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http://www.slate.com/id/2245328/

Basically, It’s Over
A parable about how one nation came to financial ruin.

By Charles Munger
Updated Sunday, Feb. 21, 2010, at 3:30 PM ET

The Europeans rapidly repopulated Basicland, creating a new nation. They installed a system of government like that of the early United States. There was much encouragement of trade, and no internal tariff or other impediment to such trade. Property rights were greatly respected and strongly enforced. The banking system was simple. It adapted to a national ethos that sought to provide a sound currency, efficient trade, and ample loans for credit-worthy businesses while strongly discouraging loans to the incompetent or for ordinary daily purchases.

Moreover, almost no debt was used to purchase or carry securities or other investments, including real estate and tangible personal property. The one exception was the widespread presence of secured, high-down-payment, fully amortizing, fixed-rate loans on sound houses, other real estate, vehicles, and appliances, to be used by industrious persons who lived within their means. Speculation in Basicland’s security and commodity markets was always rigorously discouraged and remained small. There was no trading in options on securities or in derivatives other than “plain vanilla” commodity contracts cleared through responsible exchanges under laws that greatly limited use of financial leverage.

In its first 150 years, the government of Basicland spent no more than 7 percent of its gross domestic product in providing its citizens with essential services such as fire protection, water, sewage and garbage removal, some education, defense forces, courts, and immigration control. A strong family-oriented culture emphasizing duty to relatives, plus considerable private charity, provided the only social safety net.

The tax system was also simple. In the early years, governmental revenues came almost entirely from import duties, and taxes received matched government expenditures. There was never much debt outstanding in the form of government bonds.

As Adam Smith would have expected, GDP per person grew steadily. Indeed, in the modern area it grew in real terms at 3 percent per year, decade after decade, until Basicland led the world in GDP per person. As this happened, taxes on sales, income, property, and payrolls were introduced. Eventually total taxes, matched by total government expenditures, amounted to 35 percent of GDP. The revenue from increased taxes was spent on more government-run education and a substantial government-run social safety net, including medical care and pensions.

A regular increase in such tax-financed government spending, under systems hard to “game” by the unworthy, was considered a moral imperative—a sort of egality-promoting national dividend—so long as growth of such spending was kept well below the growth rate of the country’s GDP per person.

Basicland also sought to avoid trouble through a policy that kept imports and exports in near balance, with each amounting to about 25 percent of GDP. Some citizens were initially nervous because 60 percent of imports consisted of absolutely essential coal and oil. But, as the years rolled by with no terrible consequences from this dependency, such worry melted away.

Basicland was exceptionally creditworthy, with no significant deficit ever allowed. And the present value of large “off-book” promises to provide future medical care and pensions appeared unlikely to cause problems, given Basicland’s steady 3 percent growth in GDP per person and restraint in making unfunded promises. Basicland seemed to have a system that would long assure its felicity and long induce other nations to follow its example—thus improving the welfare of all humanity.

But even a country as cautious, sound, and generous as Basicland could come to ruin if it failed to address the dangers that can be caused by the ordinary accidents of life. These dangers were significant by 2012, when the extreme prosperity of Basicland had created a peculiar outcome: As their affluence and leisure time grew, Basicland’s citizens more and more whiled away their time in the excitement of casino gambling. Most casino revenue now came from bets on security prices under a system used in the 1920s in the United States and called “the bucket shop system.”

The winnings of the casinos eventually amounted to 25 percent of Basicland’s GDP, while 22 percent of all employee earnings in Basicland were paid to persons employed by the casinos (many of whom were engineers needed elsewhere). So much time was spent at casinos that it amounted to an average of five hours per day for every citizen of Basicland, including newborn babies and the comatose elderly. Many of the gamblers were highly talented engineers attracted partly by casino poker but mostly by bets available in the bucket shop systems, with the bets now called “financial derivatives.”

Many people, particularly foreigners with savings to invest, regarded this situation as disgraceful. After all, they reasoned, it was just common sense for lenders to avoid gambling addicts. As a result, almost all foreigners avoided holding Basicland’s currency or owning its bonds. They feared big trouble if the gambling-addicted citizens of Basicland were suddenly faced with hardship.

And then came the twin shocks. Hydrocarbon prices rose to new highs. And in Basicland’s export markets there was a dramatic increase in low-cost competition from developing countries. It was soon obvious that the same exports that had formerly amounted to 25 percent of Basicland’s GDP would now only amount to 10 percent. Meanwhile, hydrocarbon imports would amount to 30 percent of GDP, instead of 15 percent. Suddenly Basicland had to come up with 30 percent of its GDP every year, in foreign currency, to pay its creditors.

How was Basicland to adjust to this brutal new reality? This problem so stumped Basicland’s politicians that they asked for advice from Benfranklin Leekwanyou Vokker, an old man who was considered so virtuous and wise that he was often called the “Good Father.” Such consultations were rare. Politicians usually ignored the Good Father because he made no campaign contributions.

