches profits after they have come into existence, other kinds of taxation increase costs of production and, therefore, may prevent profits from coming into existence.” Higher taxes increase costs; and to increase costs is to discourage employment and production. During the period Machlup analysed, decreased employment triggered higher expenditures by the state. These expenditures, in turn, were financed by more taxes and credit created out of thin air by the central bank. Both policies ultimately discouraged production and employment. Machlup summarised this dreary process: “the numerous friends of public expenditure ... reiterate every day the high productivity of these expenditures and public works. I doubt by which indexes one should measure this productivity: by the increase in unemployment; by the decrease in profits; or by the steady decline in the capital stock.”

“Social Justice” and Industrial Zombies

Austria, Machlup said in 1935, “has always been the most progressive country in the world. There is compulsory illness insurance, accident insurance, unemployment insurance, unemployment benefits and old-age pensions. There is obligatory bonus for overtime and a bonus for Sunday work. Children’s labour is forbidden and women’s night labour [is also] forbidden. Safety and sanitation in plants are strictly controlled. Every worker is entitled to be paid yearly vacations, and the first days of illness have to be paid for by the employer. Clerks are dismissed only after one to 12 months’ notice and receive, moreover, a dismissal fee in the amount of 1-12 months’ salary.”

Adam Smith and the classical economists called it mercantilism. Our grandparents knew it (and some experienced it) as fascism. As Friedrich Hayek observed during the Second World War (The Road to Serfdom, 1944, 1972, The University of Chicago Press, ISBN: 0226320774), “at least some of the forces which have destroyed freedom in Germany are also at work [in Britain ]. The character and the source of this danger are, if possible, even less understood than they were in Germany. ... Few are ready to recognise that the rise of Fascism and Nazism was not a reaction against the socialist trends of the preceding period but a necessary outcome of those tendencies.”

Nowadays people call it “social justice.” To question it – to say nothing of revealing its fascist pedigree and thus opposing it on the grounds that it creates and exacerbates problems far worse than the ones it allegedly addresses – is to be indignantly ejected from polite middle class conversation. But these sensitivities do not change the fact that social justice is a fair-sounding phrase that distracts attention from incessant and worsening assaults upon the property rights of owners and employers of capital (see in particular Alexander Shand, The Capitalist Alternative: An Introduction to Neo-Austrian Economics, New York University Press, 1984, ISBN: 0814778364). The trouble with social justice is not just that it encourages capitalists to erode their capital: for that and other reasons it also harms people of modest means (see Eric Schansberg, Poor Policy: How Government Harms the Poor, Westview Press, 1996, ISBN: 0813328241).

As ineluctably as the sun rises in the morning, to increase remuneration above market-clearing levels is to manufacture unemployment (An Austrian Critique of Neo-Classical Monopsony Theory provides a good overview). But why does social justice inevitably consume capital? Because the same politicians who foist uneconomic wages, medical obligations and the like upon businesses also encourage them, whether with carrots or sticks, to undertake operations where entrepreneurs in a free market would not – and to continue operations long after unfettered capitalists would have ceased them. To impart a mercantilist privilege, in other words, is to issue a license which invites its holder – with impunity and temporary immunity – to transform politicians’ allegedly good intentions (their determination to favour mates is more like it) into widespread economic damage. As a result, not only individual favoured businesses but entire protected industries produce at a huge loss. They consume capital and use ever more arcane methods to obscure their tracks and flatulent communications to justify their privileged existence.

Examples of zombie industries abound. The world’s airlines, despite decade after decade of massive subsidy, have in aggregate never earned a penny of profit. Nor have “biotech” companies. What do you get when you combine incomprehensible boffins and silver-tongued promoters (these categories, by the way, are not mutually exclusive)? According to The Wall Street Journal (20 May), “since the first biotechnology company went public a quarter-century ago stock-market investors have put somewhere close to $100 billion into the industry. The results so far: more than a hundred new drugs and vaccines, several hundred million people helped by biotech medicines – and cumulative net losses of more than $40 billion for the industry’s public companies.” Biotechnology can cure deadly diseases, “but it’s hard to argue that it’s a good investment. Not only has the biotech industry yielded negative financial returns for decades: it generally digs its hole deeper every year. This often gets lost during periodic bursts of enthusiasm for biotech, one of which is under way right now.”

