Donald Ruffkin works at an equity-oriented investment fund.
Buffett has come out once again, offering his view of the market and where we stand. I thought his comments provided a useful platform with which to engage what are ultimately the 2 most important questions:
- What is our problem?
- What should we do about it?
In the first couple sections of this, I offer rebuttals to some of Buffett’s statements. I use this as a lead-in to answer those 2 most important questions.
To put it simply, I believe we need the following:
- More manufacturing
- More savings
- Less debt
- Less speculation and leverage in our banking system
- More transparency and honest dealings in our financial system
Will this be painful? Yes, it will be really, really painful. But the path we are going down will make this all the more painful. If, as I am claiming, the problem is too much for the government to prop, all the resources committed to that endeavor will have been wasted.
Let’s get ready for the future, instead of bankrupting ourselves trying in vain to bring back an unsustainable past.
This is Part 1 (source). He says we are in an economic Pearl Harbor, mirroring comments he made 6 months ago. The economy has “fallen off a cliff” and the consumer is “changing their behavior like nothing he has ever seen.” There has been a reset in people’s minds. He says the level of spending we are seeing is due to their being “fearful”. He says that fear is contagious. He says that we have a great leader and we should follow his prescription. In wartime, you need to follow the leader. Now is not the time to ask questions or have internal dissent. Now is the time to follow what he says.
I had a few:
- I noted then, as I will now, that it is disingenuous at best for Buffett to be calling this an “Economic Pearl Harbor”. (1) There is no external aggressor. (2) We are more like a drug addict or an alcoholic than a populus being attacked. (3) His metaphor implies we are not at fault – we just need to fight back against the force which is fighting us. In many, many ways this is not an appropriate metaphor. I understand that he is trying to convey a sense of urgency, and a need to put aside our differences to reach a good solution. But the gaping holes in the metaphor are so large that I am left with the impression that he is simply trying to scare us into following the prescription of Obama.
- The majority of people fundamentally disagree with Geithner’s plan. Many people, including myself, Paul Krugman, Nouriel Roubini, Simon Johnson (former IMF Chief Economist), Richard Shelby, Lindsay Graham, Chris Dodd, KS Fed Chief Thomas Hoenig (source), Calculated Risk, Barry Ritholtz, John McCain, Nassim Taleb, Chris Whalen, Elizabeth Warren (head of Congressional Oversight Panel), Josh Rosner, Alan Greenspan, Gordon Brown, Nancy Pelosi, Nassim Taleb, Joseph Stiglitz and Todd Harrison, believe the plan put out by Tim Geithner is FUNDAMENTALLY FLAWED. Warren Buffett is basically saying that we should shut up and do what Obama says. However this plan is, to our belief, fundamentally flawed and could bankrupt this country. This is not some trivial minority. In fact, it appears the majority OPPOSE the “private public” toxic asset purchase plan proposed by Geithner. “Private public partnership” is a euphemism for “subsidize hedge funds with low cost 9-to-1 non-recourse loans to bail out the banking system”.
- The People versus The Oligarchs. Former chief of the IMF Simon Johnson takes it one level further and believes we have been and continue to be ravaged by the business elites in the US (source). I agree with his assertion, as do many other people. They look askance at the large number of Goldman alumni occupying positions of political power. At the backdoor bailouts to Goldman via the capital injections into AIG. At the fact that PIMCO, Blackrock and Goldman Asset Management are 3 of the biggest consultants helping the Fed and the Treasury manage their bailouts – conflict of interest? At the fact that Goldman was the biggest individual beneficiary of the AIG bailout. At the fact that Wall Street, in aggregate, got paid 2004-level bonuses in 2008. 2004 level bonuses? Are you kidding me? They would not exist if it was not for bailout money. We have privatized gains, and socialized losses.
- US consumer spending is NOT irrational. The Savings Rate was 1.4%, 2.6%, 3.1%, 3.9% and 5% in September 2008, October, November, December and January (see chart). Yet we began seeing Depression-level spending in December (source 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11). How much of this lack of spending is due to “fear”, and how much is due to a simple reversion to the sort of savings rate we are *supposed* to have? As we can see from this chart, our savings rate structurally was north of 5% from 1929 to 1994 and went down to 0% and below. As can be seen from this global comparison of savings rates, a 10% savings rate is normal. I agree with him that spending has fallen off a cliff, but I completely disagree with his implicit assertion that there is someting irrational about how much we are spending. We have seen 1 single month of an uptick in saving, and we are already moaning and crying about it.
Buffett’s comments 2
This is another part of his interview (source). Many, many times he refers to his war analogy. This is war! He mentions that the banks should be able to “earn their way out” of this downturn. He noted that Wells Fargo’s cost of funding is now extremely cheap, and earnings spreads have never been wider. When Betsy Quick retorts, asking why the banks should be able to do this and get huge bailout checks from the government, he responds that in wartime, no one ever questioned shipbuilders and the excess of profit they made during those times.
My comments 2
- Why do you keep saying war over and over again, in this manner?
- The banks are arguably the ones who goofed up the MOST. They are NOT like shipbuilders in a war. The shipbuilders didn’t instigate the war in the 1st place!
- The banks are insolvent because they extended far more loans than will get paid back, and losses far exceed the capital base of these firms.
