Leithner Letter Nos. 60-61
26 December, 2004 - 26 January, 2005

A single word indicative of doubt that anything or everything in that country is not the very best in the world produces an effect which must be seen and felt to be understood. If the citizens of the United States were indeed the devoted patriots they call themselves, they would surely not thus encrust themselves in the hard, dry, stubborn persuasion that they are the first and best of the human race; that nothing is to be learnt but what they are able to teach; and [that] nothing is worth having which they do not possess.

Fanny Trollope
The Domestic Manners of the Americans (1832)

Americans have a strange notion that the ordinary laws of economics do not apply to them. So doubtless they will think they are prosperous if the boom starts, and that deficits and indebtedness are merely signs of how prosperous they are.

Albert Jay Nock
Memoirs of a Superfluous Man (1943)

There is surely something odd about the world’s greatest power being the world’s greatest debtor. ... There is surely a question that must be asked when, in order to finance prevailing levels of consumption and prevailing levels of investment, it is necessary for the United States to be as dependent as it is on the discretionary acts of political entities in other countries. ... It surely cannot be prudent for us as a country to rely on a balance of financial terror to hold back reserve sales that would threaten our stability. ... It’s hard for me to understand why there isn’t a broader sense of concern.

Lawrence Summers
The United States and the Global Adjustment Process (2004)

Poor Principles, Phony Recoveries and Festering Problems

The end of one calendar year and the beginning of the next is an appropriate time to reflect upon the outgoing year’s twists and turns, triumphs, trials and tribulations. It is also a good time to place them into a broader context, consider their causes and consequences, learn one’s lessons and set a course for the forthcoming year. In Australia and some other Western countries, 2004 was a year during which chronic ailments continued to receive insufficient attention, improper diagnoses and incorrect treatments. Corporate finances, as a rough rule of thumb and by the standards of the second half of the twentieth century, are reasonably shipshape; but by those same standards the same can hardly be said for many individuals and governments. As a result, potentially more severe – and acute – disorders have been bequeathed to the future. If so, then economic conditions in Australia and elsewhere are more fragile than many people suppose; and the management of individual and state sector finances is more mediocre than most realise.

One problem is that people in these countries, particularly Americans, Australians and Britons (Canadians are perhaps an exception), refuse to live within their means. The moral and economic orthodoxy of the era tells them not only that profligacy is permissible: it is desirable. Australians, for example, collectively spend roughly $1.04 for every dollar they earn; and the disparity between incomings and outgoings is, if anything, accelerating. Even worse, the vast bulk of this expenditure is consumed. When investment and consumption are properly distinguished, in other words, Australians consume almost everything for today and invest little – quite possibly too little – for tomorrow.

A second problem is that few people regard the first problem as a problem. Most Australians spend without much thought for tomorrow because others (whether governments or employers or foreigners or the yet-to-be-born) allegedly owe them a high and rising standard of living. Only an unfashionable, reprobate but doughty few deplore the consumption of capital (see Letter 54). Similar attitudes prevail in other countries. According to The Weekend Australian (6-7 November), “Americans believe with a passion that Asia has no choice but to continue to fund U.S. deficits, because if [the flow of finance from Asia] ever stops the U.S. will simply stop buying their goods and there will be a deep recession in Asia.” In particular, “Republicans say the deficits are sustainable because they are funded by Asian countries that have no choice but to lend Americans money, because without those loans the U.S. could not buy Asian goods and services. ... The Republicans say the Asians are trapped and will find the money” (The Australian 4 November). By this way of thinking, if I owe my creditors $1 million and cannot pay them, then I have a problem. But if I owe them $100 million and cannot pay, I no longer have a problem: instead, my creditors have a problem.

As The Wall Street Journal (4 November) has noted, a Republican president and Congress stoutly defend America’s mounting trade and budget deficits as necessary (because they help to fight recession and a “war on terror”) or wise (because some day they will force the government to shrink) or temporary (because other policies will uncork a torrent of economic growth) or irrelevant (because they have not yet triggered a significant rise of long-term interest rates). Not until American “conservatives” – who are actually New Deal socialists in a state of denial – regard deficits as immoral will they abandon their “tax a bit less and spend much more” brand of big government. And that day is nowhere in sight.

In the meantime, it is curious that people who declare so vehemently that they defend the rights of the unborn should actually trample these rights so enthusiastically. Deficits as far as the eye can see are immoral because they reward adults by robbing children and the unborn. Quoth The WSJ: “we are buying now and figuring they will pay later. We are enjoying more government spending and subsidies today and ignoring the fact that they will have to settle for fewer benefits and a slower growing economy as a result. Oh sure, borrowing today to invest in something that pays lasting dividends makes sense, but that accounts for a very small slice of today’s government spending.” So ignore the politicians: a storm tide of deficits today means a tsunami of taxes at some point in the futur. Also, spare a thought for the unborn victims of America’s political class (as Letter 57 showed, Republicans and Democrats are no more than branches of a single Welfare-Warfare Party). The rallying cry of the unborn, if they could only voice it, would surely be “no taxation without gestation!”