Net of their many and various subsidies, vast tracts of American and European agriculture – and Australia’s sugar, textile and automotive industries – also seem to be zombies; and not for years has America’s motor industry (which one wag has dubbed “a giant finance house with a garage out back”) turned a profit from the manufacture of vehicles. Perhaps most ominously, Fanny Mae (sometimes known as the Federal National Mortgage Association) and the Federal Home Loan Mortgage Corporation (Freddie Mac) seem to be voracious consumers of capital. According to the Cato Institute, they “receive government subsidies estimated to be worth $6 billion a year. Of that total, an estimated $2 billion goes directly as income to shareholders and employees of Fannie Mae and Freddie Mac. By design, the remainder of the subsidy largely diverts investment into the middle- and upper-income housing sector and away from capital sectors of the economy.”

Like other white elephants, Fannie Mae and Freddie Mac “preserve their privileged status through a multi-million-dollar lobbying effort that includes massive ‘soft money’ campaign contributions and the payment of exorbitant salaries to politically connected executives and lobbyists. [They] also protect their government-sponsored empire through millions of dollars of charitable donations to Washington advocacy groups. Because of their quasi-governmental status, there is a market perception that Fannie Mae and Freddie Mac mortgage-backed securities and debt carry an implicit federal guarantee against default. Hence, [they] expose the federal taxpayer to an ever-increasing potential contingent liability that could ultimately cost tens of billions of dollars to rectify.”

An analysis by Barron’s (17 May) “of Fannie’s accounting methods finds that, while legal, they obfuscate rather than illuminate Fannie’s true financial condition, allowing billions of dollars of derivative-related losses not to be reflected on its income statement. As a result, Fannie’s capital strength is less robust than the company’s many fans on Wall Street and Capitol Hill would contend.” Traditionally, Fannie packaged the home loans it purchased from banks into mortgage-backed securities. It guaranteed these securities’ interest and principal and sold them to major institutional investors. More recently it has concentrated upon the more profitable – and risky – business of buying and hedging mortgage-related securities for its own portfolio. It presently guarantees or owns outright approximately half of America’s $7.8 trillion colossus of outstanding residential mortgages – and “potentially threatens the financial safety of the U.S. and, indeed, the global financial system” (according to the FAQ section of Fannie Mae’s website, “could a small mistake at Fannie Mae ever cause a big problem in the economy? No. To the contrary, Fannie Mae is capitalised to protect against enormous, devastating problems that would fell most other financial institutions.”)

Distributing Unearned Dividends

Between 1913 and 1930, Austrian enterprises “paid dividends although they had zero or negative profits.” Their motive was not altruistic. Quite the contrary: it had everything to do with “the interest of hired business managers in maintaining their jobs and their salaries.” Plus ça change: Sean Corrigan noted in early 2003 that “double taxation or no,  U.S.  non-financial corporations have shelled out 118% of after-tax profits in the past seven quarters, amounting to a $116 billion diversion of their depreciation allowances to more consumptive ends. Why, in such difficult times, are they dissipating their resources in this manner? To keep Wall Street happy, of course, as well as to maintain the existing boards of directors and claques of executives in the Lear Jet luxury to which they have become accustomed.”

Bloated Consumers’ Demand

These five factors, Machlup contended, are sufficient causes of the consumption of capital. A sixth accompanies – indeed, subsumes – them. The erosion of Austria’s capital stock coincided with a marked per capita increase in the consumption of consumer goods. High and rising taxes, “social justice” and corporate largesse and shenanigans, in other words, were symptoms of an underlying disease: the determination of rich and poor alike to live beyond their means. But neither then nor now does the diversion of resources from producers and towards consumers extract ore out of the ground. Nor does it pour metal from the mould or assemble parts into motor cars. In no country and at no point in time, then, is this diversion a recipe for durable prosperity.

