Leithner Letter Nos. 72-73
26 December, 2005 - 26 January, 2006

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 [production is] 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.

Friedrich Hayek
Prices and Production (1931)

Australia is a lucky country run mainly by second-rate people who share its luck. It lives on other people’s ideas and although its ordinary people are adaptable, most of its leaders (in all fields) so lack curiosity about the events that surround them that they are often taken by surprise.

Donald Horne
The Lucky Country (1964)

The economic situation today is reminiscent of the 1970s. The economic malaise of that era resulted from the profligacy of the 1960s, when Congress wildly expanded the welfare state and fought an expensive war in Southeast Asia. Large federal deficits led to stagflation – a combination of high price inflation, high interest rates, high unemployment, and stagnant economic growth. ... I fear that today’s economic fundamentals are worse than [those of] the 1970s: federal deficits are higher, the supply of fiat dollars is much greater, and personal savings rates are much lower. If the federal government won’t stop spending, borrowing, printing and taxing, we may find ourselves in far worse shape than 30 years ago.

Dr Ron Paul (Republican-Texas)
Deficits Make You Poorer (14 March 2005)

Another Year, Another Accident Averted?

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 these things into a broader context, consider their possible causes and consequences, learn one’s lessons and set a course for the forthcoming year. That course, it seems to me, should be cautious. In Australasia, Britain, the U.S. and many other countries during 2005, chronic ailments continued to receive insufficient attention, improper diagnoses and incorrect treatments. Once again, laws of human action were ignored and history derided. But to flout the past and to become complacent in the present is to set the stage for humbling mistakes that appear in the future.

The central problem is that no matter how comprehensively they have been disproved, the same old myths constantly reappear in deceptively authoritative guises. Damaging falsehoods about investment, finance and economics are just as prevalent today as they were in Adam Smith’s day. Despite all the logic and evidence to the contrary, people – including very powerful and influential people – continue to believe that prosperity presupposes spending by individuals and governments; that central banks’ policy of inflation (that is, artificially low short-term rates of interest and aggressive creation of credit not backed by savings) prevents “slowdowns;” that the prices of financial assets always rise over time; and that an increase of an asset’s price necessarily increases its owner’s wealth.

The principal consequence of these myths, which Australians have extended into an art form of new extremes, is that many people refuse to live within their means. Today’s moral and economic orthodoxy assures them not only that profligacy is permissible and even desirable: it also convinces them that extravagance is absolutely necessary. Thus emboldened, they take the bait. For years, Australians’ indebtedness has grown more quickly than their income; as a result, they presently carry unprecedented loads of borrowings. Considered as a whole, during 2005 they spent roughly $1.06 for every dollar they earned, and had to borrow or extract equity from their homes in order to service their growing debt. They also consumed the vast bulk of their expenditure. When investment and consumption are properly differentiated (see Letter 67), in other words, it becomes clear that Australians consume almost everything for today and invest little – and probably much too little – for tomorrow.

Consider for a moment some of the results of Australians’ epochal repudiation of thrift and investment. The habit of saving some portion of every paycheque for a rainy day has become as outré as pink garden flamingos and hoola hoops. Rates of saving lie well below zero, and according to some estimates as low as minus 3% of income. In order to finance their ambitious standards of living, Australians must either deplete past savings or borrow. The temptation to do both has in recent years been irresistible. Debt has been cheap, and the phenomenal rise of the price of residential real estate (together with a bit of financial engineering) has given Australians an easy means to convert “home equity” into a new car, overseas holiday or other desired form of conspicuous consumption.

Australians, in other words, have decided that the escalating valuation of their home, if they own it, is a source of investment income that, in effect, should appear on their income statements. Their P&Ls look superficially healthy not because wages and salaries have risen significantly – they haven’t – but because residential real estate is regarded as a realisable investment rather than a durable consumer good. The trouble is that this attitude presupposes perennial economic sunshine. But when prices decelerate (as they have in Adelaide, Brisbane and Melbourne) or halt or even reverse (Sydney), bankers might again begin to regard housing as shelter rather than a reliable source of capital gain. Under these conditions, your hitherto friendly financier might be somewhat less inclined to allow you to tap home equity in order to service growing expenditures and debts. That would put significant numbers of Australians into a bitter pickle.

If legions of Australians really do regard residential real estate as an investment, then they should analyse it accordingly. But they don’t. It is reasonable to estimate that the average annual cost of home ownership is presently roughly 7-8% of market price. That percentage comprises mortgage payments, insurance, council rates, maintenance-depreciation and (eventually) the estate agent’s commission. That percentage should prompt people to reflect, but it doesn’t. It means that, simply to recoup these costs, the market prices of houses must double every nine years. If they don’t double during the next nine years, then homeowners-investors will lose ground.

They might also find that their financial statements are less likely to accommodate their ambitions. By taking bigger mortgages, rolling consumer debt into mortgage debt and assuming ever more non-mortgage debt, consumers have elongated and deepened the liabilities column of their balance sheets; and by converting significant “home equity” into cash through the P&L, they have depleted its asset column. In exchange for lower (per dollar of debt at present rates) payments and a weaker balance sheet, they have more fun and games today and a longer-dated liability for the future. But what if interest rates eventually tell the truth about time? Before long their fancy cars will require replacement, and overseas holidays and other articles of conspicuous consumption quickly become memories. Alas, the desire for such things, once whetted, does not submit easily to financial reality. Whence will come the money to finance these ongoing desires? And from where, pray tell, will come the money to service their consequent liabilities?

