Mises Meets Graham and Dodd

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On the nature of money, capital, scarcity, growth and capital preservation. A wide-ranging discussion on investment issues with the u2018Austrian-school’ strategist of Sage Capital.

Q: Sean, during last week’s annual shareholders’ meeting of Berkshire-Hathaway, Mr. Buffett suggested that sometime in the next ten years he expects an economic disaster. Has someone converted him to a gloom-and-doomer or what?

A: As we can infer from his expressed difficulty in finding suitable investments these days, Mr. Buffett seems to realize that wealth creation is becoming impaired by, not facilitated by, the enormities of our present-day financial system. As one who has made his money partly through a close reading of balance sheets and income statements, he, of all men, must be well aware that increasing indebtedness at an exponential rate, when the pace of material progress is much less rapid and continuous, is a sure road to the poor house.

Q: Yes, but, you know, people have been forecasting disasters forever. There are a number of people out there who make tidy profits preaching doom and gloom, but it never happens. Life just goes on. Now Buffett pipes in with such melodrama. It makes one stand up and take notice, no?

A: We should be careful of making the Sage of Omaha — an investment genius — into the Oracle of Omaha — the possessor of an economic crystal ball: he himself would traditionally never have claimed any such a special insight. That said, when eminent investors such as Buffett, Sir John Templeton, Jim Rogers, and Pimco’s Bill Gross, as well as sober and well-regarded market analysts such as Richard Russell, express opinions ranging from caution to outright alarm at the state of play, we, too, should at least consider what it is that they see that the central bankers and their mainstream worshippers fail to recognize.

Q: Speaking of disasters let me ask you something. Virtually all u2018Austrians’ view the cup as being half-empty — I mean, constantly and forever bearish on the world. In the meantime and somehow, the world keeps going. Let’s be honest, can Austrians really be good investment advisers?

A: A good point! After all, Mises himself once wondered whether, instead of being a teacher, he was doomed to be merely a u2018historian of decline’, but he never yielded from the task of pointing out the right path. Austrians are not pessimists, only realists. We know that much of the present-day menu of policy choices are founded on erroneous principles and thus do more harm than good, even when well-intended. However, we also know that it is the lot of individuals, in the main, to make their own lives better by materially enriching others and that it takes a very great deal of folly and vice to stem the wellspring of entrepreneurialism which waters the fields of human endeavour.

Q: Fair enough. But again, what is it about the u2018Austrian school’ that gives you any marginal advantage in money management?

A: The Austrian school on its positive side teaches us to glory in the power of the unhampered market to increase wealth and well-being — even in the face of government interference — and it extols the roll of the honest entrepreneur as the main agent of this progress, praising his profits as a mark of his success in bringing about such improvements. However, it also teaches us that the laws of scarcity are not to be avoided by the simple printing of money; that mere technological know-how is not a sufficient condition for our advance; that savings — foregone present consumption — wisely parlayed into capital by placing them at the disposal of entrepreneurs — is what fuels the increase in our prosperity. The first helps us avoid unwanted pessimism: the second instills in us a due measure of caution and helps immunize us against investment manias — not a bad philosophical starting point for money management, surely!

Q: Yes, but you also seem to dismiss statistics and the whole lot of modern financial analytics, no?

A: Yes, Austrian economics dismisses the supposed predictive ability of statistics and offers valid criticisms of the worth of the common catch-all aggregates such as u2018growth’ and u2018CPI’, or u2018productivity’ served up to us by the bureaucrats, while it teaches us to see beyond the immediate effects of any spontaneous change or imposed policy shift. Among other benefits, this makes us Austrians suspicious of the whole spectrum of fancy financial engineering marketed to the public — an approach which always sounds impressive, with its scientific-sounding reliance on u2018back-tested’ models and volatility-based u2018Value-at-Risk’ assessments to guide investment policy, but which is really no more than an abstruse way of saying Tomorrow will look much like Yesterday, when all the evidence of history is that it never quite manages this feat!

Q: You have written a great deal over the past few years on the nature of capital in view of theory and changes in our world. Make it simpler for us: what is money or wealth and has this changed from what we used to think?

A: I will try. If you have a $10 bill in your pocket which you have earned honestly, you have a token which says you added wealth to another’s life, but you have yet to decide in what form to take your true reward. Now, if you buy a few gallons of gas with it, you have converted the money into u2018wealth’— that is, into a good which is u2018scarce’ and which is valued by you and by others for its inherent qualities.