So never mind what contemporary mainstream macroeconomists insist (and ignore Alan Wood, who mangled and confused it dreadfully in The Weekend Australian of 15-16 May): Say’s Law is valid in the form that Say originally stated it. One must produce, in other words, before one can consume; and the diversion of resources from production to consumption forecloses the fructification of capital such that over time it cannot generate a steady and rising stream of income. The consumption of capital implies a big (and undoubtedly enjoyable while it lasts) party. But human nature and big shindigs being what they are, the consumption of capital today implies a hangover tomorrow. 

Sadly, since Machlup delivered his address the causes of the consumption of capital have not been contained – indeed, albeit at different rates in different places, several have been liberated from their nineteenth century constitutional moorings. As a result, since the 1930s entrepreneurs have had to struggle – fortunately, largely successfully – to create wealth more rapidly than politicians and central bankers stunt, deform and destroy it. Machlup spoke directly to today’s Anglo-Saxons when he observed that the “[importation] of capital does not increase the productive capacity of the country but only compensates for the internal capital consumption. This was obviously the case in Austria. Money, borrowed from abroad, was lent (mostly through banks) to corporations [in order to] ... finance investments which were in reality replacements of outworn or obsolete equipment.”

Further, “in the absence of new saving, mere shifts in demand involve economic decline; in other words, an economy which is stationary in respect to the supply of savings is declining in respect to its capital base. Or, to put it another way, quick change in the objects of consumption without the emergence of new savings is itself a form of consuming capital.” Machlup identified an extreme consequence of this phenomenon. “Austria,” he concluded, “was successful in pushing through policies which are popular all over the world. Austria has most impressive records in five lines: she increased public expenditures; she increased wages; she increased social benefits; she increased bank credits; and she increased consumption.” This is clearly not capitalism. Call it what you will – mercantilism, fascism or social justice – it means interventionism, privilege, corruption, violence, economic superstition and financial voodoo. Its fruits are bitter and inedible: “after all these achievements [Austria] was on the verge of ruin.”

Savings, Capital and Intelligent Investing in 2004-2005

In a healthy economy, capital broadens and deepens over time. In contemporary Anglo-Saxon countries, on the other hand, the pace of capital accumulation is at most stagnant and the respect and recognition accorded to savings and capital is at best tepid. Ignorance can breed complacency and self-satisfaction can encourage risk-seeking behaviour. For this and other reasons, Leithner & Co.’s operations in 2004-2005 will assume that the risks to investors are significantly greater than is commonly recognised.

As Donald Kohn has said, forming such a judgment requires a view about the level of asset prices that is appropriate given economic fundamentals. My view about fundamentals is influenced by the Austrian theory of capital (see also the excellent Mises Meets Graham and Dodd: A Conversation with Sean Corrigan and James Grant’s “Low Rates, High Expectations,” The New York Times, 16 May). Historical and recent experience, viewed through the prism of this theory, lead me to doubt Alan Greenspan’s assessment that meagre domestic savings (supplemented by large infusions of foreigners’ savings) are presently being invested very effectively. Reasoning and evidence also lead me to query whether the efficiency of today’s capital offsets an exceptionally low rate of domestic savings. I suspect, in short, that the financial statements of Australians, Americans and others are rickety; and I fear that they are blithely eating their seed corn. If so, they may be more vulnerable and less wealthy – and the lofty prices of their assets less justifiable – than either they think or their politicians incessantly reassure them.

Austrian capital theory emphasises that savings and capital are necessary but not sufficient conditions of wealth and prosperity. In this respect – perhaps he has not completely abandoned the views he espoused during the 1960s after all – Mr Greenspan is entirely correct. The heart of the matter is that saving money is not the same thing as forming capital; moreover, the connection between capital today and prosperity tomorrow is much less direct and far less assured than mainstream macroeconomic models (and the politicians, brokers and funds managers who parrot them) assume. Capital is not, as mainstream models posit, an homogenous lump; and there is no such thing as a single, undifferentiated stock of capital that, as part of an aggregate production function, generates national income. Instead, capital exists in myriad forms within countless individual enterprises.

Capital is also perishable: that is, whether or not it generates a stream of income it erodes over time. Moreover, when production must be altered because technology or tastes have changed – which they constantly do – capital can become obsolete. And at no time can capital effortlessly withstand inflation, taxation and regulation. Accordingly, it is imperative to recognise that a given arrangement of capital cannot generate a permanent source of income. Capital renders income only insofar as it is maintained, rearranged and renewed according to changing conditions – and is left in peace by governments.