As preposterous as it sounds today, at some point Australians will have to strengthen their rickety finances. They must curb their appetites and accumulate assets worthy of the name. Given growing competition from China, India and elsewhere, together with Australians’ antipathy towards actions that improve the productivity of capital and labour, do you believe that wages and salaries will rise dramatically? If not, then the principles of our grandparents might again see the light of day: indebtedness will again be regarded as a vice, savings as a virtue and doing without and living within one’s means as common sense rather than an affront to the zeitgeist.

In the meantime, a second problem is that few people regard profligacy as a problem. Still less do they regard retrenchment as a benefit for the present and a necessity for the future. Many Australians consume and borrow today without thinking much about tomorrow because they believe that others (such as governments or employers or foreigners or the young and the yet-to-be-born) owe them a high and rising standard of living. In short, time preferences are too high and rates of interest, which are politicised and corrupted by governments, are too low (see also High Rises and High Time Preferences by Doug French). The result, deplored by an unfashionable, reprobate and irrelevant minority and apparently celebrated by everybody else, is the mass consumption of seed corn. Many Australians, encouraged by politicians, mainstream economists and the hedonistic ethic of the day, are energetically spending themselves into hard times – and their financial statements show it.

A third problem intensifies the first and second. The boom of the late 1990s – another in a long series ignited by aggressively interventionist policies – sowed the seeds of bust. Australia’s boom ended in 2000 (see Letter 12-13) and signs of bust gathered pace throughout 2001 (Letter 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 order 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. To deny and attempt to soften a bust, in short, is to mute and delay authentic recovery; and to bastardise an upturn – particularly by igniting an artificial but almighty debt-fuelled boom – is to ignore difficulties and thereby let them grow into the future.

For several years, I have doubted the underlying robustness of economic conditions in most Western countries. Accordingly, since 1999 Leithner & Co.’s attitude towards most investment opportunities has been sceptical and its investment program cautious. So it remains in 2005-2006. Yet the laws of economics eventually mock politicians’ rhetoric (which is mostly idiotic) and moderate their actions (which are usually destructive). In particular, during 2005 the Australian bond market began to signal – and presently continues to warn – that a recession may be coming. An inversion of the yield curve hardly guarantees recession; but a recession is almost always preceded by an inversion (see Letter 66). Alas, participants in equity markets are ignoring or denying this signal.

These unfashionable thoughts yield a cautious stance rather than a confident forecast. Genuine bust eventually follows bogus boom; and given Australians’ determination to consume more than they earn and to rely heavily upon artificially low rates of interest and money borrowed from foreigners, any such bust may yet be sharp. At the same time, however, it is important to acknowledge that I also posed dour possibilities for 2003, 2004 and 2005, and that they have not eventuated (Letter 30, Letter 36-37, Letter 42, Letter 48-49, Letter 54 and Letter 60-61). Our guns have been loaded and our powder dry, but no herds of rare and fast-moving wildlife have stormed across our paddocks. But these dour sentiments and cautious actions have not harmed Leithner & Co.’s results. Quite the contrary: in absolute and relative terms, caution and scepticism have underwritten reasonable short- and medium-term returns on its shareholders’ equity (click here for a summary).

In the Company’s experience, the higher a security’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 imparted in 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.” Proceeding into 2006, and compared to most others, I discern greater risks and fewer rewards – and remain alert for accidents.

Some Friendly Reminders for Australian Investors

As always, it is useful to respect the laws of human action and appreciate the lessons of history. An unprovoked and increasingly unpopular war launched under false pretences, largely by a privileged and arrogant American political class and against an increasingly tenacious resistance in an impoverished and distant land about which the warmongers (and, for that matter, peaceniks) know little; a tsunami of government expenditure that generates smugness among the mainstream but rankles a minuscule band of constitutionalists; persistently and artificially low rates of interest and an apparent revival of the pace of economic activity; a rebound of stock and bond prices after a nasty fall; and a growing trade deficit, steadily falling $US and erratically rising price of gold – all of these developments describe contemporary America and the policies of George W. Bush. But they also describe America in 1969-72 and the policies of Richard M. Nixon. If, as Mark Twain counselled, history does not repeat but does rhyme, then it is worth investors’ while to ponder whether Mr Bush’s policies will produce results similar to Mr Nixon’s. Australians would also do well to ask whether the consequences of John Howard’s policies will mirror those of Gough Whitlam and Malcolm Fraser. All of these scoundrels are, after all, cut from much the same big government and aggressively interventionist cloth.

The analogy, of course, is perilous: to say that two sets of policies or periods of time share characteristics a, b and c is hardly to reason validly to the conclusion that they will necessarily lead to results x, y and z. Iraq, for example, and as many self-styled “conservatives” stridently remind anybody within shouting range, is not Vietnam (see, for example, “Stand Firm in Iraq,” The Australian 5 December). But this misses the point – which is that interventionism usually unleashes unanticipated and negative consequences (see in particular Justin Raimondo, Iraq and Vietnam: Different Wars – But Not That Different). The relevant generalisation, to which the laptop bombardiers seem to be oblivious, is that interventionism begets war, that war unleashes yet more interventionism and that this spiral corrodes and eventually destroys liberty and prosperity (see also Letter 57, Letter 59 and Letter 63).

