Finance

On Common Sense on Mutual Funds

I recently finished reading Common Sense on Mutual Funds – New Imperatives for the Intelligent Investor – by John C. Bogle.

Below are key excerpts from this book that I found to be insightful:

Investing is an act of faith. We entrust our capital to corporate stewards in the faith—at least with the hope—that their efforts will generate high rates of return on our investments. When we purchase corporate America’s stocks and bonds, we are professing our faith that the long-term success of the U.S. economy and the nation’s financial markets will continue in the future.

To state the obvious, the long-term investor who pays least has the greatest opportunity to earn most of the real return provided by the stock market.

In my view, market timing and rapid turnover—both by and for mutual fund investors—betray both a lack of understanding of the economics of investing and an infatuation with the process of investing.

My guidelines also respect what I call the four dimensions of investing: (1) return, (2) risk, (3) cost, and (4) time. When you select your portfolio’s long-term allocation to stocks and bonds, you must make a decision about the real returns you can expect to earn and the risks to which your portfolio will be exposed. You must also consider the costs of investing that you will incur. Costs will tend to reduce your return and/or increase the risks you must take. Think of return, risk, and cost as the three spatial dimensions—the length, breadth, and width—of a cube. Then think of time as the temporal fourth dimension that interplays with each of the other three. For instance, if your time horizon is long, you can afford to take more risk than if your horizon is short, and vice versa.

Rule 1: Select Low-Cost Funds…Rule 2: Consider Carefully the Added Costs of Advice…Rule 3: Do Not Overrate Past Fund Performance…Rule 4: Use Past Performance to Determine Consistency and Risk…Rule 5: Beware of Stars…Rule 6: Beware of Asset Size…Rule 7: Don’t Own Too Many Funds…Rule 8: Buy Your Fund Portfolio—And Hold It.

No matter what fund style you seek, you should emphasize low-cost funds and eschew high-cost funds. And, for the best bet of all, you should consider indexing in whichever style category you want to include.

There are three major reasons why large size inhibits the achievement of superior returns: the universe of stocks available for a fund’s portfolio declines; transaction costs increase; and portfolio management becomes increasingly structured, group-oriented, and less reliant on savvy individuals.

Four principal problems are created by this overemphasis on marketing. First, it costs mutual fund shareholders a great deal of money— billions of dollars of extra fund expenses—which reduces the returns received by shareholders. Second, these large expenditures not only offer no countervailing benefit in terms of shareholder returns, but, to the extent they succeed in bringing additional assets into the funds, have a powerful tendency to further reduce fund returns. Third, mutual funds are too often hyped and hawked, and trusting investors may be imperiled by the risks assumed by, and deluded about the potential returns of, the funds. Lastly, and perhaps most significant of all, the distribution drive alters the relationship between investors and funds. Rather than being perceived as an owner oi the fund, the shareholder is perceived as a mere customer of the adviser.

On a closing note, on leadership:

To wrap up this litany, I put before you—both tentatively and humbly—a final attribute of leadership: courage. Sometimes, an enterprise has to dig down deep and have the courage of its convictions—to “press on,” regardless of adversity or scorn. Vanguard has been a truly contrarian firm in its mutual structure, in its drive for low costs and a fair shake for investors, in its conservative investment philosophy, in market index funds, and in shunning hot products, marketing gimmicks, and the carpet-bombing approach to advertising so abundantly evident elsewhere in this industry today. Sometimes, it takes a lot of courage to stay the course when fickle taste is in the saddle, but we have stood by our conviction: In the long run, when there is a gap between perception and reality, it is only a matter of time until reality carries the day.

A recommended read in the areas of investing and leadership.

On The Most Important Thing

I recently finished reading The Most Important Thing – Uncommon Sense for the Thoughtful Investor – by Howard Marks.

Below are key excerpts from the book that I found particularly insightful:

Few people have what it takes to be a great investors. Some can be taught, but not everyone… and those who can be taught can’t be taught everything. Valid approaches work some of the time but not all. And investing can’t be reduced to an algorithm and turned over to a computer. Even the best investors don’t get it right every time.

Because investing is at least as much art as it is science, it’s never my goal—in this book or elsewhere—to suggest it can be routinized. In fact. one of the things I most want to emphasize is how essential it is that one’s investment approach be intuitive and adaptive rather than be fixed and mechanistic.

Second-level thinking is deep, complex and convoluted. The second level thinker takes a great many things into account: What is the range of likely future outcomes? Which outcome do I think will occur? What’s the probability I’m right? What does the consensus think? How does my expectation differ from the consensus? How does the current price for the asset comport with the consensus view of the future, and with mine? Is the consensus psychology that’s incorporated in the price too bullish or bearish? What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

Return alone—and especially return over short periods of time—says very little about the quality of investment decisions. Return has to be evaluated relative to the amount of risk taken to achieve it. And yet, risk cannot be measured. Certainly it cannot be gauged on the basis of what “everybody” says at a moment in time. Risk can be judged only by sophisticated, experienced second-level thinkers.

The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners. Skillful risk control is the mark of the superior investor.

The pendulum swing regarding attitudes toward risk is one of the most powerful of all. In fact, I’ve recently boiled down the main risks in investing to two: the risk of losing money and the risk of missing opportunity. It’s possible to largely eliminate either one, but not both. In an ideal world, investors would balance these two concerns. But from time to time, at the extremes of the pendulum’s swing, one or the other predominates.

What weapons might you marshal on your side to increase your odds? Here are the ones that work for Oaktree: a strongly held sense of intrinsic value. insistence on acting as you should when price diverges from value. • enough conversance with past cycles—gained at first from reading and talking to veteran investors, and later through experience—to know that market excesses are ultimately punished, not rewarded. a thorough understanding of the insidious effect of psychology on the investing process at market extremes. a promise to remember that when things seem “too good to be true,” they usually are. willingness to look wrong while the market goes from misvalued to more misvalued (as it invariably will), and • like-minded friends and colleagues from whom to gain support (and for you to support).

To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality. That means the best opportunities are usually found among things most others won’t do. After all, if everyone feels good about something and is glad to join in, it won’t be bargain-priced.

What We Learn from a Crisis—or Ought To: Too much capital availability makes money flow to the wrong places…When capital goes where it shouldn’t, bad things happen…hen capital is in oversupply, investors compete for deals by accepting low returns and a slender margin for error…Widespread disregard for risk creates great risk…Inadequate due diligence leads to investment losses…In heady times, capital is devoted to innovative investments, many of which fail the test of time…Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem…Psychological and technical factors can swamp fundamentals…Markets change, invalidating models…Leverage magnifies outcomes but doesn’t add value…Excesses correct.

On a closing note:

Thus, it’s our goal to do as well as the market when it does well and better than the market when it does poorly. At first blush that may sound like a modest goal, but it’s really quite ambitious.

A must read in the area of investing.

The House Of Morgan

I recently finished reading the award-winning book The House of Morgan by Ron Chernow. As best summarized by the author: “This book is about the rise, fall, and resurrection of an American banking empire—the House of Morgan. Perhaps no other institution has been so encrusted with legend, so ripe with mystery, or exposed to such bitter polemics. Until 1989, J. P. Morgan and Company solemnly presided over American finance from the “Corner” of Broad and Wall. Flanked by the New York Stock Exchange and Federal Hall, the short building at 23 Wall Street, with its unmarked, catercorner entrance, exhibited a patrician aloofness. Much of our story revolves around this chiseled marble building and the presidents and prime ministers, moguls and millionaires who marched up its steps. With the records now available, we can follow them inside the world’s most secretive bank.”