Among the suggestions of the Good Father were the following. First, he suggested that Basicland change its laws. It should strongly discourage casino gambling, partly through a complete ban on the trading in financial derivatives, and it should encourage former casino employees—and former casino patrons—to produce and sell items that foreigners were willing to buy. Second, as this change was sure to be painful, he suggested that Basicland’s citizens cheerfully embrace their fate. After all, he observed, a man diagnosed with lung cancer is willing to quit smoking and undergo surgery because it is likely to prolong his life.

The views of the Good Father drew some approval, mostly from people who admired the fiscal virtue of the Romans during the Punic Wars. But others, including many of Basicland’s prominent economists, had strong objections. These economists had intense faith that any outcome at all in a free market—even wild growth in casino gambling—is constructive. Indeed, these economists were so committed to their basic faith that they looked forward to the day when Basicland would expand real securities trading, as a percentage of securities outstanding, by a factor of 100, so that it could match the speculation level present in the United States just before onslaught of the Great Recession that began in 2008.

The strong faith of these Basicland economists in the beneficence of hypergambling in both securities and financial derivatives stemmed from their utter rejection of the ideas of the great and long-dead economist who had known the most about hyperspeculation, John Maynard Keynes. Keynes had famously said, “When the capital development of a country is the byproduct of the operations of a casino, the job is likely to be ill done.” It was easy for these economists to dismiss such a sentence because securities had been so long associated with respectable wealth, and financial derivatives seemed so similar to securities.

Basicland’s investment and commercial bankers were hostile to change. Like the objecting economists, the bankers wanted change exactly opposite to change wanted by the Good Father. Such bankers provided constructive services to Basicland. But they had only moderate earnings, which they deeply resented because Basicland’s casinos—which provided no such constructive services—reported immoderate earnings from their bucket-shop systems. Moreover, foreign investment bankers had also reported immoderate earnings after building their own bucket-shop systems—and carefully obscuring this fact with ingenious twaddle, including claims that rational risk-management systems were in place, supervised by perfect regulators. Naturally, the ambitious Basicland bankers desired to prosper like the foreign bankers. And so they came to believe that the Good Father lacked any understanding of important and eternal causes of human progress that the bankers were trying to serve by creating more bucket shops in Basicland.

Of course, the most effective political opposition to change came from the gambling casinos themselves. This was not surprising, as at least one casino was located in each legislative district. The casinos resented being compared with cancer when they saw themselves as part of a long-established industry that provided harmless pleasure while improving the thinking skills of its customers.

As it worked out, the politicians ignored the Good Father one more time, and the Basicland banks were allowed to open bucket shops and to finance the purchase and carry of real securities with extreme financial leverage. A couple of economic messes followed, during which every constituency tried to avoid hardship by deflecting it to others. Much counterproductive governmental action was taken, and the country’s credit was reduced to tatters. Basicland is now under new management, using a new governmental system. It also has a new nickname: Sorrowland.

The Big Mac index

Taste and see

Jan 6th 2010
From Economist.com

Burgernomics shows the Chinese yuan is still undervalued

THE Big Mac index is based on the theory of purchasing-power parity (PPP)—exchange rates should equalise the price of a basket of goods in different countries. The exchange rate that leaves a Big Mac costing the same in dollars everywhere is our fair-value benchmark. So our light-hearted index shows which countries the foreign-exchange market has blessed with a cheap currency, and which has it burdened with a dear one. The most overvalued currency against the dollar is the Norwegian kroner, which is 96% above its PPP rate. In Oslo you can expect to pay around $7 for a Big Mac. At the other end of the scale is the Chinese yuan, which is undervalued by 49%. The euro comes in at 35% over its PPP rate, a little higher than half a year ago.

Before rushing to hit the sell button, however, investors should be aware that the currently stratospheric P/E ratio of the S&P 500 is skewed by the negative quarterly results in Q4 2008 ($-0.09). That number will be replaced by an estimate of $16.73 in Q4 ‘09, which would drop the P/E ratio to a still lofty, although relatively more reasonable level of 20.1 times. What the bulls are really banking on, though, is strong results throughout 2010. Based on current forecasts from S&P, analysts are expecting S&P 500 earnings to rise to $74.98 per share in 2010. With the S&P 500 currently trading at 1,130, the P/E ratio on a forward basis comes all the way down to a much more manageable 15 times. Now all the companies have to do is deliver.

What I’d like to see is a historical ratio that adjusts PEs for leverage.   Yes companies have had higher PEs in the last 10 years than they did in the 70s and 80s, but they were probably also more leveraged.   Adjusting for leverage is tricky.  If you’d pay 10x to buy 100% of a company, how much would you pay to buy 40% of the same company with 60% debt?  It makes sense that the multiple should go up, but how much is a function of spread between the company’s borrowing rate and it’s investing rate.  And this rapidly becomes a level of analysis way beyond a simple PE ratio.