Americans not only blithely ignore the brazen immorality of deficits: their governments both wear it as a badge of honour and brandish it as a weapon. They act as if foreign creditors must lend to American governments and consumers. They do not consider whether these foreigners must eventually act like sober creditors confronted by drunken debtors, i.e., stop net lending and start pulling loans (see also Raising the Debt Limit: A Disgrace by Ron Paul). Indeed, debt-ridden American governments and consumers think that they posses the whip hand because they are more militarily powerful than their creditors. Their unspoken motto seems to be “lend – or else.” On that basis, and apparently with a straight face and a clear conscience, America’s moral and economic vigour is asserted. But Australians must not smirk: as individuals they are even more indebted – and likely less creditworthy – than Americans, and they are even more dependent upon the benevolence of foreigners. Perhaps that is why Australians elect politicians who cling so tightly and stridently to Uncle Sam’s coattails.

And perhaps that is why those politicians systematically overestimate the sturdiness of this country’s finances. During the past quarter-century, the Commonwealth’s underlying budgetary position (i.e., excluding the sale of the Commonwealth Bank, Qantas, Telstra, etc.) has been negative (deficit) not positive (surplus); and in its eight years at the helm the Liberal-National Coalition has done nothing to improve matters. “Over a full [business] cycle,” The Australian Financial Review (7 May) noted, “the long-run budget position still looks to be in deficit, not balance. So in spending this year’s fiscal bounty, we should be under no illusion: we look just as vulnerable to a new run-up in debt during the next recession as we ever were – and to a longer-run debt build-up over economic cycles.”

A third festering problem intensifies the first and second. As Alan Abelson (Barron’s 9 February) put it, “we’re in a post-bubble economy – not just any bubble, but the biggest one ever. And the deep dislocations and disjointments it caused never got a chance to right themselves. ... Instead, the economy was dosed with massive amounts of [government] stimulants and the result has been an artificial recovery in the grip of a high.” Abelson continued “not the least troublesome side effects of the voodoo medicine so promiscuously administered is the revival of the bubble mentality ... it has not only resurrected the equity bubble but created an equally dangerous one in housing.” Fortunately, and despite what is likely the greatest dosage of voodoo medicine since the early 1970s, Abelson is not prophesying the end of the world. “Western civilisation, maybe, but not the world. We have no trouble envisioning a rather messy end to this odd and vaguely feverish recovery. Nor would we put too much faith in Alan Greenspan’s vaunted legerdemain to keep stocks aloft or even afloat. With Mr G at the reins, the Fed has become a one-trick pony, and that trick is awfully, even dangerously, stale.”

Similarly, according to Stephen Roach, “the current ‘recovery’ in the U.S. [and by implication other countries including Australia] has been largely a false one – unduly influenced by the ‘steroids’ of excess fiscal and monetary stimulus. Steroids have also played an unfortunate role in providing illegal stimulus to some athletes (and bodybuilders) in recent years. The problem comes in trying to break the habit without suffering serious side effects.” And if Boston Globe’s sources are accurate in the 23 November 2004 article, then Mr Roach is far more bearish in private than he can be in public.

These problems – as opposed to the actions required to resolve them – are hardly novel. At the nadir of the Great Depression, in one of a series of lectures at the London School of Economics that propelled him to prominence in English-speaking economic circles, Friedrich Hayek stated “the thing which is needed to secure healthy economic growth is the most speedy and complete return both of demand and production to its sustainable long-term pattern, as determined by voluntary consumer saving and spending. ... If [demand and production are] distorted by the creation of artificial demand, it must mean that [resources are] again led into the wrong direction and a definite and lasting adjustment is again postponed. And even if the absorption of the unemployed resources were to be quickened in this way, it would only mean that the seed would already be sown for new disturbances” (Prices and Production, Augustus M. Kelley, 1931, 1967, ISBN: 0678065152).

Murray Rothbard concurred. Concluding his outstanding analysis of economic and financial developments during the 1920s and early 1930s (America’s Great Depression, 1963, 2000, Ludwig von Mises Institute, ISBN: 0945466056), he asked “if government wishes to see a depression ended as quickly as possible, and the economy returned to normal prosperity, what course should it adopt? The first and clearest injunction is: don’t interfere with the market’s adjustment process. The more the government intervenes to delay the market’s adjustment, the longer and more gruelling the depression will be, and the more difficult will be the road to complete recovery” (see also Gene Smiley, Rethinking the Great Depression: A New View of Its Causes and Consequences, Ivan R Dee, Inc., 2002, ISBN: 1566634725).

