2. The Other Te
fl
on MenLarry Summers, with a
Financial Times
bully pulpit,had done little bullying and blown no warningwhistles of impending doom back in 2006 and 2007.And, famously, in earlier years as Treasury Secretaryhe had encouraged (I hope inadvertently) wild andreckless
fi
nancial behavior by helping to beat back attempts to regulate some of the new and mostdangerous instruments. Timothy Geithner, in turn,sat in the very engine room of the USS
Disaster
andhelped steer her onto the rocks. And there are severalothers (discussed in the 4Q 2008 Letter). You knowwho you are. All promoted!3. Misguided, Sometimes Idiotic Mortgage BorrowersThe more misguided or reckless the borrowers, themore determined the efforts to help them out, itappears, although it must be admitted these effortshad limited effect. In comparison, those who showedrestraint and either underhoused themselves or rentedreceived not even a hint of help. Quite the reverse:the money the more prudent potential buyers heldback from housing received an arti
fi
cially low rate.In effect, the prudent are subsidizing the very samebanks that insisted on dancing off the cliff into UncleSam’s arms or, rather, the arms of the taxpayers –many of whom rent.4. Reckless HomebuildersHaving magni
fi
cently overbuilt for several years byany normal relationship to the population, we havedecided to encourage even more homebuilding bygiving new house buyers $8,000 each. This cashcomes partly from the pockets of prudent rentersonce again. This gift is soon, perhaps, to be extendedbeyond
fi
rst-time buyers (for whom everyone witha heart has a slight sympathy) to any buyers, which
GMO
Q
UARTERLY
L
ETTER
October 2009
Just Desserts
I can’t tell you how surprised, even embarrassed I was to getthe Nobel Prize in chemistry. Yes, I had passed the dreadedchemistry A-level for 18-year-olds back in England in1958. But did they realize it was my third attempt? And,yes, I will take this honor as encouragement to do someserious thinking on the topic. I will also invest the awardto help save the planet. Perhaps that was really the NobelCommittee’s sneaky motive, since there are regrettably nogreen awards yet. Still, all in all, it didn’t seem deserved.And then it occurred to me. Isn’t that the point these days:that rewards do not at all re
fl
ect our just desserts? Let’sreview some of the more obvious examples.1. For Missing the UnmissableBernanke, the most passionate cheerleader of Greenspan’s follies, is picked as his replacement,partly, it seems, for his belief that U.S. houseprices would never decline and that at their peak in late 2005 they largely just re
fl
ected the unusualstrength of the U.S. economy. As well as missingon his very own this 3-sigma (100-year) eventin housing, he was completely clueless as to thepotential disastrous interactions among lower houseprices, new opaque
fi
nancial instruments, heroicallyincreased mortgages, lower lending standards, andinternationally networked distribution. For theseaccumulated bene
fi
ts to society, he was reappointed!So, yes, after the fashion of his mentor, he was lavishwith help as the bubble burst. And how can we soquickly forget the very painful consequences of theprevious lavishing after the 2000 bubble? RewardingBernanke is like reappointing the
Titanic’s
captain forfacilitating an orderly disembarkation of the sinkingship (let’s pretend that happened) while ignoring thefact that he had charged recklessly through dark anddangerous waters.