Below are key excerpts from the book that I found particularly insightful:

The story of the three Morgan banks is nothing less than the history of Anglo-American finance itself. For 150 years, they have stood at the center of every panic, boom, and crash on Wall Street or in the City. They have weathered wars and depressions, scandals and hearings. bomb blasts and attempted assassinations. No other financial dynasty in modern times has so steadily maintained its preeminence. Its chronicle holds up a mirror in which we can study the changes in the style, ethics. and etiquette of high finance. To order this vast panorama, we will divide our saga into three periods. This framework applies principally to the Morgan houses but also has, I think, more general relevance to other banks.

The House of Morgan’s future approach to business was shaped in the gloomy days of 1873. The panic was a disaster for European investors. who lost $600 million in American railroad stocks. Stung by all the railroad bankruptcies, Pierpont decided to limit his future dealings to elite companies. He became the sort of tycoon who hated risk and wanted only sure things. “I have come to the conclusion that neither my firm nor myself will have anything to do, hereafter, directly or indirectly, with the negotiation of securities of any undertaking not entirely completed; and whose status, by experience, would not prove it entitled to a credit in every respect unassailable.” Another time, he said, “The kind of Bonds which I want to be connected with are those which can be recommended without a shadow of doubt, and without the least subsequent anxiety, as to payment of interest, as it matures. ” This encapsulated future Morgan strategy—dealing only with the strongest companies and shying away from speculative ventures.

Pierpont selected partners not by wealth or to fortify the bank’s capital but based on brains and talent. If the Morgan style was royal. its hiring practices were meritocratic. The bank had many first-rate technicians.

The intellectual and political leap most damaging to the House of Morgan was a spreading notion that a Wall Street trust had created the industrial trusts and governed their subsequent destiny.

After Pierpont Morgan’s death, the House of Morgan would become less autocratic, less identified with a single individual. Power would be diffused among several partners, although Jack Morgan would remain as figurehead. In the new Diplomatic Age, the bank’s influence would not diminish. Rather, it would break from its domestic shackles and become a global power, sharing financial leadership with central banks and government! and profiting in unexpected ways from the partnership. What nobody could have foreseen in 1913 was that lack Morgan—shy, awkward, shambling Jack who had cowered in the corners of Pierpont’s life—would preside over an institution of perhaps even larger power than the one ruled by his willful, rambunctious father.

Through Strong’s influence, the Federal Reserve System would prove far more of a boon than a threat to Morgans. The New York Fed and the bank would share a sense of purpose such that the House of Morgan would be known on Wall Street as the Fed bank. So, contrary to expectations, frustrated reformers only watched Morgan power grow after 1913.

The news of war was greeted with melodramatic foreboding by Jack Morgan, who foresaw “the most appalling destruction of values in securities which has ever been seen in this country.” Later reviled as a “merchant of death” by isolationists, his first reaction, in fact, was spotlessly humane.

So the early New Deal threatened the House of Morgan in two ways: the Pecora hearings were exposing practices that could bring fresh regulation to Wall Street. And the White House attitude toward European finance augured an end to the House of Morgan’s special diplomatic role of the 1920s. After an incestuous relationship with Washington in the twenties, the bank would suffer the curse of eternal banishment.

The Glass-Steagall Act took dead aim at the House of Morgan. After all, it was the bank that had most spectacularly fused the two forms of banking. It had, ironically, proved that the two types of services could be successfully combined; Kuhn, Loeb and Lehman Brothers did less deposit business, while National City and Chase had scandal-ridden securities affiliates. The House of Morgan was the active double threat. with its million-dollar corporate balances and blue-ribbon underwriting business.

As it turned out, the House of Morgan didn’t suffer as much from Willkie’s defeat as might have been expected. Bolstered by his election victory, Roosevelt moved more vigorously to support Britain, and in this effort he needed the Morgan bank. With marvelous suddenness, the chill in Morgan-Roosevelt relations thawed and was replaced by cordiality from the White House of a sort that 23 Wall hadn’t known since the twenties. As America’s attention shifted from blistering debates over domestic policy to ways in which to deal with Europe’s dictators, the power of the House of Morgan surged accordingly.

On a closing note:

The old House of Morgan’s power stemmed from the immature state of government treasuries, companies, and capital markets. It stood sentinel over capital markets that were relatively small and primitive. Today, money has become a commonplace commodity. A company in need of capital can turn to investment banks, commercial banks, or insurance companies; it can raise it through bank loans, bond issues, private placements, or commercial paper; it can draw upon many) currencies, many countries, many markets. Money has lost its mystique, and banking. therefore, has lost a bit of its magic. The Morgan story is the story of modern finance itself. A Pierpont Morgan exercised powers that today are dispersed among vast global banking conglomerates. The activities once performed by a knot of side-whiskered men in mahogany parlors are now spread across trading rooms around the world. We live in a larger, faster, more anonymous age. There will be more deals done and more fortunes made, but there will never be another barony like the House of Morgan.

A recommended read in the areas of Finance, Banking and History.

On Den Of Thieves

I recently finished reading Den Of Thieves – by Pulitzer Price Winner, James B. Stewart.

Below are key excerpts from the book that I found to be particularly insightful:

Even now it is hard to grasp the magnitude and the scope of the crime that unfolded, beginning in the mid-1970s, in the nation’s markets and financial institutions. It dwarfs any comparable financial crime, from the Great Train Robbery to the stock-manipulation schemes that gave rise to the nation’s securities laws in the first place. The magnitude of the illegal gains was so large as to be incomprehensible to most laymen.

Nor were these isolated incidents. Only in its scale and potential impact did the Milken-led conspiracy dwarf others. Financial crime was commonplace on Wall Street in the eighties. A common refrain among nearly every defendant charged in the scandal was that it was unfair to single out one individual for prosecution when so many others were guilty of the same offenses, yet weren’t charged. The code of silence that allowed crime to take root and flourish on Wall Street, even within some of the richest and most respected institutions, continues to protect many of the guilty. To dwell on the ill-gotten gains of individuals, however, is to risk missing the big picture. During this crime wave, the ownership of entire corporations changed hands, often forcibly, at a clip never before witnessed. Household names—Carnation, Beatrice, General Foods, Diamond Shamrock—vanished in takeovers that spawned criminal activity and violations of the securities laws.

Nor should the financial implications of these crimes, massive though they are, obscure the challenge they posed to the nation’s law-enforcement capabilities, its judicial system, and ultimately, to the sense of justice and fair play that is a foundation of civilized society. If ever there were people who believed themselves to be so rich and powerful as to be above the law. They were to be found in and around Wall Street in the mid-eighties. If money could buy justice in America, Milken and Drexel were prepared to spend it, and spend it they did. They hired the most expensive, sophisticated, and powerful lawyers and public-relations advisors, and they succeeded to a frightening degree at turning the public debate into a trial of government lawyers and prosecutors rather than of those accused of crimes. But they failed, thanks to the sometimes heroic efforts of underpaid, overworked government lawyers who devoted much of their careers to uncovering the scandal, especially Charles Carberry and Bruce Baird, in the Manhattan U.S. attorney’s office, and Gary Lynch, the head of enforcement at the Securities and Exchange Lynch, the head of enforcement at the securities and exchange ness of crime on Wall Street after a decade of lax enforcement sometimes overwhelmed their resources. Not everyone who should have been prosecuted has been, and mistakes were made. Yet their overriding success in prosecuting the major culprits and reinvigorating the securities laws is a tribute to the American system of justice.