Alas, we live in a world where economic logic is obscured and history is derided, and therefore where lessons are seldom learnt and mistakes routinely repeated. Perhaps it is significant that children and politicians share an important psychological attribute: either they cannot understand that their actions have consequences, or they refuse to believe that the same action will usually produce the same result. As parents, adults are quick to scold and counsel children who violate these principles; yet as voters, they routinely support politicians and parties that ignore history, violate natural laws and therefore repeatedly commit the same mistakes.

In many countries including Australia, Britain, Canada and especially the U.S., the boom of the late 1990s – another in a long series induced by interventionist policies – sowed the seeds of bust. Australia’s boom ended in 2000 (see Letters 12-13) and signs of bust gathered pace throughout 2001 (Letters 24-25). Compounding their mistakes of the 1990s, since the second half of 2001 the Commonwealth Government and Reserve Bank of Australia have moved heaven and earth in an effort to attenuate and counteract the bust. These efforts have achieved the desired headlines and electoral results. Below the surface, however, they have cost much and achieved little (Letter 30, Letter 36-37, Letter 42 and Letter 48-49). To deny and attempt to soften a bust, in short, is to mute and delay genuine recovery; and to bastardise a recovery – particularly by igniting a debt-fuelled boom – is to ignore difficulties and thereby let them fester and grow into the future.

Investors have absolutely no reason to expect other or better behaviour from their rulers. “It appears with sober wisdom of experience,” concluded John W. Dafoe, editor-in-chief of The Winnipeg Free Press (1903-1944), “that there are only two types of government: the scarcely tolerable and the absolutely unbearable.” Dafoe was tragically misguided about some important things, particularly his advocacy of interventionist foreign policies. But in other matters he was sound. A political party is “an organised hypocrisy dedicated to getting and holding office.” More generally, “one of the primary weaknesses of democracy has been its faith that if the majority will not see a fact, the fact does not exist; and that if it declines to adopt policies indicated as necessary by the facts it prefers not to see, it does not thereby prejudice its future freedom of action by putting itself at the mercy of conditions created by external developments.”

Little has changed since Dafoe’s day. Anglo-American governments’ and central banks’ relentless economic interventionism, which in recent years has fixated upon the inflation of booms and the denial of busts, places them squarely in an unbearably hypocritical category (see also Let the Facts Speak for Themselves, Mr Kudlow by Asha Bangalore, Prolonged Growth is Blotting Out Some Harsh Realities by Peter Hargreaves, Investment Implications of the Inevitable Rebalancing of the U.S. Economy by Paul Kasriel, America’s Unsustainable Boom by Stefan Karlsson and Pulling Out the Rug by Kurt Richebächer).

This sceptical stance is highly unconventional but hardly iconoclastic. Even Access Economics, one of Australia’s most prominent consultancy firms and a pillar of Keynesian – and therefore staunchly big government interventionist – orthodoxy, says that “we’ve spent public money all too fast, wasting a lot of it, and we’re nearer the bottom of that barrel than we think. And neither side of politics has debated the key longer term policy issues in anything like the depth Australians deserve. They therefore haven’t built up the public support for the better policies that could help to cement Australia’s current prosperity for decades to come. That means we may well have muffed it. Judged against the yardsticks of raising productivity, raising participation [in the workforce] and saving for the future, 2004 was mostly a missed chance. Today’s Australians, and later generations and history, may well come to rue that lost opportunity” (quoted in The Weekend Australian 9-10 October).

Like Stephen Roach but for somewhat different reasons, since 2000 I have held rather cheerless views about the underlying robustness of economic conditions in most Western countries. According to Roach, “this view served ... well for the first four years of the post-bubble workout but didn’t work all that well over the four-quarter period from 2Q03 through 2Q04. But with momentum on the wane again, it pays to ponder the downside.”

Similarly, since 2000 Leithner & Co.’s attitude towards most investments has been sceptical and its investment program cautious. So it remains into 2005. More specifically, this attitude and program remain based upon four unconventional premises. The first is that the excesses of the 1990s remain imperfectly recognised and incompletely purged, particularly by households and governments, and therefore that the moods of market participants and the prices of financial assets remain unrealistically high. The second is that aggressive government intervention has impeded and delayed rather than facilitated genuine recovery from The Great Bubble (as Mr Buffett has called it). The third premise, a corollary of the first and second, is that Australia’s debt-propelled “recovery” is largely artificial; and the fourth is that the laws of economics ultimately mock politicians’ rhetoric (which is mostly idiotic) and negate their actions (which are usually preposterous). These premises yield an anticipatory stance rather than a firm forecast. Genuine bust eventually follows bogus boom; and given Australians’ determination to consume rather than invest, as well as their heavy reliance upon artificially low rates of interest and foreigners’ savings, any such bust may yet be sharp. If so, it will be because Australians and their rulers have unwittingly connived to make it so.

