Category: Special Events

Warren Buffett is one of my investment heroes. I’ve been a shareholder of the company that he runs, Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B), since August 2011. On 2 May 2020, Buffett held court at the 2020 Berkshire Hathaway AGM (annual general meeting). 

For many years, I’ve anticipated the AGM to hear his latest thoughts. This year was no exception for me. In fact, the 2020 Berkshire Hathaway AGM held even more importance, given the uncertainty that the global economy is currently facing because of the COVID-19 pandemic.

I got up at 4am on the morning of 3 May 2020 (I live in Singapore) to watch the live-stream of the entire event. It was surreal, seeing shots of a completely empty stadium that would in normal times hold tens of thousands of people. Moreover, the meeting did not have Charlie Munger, Buffett’s long-time sidekick. Berkshire thought that it did not make sense for Munger to fly from California to Omaha for the meeting. Instead, Greg Abel – who runs Berkshire’s non-insurance businesses – sat at the podium with Buffett.

But I wasn’t disappointed by this year’s AGM. The whole event lasted for over four hours. Buffett kicked it off with a tour-de-force presentation on the history and future of the US economy. He then tackled a whole host of questions – collated from the public and asked by CNBC host Becky Quick – together with Abel.  

I thought it would be worth sharing my favourite comments from Buffett and Abel.

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Betting on the future of the US

Warren Buffett: “In 2008 and 2009, our economic train went off the tracks, and there were some reasons why the road-bed was weak in terms of the banks and all of that sort of thing. But this time, we just pulled the train off the tracks and put it on the side.

And I don’t really know of any parallel of one of the most important countries in the world – the most productive, with a huge population – in effect, sidelining its economy and its workforce. And obviously and unavoidably, creating a huge amount of anxiety and changing people’s psyche and causing them to somewhat lose their bearings, in many cases understandably. 

This is quite an experiment, and we may know the answer to most of the questions reasonably soon, but we may not know the answers to some very important questions for many years. So it still has this enormous range of possibilities.

But even facing that, I would like to talk to you about the economic future of the country because I remain convinced as I have. I was convinced of this in World War II, I was convinced of this during the Cuban Missile Crisis, 9/11, the financial crisis – that nothing can basically stop America. And we faced great problems in the past. We haven’t faced this exact problem. In fact, we haven’t really faced any that quite resembles this problem. But we faced tougher problems. And the American miracle, the American magic has always prevailed, and it will do so again.”

The importance of deposit insurance

Warren Buffett: “And one of the things as I look back on that period [referring to the Great Depression] – and I don’t think the economists generally like to give it that much of a point of importance – but if we had the FDIC [Federal Deposit Insurance Corporation] 10 years earlier…  The FDIC started on January 1, 1934. It was part of the sweeping legislation that took place when Roosevelt came in. If we had the FDIC, we would have had a much, much different experience, I believe, in the Great Depression. 

There was Smoot-Hawley – I mean, there’s all kinds of things and the margin requirements in ’29 and all of those things entered into creating a recession. But if you have over 4,000 banks fail, that’s 4,000 local experiences where people save and save and save and put their money away, and then someday, they reach for it and it’s gone. And that happens in all 48 states, and it happens to your neighbors, and it happens to your relatives. It has an effect on the psyche that’s incredible.

So one very, very, very good thing that came out of the Depression, in my view, is the FDIC. And it would have been a somewhat different world, I’m sure, if the bank failures hadn’t just rolled across this country – and with people who thought that they were savers, find out that they had nothing when they went there and there was a sign that said “Closed.” 

Incidentally, the FDIC – I think very few people know this, or at least, they don’t appreciate it. But the FDIC has not cost the American taxpayer a dime. I mean its expenses have been paid, its losses have been paid, all through assessments on banks. It’s been a mutual insurance company of the banks backed by the federal government, associated with the federal government. But now it holds [US]$100 billion, and it consists of premiums that were paid in and investment income on the premium less the expenses and paying off all the losses. And think of the incredible amount of peace of mind that’s given to people that were not similarly situated when the Great Depression hit.”

The US stock market and economy’s incredible rise

Warren Buffett: “I remember 1954 because it was the best year I ever had in the stock market. And the Dow went from essentially 280 or thereabouts at the start of the year to a little over 400 at the end of the year. 

And when it went to 400 – as soon as it crossed 381, that famous figure from 1929 – and this will be hard for some of you to believe, but everybody wondered: Is this 1929 all over again? And that seemed a little far-fetched because it was a different country in 1954. But that was the common question.

It actually achieved such a level of worry about whether we were about to jump off another cliff because the 381 [high] of 1929 had been exceeded that they had Senator Fulbright – Will Fulbright of Arkansas, who became very famous later in the Foreign Relations Committee. But he had set up a Banking Committee, and he called for a special investigation – if you read through it, he really was questioning whether we had built another house of cards again. And on this committee, one of the members was Prescott Bush, the father of George H. W. Bush, and grandfather of George W. Bush. It had some illustrious names. 

And his committee in March of 1955, with the Dow at 405, assembled 20 of the best minds in the United States to testify as to whether we were going crazy again because the market was at 400, the Dow was at 400, and we’ve gotten in this incredible trouble before. But that was the mindset of the country. It’s incredible. We didn’t really believe America was what it was.

The reason I’m familiar with this thousand-page book that I have here – they found it last night in the library – was that I was working in New York for 1 of the 20 people who was called down to testify before Senator Fulbright. And he testified right before Bill Martin (who was running the Federal Reserve) testified and right after General Wood (who was running Sears) testified. And Bill Martin, of course, is the longest-running Chairman in the history of the Fed, and he’s the one who gave the famous quote that “The function of the Fed was to take away the punch bowls just when the party starts to get really warmed up.” But Ben Graham, my boss, sent me over to the public library in New York to gather some information, something you could do in 5 minutes with the computer now. I dug out something, and he went to testify. 

And on Page 545 of this book — I knew where to look. I didn’t have to go through it all. But he had the quote, which I remember. And I remember because Ben Graham was 1 of the 3 smartest people I’ve met in my life. He was the Dean of the people in the securities business. He wrote the classic Security Analysis book in 1934. He wrote the book that changed my life, The Intelligent Investor, in 1949. He was unbelievably smart. And when he testified with the Dow at 404, he had one line in there toward the start in his written testimony. He said, “The stock market is high. Looks high. It is high, but it’s not as high as it looks.” But he said it is high. 