- Why should we save the equityholders of insolvent banks? Why should the taxpayers bail out the debtholders of insolvent banks? I understand that we need to protect depositors. But there is a BIG DIFFERENCE between protecting customers, and protecting speculators. Protecting debtholders is what one would expect not under democracy, but KLEPTOCRACY. We cease being a market system. There are pros and cons to everything, but I just hope we are clear what market system we are operating in.
My belief – not a war, but a drug addiction that began in earnest in 1980
I wrote a few pieces earlier which convincingly argue that our real problem is simple – too much debt.
- 15%+ of aggregate demand (GDP) in the US in 2007 was from growth in debt (source) alone. It is as if I spent all of $100 in income, and then borrowed another $15 to spend it. When debt growth simply goes flat, that 15% of GDP will vanish. Debt goes flat when it gets way too large, and borrowers pull back. That is what is happening as we speak.
- We foisted all this debt on the mistaken belief that housing prices, globally, were worth far more than they were actually worth (source). We then foisted a bunch more debt on a bunch of other things, like our corporations (source). Now that asset appreciation is going away.
- We repealed Glass Steagal, which separated speculation from traditional banking, and which imposed leverage limits on our banks – leverage limits that had been place since the era of the Great Depression. Old restrictions capped us at 12x leverage. We ended up with 33x leverage (and higher!), leaving us vulnerable to even the smallest of shifts in valuation (source).
- We had a global debt bubble – we can see this clearly in Japan (source), in Australia (source), in the UK (source), in Ireland (source), in Switzerland and Belgium (source), in the OECD as a whole (source).
Debt is in many ways like a drug. It provides an up front “high” (cash) at the expense of the future (interest payments). At the beginning its impact is a lot stronger than it is later after repeated use. It can create addiction, where later on, doses are required simple to remain “even” (if you borrow interest over time, debt continues to rise, requiring debt simply to pay off the interest payments). If the dosage gets high enough in the blood stream it can be fatal.
A person making $1000 per year can support $300 of debt a lot easier than $1000. But we are way worse than that. There are 116M households in the US, generating average income of $68k per year. We have $52T of total debt in our country. This is $450k per household. $68k supporting $450k of debt is extremely high, and is larger than we have ever had before (source).
The picture is clear – we are spending too much, and working too little. And that this really began starting in about 1980.
- Secular shift out of manufacturing started then (source)
- Real Industrial production peaked in 1975 (source)
- Domestic non-financial debt / GDP began spiking in 1980 (source)
- Imports began consistently outstripping exports in 1975 (source)
- Savings rate secularly shifted from 10% to 0% in 1980 (source)
- Financial sector profits rose from 5% of total US corporate profits to about 40% (source)
Solution – Reversing the problem
We are now trying to nurse our banks back to health by putting them on extremely expensive life support systems. The patient is going to get badly damaged anyways. Let’s not bankrupt the USA trying to support what is unsustainable. The pain is coming regardless. Let’s focus on getting back to our roots, to what made us a strong country to begin with.
- Let’s manufacture more. People warn that protectionism is evil. I agree. China has been pursuing protectionist policies in spades, especially starting in 2000. Just have a look at their Treasury holdings (source). We have systematically routed our unions, halved our real industrial production, outsourced it to foreign countries, routed our manufacturing workforce (source), borrowed to pay for imports, and made up the difference via financial services jobs. Let’s manufacture more – do some real work.
- Let’s save more. Let’s remain at 5%+. Too much debt got us into this mess. Weaning ourselves off of the drug, even if we must do so slowly, is the way to get out of the mess.
- Let’s forbid banks from engaging in excess speculation and leverage. It got us into trouble in the Great Depression. We then put in place rules to stop that in the future. We then repealed those rules recently. We then re-created a huge mess of leverage and speculation. Here we are. We learned our lesson. Re-institute Glass Steagall.
- Let’s let financial services shrink back to a suitable size.
- Let’s re-impose rules to create transparency and stability in our marketplace. Ban naked short selling. Clean up the CDS market. Break up the banking and ratings monopolies. Enact position limits in the commodities market. Bring back the uptick rule. Replace Goldman Sachs alumni with capable individuals with fewer conflicts of interest. Enforce policies promoting disclosure – let us know who AIG’s counterparties are, instead of dragging your feet and then having that information leaked “through the grapevine”.
Will this be painful? Yes, it will be really, really painful. But the path we are going down will make this all the more painful. If, as I am claiming, the problem is too much for the government to prop, all the resources committed to that endeavor will have been WASTED.
All those resources can be used on the reconstruction efforts mentioned above. Change is coming, whether we want it or not. Let’s get ready for the future, instead of bankrupting ourselves trying in vain to bring back an unsustainable past.
Addendum – Want a risk free 4-6% return? I have a solution for you
Pay off your mortgage.
These are conventional mortgage rates from 1972 to 2008 (source). Your money is probably sitting in a money market account right now, earning less than 1%. As Buffett himself had said, Wells Fargo had a cost of funds of around 1.4% last year. That is because Wells is paying YOU 1.4% on average.
Instead of putting what little you have remaining in the stock market, you might want to consider paying down your mortgage.
- Mortgage rates have remained above 6% so this is likely around the rate you are paying. Even after accounting for mortgage interest deductibility, paying off your mortgage is a risk free return well in excess of what you would get elsewhere.
- Obama is considering hacking away at mortgage interest deductibility for couples earning north of $250k per year. Even the interest deductibility might be going away (source).
- One of our problems, as an economy, is too much debt. This will lower our debt.
Just something to consider.