It is important to acknowledge that I nominated similarly dour possibilities for 2003 and 2004, and that they did not eventuate. Our guns were loaded and our powder dry, but no herd of rare and fast-moving wildlife stormed across our paddocks. But these dour sentiments and the cautious actions that followed from them did not harm Leithner & Co.’s results. Quite the contrary: in absolute and relative terms, caution and scepticism have underwritten reasonable short- and medium-term returns on shareholders’ equity (click here for a five-year summary).

In the Company’s experience, the higher an investment’s initial yield and the lower its payback period, the quicker the return of the investment, the lower its risk and hence the greater the return on the investment. Flatly contradicting the dogma of the business schools, in other words, the lower an investment’s risk (properly construed) the higher its return. As Mr Buffett’s put it, “sometimes risk and reward are correlated in a positive fashion ... [but the] exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the later case. The greater the potential for reward in the value portfolio, the less risk there is.” On this basis we proceed into 2005.

The Illusion of Household Wealth

But we continue to proceed with few companions. Many Australians are presently quite happy, in effect, to pay $1.25 or more for their dollars. Perhaps they believe they can afford to do so. Australians, print and electronic media announced on several occasions during 2004, have never been richer than they are today. The median net worth of households (net of mortgage and other debt) is presently approximately $250,000, and in recent years has increased at an annualised compound rate of roughly 7%. This increase is partly the consequence of the country’s relatively high (by international standards) level of share ownership. It also stems partly from the reasonably steady levitation of Australian equities during the past decade. But given their high level of home ownership and the fact that the capitalisation of the median family’s home greatly exceeds that of its share portfolio, the increase of Australian households’ net worth owes most to the sharp increase of the price of residential real estate.

This rise of median household net worth – which media coverage typically and erroneously interprets as an increase of wealth, if time is money, as Ben Franklin quipped, and if lack of time is dearth of capital, as Ludwig von Mises demonstrated, then wealth is time. An appropriate measure of a household’s wealth, in other words, is the number of years that the stream of income generated by its assets (as opposed to the salaries of its members) can maintain a desired standard of living. My guess, bearing in mind its innate subjectivity, is that the wealth of the median Australian household is little more than three years. If so, then few Australians are wealthy.

But more than a few are “rich.” Consider the couple who, according to the stereotypes propounded by politicians and the general public, are affluent. They earn relatively high salaries, higher than perhaps 90% of other households, and by international standards pay high marginal rates of income tax (plus the superannuation surcharge, Medicare levy, etc.). To fulfil their aspirations, they must also adorn themselves smartly, drive foreign cars, frequent trendy restaurants and travel destinations and inhabit a waterfront townhouse or other suitably prestigious abode. They must, in other words, consume; and they must finance these expenditures with after-tax income and growing amounts of consumer and mortgage debt. This “rich” couple depends overwhelmingly upon fortnightly paycheques in order to meet its considerable expenses (including interest). Accordingly, they are hardly financially independent. Reduce the rate at which their income grows (or even worse, eliminate one salary for a time and replace it with a lower salary) and their cash flow will suffer – perhaps to the point where the much-desired trappings of “lifestyle” become albatrosses around the neck.

The rise in median household net worth in Australia is also largely illusory because a real increase in the wealth of individuals and households and therefore of nations, as Paul Kasriel emphasises in his excellent article Wealth Illusion, presupposes the growth of capital stock and of the productivity of capital (see also Letter 41). Alas, according to Kasriel’s analysis of American data (trends for Australian households are roughly comparable), “in recent years, growth in our capital stock has slowed and the composition of the slower growth has moved in favour of McMansions and SUVs, which do little to increase the productive capacity of our economy.”

Kasriel notes that a household’s net worth increases either because expenditure falls relative to income (“saving”) or the market prices of assets acquired through past saving rise (“capital gain”). In recent years, households in neither country have been significant savers. In Australia, the household savings ratio (i.e., saving as a percentage of household disposable income) averaged approximately 10% during the 1960s. During the 1970s it rose to 12.5%–and at one point as spiked as high as 18%–and in 1975-1980 averaged 15%. But since the early 1980s it has fallen steeply and almost without interruption: during the 1980s it averaged 10%, during the 1990s it averaged 5%, since 2002 has been below 0 and is presently as low as minus 3%–a level not seen in this country since the 1930s.

How, then, has the median net worth of Australian households risen in recent years? First, liberalisation and deregulation of financial services during the 1980s have enabled – and the irregular but cumulatively very appreciable decrease of interest rates since 1990 have encouraged – households to borrow. Second, households’ borrowing has financed not just current consumption (i.e., the purchase of clothes, dinners and holidays) but also non-current consumption (i.e., the purchase of cars, plasma screen TVs and real estate). Third, and no small thanks to the decrease of interest rates, the prices of stocks, bonds and residential real estate have increased. In response to these developments, Australian households have leveraged their balance sheets ever more aggressively. They have borrowed, in other words, partly to buy things whose prices have risen more quickly than income. During the 1960s and 1970s, total household liabilities rose from 40% to 45% of average annual income. In the 1980s this ratio rose more quickly (from 45% to 65%); during the 1990s it accelerated even more rapidly (from 65% to 110%); and since 2000 it has rocketed from 110% to 155%.