And since that time, of course, we felt the American tailwind at full force. And the Dow is about 24,000. So you’re looking at a market today that has produced $100 for every dollar. All you did was you had to believe in America – just buy a cross section of America. You didn’t have to read the Wall Street Journal. You didn’t have to look up the price of your stock. You didn’t have to pay a lot of money in fees to anybody. You just had to believe that the American miracle was intact. 

But you had this testing period between 1929 and 1954 as indicated by what happened when it got back up to 380. You had this testing period. And people – they’d lost faith to some degree. They just didn’t see the potential of what America could do. And we found that nothing can stop America when you get right down to it. And it’s been true all along. They have been interrupted. One of the scariest of scenarios was when you had a war with one group of states fighting another group of states, and it may have been tested again in the Great Depression, and it may be tested now to some degree. But in the end, the answer is never bet against America, and that in my view is true today as it was in 1789 and even was true during the Civil War and in the depths of the Depression.”

The right way to approach stocks

Warren Buffett: “Imagine for a moment that you decided to invest money now and you bought a farm. Let’s say about 160 acres, and you bought it $X per acre. And the farmer next to you has 160 identical acres – same contour, same quality of soil. So it was identical. But that farmer next door to you is a very peculiar character. Every day that farmer with the identical farm says “I’ll sell you my farm or I’ll buy your farm at a certain price,” which he would name.

Now that’s a very obliging neighbor. I mean that’s got to be a plus to have a fellow like that in the next farm. You don’t get that with farms. You get it with stocks. You want 100 shares of General Motors on Monday morning, somebody will buy your 100 shares or sell you another 100 shares at exactly the same price, and that goes on 5 days a week. But just imagine if you had a farmer doing that.

When you bought the farm, you looked at what the farm would produce. That was what went through your mind. You were saying to yourself, “I’m paying $X per acre, I think I’ll get so many bushels of corn or soybeans. On average, some years, good; some years, bad; some years, the price will be good; some years, the price will be bad; etc.” But you think about the potential of the farm. 

And now you get this idiot that buys a farm next to you. And on top of that, he’s sort of manic depressive. And he drinks, maybe smokes a little pot. So his numbers just go all over the place. Now the only thing you have to do is to remember that this guy next door is there to serve you and not to instruct you. You bought the farm because you thought the farm had the potential. You don’t really need a quote on it. If you bought in with John D. Rockefeller or Andrew Carnegie, there were never any quotes, although there were quotes later on. But basically, you bought into the business.

That’s what you’re doing when you buy stocks, but you get this added advantage. You have this neighbor who you’re not obliged to listen to at all, but who is going to give you a price every day. And he’s going to have his ups and downs, and maybe he’ll name his selling price that he’ll buy at, in which case you sell if you want to; or maybe he’ll name a very low price, and you’ll buy his farm from him. But you don’t have to, and you don’t want to put yourself in a position where you have to. So stocks have this enormous inherent advantage of people yelling out prices all the time to you, and many people turn that into a disadvantage.

And of course, many people profit in one way or another from telling you that they can tell you what your neighboring farmer’s going to yell out tomorrow or next week or next month. There’s huge money in it. So people tell you that it’s important and they know and that you should pay a lot of attention to their thoughts about what price changes should be, or you tell yourself that there should be this great difference.

But the truth is if you own the businesses you liked prior to the virus arriving – it changes prices, but nobody is forcing you to sell. And if you really like the business and you like the management you’re in with, and the business hasn’t fundamentally changed – and I’ll get to that little one report on Berkshire, which I will soon, I promise – the stocks have an enormous advantage.

And you still can bet on America. But you can’t do that, unless you’re willing and have an outlook to independently decide that you want to own a cross section of America because I don’t think most people are in a position to pick single stocks. A few maybe. But on balance, I think people are much better off buying a cross section of America and just forgetting about it. If you’ve done that – if I’d done that when I got out of college, it’s all I had to do to make 100 on 1 and then collect dividends on top of it, which increased substantially over time.”

More on the right approach to stocks

Warren Buffett: “The American tailwind is marvelous. But it’s going to have interruptions and you’re not going to foresee the interruptions. And you do not want to get yourself in a position where those interruptions can affect you, either because you’re leveraged or because you’re psychologically unable to handle looking at a bunch of numbers.

If you really had a farm and you had this neighbor. And Monday, he offered you $2,000 an acre. And the next day, he offers you $1,200 an acre. And maybe the day after that, he offers you $800 an acre. Are you really going to – at $2,000 an acre when you had evaluated what the farm would produce – going to let this guy drive you into thinking “I better sell because his number keeps coming in lower all the time”? It’s a very, very, very important matter to bring the right psychological approach to owning common stocks.

But I will tell you, if you bet on America and sustain that position for decades, you’re going to do – in my view – far better than owning Treasury securities, or far better than following people who tell you what the farmer is going to yell out next. There’re huge amounts of money that people pay for advice they really don’t need. And for the person giving it, it can be very well-meaning and they believe their own line. But the truth is that you can’t deliver superior results to everybody by just having them trade around a business. A business is going to deliver what the business produces. And the idea that you can outsmart the person next to you or the person advising you can outsmart the person sitting next to you – well, it’s really the wrong approach.”

Even more on the right way to approach stocks

Warren Buffett: “I’m not saying that this is the right time to buy stocks – if you mean by “right” that they’re going to go up instead of down. I don’t know where they’re going to go in the next day or week or month or year, but I hope I know enough to know.

Well, I think I can buy a cross section and do fine over 20 or 30 years, and I think that’s kind of an optimistic viewpoint. But I hope that really, everybody would buy stocks with the idea that they’re buying partnerships and businesses and they wouldn’t look at them as chips to move around up or down.”

On integrity

Warren Buffett: “I would never take real chances with other people’s money under any circumstances. Both Charlie [Munger] and I come from a background where we ran partnerships. I started mine in 1956 for seven either actual family members or the equivalent. And Charlie did the same thing 6 years later.

And neither one of us, I think — I know I didn’t and I’m virtually certain the same is true of Charlie – neither one of us ever had a single institution investment with us. The money we managed for other people was from individuals, people with faces attached to them, or entities’ money with faces attached to them.

We’ve always felt that our job is basically that of a trustee, and hopefully a reasonably smart trustee in terms of what we were trying to accomplish. But the trustee aspect has been very important. It’s true for the people with the structured settlements. It’s true for up and down the line, but it’s true for the owners very much, too. So we always operate from a position of strength.”