Most importantly, capital without intelligent entrepreneurial activity is sterile (see in particular Israel Kirzner, Essays on Capital and Interest: An Austrian Perspective, Edward Elgar, 1996, ISBN: 1858984076). Even John Maynard Keynes – of all people – once thought so. In The Applied Theory of Money (1930) he wrote “it has been usual to think of the accumulated wealth of the world as having been painfully built up [purely] out of the voluntary abstinence of individuals from the immediate enjoyment of consumption, which we call thrift. But it should be obvious that mere abstinence is not enough by itself to build cities or drain fens. It is enterprise which [harnesses savings and] builds and improves the world’s possessions. ... If enterprise is asleep, wealth decays whatever thrift may be doing.”

If individual entrepreneurial acumen were superfluous – if, in other words, a key assumption of contemporary mainstream macroeconomics actually corresponded to reality – then economic development and the fructification of wealth would be child’s play. Poor people could quickly and easily become rich by borrowing the required amounts of others’ savings; and rich people could delegate to government their desired level of future wealth and then retire to the beach. But entrepreneurship is essential, there are many poor people and destitute countries and governments’ ability to enrich Peter without impoverishing Paul is, to put it mildly, questionable. Only to the extent that savings are lent to or generated by capitalists who are able to discern and respond to their customers’ wishes will those savings maintain and increase standards of living.

It is the ability of entrepreneurs and the existence of a specific environment (i.e., one in which titles to property are clear and respected, its transfer is straightforward and taxation and regulation are strictly limited) that determine whether savings are allocated productively or squandered. Savings will maintain, lengthen and deepen a capital structure when they are used by capable entrepreneurs and when capitalism is allowed to thrive. Conversely, savings will be wasted when they are allocated to enterprises run by managers who lack foresight, acumen and prudence, or when marauding politicians stunt, regiment and destroy these entrepreneurial qualities.

It follows that the idle expectation that “the stock market will generate wealth” is as absurd as the self-assured belief that politicians can provide physical security for their minions. Virtually everybody believes – fervently – that “a higher stock market” and “the creation of wealth” are synonyms. Perhaps fewer than one in a thousand realises that it is not today’s nominal price of an asset that constitutes wealth: rather, wealth is the stream of real income that flows over time from a capitalist structure of production meeting customers’ ever-changing demands. The expectation that investment now guarantees capital gains tomorrow is as illusory as the promise by politicians that (ever rising) taxes can finance decent educational and medical services. It is as illusory as the claim that bigger contributions now will guarantee higher pensions later. A growing number of people, particularly in the U.S., doubt the latter proposition; and perhaps (but don’t hold your breath) during 2004-2005 Australians will become more sceptical about the former claim. To doubt both is to redirect attention towards a pillar of civilisation: namely, that if they are going to generate wealth then savings must be placed into capable capitalist hands.

Hence the essential and enduring role of the value investor. He rations savings so that sound firms can get the resources they need, ramshackle ones wither on the vine and misused assets redeploy into more productive hands. He welcomes bear markets because they are times when capital returns to its rightful owners. His job is to maintain, renew, rearrange and extend precious and fragile stuff – capital – such that it conforms to consumers’ wishes. A successful investor is a steward and shepherd of long-term capital. Together with the saver, he is therefore a cornerstone of capitalism and a bulwark of civilisation.

The contemporary value investor does these things in a world in which most people want (and politicians’ cant and lies encourage them) to consume for today rather than accumulate for the future. Today’s investor must therefore be detached, sceptical, independent and thick-skinned. So it has always been. Keynes, an appalling economist but a good investor, noted in The General Theory (1936) that “human nature desires quick results, there is particular zest in making money quickly and remoter gains are discounted by the average man at a very high rate. ... It is [therefore] the long-term investor ... who will in practice come in for most criticism.” During 2004-2005, in exchange for reasonable safety of principal and decent results, Leithner & Co. will happily abide any brickbats that come its way.

Chris Leithner


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