For Levine, the experience only reinforced his view that without extraordinary measures, he was never going to realize his grand ambitions. Not that he was particular surprised. As he told Wilkis constantly, he was convinced that everyone was using inside information to get ahead: the game was rigged.

The causes of the boom were probably as much psychological as financial, though many economic explanations have been offered to explain the sudden, almost frenzied effort to buy existing companies rather than create new ones. Throughout the 1970s, investors had focused on company earnings, and the corresponding price/ earnings ratios, as a measure of value. With an economy ravaged by post-Vietnam War and OPEC-induced inflation, high tax rates, and soaring interest rates, profits had been meager. So stock prices Stayed low even as inflation pushed the value of income-producing assets ever higher. Coupled with low-priced assets was the tax code’s very generous treatment of interest payments on debt. Corporate dividends paid on stock aren’t deductible; interest payments on debt are fully deductible. Buying assets with borrowed funds meant shifting much of the cost to the federal government. The election of Ronald Reagan in 1980 sent a powerful “anything goes” message to the financial markets. One of the first official acts of the Reagan Justice Department was to drop the government’s massive ten-year antitrust case against IBM. Bigness apparently wasn’t going to be a problem in the new era of unbridled capitalism. Suddenly, economies of scale could be realized in already oligopolistic industries such as oil, where mergers wouldn’t even have been considered in the Carter years.

Yet history offers little comfort. The famed English jurist Sir Edward Coke wrote as early as 1602 that “fraud and deceit abound in these days more than in former times.” Wall Street has shown itself peculiarly susceptible to the notion, refined by Milken and Boesky and their allies, that reward need not be accompanied by risk. Perhaps no one will ever again dominate the financial world like Milken with his junk bonds. But surely a pied piper will emerge in some other sector. Over time, the financial markets have shown remarkable e resilience and an ability to curb their own excesses. Yet they are surprisingly vulnerable to corruption from within. If nothing else, the scandals of the 1980s underscore the importance and wisdom of the securities laws and their vigorous enforcement. The Wall Street criminals were consummate evaluators of risk—and the equation as they saw it suggested little likelihood of getting caught.

A highly recommended read in the area of finance.

On Lords Of Finance

I recently finished reading the Pulitzer Prize winning, Lords of Finance – The Bankers Who Broke The World by Liaquat Ahamed. This book aim, as best described by the author is: “The collapse of the world economy from 1929 to 1933—now justly called the Great Depression—was the seminal economic event of the twentieth century. No country escaped its clutches; for more than ten years the malaise that it brought in its wake hung over the world, poisoning every aspect of social and material life and crippling the future of a whole generation. From it flowed the turmoil of Europe in the “low dishonest decade” of the 1930s, the rise of Hitler and Nazism, and the eventual slide of much of the globe into a Second World War even more terrible than the First. The story of the descent from the roaring boom of the twenties into the Great Depression can be told in many different ways. In this book, I have chosen to tell it by looking over the shoulders of the men in charge of the four principal central banks of the world: the Bank of England, the Federal Reserve System, the Reichsbank, and the Banque de France…Governments then believed matters of finance were best left to bankers; and so the task of restoring the world’s finances fell into the hands of the central banks of the four major surviving powers: Britain, France, Germany, and the United States. ”

Below are key insights from the book that I wish to share:

On Central Banks:

To understand the role of central bankers during the Great Depression, it is first necessary to understand what a central bank is and a little about low it operates. Central banks are mysterious institutions, the full details of their inner workings so arcane that very few outsiders, even economists. fully understand them. Boiled down to its essentials, a central bank is a bank that has been granted a monopoly over the issuance of currency. This power gives it the ability to regulate the price of credit—interest rates—and hence to determine how much money flows through the economy. Despite their role as national institutions determining credit policy for their entire countries, in 1914 most central banks were still privately owned.

On the start of WW1:

As the lights started to go out over Europe that fateful first week of August, every banker and finance minister seemed to be fixated not on military preparations or the movements of armies but on the size and durability of his gold reserves. The obsession was almost medieval. This was, after all, 1914, not 1814. Paper money had been in wide use for more than two centuries, and merchants and traders had developed highly sophisticated systems of credit. The idea that the scope of the war might be limited by the amount of gold on hand seems anachronistic. Nevertheless, here was the London magazine United Empire declaring that it was “the amounts of coin and bullion in the hands of the Continental Great Powders at the outbreak of hostilities” that would largely determine “the intensity and probable duration of the war.”

On the effect of the war on the US:

More important, the war had irrevocably changed the economic and financial position of the United States in relation to the rest of the world. The Fed, which barely existed in 1914, now sat on the largest reservoir of gold bullion in the world, making it potentially the dominant player if and when the international gold standard was restored.

On the impact of reparations on Germany:

Behind all the divisions that were to wreck Germany for the next few years, the one single factor that united every class and every political party—democrats and royalists, liberals and Socialists, Catholics and Protestants, northerners and southerners, Prussians, Bavarians, Saxons, and Hessians—was the injustice of the peace treaty, or as it was called the Diktat. And of all the various penalties heaped on Germany by the treaty – disarmament, dismemberment, occupation, and reparations—it was reparations that would become the single most consuming obsession of German foreign policy.

On the US monetary policy and Keynes:

The hidden irony was that every one of Keynes’s main recommendations—that the link between gold balances and the creation of credit be severed, that the automatic mechanism of the gold standard be replaced with a system of managed money, that credit policy be geared toward domestic price stability—corresponded precisely to the policies Strong had instituted in the United States.

On the expanding role of the Central Banks:

This new set of principles, somewhat cobbled together on the fly, represented a quiet, indeed carefully unheralded, revolution in monetary policy. Until then central bankers had seen their primary task as protecting the currency and confined their responsibilities to ensuring that the gold standard was given free rein, only stepping in at times of crisis or panic. The credit policy of every industrial country had been driven by one factor alone: gold reserves. The United States was, however, now so flush with gold that the solidity of its currency was assured. Led by Strong, the Fed had undertaken a totally new responsibility—that of promoting internal economic stability.

On Churchill and the return to gold standard:

Though Churchill remained chancellor until 1929, by 1927 he had come to realize that the return to gold at the old prewar exchange rate had been a misjudgment. But by then there was little he could do about it except fulminate in private about the evil effects of the gold standard. In later life, he would claim that it was “the biggest blunder in his life.” He blamed it on the bad advice he had received.

On the opposable forces facing Central Banks:

The men in charge of central banks seem to face a similar unfortunate fate—although not for eternity—of watching their successes dissolve in failure. Their goal is a strong economy and stable prices. This is, however, the very environment that breeds the sort of over-optimism and speculation that eventually ends up destabilizing the economy. In the United States during the second half of the 1920s, the destabilizing force was to be the soaring stock market. In Germany it was to be foreign borrowing.