Why Buffett thinks he holds a lot more investments than people generally think, and why he keeps a lot of cash

Warren Buffett: “I show our cash and Treasury bills, positioned on March 31. And you might look at that and say, well, you’ve got [US]$125 billion or so in cash and treasury bills, and you’ve got — at least at that point, [US]$180 billion or so in equities. And you can say, well, that’s a huge position having Treasury bills versus just [US]$180 billion in equities. But we really have far more than that in equities because we own a lot of businesses. We own 100% of the stock of a great many businesses, which to us are very similar to the marketable stocks we own – we just don’t own them all. We don’t have a quote on them. But we have hundreds of billions of wholly owned businesses. 

So there are [US]$124 billion – it’s not some 40% or so cash position. It’s far less than that. And we will always keep plenty of cash on hand for any circumstances. When the 9/11 comes along, if the stock market is closed as it was in World War I – it’s not going to be, but I didn’t think we were going to be having a pandemic when I watched that Creighton-Villanova game in January either.

So we want to be in a position at Berkshire where – you remember Blanche DuBois in A Streetcar Named Desire that goes back before many of you. In Blanche’s case, she said that she’s dependent on the kindness of strangers. And we don’t want to be dependent on the kindness of friends even, because there are times when money almost stops. And we had one of those, interestingly enough. We had it, of course, in 2008 and ’09 but right around the day or two leading up to March 23rd, we came very close. But fortunately, we had a Federal Reserve that knew what to do. But investment-grade companies were essentially going to be frozen out of the market.”

It’s a bad idea to borrow to juice returns

Warren Buffett: “CFOs all over the country have been taught to sort of maximize returns on equity capital, so they would finance themselves – to some extent – with commercial paper because that was very cheap. And it was backed up by bank lines and all of that. And they let the debt creep up quite a bit in many companies. 

And then, of course, they all were scared by what was happening in markets [in March 2020], particularly the equity markets. And so they rushed to draw down lines of credit, and that surprised the people who had extended those lines of credit. They got very nervous. And the capacity of Wall Street to absorb a rush to liquidity that was taking place in mid-March was strained to the point where the Federal Reserve, observing these markets, decided they had to move in a very big way.

We got to the point where the US treasury market, the deepest of all markets, got somewhat disorganized. And when that happens, believe me, every bank and CFO in the country knows it. And they react with fear, and fear is the most contagious disease you can imagine. It makes the virus look like a piker [a North American term referring to a gambler who makes only small bets].”

Praise for the Federal Reserve

Warren Buffett: “We came very close [in March 2020] to having a total freeze of credit to the largest companies in the world who were depending on it. To the great credit of Jay Powell. 

 I’ve always had Paul Volcker up on a special place, a special pedestal in terms of Federal Reserve chairmen over the years. We’ve had a lot of very good Fed Chairman. But Paul Volcker, I had him at the top of the list. And I’ll recommend another book. Paul Volcker died about less than maybe a year ago, or a little less. But not much before he died, he wrote a book called Keeping At It. And if you call my friends at The Bookworm, I think you’ll enjoy reading that book. Paul Volcker was a giant in many ways, and he was a big guy, too. He and Jay Powell couldn’t see more in temperament or anything.

But Jay Powell, in my view, and the Fed board – I put him up there on that pedestal because with him, they acted in the middle of March, probably somewhat instructed by what they had seen in 2008 and ’09. They reacted in a huge way and essentially allowed what’s happened since that time to play out the way it has. 

In March, the market had essentially frozen. But in a little after mid-month, it ended up – because the Fed took these actions on March 23 – it ended up being the largest month for corporate debt issuance, I believe, in history. And then April followed through with an even larger month. And you saw all kinds of companies grabbing everything coming to market. And spreads actually narrowed. 

Every one of those people that issued bonds in late March and April should send a thank you letter to the Fed because it would not have happened if they hadn’t operated with really unprecedented speed and determination.”

Unknown consequences from the Fed’s actions

Warren Buffett: “We’ll know the consequences of swelling the Fed’s balance sheet. You can look at the Fed’s balance sheet. They put it out every Thursday. It’s kind of interesting reading, if you’re sort of a nut like me. But it’s up there on the Internet every Thursday, and you’ll see some extraordinary changes there in the last 6 or 7 weeks.

And like I say, we don’t know the consequences of that, and nobody does exactly. We don’t know the consequences of what undoubtedly we’ll have to do – but we do know the consequences of doing nothing. That would have been the tendency of the Fed in many years past – not doing nothing, but doing something inadequate. But Mario Draghi brought the “whatever it takes” to Europe. And the Fed in mid-March sort of did “whatever it takes squared”, and we owe them a huge thank you.

But we’re prepared at Berkshire. We always prepare on the basis that maybe the Fed will not have a Chairman that acts like that. And we really want to be prepared for anything. So that explains some of the [US]$124 billion in cash and bills. We don’t need it all. But we do never want to be dependent on not only the kindness of strangers, but the kindness of friends.”

Why Buffett thought his airline investments were a mistake

Warren Buffett: “You’ll see in the month of April that we net sold [US]$6 billion or so of securities. That isn’t because we thought the stock market was going to go down or because somebody changed their target price or they changed this year’s earnings forecast. I just decided that I’d made a mistake in evaluating – that was an understandable mistake, it was a probability-weighted decision when we bought. 

We were getting an attractive amount for our money when investing across the airlines business. So we bought roughly 10% of the four largest airlines, and – this is not 100% of what we did in April – but we probably paid somewhere between [US]$7 billion and [US]$8 billion to own 10% of the four large companies in the airline business [in the US]. And we felt for that, we were roughly getting [US]$1 billion of earnings. Now, we weren’t getting [US]$1 billion of dividends, but we felt our share of the underlying earnings was [US]$1 billion. And we felt that that number was more likely to go up than down over a period of time. It would be cyclical, obviously. But it was as if we bought the whole company, but we bought it through the New York Stock Exchange. We can only effectively buy 10%, roughly, of the four. We treat it mentally exactly as if we were buying a business. 