Just Desserts and Markets Being Silly Again
Jeremy Grantham
2
GMO
Quarterly Letter – Just Desserts – October 2009
would be blatant vote-buying by Congress. So whatelse is new?5. Over-spenders and Under-saversTo celebrate the overwhelming consensus amongeconomists that U.S. individuals have beendangerously overconsuming for the last 15 years, wehave decided to encourage consumption and penalizesavers by maintaining the aforementioned arti
fi
ciallylow rates, which beg everyone and sundry to borroweven more. The total debt to GDP ratio, which underour heroes Greenspan and Bernanke rose from 1.25xGDP to 3.25x (without even counting our SocialSecurity and Medicare commitments), has continuedto climb as growing government debt more thanoffsets falling consumer debt. Where, one wonders,does this end, and with how much grief?6. Banks Too Big to FailHere we have adopted a particularly simple andcomprehensible policy: make them bigger! Indeed,force them to be bigger. And whatever you do, don’thave any serious Congressional conversation aboutbreaking them up. (Leave that to a few journalists andcommentators. Only pinkos read pink newspapersanyway!) This is not the
fi
rst time that a cliché hastriumphed. This one is: “You can’t roll back the clock.”(See this quarter’s Special Topic: Lesson Not Learned:On Redesigning Our Current Financial System.)7. Over-bonused Financial TypesJust look at Goldman’s recent huge “pro
fi
ts,” two-thirdsof which went for bonuses. It is now estimated that thisyear’s bonus pool will be plus or minus $23 billion,the largest ever. Less than a year ago, these same guyswere on the edge of a run on the bank. They weresaved only by “government” – the taxpayers’ supposedagents – who decided to interfere with the formerlyinfallible workings of capitalism. Just as remarkably, itis now reported that remuneration for the entire bankingindustry may be approaching a new peak. “Well, wegot rid of some of those pesky competitors, so now wecan really make hay,” you can almost hear Goldmanand the others say. And as for the industry’s concernabout the widespread public dismay, even disgust, aboutexcessive remuneration (and, I would add, plunderingof the shareholders’ rightful pro
fi
ts)? Fuhgeddaboudit!In the thin book of “lessons learned,” this one, like mostof our other examples, will not appear.8. Overpaid Large Company CEOsEven outside the
fi
nancial system, there are manypainfully obvious unjust desserts in the form of topmanagement rewards. And most of the excessiverewards come out of the pockets of our clients andother stockholders, which is particularly galling.When I arrived in the States in 1964, the ratio of CEOpay to the average worker was variously reported tobe between 20/1 and 40/1. This seemed perfectlyrespectable and had held for the previous 30 years.By 2006, this ratio had exploded to between 400/1 and600/1, which can only be described as obscene. Theresults certainly don’t suggest such high rewards: a)10-year stock market returns are close to zero in realterms; and b) U.S. GDP growth has
fi
nally slippedbelow its 100-year trend of 3.5%. After deducting theeffect of the rampant increase in the
fi
nancial system,the growth in GDP ex-
fi
nance has fallen to 3.1% since1982 and well below 3% since 2000, all measuredto the end of 2007 to avoid the recent crisis. Thecorporate system, to be frank, seemed to run fasterand more ef
fi
ciently back in the 1960s before CEOsand
fi
nancial types began to gobble up other people’slunches. I suppose I have done my share of gobbling.But, it still ain’t right!9. Holders of the Stocks of Ridiculously Overleveragedand Wounded CorporationsYes, I admit this is part envy and part hindsightinvestment regret. But, really, our
fi
nancial leadersso overstimulated the risk-taking environment that junky, weak, marginal companies and zombie banksproduced a record outperformance (the best since1933) of junk over the great blue chips. (Ouch!)In a world with less moral hazard, which would bea world of just, although painful desserts, scores of these should-be-dead companies would be. As itis, they live to compete against the companies thatactually deserve to be survivors. Excessive bailoutsare just not healthy for the long-term well-being of the economy.10. The Well-managed U.S. Auto IndustryWhile
fi
rms in other industries fail and their workerslook for new jobs, the auto industry is rewarded bydirect subsidized loans, governmental arm-twisting of creditors forced to settle far below their legal rights,and direct subsidies for their products. All of this for
3
GMO
Quarterly Letter – Just Desserts – October 2009
their well-deserved ranking as the most short-sightedindustry of the last 20 (40?) years, and one of theworst managed.11. The World’s Most Over-vehicled CountryWe chew up a dangerously large amount of MiddleEastern oil (and oil desperately squeezed fromCanadian tar sands), which is ruinous for our global-political well-being (and ability to avoid war) andalso not so good for an overheating world. So theanswer must be to subsidize more car purchases, andwhen the subsidies run out, you can have all the funagain. Good long-term thinking!12. Stock OptionsThis, of course, is the crème de la crème of unjustdesserts. Recent practices have basically been alegalized way to abscond with the stockholders’ equity.So if the stock price crashes, perhaps with considerablehelp from management, that’s all right – just rewritethe options at the new low prices. There has beenno serious attempt to match stock option rewards (ortotal
fi
nancial rewards for that matter) to the buildingof long-term franchise value. Instead, the motto is:grab it now and run! You can
fi
ll in your own favoriteanecdotes here – there are so many of them!13. Finally, Just in Case You’ve Forgotten, We Have MyOld Nemesis, GreenspanAlan Greenspan receives the title of Maestro in theU.S. and is knighted by the Queen for thoroughlydemolishing the integrity of the U.S.