On that basis, perhaps the closer and better analogy of today’s tragedy in Iraq is to the French débâcle in Algeria in the 1950s and 1960s and to Israel’s imbroglio in Lebanon during the 1980s and 1990s. Insurgents sap invaders’ morale often enough to make insurgency worth the long time and horrible costs it entails. And how similar to contemporary Iraq is the Iraq of yesteryear? Perhaps because the answer to that question is hardly reassuring, virtually nothing has been uttered about the parallels of today’s disaster with Britain’s ruinous intervention in Mesopotamia during and after the First World War (an exception is “An Unfortunate Occupation” by Karl Meyer in The Australian Financial Review 15 July). On that fiasco see Thomas Lawrence, usually known as Lawrence of Arabia, and his Report on Mesopotamia.

Perilous or not, the economic comparison between the Nixon and Bush administrations is tempting – and ominous. In 1970, a year of mild recession (according to the National Bureau of Economic Research, the semi-official arbiter of such things), Mr Nixon, with an accommodative central bank blowing briskly at his back, opened a floodgate of expenditure, artificially stimulated economic activity and revived animal spirits in financial markets. In 1972, allegedly a year of strong recovery, Nixon hit the campaign trail and, promising even better times to come, won re-election by an extraordinary landslide. His second term was correspondingly historic. But it did not, to put it mildly, unfold in quite the way he intended. In 1973-75 the structure of production, stock and bond markets, South Vietnam – and the Nixon administration itself – collapsed. The proximate causes of the disintegration (i.e., the Keynesian policies that generated stagflation and a Machiavellian mind set that spawned felonies at home, war crimes abroad and denials and cover-ups everywhere) had been implemented years before. Indeed, whilst Nixon assiduously fanned its flames, in both economic and military terms the interventionist kindling was lit during the Kennedy and Johnson presidencies.

Barron’s (“That 70’s Show” 17 November 2003) noted that “wilfully or not, the Bush administration seems to have ignored the two biggest economic lessons of the Nixon era: artificial stimulation of the economy, via tax or interest-rate cuts, almost always backfires; and running deficits can be dangerous, particularly when foreigners finance them.” Wayne Nordberg, chairman of Hollow Brook Associates of Gladstone, New Jersey and cited in the Barron’s article, presaged a possible consequence of today’s policies. “We’ve revived the stock market, but at a tremendous cost to our national balance sheet. The real bear market is ahead of us, not behind us.”

Setting aside the two world wars, the worst financial and economic disaster of the twentieth century was the Crash of 1929 and the Great Depression that followed (but was not caused by) it. The second-worst was the recession and bear market that began in the early 1970s. As in 1929 and into the 1930s, the 1970s bear market and recession was felt in all Anglo-American countries. Depending upon the country and one’s definitions, it lasted up to 20 years. But unlike the Crash, the funk of the 1970s did not unfold suddenly. Nor was the destruction it wrought as widespread or as devastating as the Depression. And in Australia, attention was distracted from economic matters towards an unprecedented political drama. (The upper house of Parliament refused supply to the lower house; and HM the Queen’s representative, the Governor-General, sacked a Prime Minister with a clear and workable majority in the lower house.) Perhaps for those reasons, and despite their greater temporal proximity, the recession and bear market of the 1970s do not evoke the same uniformly dreadful memories as the 1930s.

That is unfortunate. The recession and bear market of the 1970s was an excruciatingly extended affair. Month after month – indeed, year after year – the prices of stocks and bonds fell. One of Benjamin Graham’s employees and Warren Buffett’s colleagues at Graham-Newman Corp. during the early 1950s, William Ruane, managed funds throughout the 1970s. He recalled “we had the blurred vision to start the Sequoia Fund in mid-1970 and suffered the Chinese water torture of under performing the S&P four straight years. We hid under the desk, didn’t answer the phones and wondered if the storm would ever clear.”

Moods were bleak because things that from the point of view of a mainstream (i.e., Keynesian) economist were impossible and thus inexplicable occurred at the same time. There was not just a recession and rising unemployment but also interest rates and a Consumer Price Index soaring into double digits. In partial recognition of the shock these events delivered to the mainstream – and of the ability of Austrian School economists to explain them – in 1974 Friedrich Hayek, whose insights had been marginalised, ridiculed or ignored since the 1930s, was awarded The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel. But this recognition was grudging: to Hayek’s intense irritation, he shared that year’s prize with the unrepentant socialist Gunnar Myrdal.

Another Look at the 1970s-1990s Bear Market

The four-fold lesson that emerges from this analogy, if it is valid, is that (1) Australians can find themselves on the losing side of a war; (2) they can also congregate on the losing side of investments; (3) errors 1 and 2 can entail years of penitence; and (4) because they are remarkably incurious, Australians prefer to forget than to analyse their mistakes. Again and again, therefore, they dig themselves into similar holes.