It turned out I was wrong about that business because of something that was not in any way the fault of four excellent CEOs. Believe me, there’s no joy being a CEO of an airline. But the companies we bought were well managed. They did a lot of things right. That’s a very, very, very difficult business because you’re dealing with millions of people every day. And if something goes wrong for 1% of them, they are very unhappy. So I don’t envy anybody the job of being CEO of an airline. But I particularly don’t enjoy them being in a period like this where people have been told basically not to fly. I’ve been told not to fly for a while. I’m looking forward to flying – I may not fly commercial, but that’s another question. 

The airline business – I may be wrong, and I hope I’m wrong – but I think it changed in a very major way. And it’s obviously changed in the fact that the four companies are each going to borrow perhaps an average of at least [US]$10 billion or [US]$12 billion each. Well, you have to pay that back out of earnings over some period of time. I mean you’re [US]$10 billion or [US]$12 billion worse off if that happens. And of course, in some cases, they’re having to sell stock or sell the right to buy a stock at these prices, and that takes away from them the upside. 

And I don’t know whether 2 or 3 years from now that as many people will fly as many passenger miles as they did last year. They may and they may not. The future is much less clear to me about how the business will turn out through absolutely no fault of the airlines themselves. A low-probability event happened, and it happened to hurt the travel business, the hotel business, cruise business, theme park business, but particularly the airline business. And of course, the airline business has the problem that if the business comes back 70% or 80%, the aircraft don’t disappear. So you’ve got too many planes. And it didn’t look that way when the orders were placed a few months ago and arrangements were made. But the world changed for airlines and I wish them well.”

Preparing for the worst

Becky Quick: ”Okay. The next question comes from Robert Tomas from Toronto, Canada. And he says, “Warren, why are you recommending listeners to buy now, yet you’re not comfortable buying now as evidenced by your huge cash position?”

Warren Buffett: “Well, (A) as I explained, the position isn’t that huge when I look at worst-case possibilities. I would say that there are things that I think are quite improbable. And I hope they don’t happen, but that doesn’t mean they won’t happen. For example, in our insurance business, we could have the world’s or the country’s Number 1 hurricane that it’s ever had – but that doesn’t preclude the fact we’re going to have the biggest earthquake a month later. So we don’t prepare ourselves for a single problem. We prepare ourselves for problems that sometimes create their own momentum. 

In 2008 and ’09, you didn’t see all the problems the first day. What really kicked it off was when Freddie and Fannie – the GSEs [government-sponsored enterprises] – went into conservatorship in early September and then when money market funds broke the buck. I mean there are things to trip other things, and we take very much a worst-case scenario into mind that probably is considerably worse than most people do. So I don’t look at it as huge.”

Thoughts on capital allocation

Becky Quick: “Greg, let me ask you one of these capital allocation questions. This one comes from Matt Libel. And he says, Berkshire directed 46% of capital expenditure in 2019 to Berkshire Hathaway Energy. Can you walk us through with round numbers how you think differences in capex spending versus economic depreciation versus GAAP depreciation and help explain the time frame over which we should recognize the contracted return on equity from these large investments as we as shareholders are making in Berkshire Hathaway Energy?”

Greg Abel: “Right. So when we look at Berkshire Hathaway Energy and their capital programs, we try to really look at — look at it in a couple of different packages.

One, what does it actually require to maintain the existing assets for the next 10, 20, 30 years, i.e. it’s not incremental. It’s effectively maintaining the asset, the reflection of depreciation. And our goal is always to clearly understand across our businesses, do we have businesses that require more than our depreciation or equal or less? And I’m happy to say with the assets we have in place and how we’ve maintained the energy assets, we generally look at our depreciation as being more than adequate if we deploy it back into capital to maintain the asset.

Now the unique thing in the lion’s share of our energy businesses that are regulated, and that exceeds 85% of them – 83% of them – we still earn on that capital we deploy back into that business. So it’s not a traditional model where you’re putting it in, but you’re effectively putting it in to maintain your existing earnings stream. So it’s not drastically different, but we do earn on that capital.

But what we do spend a lot of time on – when Warren and I think about the substantial amounts of opportunities, that’s incremental capital that is truly needed within new opportunities. So it’s to build incremental wind, incremental transmission that services the wind, or other types of renewable solar. That’s all incremental to the business and drives incremental, both growth in the business – it does require capital – but it does drive growth within the energy business. So there’s really the 2 buckets. I think we would use a number a little bit lower than the depreciation. We’re comfortable the business can be maintained at that level. And as we deploy amounts above that, we really do view that as “incremental or growth capex”.”

Warren Buffett: “Yes, we have what, [US]$40 billion or something? What do we have kind of in the works?” 

Greg Abel: “Well, yes. So we have basically, as Warren is highlighting, [US]$40 billion in the works of capital. That’s over the next, effectively, 9-year, 10-year period. Approximately half of that, we would view as maintaining our assets. A little more than half of it is truly incremental. But those are known projects we’re going to move forward with. And I would be happy to report, we probably have another [US]$30 billion that aren’t far off of becoming real opportunities in that business.

So as Warren said, that takes a long time. It’s a lot of work. The transmission projects, for example, that we’re finishing in 2020 were initiated in 2008 when we bought PacifiCorp. I remember working on that transmission plant, putting it together, thinking 6 to 8 years from now, we’ll have them in operation. 12 years later – and over that period of time, we earn on that capital we have invested and then when it comes into service, we earn on the whole amount. So we’re very pleased with the opportunity. We plant a lot of seeds, put it that way.” 

Warren Buffett: “Yes. And it’s not like they’re super high-return, but they’re decent returns over time. And we’re almost uniquely situated to deploy the capital – I mean you could have government entities do it too, but in terms of the private enterprise. They take a long time. They earn decent returns. I’ve always said about the energy business: It’s not a way to get real rich, but it’s a way to stay real rich.

We will deploy a lot of money at decent returns, not super returns. You shouldn’t earn super returns on that sort of thing. You are getting rights to do certain things that governmental authorities are authorizing and they should protect consumers – but they also should protect people that put up the capital. It’s worked now for 20 years and it’s got a long runway ahead.”

The risks of investing in oil & gas companies

Becky Quick: “Let me follow-up with this one, and this one comes in from Amish Bal, who says, “Is there a risk of permanent loss of capital in the oil equity investment?”” 