fi
nancial system.He overtly ignored the great threat of bubbles inasset classes and, in fact, encouraged them. He AynRand-ishly facilitated the progressive dismantlingof governmental restrictions on
fi
nancial behavior,he deliberately kept real interest rates at zero foryears, etc., etc., etc. You have heard it before. Now,remarkably, in his very old age he has become imbuedwith the spirit of Hyman Minsky: “Unless somebodycan
fi
nd a way to change human nature, we will havemore crises.” Now he
fi
nally gets it. Too late! In hismerely old age, he ignored or abhorred Minsky, andconsistently behaved as though markets were ef
fi
cientand the players were honest and sensible at all times.But for all of the egg on his face, the Maestro continuesto consult with the rich and famous, considerably tohis
fi
nancial advantage. In the good old days, hewould have been set in the village stocks, and not thekind you buy and sell. And I would have been rightthere, Alan, with very ripe tomatoes.
The Last Hurrah and Markets Being Silly Again
The idea behind my forecast six months ago was thatregardless of the fundamentals, there would be a sharprally.
1
After a very large decline and a period of somewhatblind panic, it is simply the nature of the beast. Exhibit 1shows my favorite example of a last hurrah after the
fi
rstleg of the 1929 crash.After the sharp decline in the fall of 1929, the S&P 500rallied 46% from its low in November to the rally high of April 12, 1930. It then, of course, fell by over 80%. Buton April 12 it was once again overpriced; it was downonly 18% from its peak and was back to the level of June1929. But what a difference there was in the outlook between June 1929 and April 1930! In June, the economicoutlook was a candidate for the brightest in history witheffectively no unemployment, 5% productivity, andover 16% year-over-year gain in industrial output. ByApril 1930, unemployment had doubled and industrialproduction had dropped from +16% to -9% in 5 months,which may be the world record in economic deterioration.Worse, in 1930 there was no extra liquidity
fl
owingaround and absolutely no moral hazard. “Liquidate thelabor, liquidate the stocks, liquidate the farmers”
2
wastheir version. Yet the market rose 46%.How could it do this in the face of a world going to hell?My theory is that the market always displayed a belief in a type of primitive market ef
fi
ciency decades beforethe academics took it up. It is a belief that if the marketonce sold much higher, it must mean something. Andin the case of 1930, hadn’t Irving Fisher, arguably thegreatest American economist of the century, said thatthe 1929 highs were completely justi
fi
ed and that it wasthe decline that was hysterical pessimism? Hadn’t E.L.Smith also explained in his
Common Stocks as LongTerm Investments
(1924) – a startling precursor to JeremySiegel’s dangerous book
Stocks for the Long Run
(1994) –that stocks would always beat bonds by divine right? Andthere is always someone of the “Dow 36,000” persuasion
1
Erratum: Last quarter I cast mild aspersions on
Finanz und Wirtschaft
bysuggesting that I had not precisely said that the S&P would scoot rapidlyup to 1100; I remembered it more as between 1000 to 1100. Never messwith a Swiss journalist: this one duly pointed out that his tape of April 1confirmed his accuracy. Either way, here we are, more or less (at 1098 onOctober 19).
2
Andrew Mellon, Secretary of the Treasury, 1931.
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