As a result, Australian households presently have grounds to claim the dubious prize as the world’s most heavily debt-ridden. But not to worry: according to The Australian Financial Review (3 November) they benefit from a virtuous – and seemingly permanent – circle. “The dramatic rise in household debt has not greatly alarmed the markets because of solid growth in jobs, incomes and house prices. The sustained low interest rate environment, too, has helped encourage more households to take on more debt, market economists say, pushing consumer and business confidence to record levels.” Indeed, “Australia’s past 13 years of stable economic growth and low inflation combined with surging property prices have substantially increased households’ propensity to borrow. New and more flexible loans are encouraging borrowers to use equity in their homes to fund either consumption or other investments.” This circle is virtuous because influential politicians say so, and they say so because their economic advisors tell them that it is so. Hence the Treasurer, Mr Costello, opines that an increase of home prices is a good thing because “it has given [Australians] an asset base, it has given them confidence, it has given them spending power” (The Herald-Sun 30 July 2003).

Elaborating this point, The Australian (3 August 2004) reported that “financial innovation is enabling households to spend and consume much more than they earn by unlocking the wealth of their largest asset – the family home. With house prices having more than doubled since 1996, most people who have owned a house over that period have seen their wealth increase by multiples of often several times their annual household income. The incentive to tap some of that increased wealth to achieve some other financial or personal goals has been answered by financial markets providing the means to do so.”

During the 1980s, according to figures from the ABS, Reserve Bank and Treasury, Australian households repaid not only the interest on their mortgages: every year they also reduced the principal of their home loans by an amount equivalent to roughly 5% of average disposable income. In so doing, and particularly as the market prices of homes rose, they “built equity.” During the 1990s this tendency continued but at only half this pace (i.e., by approximately 2.5% of disposable income). Since 2000, however, households have ceased to “build equity” in their houses. Instead, they have decreased it, i.e., borrowed against equity, and have withdrawn a rapidly growing amount that is presently equivalent to as much as 8% of annual disposable income.

Two Risks

By borrowing against a home whose price is rising, sometimes substantially, households have been able to extract equity and consume the proceeds; and the growing magnitude of extraction has enabled them to increase their consumption at a rate that greatly exceeds the increase of household income. This behaviour, the RBA cautioned on several occasions in 2004, cannot continue indefinitely. All financial transactions incur risk, and the most immediate risk of this behaviour is the sturdiness of the assumption that the prices of households’ assets, particularly houses and stocks, can continue to rise more quickly than income. Private sector analysts, as a whole, seem to discount this risk. One exulted to The AFR (3 November) “we’re experiencing a cultural revolution, as the ‘old school’ make way for a less debt-averse set of borrowers, and we can expect household debt to continue growing faster than income growth for quite some time.”

A less immediate but ultimately much more significant risk that results from this behaviour is the weakening of the capital structure. A weaker structure today implies sluggishly growing or stagnant or even falling living standards in the future. Using American data from 1952 to 2003, Kasriel has charted the relative importance of savings and capital gains as components of households’ net worth. In the mid-1990s, the impact of capital gains began to outstrip savings by a wide margin. From 1995 to 1999, a steady increase in the prices of the household’s portfolio of stocks drove the increase of its net worth; and since 2000, increases in the market price of the family home have done so. During the period 1952-1994, capital gains on stocks or real estate were, on average, 1.7 times greater than household saving; and from 1995 to 2003 these gains averaged 4.4 times household saving. Consumers, cheered by politicians, concluded that capital gains are – and that savings are not – the route to higher net worth.

Far better than most contemporary economists, who seem to comprehend it not at all, Kasriel understands the concept of capital. He notes that capital stock is conventionally defined as the sum of business assets, private residential housing, consumer durables and government property. Although he does not explicitly say so, he seems to recognise that residential real estate, consumer durables and government property are not capital goods – and therefore that they should not be regarded as components of the capital stock. With a few caveats, these things are better regarded as consumption goods (see Letter 41).

Kasriel makes a second point about the nature and contemporary misconception – and hence misallocation – of capital. “Just because an existing house goes up in [price] does not necessarily mean that the more expensive house ‘produces’ more actual housing services. Does a rise in the price of the house enable more people to live in it? Does the increase in the price of an existing drill press necessarily mean that the drill press is now capable of drilling more holes in an hour? The economic wealth of a nation is related to an increase in the number of drill presses, not the nominal value of the existing stock of drill presses. The more drill presses an economy has, the more holes can be drilled in the production of other goods. The greater the capital stock of an economy, the more productive is its labour force. In short, the greater the capital stock of an economy, the more goods and services that economy is likely to be able to produce” (italics added).