Warren Buffett: “Well, there certainly is. There’s no question. If oil stays at these prices, there’s going to be a whole lot of money – and it will extend to bank loans and it will affect the banking industry to some degree. It doesn’t destroy them or anything, but there’s a lot of money that’s been invested that was not invested based on a [US]$17 or [US]$20 or [US]$25 price for WTI, West Texas Intermediate oil. But you can do the same thing in copper and you can do the same thing in some of the things we manufacture. But with commodities, it’s particularly dramatic. Farmers have been getting lousy prices, but to some extent, the government subsidized them. I’m all for it, actually.

But if you’re an oil producer, you take your chances on future prices unless you want to sell a lot of futures forward. OXY [Occidental Petroleum] actually did sell 300,000 barrels a day of puts in effect – or they bought puts and sold calls in effect to match it. And they were protected for a layer of [US]$10 a barrel on 300,000 barrels a day. But when you buy oil, you’re betting on oil prices over time and over a long time. And there’s risk, and the risk is being realized by oil producers as we speak. If these prices prevail, there will be a lot of bad loans and bad debts in energy loans. And if there are bad debts in energy loans, you can imagine what happens to the equity holders. So yes, there’s a risk.”

Effects of negative interest rates on Berkshire’s insurance business

Becky Quick: “All right. This question comes from Rob Grandish in Washington, D.C. He says “Interest rates are negative in much of Europe, also in Japan. Warren has written many times that the value of Berkshire’s insurance companies derived from the fact that policyholders pay upfront, creating insurance float on which Berkshire gets to earn interest.

If interest rates are negative, then collecting money upfront will be costly rather than profitable. If interest rates are negative, then the insurance float is no longer a benefit but a liability. Can you please discuss how Berkshire’s insurance companies would respond if interest rates became negative in the United States?””

Warren Buffett: “Well, if they were going to be negative for a long time, you better own equities. You better own something other than debt. I mean it’s remarkable what’s happened in the last 10 years. I’ve been wrong in thinking that – you could really have had the developments we’ve had without inflation taking hold.

But we have [US]$120-odd billion — well, we have a very high percentage in treasury bills — in cash. Those treasury bills are paying us virtually nothing. They’re a terrible investment over time. But they are the one thing that when opportunity arises – it will arise at the time and it may be the only thing you can look to, to pay for those opportunities, is the treasury bills you have. I mean, the rest of the world may have stopped. And we also need them to be sure that we can pay the liabilities we have in terms of policyholders over time. And we take that very seriously. 

So if the world turns into a world where you can issue more and more money and have negative interest rates over time, I’d have to see it to believe it. But I’ve seen a little bit of it and I’ve been surprised, so I’ve been wrong so far. I would say this, if you can have negative interest rates and pour out money and incur more and more debt relative to productive capacity, you’d think the world would have discovered it in the first couple of thousand years rather than just coming onto it now. But we will see.

 It’s probably the most interesting question I’ve ever seen in economics: Can you keep doing what we’re doing now? And we’ve been able to do it. The world has been able to do it for now, a dozen years or so. But we may be facing a period where we’re testing that hypothesis that you can continue it with a lot more force than we’ve tested it before. Greg, do you have any thoughts on that? I wish I knew the answer, maybe you do.”

Greg Abel: “No, I think as you articulated – I think it was in the annual report too – we don’t know the answer. But as you said, some of the fundamentals right now are very interesting relative to having a negative interest rate. But no, I hate to say it, but I don’t have anything to add.” 

Warren Buffett: “I’d love to be Secretary of Treasury, if I knew I can keep raising money at negative interest rates. That makes life pretty simple. We’re doing things that we really don’t know the ultimate outcome. And I think in general, they’re the right things, but I don’t think they’re without consequences. And I think they could be kind of extreme consequences if pushed far enough, but there would be kind of extreme consequences if we didn’t do it as well. So somebody has to balance those questions.”

The risk of the US government defaulting on its debt

Becky Quick: “All right. This question comes from Charlie Wang. He’s a shareholder in San Francisco. He says, “Given the unprecedented time of the economy and the debt level, could there be any risks and consequences of the U.S. government defaulting on its bonds?””

Warren Buffett: “No. If you print bonds in your own currency, what happens to the currency is that it can be a question because you don’t default. And the United States has been smart enough – and people have trusted us enough – to issue its debt in its own currency. And Argentina is now having a problem because the debt isn’t in their own currency and lots of countries have had that problem, and lots of countries will have that problem in the future. It’s very painful to owe money in somebody else’s currency. 

Listen, if I could issue a currency – Buffett bucks – and I had a printing press, and I could borrow money in that, I would never default. So what you end up getting in terms of purchasing power can be in doubt. But in terms of the US government.. When Standard & Poor’s downgraded the United States government – I think it was Standard & Poor’s, some years back – that, to me, did not make sense. How you can regard any corporation as stronger than the person who can print the money to pay you, I just don’t understand. So don’t worry about the government defaulting.

I think it’s kind of crazy incidentally. This should be said. To have these limits on the debt and all of that sort of thing, and then stopped-government arguing about whether it’s going to increase the limits – we’re going to increase the limits on the debt. The debt isn’t going to be paid, it’s going to be refinanced. And anybody that thinks they’re going to bring down the national debt.. I mean there’s been brief periods and I think it’s in the late ’90s or thereabouts, when it has come down a little bit. The country is going to grow in terms of its debt-paying capacity. But the trick is to keep borrowing in your own currency.”

How to detect malfeasance in banks, and the current state of the banking industry in the US

Becky Quick: “This is one that comes from Thomas Lin in Taiwan. He says, “Warren once said that banking is a good business if you don’t do dumb things on the asset side. Given that the pandemic might put a lot of pressure on the loans, dumb things that got done in the past few years are likely to explode. Through reading annual reports, 10-Qs and other public information, what clues are you looking for to decide whether a bank is run by a true banker who avoids doing dumb things?”” 

Warren Buffett: “That’s a very good question. But I would say that the one thing that made Chairman Powell’s job a little easier this time than it was in 2008-09 is that the banks are in far better shape. So in terms of thinking about what was good for the economy, he wasn’t at the same time worrying about what he was going to do with Bank A or Bank B, to merge them with somebody else, or put added strains on the system or anything.

The banks were very involved with a problem in 2008 and ’09. They had done some things they shouldn’t have done in some of them. And they were certainly in far different financial condition. So the banking system is not the problem in this particular — I mean, we decided as a people to shut down part of the economy in a big way. And it was not the fault of anyone that it happened. Things do happen in this word. Earthquakes happen. Huge hurricanes happen. This was something different.