An important corollary of this lesson is that investors must (but usually neglect to) protect themselves against the consequences of their rulers’ misguided actions. Investors must preserve the purchasing power of their capital; yet interventionist politicians inevitably erode (and cumulatively destroy) it. The erosion of purchasing power is an unavoidable consequence of central banks’ policy of creating money not backed by savings. Central banks manufacture inflation because they have no incentive to gainsay governments’ and/or consumers’ determination to live beyond their means. For almost a century, central banks have virtually always inflated; and inflation always begets rising prices – that is, declining purchasing power. Over relatively short periods of time, its visible consequence can take the form either of rising producer and consumer prices or of rising stock, bond or real estate prices. But over longer (multi-decade) periods, inflation eventually boosts consumer prices.

It is therefore imperative to recognise that the Consumer Price Index (despite its myriad conceptual and empirical shortcomings) and inflation are related but distinct things. Inflation is a cause; and a rising CPI is one of its eventual consequences. Like value and price, they eventually regress towards one another; but at any given point in time they may diverge (sometimes by a wide margin). Alas, like the distinction between value and price, very few people recognise the fundamental difference between CPI and inflation.

Figure 1 expresses the CPIs of Australia and the U.S. in terms of a common (September 1969=100) base, and plots the declining purchasing power (in terms of consumer goods) of the $A and $US until July 2005. The purchasing power of the $A fell from the beginning base of 100 cents to the dollar to $.90 in 1972, $0.80 in 1973, $0.60 in 1975, $0.50 in 1977, $0.40 in 1979, $0.30 in 1982, $0.20 in 1987 and $0.116 in July 2005. Between September 1969 and July 2005, in other words, the Reserve Bank of Australia destroyed 88% of the currency’s purchasing power. Accordingly, the good or service (say, a box of Granny Smith apples) that cost $A1 in the spring of 1968 cost $A8.62 in the winter of 2005.

Figure 1
Fiat Money Constantly Erodes

Fiat Money Constantly Erodes

The CPI has risen without interruption and at an average annual compound rate of 5.7% – interestingly, a rate that is slower but not dramatically different (depending upon one’s definition of money) from the rate of inflation of the money supply. Purchasing power has melted more quickly at some times than others, and its rate of dissolution has steadily decelerated since 1969. It evaporated at an averaged annual rate of 8.1% during the 1970s, 7.7% during the 1980s and 2.2% since 1990. Celebrating this most recent rate, nowadays politicians and economists crow incessantly and triumphantly that Australians inhabit a “low-inflation” country. But they somehow neglect to admit that even during the past fifteen years Australians have cumulatively lost 30% of their purchasing power. That’s much better than the Whitlam-Fraser era; but then again, most eras were much better than the Whitlam-Fraser era.

The story in the U.S. is similar but somewhat less dramatic. Purchasing power fell from the beginning base of 100 cents in September 1969 to $.90 in 1971, $0.80 in 1973, $0.60 in 1978, $0.50 in 1979, $0.40 in 1981, $0.30 in 1989, $0.20 in 2002 and $0.193 in 2005. Between September 1969 and July 2005, in other words, the Greenback has lost 81% of its purchasing power. It has dissolved without interruption (at an average annual compound rate of 4.3%), but its rate of melt has steadily decelerated over time. Purchasing power evaporated at an average annual rate of 6.0% during the 1970s, 4.0% during the 1980s and 2.4% (slightly faster than in Australia) since 1990. During Mr Greenspan’s tenure at the Fed since mid-1987, a rising CPI has robbed American consumers of 41% of their purchasing power. That is The Maestro’s unspoken legacy (see also Letter 71).

Why does this matter? Because investors have two objectives. The first is to preserve their wealth. To do so, they must compound it at a rate that compensates for the central bank’s gradual destruction of the currency. Simply in order to stand still (in terms of the CPI), since 1969 Australian investors have had to earn an average return of 5.7% per annum, and their American counterparts 4.3% per year. The second objective, subject to the first, is to fructify wealth; that is, to compound it more quickly than the government destroys it. Inflation and the fire it eventually lights under consumer prices matter because they erect ever-higher hurdles over which investors must jump. Clearly, the attempt to surmount them can cause injury.

At this point, the equity bulls are usually quick to interject that stocks are means par excellence to defend against central bankers’ relentless debasement of money. The prices of stocks, they insist, reliably rise at least as quickly as the CPI. Ben Graham, of course, knew better. Later editions of The Intelligent Investor included a chapter entitled “The Investor and Inflation.” Graham said many wise things about monetary mischief. He correctly observed that the U.S. had suffered much inflation since the creation of the Federal Reserve in 1913. He rightly noted that “inflation and the fight against it” is a perennial struggle to maintain the purchasing power of one’s capital. He properly challenged the conventional wisdom that stocks necessarily withstand the ravages of inflation; and he saw that corporate earnings and return on equity do not rise in tandem with the CPI. He showed that the growth of earnings is more often a consequence of increased corporate debt and the productive investment of retained profits – and not of the fructification of previously existing capital.

But nobody is perfect, and Graham also dropped a few howlers. Perhaps most notably, in the 1973 edition of The Intelligent Investor he stated “official government policy has been strongly against large-scale inflation, and there are some reasons to believe that Federal policies will be more effective in the future than in recent years.” Much more sensibly, “there is no certainty that [the] stock component [of an investor’s portfolio] will insure adequately against such inflation, but it should carry more protection than the bond component. ... It must be evident to the reader that we have no enthusiasm for common stocks at these levels [892 for the Dow in 1965]. For reasons already given, we feel that the defensive investor cannot afford to be without an appreciable proportion of common stocks in his portfolio, even if we regard them as the lesser of two-evils – the greater being the risks in an all-bond holding.”