I’ve struggled with this idea for a long time.  Dollars don’t earn interest by themselves either.  They only acquire their interest earning properties when lent to another party to pay it back.  So it’s the borrowing and lending of an asset that creates the interest, not the asset itself.  And the market to borrow and lend dollars is enormous.

True, it’s much harder to borrow and lend gold.  But it is possible to earn something resembling interest on gold.  Over at Hard Assets Investor, Brad Zigler writes about how to do it.  Here are a few excerpts:

Who Says Gold Doesn’t Earn Interest?

Written by Brad Zigler

Monday, 04 January 2010 10:12

Real-time Monetary Inflation (last 12 months): 1.5%

Gold aficionados have for many years contended with the plaints about the metal’s sterility. “Gold doesn’t earn interest” is a constant refrain heard from nonowners. But that’s not necessarily true. Gold can offer a money market return regardless of its price trajectory. Spreads between gold futures’ delivery months, in fact, implicitly reflect short-term rate expectations. The gold market, through cash-and-carry operations, tells us what traders think short-term rates ought to be. A cash-and-carry is accomplished by taking possession of gold through nearby futures (or the cash market) and redelivering the metal against a forward contract. A December 2010 gold contract, for example, might be purchased with the intent to take delivery and store the metal until the expiration of a December 2011 future sold short. If storage costs ran $10 per month per 100 oz. bar, a return of 1.1 percent could be earned currently. That’s a 63 basis point (0.63 percent) premium over one-year Treasurys. In fact, the rates for one-year cash-and-carries - essentially “risk-free” transactions - have been, on average, 60 basis points above Treasurys this past quarter. Thus, the market’s pointing the way to higher Federal rates. How so?

We’ll know gold is overcrowded when . . .

For the long-gold trade to really become too crowded, certain events will need to occur:

• Goldman Sachs (GS, news, msgs) will have had “bus tours” to a bunch of mines, like the tours it and other companies have arranged for different industries, particularly technology.
• The public will have to be involved in a major way, and we’ll see ads on Bubblevision encouraging people to buy gold instead of prodding them to sell their jewelry, as is the case these days.
• Banks will need to find a way to put money into gold — because no modern mania has ever ended without the banks finding a way to lose money in it.
• We will most likely need to see a frenzy of mergers and acquisitions, and a leveraged buyout or two.

Last, BusinessWeek will have to put gold on the cover, telling us how it’s the wave of the future, or some variation of that theme.

For what it’s worth, here’s the Periodic Table of the Elements from Wikipedia.

Other observations:
* It makes me wonder if I were a CEO or a CFO pondering a public offering, that could list anywhere, where would I want to list? On the Chinese exchanges where I might get a higher valuation? Or would I prefer a lower valuation on the NYSE or Nasdaq, and the related SOX and reporting obligations? Makes me think twice.
* Both China and Brazil are growing mightily. Why then the massive difference in valuations? Short China/Long Brazil?
* Are the Chinese multiples the logical result of capital controls on the Yuan. Chinese savers buy Chinese stocks, because capital controls prevent them from buying in any other markets. This is the reason for the disconnect in valuations for companies listed in China and Hong Kong.

On the Too Big to Fail Doctrine and Lehman

The proper way to deal with too-big-to-fail, or too inter-connected to fail, is to makesure that no institution is too big or inter-connected to fail. The test ought to be that noinstitution should ever be of individual importance such that if we were faced with its demise the government would be forced to intervene. The real solution is to break up anything that fails that test.

The lesson of Lehman should not be that the government should have prevented its
failure. The lesson of Lehman should be that Lehman should not have existed at a scale that
allowed it to jeopardize the financial system. And the same logic applies to AIG, Fannie,
Freddie, Bear Stearns, Citigroup and a couple dozen others.

On Government Accounting

When the government calculates its debt and deficit it does so on a cash basis. This
means that deficit accounting does not take into account the cost of future promises until the
money goes out the door. According to shadowstats.com, if the federal government counted
the cost of its future promises, the 2008 deficit was over $5 trillion and total obligations are
over $60 trillion. And that was before the crisis.

On Moody’s and Sovereign Risk

My firm recently met with a Moody’s sovereign risk team covering twenty countries
in Asia and the Middle East. They have only four professionals covering the entire region.
Moody’s does not have a long-term quantitative model that incorporates changes in the
population, incomes, expected tax rates, and so forth. They use a short-term outlook – only
12-18 months – to analyze data to assess countries’ abilities to finance themselves. Moody’s
makes five-year medium-term qualitative assessments for each country, but does not appear to
do any long-term quantitative or critical work.

Their main role, again, appears to be to tell everyone that things are fine, until a real
crisis emerges at which point they will pile-on credit downgrades at the least opportune
moment, making a difficult situation even more difficult for the authorities to manage.
I can just envision a future Congressional Hearing so elected officials can blame the
rating agencies for blowing it, as the rating agencies respond by blaming Congress.