But the banks need regulation. I mean they benefit from the FDIC. But part of having the government standing behind your deposits is to behave well, and I think that the banks have behaved very well. And I think they’re in very good shape. That’s how the FDIC has built up the [US]$100 billion that I’ve talked about. They’ve assessed the banks in recent years at accelerated amounts in certain periods, and they even differentiated against the big banks. So they built up great reserves there. And they built their own balance sheets, and they are not presently part of Chairman Powell’s problem, whereas they were very much part of Chairman Bernanke’s problem back in 2008 and ’09.

How will you spot the people that are doing the dumb things? It’s not easy – well, sometimes it’s easy. But I don’t see a lot that bothers me. But banks are, in the end, institutions that operate with significant amounts of other people’s money. And if problems become severe enough in an economy, even strong banks can be under a lot of stress and we’ll be very glad we’ve got the Federal Reserve system standing behind them. I don’t see special problems in the banking industry.

Now I could think of possibilities, and Jamie Dimon referred to this a little bit in the JPMorgan report. You can dream of scenarios that put a lot of strain on banks. They’re not totally impossible – that’s why we have the Fed. I think overall, the banking system is not going to be the problem. But I wouldn’t say that with 100% certainty because there are certain possibilities that exist in this world where banks can have problems. They’re going to have problems with energy loans. They’re going to have extra problems with consumer credit. But they know it, and they’re well reserved – well, they’re well capitalized for it. They were reserve-building in the first quarter, and they may need to build more reserves, but they are not a primary worry of mine at all. We own a lot of banks, or we own a lot of bank stocks.”

Recognising heroes and making sure no one’s left behind

Becky Quick: “Warren, this question comes from Bill Murray, the actor, who is also a shareholder in Berkshire. He says “This pandemic will graduate a new class of war veterans, health care, food supply, deliveries, community services. So many owe so much to these few. How might this great country take our turn and care for all of them?” 

Warren Buffett: “Well, we won’t be able to pay actually – it’s like people that landed at Normandy or something. The poor, the disadvantaged, they suffer – there’s an unimaginable suffering. And at the same time, they’re doing all these things – they’re working 24-hour days and we don’t even know their names. So we ought to – if we go overboard on something, we ought to do things that can help those people.

This country – I’ve said this a lot of times before – we are a rich, rich, rich country. And the people that are doing the kind of work that Bill talks about, they’re contributing a whole lot more than some of the people that came out of the right womb, or got lucky and things, or know how to arbitrage bonds or whatever it may be. In a large part, I’m one of those guys. So you really try to create a society that under normal conditions with more than [US]$60,000 of GDP per capita, that anybody that works 40 hours a week can have a decent life without a second job and with a couple of kids. They can’t live like kings, I don’t mean that, but nobody should be left behind.

It’s like a rich family. You find rich families and they have 5 heirs or 6 heirs. They try and pick maybe the most able one to run the business. But they don’t forget about the kid that actually may be a better citizen in some ways than even the one that does the best at business, but they just don’t happen to have market-value skills. So I do not think a very rich company ought to totally abide by what the market dishes out in 18th-Century style or something of the sort.

So I welcome ideas that go in that direction. We’ve gone in that direction. We did come up with social security in the ’30s. We’ve made some progress. But we ought to – we have become very, very, very rich as a country. Things have improved for the bottom 20%. You see various statistics on that. I’d rather be in the bottom 20% now than be in the bottom 20% 100 years ago or 50 years ago. But what’s really improved is the top 1% – and I hope we, as a country, move in a direction where people Bill’s talking about get treated better. And it isn’t going to hurt the country’s growth and it’s overdue. A lot of things are overdue.

I will still say we’re a better society than we were 100 years ago. But you would think with our prosperity, we would hold ourselves to even higher standards of taking care of our fellow man, particularly when you see a situation like you’ve got today where it’s the people whose names you don’t know that are watching the people come in and watching the bodies go out. Greg?”

Greg Abel: “Yes. The only other group that I would highlight – I think it will be very interesting how it plays out – is with the number of home schooling and the children that are home. We’ve always had so much respect for teachers, but we all talk about how we don’t take care of them. And it is remarkable to hear how many people comment that, clearly, we don’t recognize – I have a little 8-year old back at home and plenty of challenges for Mom – but all of a sudden, you respect the institution, the school, the teachers and everything around it. 

And then when I think of our companies and the delivery employees we have, it’s absolutely amazing what they’re doing. They’re truly on the front line. That’s where we have our challenges around keeping their health and safety. And then you go all the way to the rail. The best videos you see out of our companies are when we have folks that are actively engaged in moving supplies, food, medical products – and they’re so proud of it. They recognize they’re making a difference. So a lot of it is we just owe them a great thanks.

And Warren, you touched on it, we can, in some way, maybe, hopefully longer-term, compensate them. But there’s a great deal of thanks, and I probably just think an immense amount of new appreciation for a variety of folks.”

Warren Buffett: “We’re going in the right direction all around the country but it’s been awfully slow.”

Is capitalism broken?

Becky Quick: “Gentlemen, I’ll make this the last question. It comes from Phil King. He says “Many people in the press and politics are questioning the validity of capitalism. What can you say to them that might prompt them to take a look at capitalism more favorably?”

Warren Buffett: “Well, the market system works wonders, but it’s also brutal if left entirely to itself. We wouldn’t be the country we are, if the market system hadn’t been allowed to function. And you can say that other countries around the world that have improved their way of life dramatically, to some extent, have copied us. 

So the market system is marvelous in many respects. But it needs government. It is creative destruction. But for the ones who are destroyed, it can be a very brutal game, for the people who work in the industries and all that sort of thing. So I do not want to come up with anything different than capitalism, but I certainly do not want unfettered capitalism.I don’t think we’ll move away from it, but I think… Capitalists, I’m one of them. I think there’s a lot of thought that should be given to what would happen if we all draw straws again for particular market-based skills.

Somewhere way back, somebody invented television, I don’t know who it was. And then they invented cable, then they invented pay systems and all of that. And so a fellow who could bat 0.406 in 1941 was worth [US]$20,000 a year. And now a marginal Big Leaguer will make vastly greater sums because in effect, the stadium size was increased from 30,000 or 40,000 or 50,000 people, to the country. The market system – capitalism – took over. And it’s very uneven, and in same way – I think that Ted Williams is worth a lot more money than I’ve ever should make. But the market system can work toward a winner-takes-all type situation. And we don’t want to discourage people from working hard and thinking.