Graham, in short, counselled that stocks, if bought at sensible prices, would likely mitigate much but not necessarily all of the damage wrought by governments. Accordingly, it is unlikely that results like those depicted in Figure 2 would surprise him. It expresses the All Ordinaries Index and Dow Jones Industrial Average in terms of a common (September 1969=100) base, and plots these indexes net of their respective CPIs to July 2005. In other words, Figure 2 calibrates the purchasing power of a unit of currency invested in these countries’ major stock market indexes in September 1969, and then plots this purchasing power to July 2005.

Figure 2
Who Says Stocks Always Protect Against the CPI?

Who Says Stocks Always Protect Against the CPI?

The results should startle and humble the bulls: if stocks are bought at the wrong time – i.e., at the wrong prices – then over the long term their ownership can destroy much of an investor’s capital. In retrospect, September 1969 was clearly a very bad time to buy stocks. The investor who purchased a perfectly representative sample of companies in the All Ordinaries Index in that month received (ignoring brokerage for the sake of simplicity) 100 cents’ worth of stocks in exchange for his investment dollar. Alas, the purchasing power of that dollar fell to 36 cents – that is, declined 64% – by 1977. On an annualised basis, from 1969 to 1977 the Australian investor’s purchasing power fell more than 11% per year over these eight long years. It then rose very slowly but steadily, and did not return to 100 cents until 1999 – thirty years later! In July 2005 the purchasing power of the money invested in the All Ordinaries rose to 121. In real (net of CPI) terms, from 1969 to 2005 it rose at an annualised compound rate of 0.5% per year.

How on earth could this happen? Then as now, Australians were blinded by the “money illusion” (see Letter 45). In 1969, Australian shares were dear. Between 1969 and 1977, the CPI advanced by a cumulatively whopping 295% and at an annualised compound rate of 8.1%. Meanwhile, the nominal level of the All Ordinaries fell by 26% and at an annualised compound rate of -3.6%. The combined and cumulative effect of these pincers shredded two-thirds of the investor’s capital. Thereafter, as the CPI’s gallop decelerated and the nominal level of the All Ords recovered, this investor gradually recouped her purchasing power and, by the late 1990s, began to eke a small increase (relative to the 1969 base level). Euphoria and the high prices they spawn matter because these things have destructive consequences. Conversely, the gloominess that produces low stock and bond prices is the investor’s best friend. The tough-skinned investor who invested $1.00 in a perfectly representative facsimile of the All Ords at the bear market’s nadir in 1982 would have increased its purchasing power to $3.18 in July 2005 – i.e., at a real (CPI-adjusted) annualised compound rate of 5.0% per annum.

The American investor who in September 1969 bought a perfectly representative sample of stocks in the DJIA also fared poorly for most of the intervening years, but since the late 1980s has handily outpaced his Australian counterpart. This investor received (ignoring brokerage for the sake of simplicity) 100 cents worth of stocks in exchange for his dollar. Alas, the purchasing power of the nest egg invested in the DJIA fell to 37 cents – that is, declined 63% – by 1982. It then rose steadily, and did not return to 100 cents until 1992. In July 2005 the purchasing power of the money invested in the Dow in 1969 rose to $2.15. Over these 36 years, in real (net of CPI) terms, the purchasing power of the investor’s capital rose by 115% and at an annualised compound rate of 2.6% per year.

In the U.S., too, rising CPI and falling nominal stock prices during the 1970s and 1980s cumulatively destroyed the bulk of the investor’s capital. Only as the CPI subsequently decelerated and stock prices rose ever more quickly, particularly in the late 1990s, did this investor eventually recover the purchasing power that, like the booty from some old shipwreck, had been submerged so long. In America, too, price matters: the intrepid investor who invested $1.00 in the DJIA in 1982 would have increased its purchasing power to $5.86 by July 2005 – i.e., at a CPI-adjusted annualised compound rate of 7.6% per annum.

Figures 1 and 2 encapsulate some fundamental lessons for value investors – lessons that corroborate points Graham made in The Intelligent Investor. Logically and historically, it is simply wrong to assert that the nominal prices of stocks, bonds and real estate always rise. Considered as a whole (i.e., at the level of the All Ords or other index) and over several decades they do increase – central banks’ policy of inflation sees to that. But during shorter expanses of time – including up to 20 years – the nominal prices of financial assets can stagnate or even fall. Further, it is dangerously wrong to maintain that prices net of CPI, even over long intervals of time, always rise. Most dangerously, during shorter expanses of time falling asset prices and rising CPI can destroy much of one’s nest egg. If you buy at the wrong prices it can take a very long time – far longer than the vast majority of today’s market participants, professional as well as amateur, are prepared to contemplate – to recover your position.

What, Then, To Do?

For his students, employees and investors at large, Benjamin Graham’s positive attributes vastly exceed his defects. Each day, he sought to do something wise, something generous and something whimsical; and on his birthday, he gave presents to his closest friends. Graham asked his students “have you ever seen a human being mentioned in a corporate business plan?” and beseeched them to “always remember that you are dealing with people and their hard-earned savings.” Even more than his approach to investment and financial matters, these aspects of Graham’s ethics deserve emulation.