On the blame attributed to the US and France regarding their “hoarding of gold”:

The Sunday Chronicle of September 20 carried a profile of Montagu Norman by Winston Churchill, as part of a commissioned series on contemporary figures. Since leaving office in June 1929, Churchill had quarreled with his Conservative colleagues over Indian self-rule and, now isolated and out of favor, felt free to express his disillusionment with the gold standard orthodoxy openly. The problem was not so much the standard itself, he argued, but the way it had been allowed to operate. It was the hoarding of gold by the United States and France and the resulting shortage in the rest of the world that had brought on the Depression. He had begun to sound almost like Keynes—in a speech to Parliament the week before he had described how gold “is dug up out of a hole in Africa and put down in another hole that is even more inaccessible in Europe and America.”

On the steps taken by the US Government to alleviate the great depression:

In February 1932, he pressed Congress to pass legislation that would make government securities an eligible asset to back currency. At the stroke of a pen the gold shortage was lifted, allowing the Fed to embark on a massive program of open market operations, injecting a total of $1 billion of cash into banks. The two new measures combined—the infusion of additional capital into the banking system and the injection of reserves allowed the Fed finally to pump money into the system on the scale required. But Meyer had left it too late. A similar measure in late 1930 or in 1931 might have changed the course of history. In 1932 it was like pushing n a string. Banks, shaken by the previous two years, instead of lending It the money used the capital so injected to build up their own reserves. Total bank credit kept shrinking at a rate of 20 percent a year…By Thursday, March 9, the Emergency Banking Act was ready to be submitted to Congress. Most of it was based on the original Mills proposal. Banks in the country were to be gradually reopened, starting with those known to be sound, and progressively moving to the shakier institutions, which would need government support. A whole class of insolvent banks would never be permitted to reopen. The bill also granted the Fee the right to issue additional currency backed not by gold but by bank assets. And it gave the federal government the authority to direct the Fed to provide support to banks. The legislation was supplemented by a commitment from the Treasury to the Fed that the government would indemnify it for any losses incurred in bailing out the banking system. This unprecedented package finally forced the Fed to fulfill its role as lender of last resort to the banking system. But to achieve this, the government was in effect providing an implicit blanket guarantee of the deposits of every bank allowed to reopen.

On the US coming off of the Gold standard:

Roosevelt’s decision to take the dollar off gold rocked the financial world. But in the days after the Roosevelt decision, as the dollar fell against gold, the stock market soared by 15 percent. Financial markets gave the move an overwhelming vote of confidence. Even the Morgan bankers. historically among the most staunch defenders of the gold standard, could not resist cheering. “Your action in going off gold saved the country from complete collapse,” wrote Russell Leffingwell to the president.

On the IMF:

Much of the negotiating had been done prior to the conference between the Americans and the British. At Bretton Woods, the biggest controversy was over how much money each country would be eligible to borrow from what was now being called the International Monetary Fund. The Russians, who were there in strength though very few of them spoke English, demanded that the borrowing rights reflect not simply economic power but also military strength, and insisted on equality with the British; India wanted to be on a par with China; the Bolivians wanted parity with the Chileans and the Chileans with the Cubans. The United States, as the find’s prime financier, set these quotas in a series of backroom deals orchestrated by White. On July 22, the conference came to its formal close with a great banquet. Keynes gave a final address. He reminding the participants of the economic chaos that had afflicted the world for almost a generation and paid tribute to the spirit of cooperation that had informed the discussions: “If we can so continue, this nightmare, in which most of us present have spent too much of our lives, will be over. The brotherhood of man will have become more than a phrase.” As he left the room, the delegates sang “For He’s Jolly Good Fellow.”

On a Concluding Note:

For many years people believed—even today many continue to do so—that an economic cataclysm of the magnitude of the Great Depression could only have been the result of mysterious and inexorable tectonic forces that governments were somehow powerless to resist…To the contrary, in this book I maintain that the Great Depression was not some act of God or the result of some deep-rooted contradictions of capitalism but the direct result of a series of misjudgments by economic policy makers, some made back in the 1920s, others after the first crises set in—by any measure the most dramatic sequence of collective blunders ever made by financial officials. Who then was to blame? The first culprits were the politicians who presided over the Paris Peace Conference. They burdened a world economy still trying to recover from the effects of war with a gigantic overhang of international debts…The second group to blame were the leading central bankers of the era in particular the four principal characters of this book, Montagu Norman, Benjamin Strong, Hjalmar Schacht, and Emile Moreau. Even though they, especially Schacht and Norman, spent much of the decade struggling to mitigate some of the worst political blunders behind reparations and war debts, more than anyone else they were responsible for the second fundamental error of economic policy in the 1920s: the decision to take the world back onto the gold standard…More than anything else, therefore, the Great Depression was caused by a failure of intellectual will, a lack of understanding about how the economy operated. No one struggled harder in the lead-up to the Great Depression and during it to make sense of the forces at work than Maynard Keynes. He believed that if only we could eliminate “muddled” thinking—one of his favorite expressions—in economic matters, then society could allow the management of its material welfare to take a backseat to what he thought were the central questions of existence, to the “problems of life and of human relations, of creation, behavior and religion.” That is what he meant when in a speech toward the end of his life he declared that economists are the “trustees, not of civilization, but of the possibility of civilization.” There is no greater testament of his legacy to that trusteeship than that in the sixty-odd years since he spoke those words, armed with his insights, the world has avoided an economic catastrophe such as overtook it in the years from 1929-33.

A must read for anyone seeking to gain a deeper understanding of the global financial system.

On The General Theory of Employment, Interest, and Money

Being passionate about economics, reading John Maynard Keynes‘ classic – The General Theory of Employment, Interest, and Money – has been on my to do list for quite some time and I am glad I have finally been able to read it.

Below I wanted to share seven key learnings from this masterpiece:

Lesson 1: The equivalence of saving and investment:

Income=value of output = consumption + investment; saving = income – consumption; saving = investment.

The equivalence between the quantity of saving and the quantity of investment emerges from the bilateral character of the transactions between the producer on the one hand and, on the other hand, the consumer or the purchaser of capital equipment. Income is created by the value in excess of user cost which the producer obtains for the output he has sold; but the whole of this output of user cost which the producer obtains for the output he has sold; but the whole of this output must obviously have been sold either to a consumer or to another entrepreneur; and each entrepreneur’s current investment is equal to the excess of the equipment which he has purchased from other entrepreneurs over his own user cost. Hence, in the aggregate the excess of income over consumption, which we call saving, cannot differ from the addition to capital equipment which we call investment. And similarly with net saving and net investment. Saving, in fact, is a mere residual. The decisions to consume and the decisions to invest between them determine incomes. Assuming that the decisions to invest become effective, they must in doing so consumption or expand income. Thus the act of investment in itself cannot help causing the residual or margin, which we call saving, to increase by a corresponding amount.