Q: Help me out here, why is gas u2018scarce’?

A: An economist might say it is u2018scarce’ because it has a price, but I suspect that answer would not satisfy you too much!

Q: Make it a little simpler.

A: I am only using gas as an example here, but the point is that the quality of scarcity means that gas is not created costlessly and that it is not available without limit. u2018Scarcity’ here is a technical term which must not be confused with shortage. Free markets ration scarce goods via the price mechanism: only Providence — or that less benign deity, the State, can ever create an actual shortage! Gas, then, may seem to be readily available at the price at which it is offered today —there is no u2018shortage’ of it — but that price must, in the long run, reflect the extraordinary amount of effort, of capital resource, of human sweat and intellectual input, needed to take it out of the depths of the ocean, to refine it, ship it and arrange for you to be able to pump it into your Hummer — in other words, it is u2018scarce’.

Q: Thank you. Please go on.

A: If you now use the gas to drive to the beach for a day out, or use it to light your barbecue, you have consumed it once and for all and so you must see that while we obviously acquire wealth in the first place in order to gratify our desires, consuming it does just that — it exhausts it, once and for all.

Q: Makes sense to me.

A: If, however, we use the gas in the course of picking up goods to stock in our corner store, or in running a power lathe to make an ax handle, we are using up this material in a productive fashion. Now, though we may have consumed the gas itself, we have replaced it with another, potentially more valuable, form of wealth — the wares in our store-room, or the tool with which we will cut timber, to sell direct or with which to build something, in turn. You must see that the initial decision to buy gas has now been seen to have been nothing less than an investment and this has led to the formation of capital — whether circulating capital such as goods-in-process or inventory — or fixed capital; plant and equipment. The gas itself has been used up just the same, but its consumption has now been productive — it has led to the creation of some other form of wealth in its place — not exhaustive — as it was when we grilled our dinner with it.

Getting the balance wrong between these two uses lies at the root of much of our economic woe and the inability to distinguish between them — so that we parrot nonsense like, u2018the consumer is seven-tenths of the economy’ — is the occasion for most of the wrong-headed interference by central banks and governments who think that u2018consumption’ must always be stimulated, no matter how wastefully, or at whatever cost to our financial status. To sum up this matter of the difference between u2018money’ and wealth’; nowadays, sadly, too many people believe a bank balance represents u2018wealth’ — even if this balance was instantly conjured into being by the bank writing us down for a loan. In the topsy-turvy world in which we live today, consumption of the exhaustive kind — not production — is supposed to bring us prosperity and possessing a credit line (i.e. the ability to go into debt and so to pre-empt tomorrow’s creation of wealth) is seen as a mark of our riches!

Q: As one looks around, he sees what appears to be an incredible love affair with u2018things financial’ — perhaps to the point of absurdity. As I can vaguely remember the lives of my parents and grandparents, this was not the case in years past. What has changed? And is this good or bad?

A: u2018All things in moderation’ is as sound a precept in finance as it is in dietary science. I sometimes point to the contrast between today’s Casino economy — with a pawn shop outside every saloon — and our Father’s Machine Shop economy — with a savings bank at the corner of every block. Having an enhanced ability to lend or to borrow and having more liquid and transparent markets through which to raise and in which to place funds is obviously a benefit, but when there is no connection between the amount of credit extended and the volume of savings voluntarily made beforehand, and when finance becomes both a speculative end in itself, as well as a means by which to confuse those to whom greedy executives and self-enriching directors have a duty of trust, then matters have clearly gone too far.

Q: You once described General Motors as a giant finance house with a garage in back. But, if the idea is to make a profit, and if industry is making a profit, does it matter how? I mean, isn’t profitability the sine qua non of capitalism? If companies can deliver these by financial means and if individuals want to speculate in index funds and so long as the activity is profitable for both, what difference does it make?

A: Buffett himself had words to say on this score, a year or two back, when he asked how it was that people, who had simply borrowed money to dabble in the market and had then sat back while their actions and those of all their neighbors, who were out doing the same thing, drove ALL stock prices higher, could come to believe that they had miraculously all become wealthier. After all, nobody here had actually DONE anything. No-one had hoed a row of beans, or cut out the pattern for a dress. No-one had invented a better beer can, or had shipped some mineral from where it was relatively cheap to where it was more urgently wanted and thus, more highly priced.