Further, in a field that has usually attracted narrow and technical minds, Graham cultivated broad and deep interests. Upon his graduation from Columbia University he was offered academic posts in three departments; for decades he taught part-time in Columbia’s Business School; he was a life-long scholar of classics, languages, literature, mathematics and philosophy; he retired in order to pursue these passions; and he commended to his grandchildren “the incomparable richness of intellectual endeavour – for its own sake, independent of material acquisition.” Further, in a field where avarice and sharp practice are perceived to be more prevalent and necessary than generosity and plain dealing, during the Great Depression he declined any salary until his investors’ losses had been recouped. And in a line of work where “growth” is worshipped, for years he withstood the temptation to increase the bulk of Graham-Newman Corp. Instead he concentrated upon maximising the returns to its owners.

Benjamin Graham richly deserves his reputation as the founder of modern security analysis. His enduring legacy is that the fortunate few who absorb and practice his methods are likely to generate reasonable investment results over the years and decades. Yet even men of Graham’s calibre can and do occasionally miscalculate. Among his biggest gaffes, in addition to his misplaced confidence in central bankers, was his dismissal of gold. “The standard policy of people all over the world who mistrust their currency,” said Graham in the last edition of The Intelligent Investor, “has been to buy and hold gold. This has been against the law for American citizens since 1935 – luckily for them. In the past 35 years the price of gold in the open market had advanced from $35 per ounce to $48 in early 1972 – a rise of only 35%. But during this time the holder of gold has received no income return on his capital, and instead has incurred some annual expense for storage.” All of this is true. Unfortunately, Graham then extrapolated from what he mistook as a base rate: “the near-complete failure of gold to protect against a loss in the purchasing power of the dollar must cast grave doubt on the ability of the ordinary investor to protect himself against inflation by putting his money in ‘things.’”

Graham was flatly wrong about gold (and, more generally, about precious metals). Indeed, the period 1969-1980 was an outstanding time to buy and hold gold. Figure 3 should thus startle and humble not just the legions that are perennially bullish about equities: it should also give traditional value investors – many of whom share Graham’s aversion to gold – food for thought. It shows that if gold is bought at the right price, then, over the very long term and as well as or better than stocks, it protects the purchasing power of the investor’s capital against the government’s assaults.

Figure 3
Who Says Gold Is a Poor Long-Run Investment?

Who Says Gold Is a Poor Long-Run Investment?

September 1969 was clearly a very good time to buy gold. The investor who purchased $A1 or $US1 of the stuff in that month saw its purchasing power treble by 1975 and zoom six-fold or more by 1980. By July 2005 the purchasing power of the Australian capital stood at 210 cents, and thereby generated a compound rate of real growth of 2.0% per annum. This CPI-adjusted rate of return, it is important to note, outpaced that of the All Ordinaries Index (0.5% p.a.). So who says that gold is always a poor investment, and who says that stocks invariably leave it in the dust? This lesson also applies to Americans: the purchasing power of the 100 cents invested in gold in September 1969 grew to 215 cents in July 2005 – identical to the 100 cents simultaneously invested in the DJIA.

It is true that the twenty-five years since 1980 have been unfriendly to the owners of gold. The Australian who bought $1 worth of gold at its peak in 1980 saw its purchasing power fall to $0.35 in July 2005 (i.e., shrink by 4.0% per year). Nonetheless, she who bought gold in 1969 was able to protect her purchasing power without interruption during the next 36 years. Unlike stocks, in other words, since 1969 the CPI-adjusted price of gold has never fallen below 100. The implication is quintessentially Grahamite. As with stocks, so too with gold: if one buys at a sensible price and holds for a very long time, it is not reasonable to expect that one will thereby become rich. There are, however, solid grounds to expect that one will avoid becoming poor. Over very long periods of time, in other words, gold can be an excellent Grahamite “defensive” investment; and under particular circumstances and shorter intervals, it can also repay the attention of “enterprising” investors.

The Patriot’s and Investor’s Case for Gold

Just as true patriots must defend their country from its government, intelligent investors must patrol the perimeter around their capital against politicians. (“Loyalty to the country always,” said Mark Twain. “Loyalty to the government [only] when it deserves it.”) In many walks of life, vigilance is the price of liberty and prosperity. It follows that the ranks of a country’s true patriots include its intelligent investors.

Antagonism towards gold – usually latent but sometimes explicit and even hysterical – unites high spenders, inflationists and statists. That motley crew, among whom politicians, mainstream economists, bankers, property developers, M&A lawyers and funds managers are vocal members, accurately senses that ownership of gold, genuine prosperity and economic liberty are inseparable, and that the one implies and requires the other. Why are they so antagonistic towards gold? One specific reason, as this Newsletter has shown, is that over a very long period of time gold protects its owner against his government’s ceaseless debasement of the currency. Inflationists, on the other hand, and particularly politicians, profit massively from inflation. Without it, they would have to get real jobs and earn honest money.

A much more general reason is that gold is a bulwark of a free society. Money, defined as the commodity that serves as the medium of exchange, is the common denominator of economic transactions. It thereby provides an objective measuring stick of subjective value, a standard of accounting and a means of saving. A medium of exchange is a precondition of any trade beyond simple barter. It is therefore a necessary condition of a division of labour and of a capitalist structure of production. If buyers and sellers in the market could not utilise some such commodity, they would have to forgo the advantages of specialisation and inhabit self-sufficient farms; and if people had no means to save, then long-range planning and calculation would at best be impractical and at worst intractable. Sound money is thus a basis of civilisation and prosperity; and absent sound money, these things rest upon insecure foundations.