Lesson 2: Credit Impacts Output and Wages

The notion that the creation of credit by the banking system allows investment to take place to which “no genuine saving” corresponds can only be the result of isolating one of the consequences of the increased bank-credit to the exclusion of the others. If the grant of a bank credit to an entrepreneur additional to the credits already existing allows him to make an addition to current investment which would not have occurred otherwise, incomes will necessarily be increased and at a rate which will normally exceed the rate of increased investment. Moreover, except in conditions of full employment, there will be an increase of real income as well as of money-income. The public will exercise “a free choice” as to the proportion in which they divide their increase of income between saving and spending; and it is impossible that the intention of the entrepreneur who has borrowed in order to increase investment can become effective (except in substitution for investment by other entrepreneurs which would have occurred otherwise) at a faster rate than the public decide to increase their savings. Moreover, the savings which result from this decision are public decide to increase their savings. Moreover, the savings which result from this decision are corresponding to the new bank-credit, unless he deliberately prefers to hold more money rather than some other form of wealth. Yet employment, incomes and prices cannot help moving in such a way that in the new situation someone does choose to hold the additional money. It is true that in the new situation someone does choose to hold the additional money, it is true that an aggregate saving and investment which would not have occurred if it had been sufficiently foreseen. It is also true that the grant of the bank-credit will set up three tendencies (1) for output to increase, (2) for the marginal product to rise in value in terms of the wage-unit (which in conditions of decreasing return must necessarily accompany an increase of output), and (3) for the wage-unit to rise in terms of money (since this is a frequent concomitant of better employment); and these tendencies may affect the distribution of real income between different groups. But these tendencies are characteristic of a state of increasing output as such, and will occur just as much if the increase in output has been initiated otherwise than by an increase in bank-credit. They can only be avoided by avoiding any course of action capable of improving employment. Much of the above, however, is anticipating the result of discussions which have not yet been reached.

Lesson 3: The Below Six Factors Drive The Propensity to Consume

The principal objective factors which influence the propensity to consume appear to be the following: (1) A change in the wage-unit. Consumption (C) is obviously much more a function of (in some sense) real income than of money-income…(2) A change in the difference between income and net income. We have shown above that the amount of consumption depends on net income rather than on income, since it is, by definition, his net income that a man has primarily in mind when he is deciding his scale of consumption…(3) Windfall changes in capital-values not allowed for in calculating net income(4) Changes in the rate of time discounting, i.e. in the ratio of exchange between present goods changes in the purchasing power of money in so far as these are foreseen(5) Changes in fiscal policy. In so far as the inducement to the individual to save depends on the future return which he expects, it clearly depends not only on the rate of interest but on the fiscal policy of the Government. Income taxes, especially when they discriminate against “unearned’ income, taxes on capital-profits, death-duties and the like are as relevant as the rate of interest; whilst the range of possible changes in fiscal policy may be greater, in expectation at least, than for the rate of interest itself. If fiscal policy is used as a deliberate instrument for the more equal distribution of incomes, its effect in increasing the propensity to consume is, of course, all the greater…(6) Changes in expectations of the relation between the present and the future level of income. We must catalogue this factor for the sake of formal completeness. But, whilst it may affect considerably a particular individual’s propensity to consume, it is likely to average out for the community as a whole. Moreover, it is a matter about which there is, as a rule, too much uncertainty for it to exert much influence.

Lesson 4: Three Types of Risk Affect the Volume of Investments:

Two types of risk affect the volume of investment which have not commonly been distinguished, but which it is important to distinguish. The first is the entrepreneur’s or borrower’s risk and arises out of doubts in his own mind as to the probability of his actually earning the prospective yield for which he hopes. If a man is venturing his own money, this is the only risk which is relevant. But where a system of borrowing and lending exists, by which I mean the granting of loans with a margin of real or personal security, a second type of risk is relevant which we may call the lender’s risk. This may be due either to moral hazard, i.e. voluntary default or other means of escape possibly lawful, from the fulfillment of the obligation, or to the possible insufficiency of the margin of security, i.e. involuntary default due to the disappointment of expectation. A third source of risk might be added, namely, a possible adverse change in the value of the monetary standard which renders a money-loan to this extent less secure than a real asset; though all or most of this should be already reflected, and therefore absorbed, in the price of durable real assets.

Lesson 5: The True Definition of the Rate of Interest is one of Balancing Liquidity

Thus the rate of interest at any time, being the reward for parting with liquidity, is a measure of the unwillingness of those who possess money to part with their liquid control over it. The rate of interest is not the “price” which brings into equilibrium the demand for resources to invest with the readiness to abstain from present consumption. It is the “price” which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash; which implies that if the rate of interest were lower, i.e. if the reward for parting with cash were diminished, the aggregate amount of cash which the public would wish to hold would exceed the available supply, and that if the rate of interest were raised, there would be a surplus of cash which no one would be willing to hold. If this explanation is correct, the quantity of money is the other factor, which, in conjunction with liquidity-preference, determines the actual rate of interest in given circumstances…Nevertheless, circumstances can develop in which even a large increase in the quantity of money may exert a comparatively small influence on the rate of interest. For a large increase in the quantity of money may cause so much uncertainty about the future that liquidity-preferences due to the precautionary-motive may be strengthened; whilst opinion about the future of the rate of interest may be so unanimous that a small change in present rates may cause a mass movement into cash. It is interesting that the stability of the system and its sensitiveness to changes in the quantity of money should be so dependent on the existence of a variety of opinion about what is uncertain. Best of all that we should know the future. But if not, then, if we are to control the activity of the economic system by changing the quantity of money, it is important that opinions should differ Thus this method of control is more precarious in the United States, where everyone tends to hold the same opinion at the same time, than in England where differences of opinion are more usual.

Lesson 6: The General Theory of Employment Re-stated:

There will be an inducement to push the rate of new investment to the point which forces the supply-price of each type of capital-asset to a figure which, taken in conjunction with its prospective yield, brings the marginal efficiency of capital in general to approximate equality with prospective yield, brings the marginal efficiency of capital in general to approximate equality with the state of confidence concerning the prospective yield, the psychological attitude to liquidity and the quantity of money (preferably calculated in terms of wage-units) determine, between them, the rate of new investment.

Lesson 7: The Government has an Active Role to Play to Ensure an Effective Economy

In some other respects the foregoing theory is moderately conservative in its implications. For whilst it indicates the vital importance of establishing certain central controls in matters which are now left in the main to individual initiative, there are wide fields of activity which are unaffected. The State will have to exercise a guiding influence on the propensity to consume partly through its scheme of taxation, partly by fixing the rate of interest, and partly, perhaps, in other ways scheme of taxation, partly by fixing the rate of interest, and partly, perhaps, in other ways. Furthermore, it seems unlikely that the influence of banking policy on the rate of interest will be sufficient by itself to determine an optimum rate of investment. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment; though this need not exclude all manner of compromises and of devices by which public authority will co-operate with private initiative. But beyond this no obvious case is made out for a system of State Socialism which would embrace most of the economic life of the community. It is not the ownership of the instruments of production which it is economic life of the community. It is not the ownership of the instruments of production which it is resources devoted to augmenting the instruments and the basic rate of reward to those who own them, it will have accomplished all that is necessary. Moreover, the necessary measures of socialisation can be introduced gradually and without a break in the general traditions of society…The authoritarian state systems of to-day seem to solve the problem of unemployment at the expense of efficiency and of freedom. It is certain that the world will not much longer tolerate the unemployment which, apart from brief intervals of excitement, is associated and, in my opinion inevitably associated with present-day capitalistic individualism. But it may be possible by a right analysis of the problem to cure the disease whilst preserving efficiency and freedom.

