Easy Money

Common sense tells us that tight money is bad for profits. The cost of money is an expense, and if money is hard to get, it limits the amount of capital available for expansion. Easy monetary policy promotes full employment and low interest rates, but, life is a paradox where all blessings are mixed. Easy money is like a drug that feels good for a while, but eventually leads to all kinds of bad behavior, and eventually to a crash and burn.

Below is a list of links to investment manager's feeble attempts describe a few examples of the bad behavior that were the intended or more often the unintended result of the moral hazard of easy money. This is not behavior that is unique to current times, but has been with us as long as there have been markets. One lesson is that without easy credit there would be no bubbles. It is an important lesson because the thing about bubbles is that sooner or later they always pop. Important though this lesson is it does not appear to be one that can be learned without pain it is like the lesson you learn by trying to carry a cat home by its tail. Nor is the memory of this lesson one that lasts very long, and it certainly does not pass from one generation to the next.

Investment Manager's Letter June 2009 – Leaning Things the Hard Way IV - Moral Hazard

Investment Manager's Letter Letter June 2008 – Moral Hazard

Investment Manager's Letter Letter September 2005 – The Credit Bubble

Investment Manager's Letter Letter August 2005 – Unintended Consequences

Investment Manager's Letter Letter December 2003 – Hedged Fund

Investment Manager's Letter Letter January 2001 – Other People's Money

Investment Manager's Letter Letter November 2000 – Build it and Money will come

 

The Federal Reserve Board and Monetary Policy

This is also a story about central banks. Central banks occasionally become enamored with easy money and every time the eventual result is disaster. Think about the United States in 1920's and 1970's, and about Japan in the 1980's. Periods of easy money have been very bad for the nation's economy. Not only does easy money breed inflation, it seems to encourage accounting games and Ponzi schemes. There can be no better example of this phenomenon than the tech bubble and the real estate bubble. We were not great fans of Alan Greenspan and his goldilocks economy. Below are links to Investment Manager's Letters where we had something to say about FED policy.

Investment Manager's Letter March 2009 – On Learning Things The Hard Way

Investment Manager's Letter November 2007 – Greenspan on Inflation

Investment Manager's Letter June 2007 – Stability is Unstable

Investment Manager's Letter February 2006 – Inflation Is

Investment Manager's Letter November 2005 – The Price of Easy Money

Investment Manager's Letter July 2002 – A Greenspan Put Floats Charlie's Ducks

Investment Manager's Letter March 2002 – Stupid FED Tricks

Investment Manager's Letter July 2001 – Bubble Watching

Investment Manager's Letter July 2000 – Identifying Problems

Investment Manager's Letter April 2000 – Big Al and the Bubble Machine

 

Warren Buffett on Capital allocation

At one of the first Berkshire Hathaway annual meetings I, as investment manager, attended, Warren Buffett described his system for allocating capital. The managers of Berkshire Hathaway's various wholly-owned businesses could get all the money that they wanted, but they had to pay. I forget the actual numbers, but as I, as investment manager, recall the rates varied from company to company depending upon the industry and typical capital requirements within their sector. Interest rates were generally a couple hundred basis points above market rates. On the other hand if the CEO returned money from earnings to the parent, Berkshire Hathaway paid a very nice return (2 to 3 percent above the respective interest charged). It seemed a strange system to me then, but as I, as investment manager, have thought about it over the years it has started to make sense.

The point is to make money expensive. The business can have all the money it wants but in most cases they are going to be better off giving the money to Warren to manage. The real cost of money within the Berkshire Hathaway system is not the interest rate (the amount that you paid Berkshire Hathaway to use the money), but the opportunity cost (the profit you lost by not turning the money over to Warren Buffett). This makes money at Berkshire Hathaway very expensive all of the time.

 

Lessons for the investor - Boring Is Good

As a investment manager, we like to invest in stocks that are not popular and try to avoid, like the plague, all areas were stocks have become popular and money is flowing freely. The best returns on capital investment come from investment at times or in places were money is hard to get.

With equity investments there is a direct relationship between popularity and risk. The more popular a stock or an industry sector has become, the higher the risk an investment in that area carries. Risk builds in any market as money pours into a particular vehicle. The more the money moves in a particular direction, the higher the risk. Risk is always a moving target, where as concepts such as Beta perceives it as static. In the 1950's it was accepted wisdom that bonds where a low-risk investment, but the 1970's proved this was not true.

The perception of risk and real risk are entirely different things. Market psychology and mechanics make it that way. As people run from the risk that they see in the rear view mirror they tend to rush toward the risks they can not see. The best way to insulate your investments from risk is to avoid the crowd. Recent history is a great example, for years money poured into large cap tech stocks and out of small cap value. By March 2000 this had created a situation where the risk in tech was astronomical, whereas risk in small cap had decreased to point where there were margins of safety were.

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