Austrian School economists have demonstrated that sound money does not emerge arbitrarily. Nor, by definition, is it defined or managed by government. First and foremost, sound money is freely acceptable by all participants in the market. It must also be durable. A metal is generally chosen because it is homogeneous and divisible: every unit is the same as every other and it can be (re)formed into any desired quantity. In contrast, precious jewels are neither homogeneous nor easily separable into standard weights. Thirdly, the medium must be costly to produce and be regarded as a luxury. (Clearly, money printed by a government printing press and backed by nothing but faith in the printer is not costly to produce. Only when legal tender laws force people to accept it does the government’s “fiat” money serve as money. History shows us no instance where people accepted such money without coercion. Fiat money is inherently unnatural and thus unsound.) People’s desire for luxury goods is unlimited, and so they are always in demand. The term “luxury good” implies scarcity and high unit value, and a high unit value implies portability.

Historically, gold (subsequently supplemented by warehouse receipts) has best fulfilled these criteria; and only relatively recently have governments successfully demonetised it. The critical point is that it is very difficult to increase the supply of gold quickly and vastly. In diametric contrast, it is alarmingly easy to inflate the supply of fiat money. The supply of gold relative to paper money is always limited, and the demand for gold is usually stronger than the demand for paper money. Governments have demonetised gold, but they have not destroyed its subjective value. Over extended periods, its value (relative to that of paper money) thus remains constant or rises.

Gold has another compelling advantage over paper: from the point of view of the patriot and intelligent investor, its use requires no absurd leap of faith. Benjamin Anderson analysed the economic characteristics of gold in his financial history of the United States (Economics and the Public Welfare: A Financial and Economic History of the United States, 1914-1946, Liberty Press, 1949, 1979). In a chapter entitled “The Tyranny of Gold,” he wrote “gold needs no endorsement. It can be tested with scales and acids. The recipient of gold does not have to trust the government stamp upon it, if he does not trust the government that stamped it. No act of faith is called for when gold is used in payments, and no compulsion is required.”

From the point of consumers and producers, then, gold is an ideal medium of exchange. It is ideal not least because, from governments’ point of view, it is an intolerably rigid and unforgivably hard taskmaster. If governments spend too much money (which they constantly strive to do) and issue too much money to finance their profligacy (ditto), seeds of doubt are planted in the market. But like stocks and bonds, so too fiat money: distrust does not sustain value. The market’s reaction, when it eventually comes, can be swift and powerful. James Grant, writing in Forbes (10 January 2005), noted

The hallmark of the classical gold standard was the prompt adjustment of international payments imbalances. The hallmark of [today’s] pure paper standard is the indefinite postponement of international payments imbalances. Under the gold standard, a deficit country, if it persisted in its deficit, would eventually run out of gold. Under the pure paper standard, a deficit country, if it’s the U.S., can keep right on printing money. That is, it can keep on printing until its creditors cry: “Uncle!”

These days, the discipline once imposed upon governments by the gold standard is nowhere to be seen. For decades – indeed, for the roughly 90 years since the gold standard’s destruction – inflation has far exceeded what would be possible if money were backed by gold rather than blind faith in big government. As a result, and given both the rapaciousness of governments and their subjects’ apparent indifference to all but the most appalling of their rulers’ actions, the inevitably dwindling purchasing power of fiat money has become an unremarkable and unremarked (except by true patriots and intelligent investors) state of affairs.

Gold Promotes Stability and Peace; Fiat Money Foments Disorder and War

Inflationists denigrate and denounce the gold standard because they realise that it does not abide government-sponsored welfare and warfare. Stripped of their academic garb, policies of guns and butter are indistinguishable: both are mechanisms whereby politicians confiscate wealth from the productive, undertake myriad wealth-sapping schemes, pocket some of the proceeds and redistribute the remainder to their mascots. A substantial part of the confiscation occurs via taxation. But statists have recognised that if they wish to retain popular support and political power, then they must limit the amount of overt taxation they impose upon their subjects. Indeed, they have realised that the lure of “tax cuts” distracts attention from covert forms of taxation – that is, inflation and deficit spending. Hence inflationists’ desire is to create and borrow money in order to finance their various wars.

Under civilised monetary arrangements, the amount of credit that a structure of production can support depends upon it’s the extent of its assets. This is because every credit instrument is ultimately a claim upon some asset (see Letter 67). Notice, however, that no asset backs any government bond – instead, only the government’s promise to pay interest and repay principal out of future tax revenues underwrites it. Under a gold standard, financial markets cannot easily absorb such suspect instruments: after all, who in his right mind lends to somebody who will have to borrow (or racketeer) in order to repay the debt? Accordingly, any significant volume of government bonds can be flogged to the public only at progressively higher rates of interest. Further, under these conditions (and reflecting its relatively higher risk) government paper offers higher yields than corporate debt. Hence inflation and government deficit spending under a gold standard is severely restricted.