Kasriel examines the development in recent years to America’s capital stock, and the relationship between capital stock and household net worth. Before and during past periods when the stock of capital grew, the composition of the increase in household net worth was skewed towards saving. He also finds, generally speaking, the more that households save the faster the capital stock subsequently grows. But the late 1990s upset this rule. The stock of capital grew at a pace that was moderate by historical standards; yet this growth owed little to the savings of households. Instead, the late 1990s was a time when foreigners’ investment in the U.S. reached unprecedented levels; and their savings and investment more than offset weak and weakening saving by American households. Without foreign investment, the growth of America’s capital stock during these years would have been lethargic.

Ornaments Versus Streams of Income

Kasriel thus provides – actually, he restates for the legions of people who have either forgotten them or never learnt them – two critical insights into the nature and causes of the growth of a country’s real wealth. The first is that it owes much more to savings than to capital gains. The second insight is that wealth also depends upon the composition of the country’s capital stock. In particular, wealth presupposes an increase in the number of “drill presses” (i.e., capital goods that increase production and productivity). In sharp contrast, the prominence of consumption goods mislabelled as capital goods (things such as owner-occupied real estate, SUVs, military and other government expenditure and the like) is a possible consequence – but certainly not a cause – of wealth.

It follows that some forms of capital as it is conventionally defined – but not others – generate wealth. “For example, housing is part of the capital stock. But does a physically bigger house (more square footage) with granite kitchen [benchtops] enable the occupants to produce more widgets? Does the massive SUV driven by the suburban Mum [enable] her or anyone else to produce more widgets? Bigger houses and bigger household vehicles add to the nation’s capital stock. But I would submit to you that increases in business equipment and business structures are more reflective of a nation’s wealth than increases in consumer durables and houses.” Buying a plasma screen TV, in other words, does not make you richer; instead, the accumulation of income-generating assets – such as productive business equipment and structures – will enrich you enough to afford consumption goods like fancy TVs.

Kasriel examines the composition of America’s capital stock over the years. Most notably, he ascertains whether production- and productivity-enhancing “business” capital is becoming a greater share of the total stock of capital. Its percentage rose sluggishly during the 1990s, in 2001 it began to fall and in 2002-2003 it decreased at the fastest pace since the early 1950s. He concludes “if the share of the business capital stock is falling relative to the total since the stock market and business investment bust of 2000, what shares are rising? You guessed it ... McMansions and SUVs are gaining as a share of the total capital stock. So, in the past four years, not only has the growth in the nation’s capital stock slowed, but the growth in the truly productive part of that capital stock – the business capital stock – has slowed even more.”

Americans, then, are tending their fields less diligently and are eating more of their seed corn. Much the same problem exists in Australia. The Australian Local Government Association’s State of the Regions Report, released on 7 November and summarised in the next day’s Australian Financial Review, stated that high levels of debt in “dispersed metro regions” (i.e., the suburbs of major capital cities where the bulk of Australians live) have been “invested [sic] in housing and lifestyle purchases, not future productive capacity.” As a result, “there is now doubt that these regions have gained an enormous amount from the economic growth which has been achieved on the back of this borrowing. ... The point remains whether a similar level of debt invested in something other than housing and shopping [would] have delivered more in the long run.” Perhaps most importantly, this “investment in consumption ... results in lower wage and income growth, with high interest payments eating into consumption expenditure now and into the future.”

Here, then, is the example par excellence of an improperly diagnosed ailment that during 2004 continued to receive insufficient attention. Many English-speaking people are consuming their wealth (which is more meagre than they suppose) in order to finance today’s lifestyle; in so doing, and in cahoots with their governments, they have decided to ignite a short-term boom rather than address long-term problems. To the very limited extent to which the impairment of the stock of capital in Anglo-American countries has been diagnosed, policymakers have treated it incorrectly. In short, policies that encourage saving and investment – and do not sanctify spending and consumption – are required. But to expect politicians to change their profligate spots is to suppose that leopards will become vegetarians. As a result, potentially more severe disorders have been bequeathed to the future.

The gist of Kariel’s conclusion applies as much to Australia as to the U.S.: “Fed Chairman Greenspan can crow about the continued rise in household net worth as percent of after-tax income if he wants. And, indeed, he has helped bring about an increase in household net worth through his easy money policies, first inflating the value of corporate equities, and then the value of residential real estate. But his measure of wealth is illusory. The growth in the true wealth of this nation is slowing, Chairman Greenspan, despite your best efforts to ‘paper’ over it”.