But that alone doesn’t do it, there’s a lot of randomness in the capitalist system, including inherited wealth. I think we can keep the best parts of a market system and capitalism and we can do a better job of making sure that everybody participates in the prosperity that that produces. Greg?” 

Greg Abel: “I think it’s always keeping the best parts of it. I even think if we look at the current environment we’re in – the pandemic – and we have to do it only when we can do it properly and reemerge. But in some ways, the best opportunity for people is when we’re back working clearly and that the system is functioning again. But that’s the obvious. And Warren, you’ve highlighted, there’s a lot of imperfections, but it’s definitely the best model out there that just needs some fine tuning.”

The amazing Ben Graham

Becky Quick: “Can I just slip in one more quick question? I forgot this one, someone sent it in earlier. Anderson Hexton wrote in. He said: “Warren mentioned that Ben Graham is one of the three smartest people he’s ever met. I’d like to ask him the names of the other two.”” 

Warren Buffett: “[Laughs] Well, I may not be one of the smartest, but I’m smart enough not to name the other two. I make only two people happy. 

Ben Graham is one of the smartest people, and I know some really smart people. Smartness does not necessarily equate to wisdom, either. And Ben Graham, one of the things he said he liked to do every day was he wanted to do something creative, something generous, and something foolish. And he said he was pretty good at the latter, but he was pretty good. He was amazing, actually.”

Closing remark: Never bet against America

Warren Buffett: “And Becky, I would just say again that – I hope we don’t – but we may get some unpleasant surprises. And we are dealing with a virus that spreads its wings in a certain way, in very unpredictable ways and how all Americans react to it. There’s all kinds of possibilities, but I definitely come to the conclusion after weighing all that, sort of – never bet against America. So thanks.”

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This post is my self-directed attempt to translate a Mandarin essay penned by Li Lu that was published in November 2019. The topic of the essay is Li’s review and thoughts on the book The Other Half of Macroeconomics and the Fate of Globalization written by economist Richard C. Koo (Gu Chao Ming).

I want to do this translation for three reasons. 

First, Li Lu’s views on China’s economy are worth paying attention to. Many of you likely don’t know who he is, but he’s an excellent investor in China. I have never been able to find Li’s investment track record, but one piece of information that I’ve known for years convinces me of his brilliance: Charlie Munger’s an investor in Li’s fund, and Munger has nothing but praise for it. Munger himself is an incredible investor with a well-documented track record, and he’s the long-time right-hand man of Warren Buffett. In a May 2019 interview with The Wall Street Journal, Munger talked about Li:

“There are different ways to hunt, just like different places to fish. And that’s investing.

And knowing that, of course, one of the tricks is knowing where to fish. Li Lu [of Himalaya Capital Management LLC in Seattle] has made an absolute fortune as an investor using Graham’s training to look for deeper values. But if he had done it any place other than China and Korea, his record wouldn’t be as good. He fished where the fish were. There were a lot of wonderful, strong companies at very cheap prices over there…

…Now, so far, Li Lu’s record [at Himalaya] is just as good with a lot of money as it was with very little. But that is a miracle. It’s no accident that the only outside manager I’ve ever hired is Li Lu. So I’m now batting 1.000. If I try it one more time, I know what will happen. My record will go to hell. [Laughter.]”

Second, I think Li’s essay contains thought-provoking insights from him and Koo on the economic future of the Western world, Japan, and China. These insights are worth sharing with a wider audience. But they are presented in Mandarin, and there are many investors who have little or no knowledge of the language. I am fortunate to have sufficient proficiency in Mandarin to be able to grasp the content (though it was still painful to do the translation!), so I want to pay it forward. This also brings me to the third reason.

Google’s browser, Google Chrome, has a function to automatically translate Li’s Mandarin essay into English. But the translation is not the best and I spotted many areas for improvement.

Before I get to my translation, I want to stress again that it is my own self-directed attempt. So all mistakes in it are my sole responsibility. I hope I’ve managed to capture Li Lu’s ideas well. I’m happy to receive feedback about my translation. Feel free to leave a comment in this post, or email me at thegoodinvestors@gmail.com.

Translation of Li Lu’s essay

This year, the book I want to recommend to everyone is The Great Recession Era: The Other Half of Macroeconomics and The Fate of Globalisation, written by Gu Chao Ming.

The book discusses the biggest problems the world is currently facing. First: Monetary policy. In today’s environment, essentially all the major economies of today – such as Japan, the US, Europe, and China – are oversupplying currencies. The oversupply of these base currencies has reached astronomical levels, resulting in the global phenomena of low interest rates, zero interest rates, and even negative interest rates (in the case of the Eurozone). These phenomena have never happened in history. At the same time, the increase in the currency supply has contributed very little to economic growth. Except for the US, the economies of most of the developed nations have experienced minimal or zero growth. Another consequence of this situation is that each country’s debt level relative to its GDP is increasing; concurrently, prices of all assets, from stocks to bonds, and even real estate, are at historical highs. How long will this abnormal monetary phenomenon last? How will it end? What does it mean for global asset prices when it ends? No one has the answers, but practically all of our wealth is tied to these issues.

Second: Globalisation. The fates of many countries, each at different stages of development, have been intertwined because of the rising trend of globalisation over the past few decades. But global trade and capital flows are completely separate from the monetary and fiscal policies that are individually implemented in each country. There are two consequences to this issue. Firstly, significant conflicts have developed between globalisation and global capital flows on one end, and each country’s economic and domestic policies on the other. Secondly, international relations are increasingly strained. For instance, we’re currently witnessing an escalation of the trade conflict between the US and China. There’s also rising domestic unrest – particularly political protests on the streets – in many parts of the world, from Hong Kong to Paris and Chile. At the same time, far-left and far-right political factions are increasingly dominating the political scene of these countries at the expense of more moderate parties, leading to heightened uncertainties in the world. Under these circumstances, no one can predict the future for global trade and capital flows.

Third: How should each country’s macroeconomic and fiscal policies respond to the above international trends? Should there be differences in the policies for each country depending on the stage of development they are at?

The three problems are some of the most pressing issues the world is facing today. The ability to answer even just one of them will probably be an incredible scholarly achievement – to simultaneously answer all three of them is practically impossible. In his book, Gu Chao Ming provided convincing perspectives, basic concepts, and a theoretical framework with sound internal logic for dealing with the three big problems. I can’t really say that Gu has given us answers to the problems. But at the very least, he provides inspiration for us to think through them. His theories are deeply thought-provoking, whether you agree with them or not.