In fact, the main reason that stock prices had risen was because they were among the prime beneficiaries of the ongoing monetary inflation which was taking place, so all that was happening was that much the same amount of genuine u2018wealth’ was being measured by a yardstick onto which the Fed and its peers, via the agency of the banks and brokers, were cramming more and smaller inches. This way, people came to believe they had a few extra of these new u2018yards’ of cloth, but, in fact, they had no more material than before with which to cover their nakedness — indeed, since they now owed more money than ever before — much of the cloth they did have was effectively pledged to someone else instead.

Q: Now, aren’t you just dismissing the business of finance in general?

A: Look, finance is supposed to be a facilitator of wealth creation: it should never become an end in itself, for, then, all we end up doing is to indulge in the same illusion as that of a gambler on a hot streak who boasts of his riches while eagerly ploughing his winnings back into the same game of craps. Sooner, or later, he’s going to shoot snake eyes and, sooner or later, in a business, or under an investment policy, based on nothing more than the effects of financial manipulation, all but the lucky few and the even more uncommon number of instinctive traders, will also wake up to the true import of the adage that while assets may go down, as well as up, in price, liabilities always have 100 cents in every dollar.

Q: If a man was dropped from Mars and his job was to read the financial press, he’d undoubtedly be amazed at the divergence of opinion that exists among those who profess or imply expertise. Frankly, he’d be confused by the conflicting voices. Why is this and how can a person with genuine interest u2018separate the wheat from the chaff’, so to speak?

A: Remember that, by and large, if you wouldn’t run your own household, or manage your own family firm in the way the u2018experts’ suppose they can direct that mythical beast known as the u2018Economy’, then you are probably right and they are probably wrong, no matter which Wall Street firm, government department or academic faculty they hail from! Be suspicious of people who say more government involvement is better and that cheaper and more available money is the answer to all ills.

As to the first, consider what the very different consequences were of the Russians following Marx and the Americans initially following Jefferson. As to the second, ask yourself whether we could possibly all be better off if we all, simultaneously, took out a pen and added another nought to the end of the denomination of each dollar bill in our pockets. Finally, bear Henry Hazlitt’s famous u2018One Lesson’ in mind: namely that u2018the art of economics consists in looking not merely at the immediate, but at the longer, effects of any policy; it consists in tracing the consequences not merely for one group, but for ALL groups’.

Q. What do you mean?

A: Well, you never win at chess simply by working out your next move. Unfortunately, those who prognosticate on the economy are not grandmasters, who can look ahead ten or twenty moves, but, all too often the lobbyists for Attacks on Queens, Inc., or the envious who say it’s the Pawn’s turn to move, or the contractors who make money shifting Enemy Rooks to safer places, you see? You can be sure that there will be many more far-reaching implications to any policy than most pundits allow and your only course is to try to think them through as far as you can.

Q: Your firm’s focus is stated to be in u2018capital preservation.’ Let’s be honest, isn’t this a bit old-fashioned and simplistic? What do you expect to gain from merely preserving capital?

A: I like the use of the word u2018merely’. The people who deride that concept as quaint or trite should try it sometime!

Q: Sorry, but it is old-fashioned, isn’t it?

A: There used to be an old aphorism that the stock market wasn’t a place where you should look to acquire wealth, but rather the place where you should try to preserve it from taxes and the ravages of inflation — not a view many would find too comfortable today!

Q: Why not?

A: To u2018preserve’ capital is to make sure that the wealth we have won up until today is still there for us, whatever the phase of the business cycle, whatever the follies of the herd, whatever the depredations of the government, when we, our children, or those causes we have endowed need to call upon it. This is a task much easier to enunciate than to fulfil, in a world of hot money, shifting exchange rates, recurring investment manias, financial chicanery, political malice, legal predation, and a whole host of other risks, and this quest is one that is rarely undertaken — whether through the ignorance of the managers of funds, or because of the cupidity or lack of consideration of those funds’ investors.

Q: But, I mean, why u2018preservation’ when you have so many choices for capital growth? Can a whole financial industry be wrong?

A: And why can’t the bulk of the industry be wrong, especially, when it suffers not only from false economic reasoning, but, more importantly, from irreconcilable conflicts of interest?

Q: I was trying to focus on the u2018growth’ part as against your u2018preservation.’