Soft Assets and Hard Liabilities; Soft Heads and Hard Lessons

Kasriel’s analysis and conclusion prompt the intelligent investor not just to consider the implications of a more precise notion of capital (and of its misallocation). It also invites him to ponder the conventional conception – that is, misconception – of an asset. This fallacy afflicts the highest and mightiest. At a press conference on 8 December 2003, after he released the Commonwealth’s Mid-Year Economic and Fiscal Outlook 2003-2004, Mr Costello stated “… if interest rates come down, people tend to borrow more. That is one of the reasons why you reduce interest rates, incidentally. You reduce interest rates so that people can buy more. It is considered stimulation for the economy. And nobody should be surprised that if interest rates are lower, people buy more, that is what the whole theory of monetary policy as stimulation is all about. Now, as it turns out, the people who have been borrowing more, actually have [been] accumulating wealth. So their net asset position has actually been increasing and that is the point I have been trying to make in the Parliament. We can look at this, their net asset position has been increasing. ...” (italics added).

Although he does not state them explicitly, important assumptions underlie the Treasurer’s contention. Most significantly, owner-occupied real estate is an asset (i.e., it belongs in the “asset” column on the household’s balance sheet); an unrealised increase in the market price of owner-occupied real estate above its purchase price is also an asset; any such unrealised increase tends not only to endure but also to grow over time; and the net assets that conventionally appear on the household’s balance sheet comprise its wealth. By implication, the Treasurer’s – and most Australians’– conception of an asset is not restricted to something that, as compensation for inherent risk, generates a reasonably reliable stream of income: it also encompasses anything whose price has in recent years tended to increase. Hence owner-occupied housing, art and other collectibles are assets; and the more their prices rise the more they are prized as assets. By this way of thinking and other things equal, a rise in a house’s estimated market price increases the household’s wealth; moreover, given the observed extent and assumed permanence of this price rise, it is appropriate to borrow against this wealth.

As diplomatically as his position allows, the Governor of the Reserve Bank has rejected at least one of these premises. Not only can the prices of houses decrease: they have fallen – sometimes dramatically – in the past; they fell in many parts of the country during 2004 and may decline further in the near future. According to figures summarised in The Australian (9 November), “the downturn in housing markets is getting steeper and spreading beyond Melbourne and Sydney to other capital cities.” Across the country, and particularly in Canberra, Melbourne and Sydney, the prices of houses declined between 4.8% and 5.7% in the September quarter.

Yesterday’s unrealised gain, in other words, can disappear today and perhaps even become tomorrow’s unrealised loss. If so, then household assets as conventionally conceived are not as “hard” or objective as the Treasurer assumes. From the borrower’s point of view, a liability such as a mortgage is “hard” in the general sense that a legal obligation underlies it and in the specific sense that objective numbers attach to it. The amount of debt a household owes is not normally a matter of subjective interpretation (try telling your bank that the balance of your mortgage is, say, $50,000 less than the bank says). In sharp contrast, the market price of a house is a matter of subjective opinion; that is to say, of estimation by a valuer and estate agent, and of bargaining between a buyer and seller. For this reason, different agents, buyers and sellers will attach different – sometimes widely different – prices to the same house (see in particular Letter 52 and Gary Belsky and Thomas Gilovich, Why Smart People Make Big Money Mistakes and How to Correct Them: Lessons from the New Science of Behavioral Economics, Fireside, 2000, ISBN: 0684859386). In the real world, only when a contract is signed does the amount of money to be paid to the seller (net of the mortgage) constitute a “hard” entry in the asset (receivables) column of his balance sheet. Even then, it is not a bad idea to discount the entry until the buyer’s cheque clears.

Mr Macfarlane has cautioned that “housing investors” who believe that the price of a house is a one-way proposition could experience “a lot of personal distress.” On 8 June he told the Economics Committee of the House of Representatives “there are pockets out there where [the fall of prices] is going to hit very hard. The average owner-occupier is not going to be affected very much. It’s investors who are probably going to be affected. It could well happen that there will be a lot of personal distress. A lot of people thought they were going to get rich. They will discover that not only are they not going to get rich, but they’ve got this asset which will cost them a lot of money to service and its price is going down.”

A Salutary Blast from Berkshire Hathaway’s Past

Andrew Smithers, author of Valuing Wall Street: Protecting Wealth in Turbulent Markets (McGraw-Hill, 2002, ISBN: 0071387838) has emphasised this point. On 29 May 2000, shortly after the Great Bubble began to deflate, he told Business Week “in the end, it is real assets that must generate the real returns that investors earn – not the ... ‘investments’ based only on projections that have largely been driving the market.” Warren Buffett would surely agree. Indeed, Berkshire Hathaway’s phenomenal reversal of fortunes since 1965, when his investment partnership acquired control of it, is one of the best examples of the rewards that derive from the ownership of sound assets generating real streams of income. Berkshire’s growth and development under Mr Buffett’s stewardship has rightly been the subject of extensive description and analysis. But its rise and fall as a textile manufacturer is equally instructive. That history illustrates this principle: “assets” that do not generate reliable streams of earnings are not, in fact, assets.