The abandonment of the gold standard enabled statists to use the banking system to create hitherto unimaginable amounts of credit, and thereby to finance hitherto inconceivable amounts of pork – and total war. It is no accident that governments abandoned the gold standard in order to fight world wars. Still less is it a twist of fate that during the heyday of the classical gold standard, the century between Waterloo and Sarajevo, wars were small, few and far between. Finally, it is no coincidence that governments have continued to demonise gold in order to finance their never-ending wars, the one more costly and idiotic than the last, on Communism, poverty, drugs, and now terrorism.

What is the mechanism whereby orthodox finance can be overturned so recklessly? Statists create paper reserves in the form of government bonds that commercial banks accept as if they were assets and treat as if they were an actual deposit – i.e., as the equivalent of what was formerly a deposit of gold. Government debt, in other words, finances the excesses of commercial and investment bankers, property developers, M&A lawyers and funds managers. No wonder the latter praises the former so lavishly. The holder of a government bond or bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the cold fact is that there are now more claims outstanding than there are real assets.

Unfortunately for politicians and fortunately for their subjects, the law of supply and demand cannot be suspended forever. As the supply of money increases relative to the supply of tangible assets, prices must eventually rise. Thus the earnings saved by the productive members of the society lose value when expressed in terms of goods and services. This loss of value represents the goods commandeered by politicians for warfare, welfare and other nefarious purposes. Truly, government is a pox upon cautious, independent, thrifty and productive people.

Here, then, is the crux of the inflationists’ contempt for (and occasional tirades against) gold: to advocate guns and butter too is ultimately to promote inflation and government expenditure; and such taxing and spending, stripped of its warm and idealistic language, is simply a scheme to confiscate individuals’ wealth. But even in its present (demonetised) state, gold obstructs this insidious process. Gold is a standing rebuke to galloping government, and it thereby retains its status as a bulwark of property rights and economic liberty. Australians who grasp this truth can comprehend statists’ hostility towards gold – and ascertain its possible place in their investment portfolios.

Gold as a Component of a Grahamite Portfolio in 2005-2006 and Beyond

So is today, like 1969, a good time to buy gold or gold-linked securities? Or, like 1980, is it a rotten time to buy? The easy and obvious answer is that neither I nor you nor anybody else knows. But we can, if we put our minds to it, make some sense of history and the laws of economics. On that basis, a justifiable conclusion is that over the decades gold is likely to help protect its owner against his rulers’ economic recklessness. If so, then in one form or in combination (i.e., bullion, gold mining companies, unit trusts, hedge funds, etc.) and depending upon whether he is “defensive” or “enterprising,” gold should comprise some non-trivial percentage of the Grahamite investor’s portfolio.

A less obvious answer to these questions is that the holder of fiat money assumes an unheralded risk – namely that politicians might (from their point of view) succeed. Gold, in other words, is a hedge against the “success” of politicians who constantly strive to deliver inflation, guns and butter, manipulation of interest rates and the currency, and the politics of fear. If you are wary that John Howard and George W. Bush – and Ian Macfarlane and Ben Bernanke – will continue to get their way, then consider buying insurance against their success by buying gold. Is today a good time to buy gold? Ultimately, the answer to this question depends upon your position with respect to a much more fundamental question. Which do you trust more: gold or government?

“Moderates,” said George Will in “Republicans Lose the Plot” (The Australian Financial Review 18 November), “are people amiably untroubled by Washington’s single-minded devotion to rent-seeking – to bending government [to] the advantage of private factions. ... War is hell but, on the home front, it is indistinguishable from peace, except that government is more undisciplined than ever.” Do you believe that marauding politicians in Australia and elsewhere can and will shortly return to their barracks? Do you believe they can quickly become wise and frugal, restraining men from injuring one another but otherwise leaving them free to regulate their own pursuits? Did you believe Mr Costello when he said (The Australian Financial Review 4 March) “Australia’s prospects are very strong and any talk about a recession of course is not at all within the bounds of possibility”? If so – and doubly so if you cheer today’s crop of “conservatives” – then the conventional wisdom and mainstream economics and finance, and their conventional policies and investment programs, are for you.

But what if you are immoderate? Do the countless follies, disasters and outrages of politicians prompt you to consider a rather dour outlook regarding the next several years? Casting an eye back to the late 1960s and their similarities to our day, do your investment plans include the possibility of stagflation? Do you recognise that people who abandon thrift and embrace hedonism and abject dependence upon foreigners render themselves vulnerable to sudden reversals of fortune? Are you therefore alert to surprises?

At the same time, and despite what you behold on all sides, do you exalt freedom of conscience and trade, the unfettered play of natural economic forces and the sanctity of property and enterprise? Do you condemn privilege, the assaults of the rich upon the poor and of the improvident upon the yeomanry? Do you hope that a better day will eventually dawn, that a world gone mad will come to its senses and that citizens will recover their courage and shrink government drastically, so that elected officials work like humble servants rather than strut like fascist gauleiters? Do you also believe that these glorious things are – to put it mildly – unlikely to occur in a hurry? If so, then a respect of history, knowledge of Austrian School economics – and ownership of gold – will bolster your spirits, put a spring into your step and help you to sleep soundly. As an added bonus, in a few decades your children are likely to applaud your investment acumen.

A Seasonal Wish for Liberty, Property and Peace

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, a happy New Year, an easygoing Australia Day and a healthy and prosperous 2006.

Chris Leithner


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