A: Ok, so what do we mean by u2018growth’ and why is u2018growth’ seen as such an essential ingredient of a portfolio that we pursue it all costs, even up to the perpetration of accounting fraud. By u2018growth’, of course, we all too often simply mean an increase in the share price — hence the whole sorry history of firms destroying themselves and corrupting their executives (ethically, if not always criminally) by using financial jiggery-pokery to conjure up u2018earnings’ whose main selling point on Wall Street is that they barely fluctuate about a steadily upward trend…

Q: Surely something impossible in real life…

A: Exactly. Take the case instead of an isolated community in which there is just one baker’s shop. If the honest and hard-working baker can produce enough bread to feed his customers, year in and year out: if the proceeds of his sales are always enough to buy in his flour and coal and to repair, replace, and occasionally to upgrade, his ovens and his shop premises; if he can also compensate his staff; if, all that having been seen to, he can rely upon having enough left over to feed himself and his family, the baker has clearly secured his livelihood in the face of all foreseeable events. Now it should be obvious that there has been no hint of u2018growth’ here, yet certainly, we might wish to have a share in the baker’s business to likewise enjoy such relative security— though we would be very careful indeed to make sure we judged the price we paid to be commensurate with the prospective income.

Q: Sounds like a great business.

A: Yes, but now enter a stock promoter, a Wharton MBA, and a Harvard Law School graduate and the next thing you know, there would be no-one who would think it foolish that the baker should borrow money to buy two ovens, in place of his single one. Soon, no-one would be left to suggest that he should not be seeking to merge his business with the miller, or the butcher — or even with the man who paints his store. Nor would anyone desist from trying to persuade him that he would gain more sales through extending credit to his customers, especially if the loans could be repackaged and booked elsewhere so none might suspect he was impairing his own creditworthiness as he did. Before long, there would be a rush to enter into an auction to try to bid the shop away from him, almost irrespective of the price paid — indeed, the auction would be characterized by ever more urgent bids, the higher the price had already risen! u2018Growth’ and increased u2018shareholder value’ would now be the buzz words and there would be a brief glow of self-congratulation among the baker’s stockholders, large and small, while our trio of financial interlopers would be growing fat on fees and commissions.

Q: So, what’s wrong with that?

A: To start with, nothing suggests that the bakery would henceforth turn out any extra loaves, or that, if it did, that these would command greater aggregate revenues in the marketplace than before. Sadly, then, the fetish for u2018growth’ would have left a great many of its cult-followers to endure either lessened returns, or outright losses and, if things were to go really awry, the upshot might even be that the baker, who had devoted more time and money to making his share price, rather than his breakfast rolls, rise, might be forced out of business in the inevitable collapse, so that the people of the village might not only be monetarily the poorer, but more hungry, too.

Q: Surely there is a kind of growth that you do like, no?

A: Indeed, growth is clearly something to be welcomed, but it should be the growth of a sturdy oak, deeply-rooted on a fertile and well-watered hillside: a tree, whose rings might thicken a little more in good years than in poor, but which will continue to spread a little wider and to climb a little higher throughout all the long ages, impervious to all but the most savage tempest. But what we must never do is to listen to the blandishments of the seed catalogue salesman and to overlook the staid old oak for the newly-planted and exotic saplings stippling the field below, whose expected rapid gain in height will be only the result of extensive irrigation, the liberal application of fertilizer, and a constant dousing in pesticides. This crop — often grown precisely because it is new, or because it is the subject of a passing dietary fad, but which is inherently sickly and prey to all the vicissitudes of the season — may seem to u2018grow’ faster initially, but, it is one whose harvest of fruit is far too uncertain in both quantity and value (as fickle tastes inevitably change) to be the focus of a wise programme of investment.

Q: Is there a main thrust to this thinking?

A: Well, as the Austrians are often at pains to point out, by and large the only way to preserve capital in the long run is to identify honest, hard-working and far-sighted entrepreneurs in whom to invest— men who can peer that little bit more acutely into the fog of Tomorrow and who can take one’s own wealth — often acquired through one’s own prior entrepreneurialism — first to nurture it, then to multiply it by best and most profitably serving the identified needs of their customers. So, we can only ultimately preserve our own capital by making it contribute in some way to the improvement of the general commonwealth. Not a bad objective to which to adhere, I’d say!

Q: So, are you really mixing a bit of Ludwig von Mises with a dash of Graham and Dodd here?

A: That seems a neat way to sum it all up.

Sean Corrigan [send him mail] is investment strategist for Swiss-based Sage Capital Zurich AG.

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