Berkshire’s story, which is described best in Roger Lowenstein’s Buffett: The Making of an American Capitalist (Random House, 1997, ISBN: 0517194961), begins in 1806. In that year Oliver Chace, a carpenter once employed by Samuel Slater (who had built America’s first cotton mill in 1790), founded a mill in Rhode Island. Under Chace’s descendants, for the next century or so the business thrived. In 1929 they combined several textile operations with Berkshire Cotton Manufacturing Co., which had been incorporated in 1889, and named the resultant firm Berkshire Fine Spinning Associates. The Chace family continued to control Berkshire, and its dozen plants across New England produced staple fabrics for sheets, shirts, handkerchiefs and slips. Berkshire was a textile giant that spun as much as one-quarter of America’s cotton and consumed approximately 1% of New England’s electricity. But facing competition from mills in the South, and then the onslaught of the Great Depression, it marked time or bled red ink throughout the 1920s and 1930s. Fortunately, strong demand from the military during the Second World War and immediate post-war years brought some meagre profits, a reprieve and an opportunity.

Hathaway Manufacturing Co., based at New Bedford, Massachusetts, was founded in 1888. Its profits, like those of other commodity producers, boomed during the Great War. At its pinnacle, half of New Bedford’s labour force – thirty thousand people – worked in its mills. But during the 1920s Southern mills crushed the New England textile industry’s margins. During the inter-war years New Bedford’s workers endured repeated sackings; and those who remained took recurring pay cuts. Many mills also closed, and by 1940 the city’s textile workforce had shrunk to nine thousand. In the Second World War and the immediate post-war years Hathaway diversified into synthetic fibres, pioneered the manufacture of rayon and became one of the world’s biggest producers of men’s suit linings. But its products were easily imitable and were produced ever more cheaply by Southern and foreign competitors. Profits therefore became more erratic and meagre.

In 1955, Hathaway and Berkshire merged under the name Berkshire Hathaway, Inc. The new company was a colossus. It owned fourteen plants, employed twelve thousand workers and generated annual sales of $112m. But it was all for nought because it was unable to generate a reliable stream of earnings. More often than not, it produced losses. In 1955, Berkshire’s shareholders’ equity was $55.4m. During the next nine years, by which time Buffett Partnership Ltd gained control, equity fell by almost two-thirds to $22.1m. Berkshire’s textile business survived until 1985. When it was liquidated, said John Train in The Midas Touch (Harper & Row, 1987, ISBN: 006091505), $163,000 was received for machinery whose book value was $866,000, whose original cost was $13,000 and whose replacement value was $30-50 million.

For these “assets” unable to generate a reliable stream of income, in other words, there was absolutely no relation between the sales proceeds and book value, original cost or replacement cost. Lacking any “going concern” value, they were sold as scrap. Looms that were bought a few years earlier for $5,000 were sold for $26 – less than the cost of carting them to the junkyard. Buffett subsequently said of Berkshire’s textile business – a point that households might ponder with respect to their finances – that its assets weren’t worth what he thought they were, “but the liabilities were solid.”

Looking Into 2005: Pursuing “Bonds” and Avoiding “Rembrandts”

The moral of Berkshire’s history as an ultimately doomed textile manufacturer is not that Australian real estate or stocks or bonds are destined, either literally or figuratively, for the scrap heap. Nor is it that prices here or elsewhere must fall dramatically. Rather, the fundamental point is that the value of something regarded as an asset depends ultimately upon the stream of earnings it can generate over time. The extent and reliability of that stream is uncertain. Accordingly, value is to a significant extent a matter of cautious, subjective and error-prone entrepreneurial conjecture (see Letter 58). In practice, this means that the assumption that a given stock or bond or piece of real estate purchased at time X is an “asset” can be weakened or even disproved by subsequent events.

An asset’s price, on the other hand, is objective: it depends upon the amount of money its most eager buyer is willing to pay for it at a given point in time. Price need not – indeed, usually will not – equal value. Hence the prices of things conventionally regarded as assets often have two components: an investment component (based largely upon caution and reason and the sober analysis of historical “base rates”) and a speculative component (based largely upon emotion and the confident projection into the future of present “case rates”). A critical lesson for intelligent investors is to reject the conventional conception that anything whose price has in recent years tended to increase is, for that reason alone, an asset. Another is to pay more attention to base rates and less to case rates.

Charles Munger, Berkshire’s Vice-Chairman, has put this point evocatively. “Stocks,” he said at Wesco Financial Corp.’s AGM in 2001, “partly sell like bonds, based on expectations of future cash streams, and partly like Rembrandts, based on the fact that they’ve gone up in the past and are fashionable. If they trade more like Rembrandts in the future, then stocks will rise, but they will have no anchors. In this case, it’s hard to predict how far, how high, and how long it will last. If stocks compound at 15% going forward, then it will be due to a big ‘Rembrandt effect.’ This is not good. ... My guess is that we won’t get [permanent] ‘Rembrandtisation’ and the returns will be 6%.”

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 2005.

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Chris Leithner


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