On a concluding note, Keynes reminds us about the power of ideas and the hope they bring:

I do not attempt an answer in this place. It would need a volume of a different character from this one to indicate even in outline the practical measures in which they might be gradually clothed. But if the ideas are correct an hypothesis on which the author himself must necessarily base what he writes it would be a mistake, I predict, to dispute their potency over a period of time. At the present moment people are unusually expectant of a more fundamental diagnosis; more present moment people are unusually expectant of a more fundamental diagnosis; more particularly ready to receive it; eager to try it out, if it should be even plausible. But apart from this contemporary mood, the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. Not, indeed, immediately, but after a certain interval; for in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil.

I must admit the book is somewhat of a dry read, particularly as compared to some of the other work by Keyne’s colleagues such as Milton Friedman’s Capitalism and Freedom or F. A. Hayek’s Road to Serfdom. Nevertheless an important read for anyone with interest in economics.

On Free To Choose

I recently finished reading Free To Choose – A Personal Statement – by Milton and Rose Friedman.

Below are key excerpts from the book that I found particularly insightful:

1- “Economic freedom is an essential requisite for political freedom. By enabling people to cooperate with one another without coercion or central direction, it reduces the area over which political power is exercised. In addition, by dispersing power, the free market provides an offset to whatever concentration of political power may arise. The combination of economic and political power in the same hands is a sure recipe for tyranny.”

2- “The experience of recent years—slowing growth and declining productivity—raises a doubt whether private ingenuity can continue to overcome the deadening effects of government control if we continue to grant ever more power to government, to authorize a “new class” of civil servants to spend ever larger fractions of our income supposedly on our behalf. Sooner or later—and perhaps sooner than many of us expect—an ever bigger government would destroy both the prosperity that we owe to the free market and the human freedom proclaimed so eloquently in the Declaration of Independence.”

3- “Prices perform three functions in organizing economic activity: first, they transmit information; second, they provide an incentive to adopt those methods of production that are least costly and thereby use available resources for the most highly valued purposes; third, they determine who gets how much of the product – the distribution of income. These three functions are closely interrelated.”

4- “Our society is what we make it. We can shape our institutions. Physical and human characteristics limit the alternatives available to us. But none prevents us, if we will, from building a society that relies primarily on voluntary cooperation to organize both economic and other activity, a society that preserves and expands human freedom, that keeps government in its place, keeping it our servant and not letting it become our master.”

5- “The ballot box produces conformity without unanimity; the marketplace, unanimity without conformity. That is why it is desirable to use the ballot box, so far as possible, only for those decisions where conformity is essential.”

6- “Freedom cannot be absolute. We do live in an interdependent society. Some restrictions on our freedom are necessary to avoid other, still worse, restrictions. However, we have gone far beyond that point. The urgent need today is to eliminate restrictions, not add to them.”

7- “In one respect the System has remained completely consistent throughout. It blames all problems on external influences beyond its control and takes credit for any and all favorable occurrences. It thereby continues to promote the myth that the private economy is unstable, while its behavior continues to document the reality that government is today the major source of economic instability.”

8- “The waste is distressing, but it is the least of the evils of the paternalistic programs that have grown to such massive size. Their major evil is their effect on the fabric of our society. They weaken the family; reduce the incentive to work, save, and innovate; reduce the accumulation of capital; and limit our freedom. . These are the fundamental standards by which they should be judged.”

9- “A society that puts equality—in the sense of equality of outcome—ahead of freedom will end up with neither equality nor freedom. The use of force to achieve equality will destroy freedom, and the force, introduced for good purposes, will end up in the hands of people who use it to promote their own interests…Freedom means diversity but also mobility. It preserves the opportunity for today’s disadvantaged to become tomorrow’s privileged and, in the process. enables almost everyone, from top to bottom, to enjoy a fuller and richer life.”

10- “We believe that the growing role that government has played in financing and administering schooling has led not only to enormous waste of taxpayers’ money but also to a far poorer educational system than would have developed had voluntary cooperation continued to play a larger role…We have tried in this chapter to outline a number of constructive suggestions…These proposals are visionary but they are not impracticable…We shall not achieve them at once. But insofar as we make progress toward them—or alternative programs directed at the same objective—we can strengthen the foundations of our freedom and give fuller meaning to equality of educational opportunity.”

11- “Insofar as the government has information not generally available about the merits or demerits of the items we ingest or the activities we engage in, let it give us the information. But let it leave us free to choose what chances we want to take with our own lives.”

12- “When unions get higher wages for their members by restricting entry into an occupation, those higher wages are at the expense of other workers who find their opportunities reduced. When government pays its employees higher wages, those higher wages are at the expense of the taxpayer. But when workers get higher wages and better working conditions through the free market, when they get raises by firms competing with one another for the best workers, by workers competing with one another for the best jobs, those higher wages are at nobody’s expense. They can only come from higher productivity, greater capital investment, more widely diffused skills.”

13- “Five simple truths embody most of what we know about inflation: 1. Inflation is a monetary phenomenon arising from a more rapid increase in the quantity of money than in output (though, of course, the reasons for the increase in money may be various) 2. In today’s world government determines—or can determine -the quantity of money. 3. There is only one cure for inflation: a slower rate of increase in the quantity of money. 4. It takes time—measured in years, not months—for inflation to develop; it takes time for inflation to be cured. 5. Unpleasant side effects of the cure are unavoidable.”

14- “We have been misled by a false dichotomy: inflation or unemployment. That option is an illusion. The real option is only whether we have higher unemployment as a result of higher inflation or as a temporary side effect of curing inflation.”

15- “The two ideas of human freedom and economic freedom working together came to their greatest fruition in the United States. Those ideas are still very much with us. We are all of us imbued with them. They are part of the very fabric of our being. But we have been straying from them. We have been forgetting the basic h that the greatest threat to human freedom is the concentration of power, whether in the hands of government or anyone else. We have persuaded ourselves that it is safe to grant power, provided it is for good purposes.”

Regards,

Omar Halabieh

Free To Choose

On The Lexus and the Olive Tree

I recently finished reading The Lexus and the Olive Tree by Thomas L. Friedman.

Below are key excerpts from the book that I found particularly insightful:

1- “While there are a lot of similarities in kind between the previous era of globalization and the one we are now in, what is new today is the degree and intensity with which the world is being tied together into a single globalized marketplace and village. What is also new is the sheer number of people and countries able to partake of today’s globalized economy and information networks, and to be affected by them.”

2- “As you will see from the book, I am keenly aware of them. I believe the best way for us to deal with the brutalities of globalization is by first understanding the logic of the system and its moving parts, and them figuring out how this system can benefit the most people. While inflicting the least amount of pain. That is the spirit that motivated this book.”

3- “The driving idea behind globalization is free-market capitalism—the more you let market forces rule and the more you open your economy to free trade and competition, the more efficient and flourishing your economy will be. Globalization means the spread of free-market capitalism to virtually every country in the world. Therefore, globalization also has its own set of economic rules—rules that revolve around opening, deregulating and privatizing your economy, in order to make it more competitive and attractive to foreign investment.”

4- “Globalization also has its own demographic pattern—a rapid acceleration of the movement of people from rural areas and agricultural lifestyles to urban areas and urban lifestyles more intimately linked with global fashion, food, markets and entertainment trends.”

5- “The globalization system, by contrast, is built around three balances. which overlap and affect one another. The first is the traditional balance between nation-states…The second balance in the globalization system is between nation-states and global markets…The third balance that you have to pay attention to in the globalization system—the one that is really the newest of all—is the balance between individuals and nation-states.”

6- “So what to do? How to understand and explain this incredibly complex system of globalization? The short answer is that I learned you need to do two things at once— look at the world through a multilens perspective and, at the same time, convey that complexity to readers through simple stories, not grand theories. I use two techniques: I “do information arbitrage” in order to understand the world, and I “tell stories” in order to explain it.”

7- “The challenge in this era of globalization—for countries and Individuals—is to find a healthy balance between preserving a sense of identity, home and community and doing what it takes to survive within the globalization system. Any society that wants to thrive economically today must constantly be trying to build a better Lexus and driving it out into the world.But no one should have any illusions that merely participating in this global economy will make a society healthy. If that participation comes at the price of a country’s identity, if individuals feel their olive tree roots crushed, or washed out, by this global system, those olive tree roots will rebel. They will rise up and strangle the process. Therefore the survival of globalization as a system will depend, in part, on how well all of us strike this balance.”

8- “To fit into the Golden Straitjacket a country must either adopt, or be seen as moving toward, the following golden rules: making the private sector the primary engine of its economic growth, maintaining a low rate of inflation and price stability, shrinking the size of its state bureaucracy. maintaining as close to a balanced budget as possible, if not a surplus, eliminating and lowering tariffs on imported goods, removing restrictions on foreign investment, getting rid of quotas and domestic monopolies, increasing exports, privatizing state-owned industries and utilities. deregulating capital markets, making its currency convertible, opening its industries, stock and bond markets to direct foreign ownership and investment, deregulating its economy to promote as much domestic competition as possible, eliminating government corruption, subsidies d kickbacks as much as possible, opening its banking and telecommunications systems to private ownership and competition and allowing its citizens to choose from an array of competing pension options and foreign-run pension and mutual funds. When you stitch all of these pieces together you have the Golden Straitjacket. Unfortunately, this Golden Straitjacket is pretty much “one size fits all.” So it pinches certain groups, squeezes others and keeps a society under pressure to constantly streamline its economic institutions and upgrade its performance. It leaves people behind quicker than ever if they shuck it off, and it helps them catch up quicker than ever if they wear it right. It is not always pretty or gentle or comfortable. But it’s here and it’s the only model on the rack this historical season.”

9- “While we are on the subject of the diversity of the Electronic Herd, there is one other critically important thing we should always keep in mind about it—this herd is not simply an exogenous force. It is lot just made up of stateless offshore money funds, Internet investors from abroad and distant Supermarkets. It is also made up of locals in every country that has opened itself to the herd. What gives the herd its power is not only the fact that when capital controls in a country are lifted foreigners can easily come in and buy and sell currency, stocks and bonds. It is the fact that the locals can easily go out!”

10- “In the globalization system your state matters more, not less. Because the quality of your state really means the quality of the software and operating system you have to deal with the Electronic Herd. The ability of an economy to withstand the inevitable ups and downs of the herd depends in large part on the quality of its legal system, financial system and economic management—all matters still under the control of governments and bureaucrats.”

11- “To be an effective shaper you have to be able to attract a lot of adapters. But the key to having a lot of adapters to your standard is that it be able to create a lot of value for other people too—whether it is a product, a human value or a set of geopolitical rules. If people become reluctant members of your value network, eventually they will rebel against it by seeking a different standard. So one thing a shaper always has to be aware of is whether he is leaving room in his value chain—some food on the table—so that others will have an incentive to adapt to his standards.”

12- “The best countries and companies will mirror one another’s habits. So, after asking the two most basic questions—how wired is your country or company and is it a shaper or adapter—here are the other nine questions I ask to measure its economic power and potential. 1) How Fast Is Your Country or Company? 2) Is Your Country or Company Harvesting Its Knowledge? 3) How Much Does Your Country or Company Weigh? 4) Does Your Country or Company Dare to Be Open on the Outside? 5) Does Your Country or Company Dare to Be Open on the Inside? 6) Does Your Country’s or Company’s Management Get It and Can You Change Management If They Don’t? 7) Is Your Country or Company Willing to Shoot Its Wounded and Suckle the Survivors? 8) How Good Is Your Country or Company at Making Friends?”

13- “The Golden Arches Theory highlights one way in which globalization affects geopolitics—by greatly raising the cost of warfare through economic integration. But globalization influences geopolitics in many other ways. For instance, it creates new sources of power, beyond the classic military measures of tanks, planes and missiles, and it creates new sources of pressure on countries to change how they organize themselves, pressures that come not from classic military incursions of one state into another, but rather by more invisible invasion lie invasions of Supermarkets and Super-empowered individuals.”

14- “The other method for greening globalization is to demonstrate to corporations and their shareholders that their profits and share prices will  increase if they adopt environmentally sound production methods.”

15- “If the intellectual critics of globalization would spend more time thinking about how to use the system, and less time thinking about how to tear it down, they might realize what a lot of these little folks have already realized—that globalization can create as many solutions and opportunities as it can problems.”

16- “How we learn to strike the right balance between globalization’s inherently empowering and humanizing aspects and its inherently disempowering and dehumanizing aspects will determine whether it is reversible or irreversible, a passing phase or a fundamental revolution in he evolution of human society.”

17- “America does have a shared national interest to pursue in today’s globalization system—one that constitutes both a big opportunity and a big responsibility. Put simply: As the country that benefits most from today’s global integration—as the country whose people, products, values, technologies and ideas are being most globalized—it is our job to make sure that globalization is sustainable. And the way we do that is by ensuring that the international system remains stable and that advances lead declines for as many people as possible, in as many countries as possible, on as many days as possible.”

18- “First, we want as open, and growing, a free-market-oriented economy as possible, in which people are encouraged to swing free and take crazy leaps. Without risk takers and venture capitalists, there is no entrepreneurship and without entrepreneurship there is no growth. Therefore, at the heart of every healthy economy are the free-swinging trapeze of free markets. Because there is no better safety net than a healthy economy with low unemployment.”

19- “Democratizing globalization—it’s not only the most effective way to make it sustainable, it’s the most self-interested and moral policy that any government can pursue.”

Regards,

Omar Halabieh

The Lexus and the Olive Tree

On Fooled by Randomness

I recently finished reading Fooled by Randomness – The Hidden Role of Chance in Life and in the Markets – by Nassim Nicholas Taleb.

As stated by the author in the prologue, the main premise of the book is: “More generally, we underestimate the share of randomness in about everything, a point that may not merit a book – except when it is the specialist who is the fool of all fools…In my experience (and in the scientific literature), economic “risk takers” are rather the victims of delusions (leading to overoptimism and overconfidence with their underestimation of possible adverse outcomes) than the opposite. Their “risk taking” is frequently randomness foolishness.”

Below are key excerpts from the book that I found particularly insightful:

1- “I start with the platitude that one cannot judge a performance in any given field (war, politics, medicine, investments) by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly, the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voice only by people who fail (those who succeed attribute their success to the quality of their decision…And like many platitudes, this one, while being too obvious, is not easy to carry out in practice.”

2- “It is a fact that our brain tends to go for superficial clues when it comes to risk and probability, these clues being largely determined by what emotions they elicit or the ease with which they come to mind. In addition to such problems with the perception of risk, it is also a scientific fact, and a shocking one, that both risk detection and risk avoidance are not mediated in the “thinking” part of the brain but largely in the emotional one (the “risk as feelings” theory). The consequences are not trivial: It means that rational thinking has little, very little, to do with risk avoidance. Much of what rational thinking seems to do is rationalize one’s actions by fitting some logic to them.”

3- “There is an important and nontrivial aspect of historical thinking, perhaps more applicable to the markets than anything else: Unlike many “hard” sciences, history cannot lend itself to experimentation. But somehow, overall, history is potent enough to deliver, on time, in the medium to long run, most of the possible scenarios, and to eventually bury the bad guy…Mathematicians of probability give that a fancy name: ergodicity. It means, roughly, that (under certain conditions) very long sample paths would end up resembling each other.”

4- “1) Over a short time increment, one observes the variability of the portfolio, not the returns. In other words, one sees the variance, little else…2) Our emotions are not designed to understand the point…3) When I see an investor monitoring his portfolio with live prices on his cellular telephone or his handheld, I smile and smile.”

5- “…It is not how likely an event is to happen that matters, it is how much is made when it happens that should be the consideration. How frequent the profit is irrelevant, it is the magnitude of the outcome that counts.”

6- “…Brian Arthur, an economist concerned with nonlinearities at the Santa Fe Institute, wrote that chance events coupled with positive feedback rather than technological superiority will determine economic superiority – not some abstrusely  defined edge in a given area of expertise.”

7- “Causality can be very complex. It is very difficult to isolate a single cause when there are plenty around. This is called multi-variate analysis…People might ask me: Why do I want everybody to learn some statistics? The answer is that too many people read explanations. We cannot instinctively understand the nonlinear aspect of probability.”

8- “I am just intelligent enough to understand  that I have a predisposition to be fooled by randomness – and to accept the fact that I am rather emotional. I am dominated by my emotions – but as an aesthete, I am happy about the fact. I am just like every single character who I ridiculed in this book…The difference between me and those I ridicule is that I try to be aware of it.”

9- “People confuse science and scientists. Science is great, but individual scientists are dangerous. They are human; they are marred by the biases human have. Perhaps even more. For most scientists are hard-headed, otherwise they would not derive the patience and energy to perform the Herculean tasks asked of them…It was said that science evolves from funeral to funeral. After the LTCM collapse, a new financial economist will emerge, who will integrate each knowledge into his science. He will be resisted by the older ones, but, again, they will be must closer to their funeral date than he.”

10- “It took me an entire lifetime to find out what my generator is. It is: We favor the visible, the embedded, the personal, the narrated, and the tangible; we scorn the abstract. Everything good (aesthetics, ethics) and wrong (Fooled by Randomness) with us seems to flow from it.”

Regards,

Omar Halabieh

Fooled by Randomness

On Boomerang

I recently read Michael’s Lewis Boomerang – Travels In The New Third World.

Below are key excerpts form the book, that I found particularly insightful:

1- “The subprime mortgage crisis was more symptom than cause. The deeper social and economic problems that gave rise to it remained. The moment that investors woke up to this reality, they would cease to think of big Western governments as essentially risk-free and demand higher interest to lend to them. When the interest rates on their borrowing rose, these governments would plunge further into debt, leading to further rises in the interest rates they were charged to borrow. In a few especially alarming cases – Greece, Ireland, Japan – it wouldn’t take much of a rise in interest rates for budgets to be consumed entirely by interest payments on debt…The moment the financial markets realized this, investor sentiment would shift. The moment investor sentiment shifted, these governments would default. And then what? The financial crisis of 2008 was suspended only because investors believed that governments could borrow whatever they needed to rescue their banks. What happened when the governments themselves ceased to be credible. There was another, bigger, financial crisis waiting to happen – the only question in Kyle Bass’s mind was when.”

2- “When you borrow a lot of money to create a false prosperity, you import the future into the present. It isn’t the actual future so much as some grotesque silicone version of it. Leverage buys a glimpse of a prosperity you haven’t really earned. The striking thing about the future the Icelandic male briefly imported was how much it resembled the past that he celebrates. I’m betting now they’ve seen their false future the Icelandic female will have a great deal more o say about the actual one.”

3- “The costs of running the Greek government are only half the failed equation: there’s also the matter of government revenues.”

4- “The structure of the Greek economy is collectivist, but the country, in spirit, is the opposite of a collective. Its real structure is every man for himself. Into this system investors had poured hundreds of billions of dollars. And the credit boom had pushed the country over the edge, into total moral collapse.”

5- “The Irish real estate bubble was different from the American version in may ways. It wasn’t disguised, for a start. It didn’t require a lot of complicated financial engineering beyond the understanding of mere mortals. It also wasn’t as cynical. There aren’t a lot Irish financiers, or real estate people, who have emerged with a future. In America the banks went down but the big shots in them still got rich; in Ireland the big shots went down with the banks.”

6- “The Greeks not only have massive debts but are still running big deficits. Trapped by an artificially strong currency, they cannot turn deficits into surpluses, even if they do everything outsiders want them to do. Their exports, priced in euros, remain expensive. The German government wants the Greeks to slash the size of their government, but that will also slow economic growth and reduce tax revenues. And so one of two things must happen. Either the Germans must agree to integrate Europe fiscally, so that Germany and Greece bear the same relationship to each other as, say, Indiana and Mississippi – the tax dollars of ordinary Germans would go into the coffer and be used to pay for the lifestyle of ordinary Greeks – or the Greeks (and probably, eventually, every non-German) must introduce “structural reform,” a euphemism for magically and radically transforming themselves into a people as efficient and productive as the Germans. The first solution is pleasant for Greeks but painful for Germans. The second solution is pleasant for the Germans but painful, possibly even suicidal, for Greeks.”

7- “The curious thing about the eruption of cheap and indiscriminate lending of money between 2002 and 2008 was the different effects it had from country to country. Every developed country was subjected to more or less the same temptation, but no two countries responded in precisely the same way. Much of Europe had borrowed money cheaply to buy stuff it couldn’t honestly afford. In effect, lots of non-Germans had used Germany’s credit rating to indulge their material desires. The Germans were the exception. Given the chance to take something for nothing the German people simply ignored the offer. “There was no credit boom in Germany,” says Asmussen. “Real estate prices were completely flat. There was no borrowing for consumption. Because this behavior is totally unacceptable in Germany. This is what the German people are. This is deeply in German genes. It is perhaps a leftover of the collective memory of the Great Depression and the hyperinflation of the 1920s.” The German government was equally prudent because, he went on, “there is a consensus among the different parties about this: if you’re not adhering to fiscal responsibility you have no chance in elections, because the people are that way.”

8- “When people pile up debts they will find difficult and perhaps even impossible to repay, they are saying several things at once. They are obviously saying that they want more than they can immediately afford. They are saying, less obviously, that their present wants are so important that, to satisfy them, it is worth some future difficulty. But in making that bargain they are implying that when the future difficulty arrives, they’ll figure it out. They don’t always do that. But you can never rule out the possibility that they will. As idiotic as optimism can sometimes seem, it has a weird habit of paying off.”

Regards,

Omar Halabieh

Boomerang