Now let’s talk about the author, Gu Chao Ming [Richard C. Koo]. He is the Chief Economist of Nomura Research Institute and has had a strong influence on the Japanese government over the past 30 years. I first heard of him tens of years ago, at a YPO international conference held in Japan. He delivered a keynote speech at the event, explaining Japan’s then “lost decade” (it’s now probably a “lost two decades” or even “lost three deacdes”). Gu Chao Ming explained the various economic phenomena that appeared in Japan after its bubble burst. These include zero economic growth, an oversupply of currency, zero interest rates, massive government deficit, high debt, and more. The West has many different views on the causes for Japan’s experience, but a common thread is that they resulted from the failure of Japan’s macroeconomic policies.

Gu Chao Ming was the first to provide a completely opposite viewpoint that was also convincing. He introduced his unique and new economic concept: A balance sheet recession. After the bursting of Japan’s asset-price bubble, the balance sheet of the Japanese private sector (businesses and households) switched from rapid expansion to a mode of rapid contraction – he attributed Japan’s economic recession to the switch. Gu provided a unique view, that driving the balance sheet recession was a radical change in the fundamental goal of the entire Japanese private sector from maximising profits to minimising debts. In such an environment, the first thing the private sector and individuals will do when they receive money is not to invest and expand business activities, but to repay debt – it does not matter how much currency is issued by the government. The sharp decline in Japanese asset prices at that time placed the entire Japanese private sector and households into a state of technical bankruptcy. Because of this, what they had to do, and the way they repaired their balance sheets, was to keep saving and paying off their debts. This scenario inevitably caused a large-scale contraction in the economy. The Japanese experience is similar to the US economic crisis in the 1930s. Once the economy begins to shrink, a vicious cycle forms to accelerate the downward momentum. During the Great Depression in the 1930s, the entire US economy shrank by nearly 46% within a few years.

The Japanese government dealt with the problem by issuing currency on a large scale, and then borrowing heavily to make direct infrastructure investments to digest the massive savings of Japanese residents. Through this solution, the Japanese government managed to maintain the economy at the same level for decades. There’s no growth, but the economy has not declined either. In Gu Chao Ming’s view, the Japan government’s macroeconomic policies were the only right choices. The policies prevented the Japanese economy from experiencing the 46% decline in economic activity that the US did in the 1930s. At the same time, the Japanese private sector was given the time needed to slowly repair their balance sheets. This is why Japan’s private sector and households have gradually returned to normalcy today. Of course, there was a price to pay – the Japanese government’s own balance sheet was hurt badly. Japanese government debt is the highest in the world today. Nonetheless, the Japanese government’s policies were the best option compared to the other choices. At that time, that was the most unique view on Japan that I had come across. Subsequently, my observations on Japan’s economy have also confirmed his ideas to a certain extent.

The Western world was always critical of Japan’s policies. Their stance on Japan started to change only after they encountered the Great Recession of 2008-2009. This is because the Western world’s experience during the Great Recession was very similar to what Japan went through in the late 1980s after its big asset-bubble burst. At the time, prices of major assets in the West were falling sharply, leading to technical bankruptcy for the entire private sector – this was why the subsequent experience for the West was eerily similar to Japan’s. To deal with the problem, the main policy implemented by the key Western countries was the large-scale issuance of currency, and they did so without any form of prior agreement. At the time, the experience of the Great Depression of the 1930s was the main influence on the actions of the central banks in the West. The consensus among the economic fraternity after evaluating the policies implemented to handle the Great Depression of the 1930s was based predominantly on Milton Friedman’s views, that major mistakes were made in monetary policies in that era. Ben Bernanke, the chairperson of the US Federal Reserve in 2008, is a strong proponent of this view. In fact, Bernanke thinks that distributing money from helicopters is an acceptable course of action in extreme circumstances. Consequently, Western governments started issuing currency at a large scale to deal with the 2008 crisis. But the currency issuance did not lead to the intended effect of a rapid recovery in economic growth. The money received by the private sector was being saved and used to repay debts. This is why economic growth remains sluggish. In fact, the economy of the Eurozone is bordering on zero growth; in the US economy, there are only pockets of weak growth.

The first response by Western governments to the problem is to continue with their large-scale currency issuance. Western central banks have even invented a new way to do so: Quantitative easing (QE). Traditionally, central banks have regulated the money supply by adjusting reserves (the most important component of a base currency). After implementing QE, the US Federal Reserve’s excess reserves have grown to 12.5 times the statutory amount. The major central banks in the West have followed the US’s lead in implementing QE, resulting in the selfsame ratio reaching 9.6 times in the Eurozone, 15.3 times in the UK, 30.5 times in Switzerland, and 32.5 times in Japan! In other words, under normal economic conditions, inflation could reach a similar magnitude (for example, 1,250% in the US) if the private sector could effectively deploy newly issued currency. Put another way, if the newly issued currency were invested in assets, it could lead to asset prices rising manifold to reach bubble levels or provide strong stimulus to GDP growth.

But the reality is that economic growth is anaemic while prices for certain assets have been rising. The greatest consequence of this policy is that interest rates are close to zero. In fact, the Eurozone has around US$15 trillion worth of debt with negative rates today. This has caused questions to be raised about the fundamental assumptions underpinning the entire capitalistic market system. At the same time, it has also not produced the hoped-for economic growth. Right now, the situation in Europe is starting to resemble what Japan experienced back then. People are starting to rethink the episode in Japan. Interest in Gu Chao Ming’s viewpoints on Japan and its fiscal policies are being reignited in the important Western countries.

Gu Chao Ming used a relatively simple framework to explain the phenomena in Japan. He said that an economy will always be in one of the following four regimes, depending on the actions of savers and investors:

Under normal circumstances, an economy should have savers as well as borrowers/investors. This places the economy in a positive state of growth. When an ordinary economic crisis arrives, savers tend to run out of capital but borrowers and investing opportunities are still present. In this scenario, it’s crucial that a central bank plays the role of supplier of capital of the last resort. This viewpoint – of the central bank having to be the lender and supplier of capital of the last resort – is the conclusion that the economic fraternity has from studying the Great Depression of the 1930s. Central banks provide the capital, which is then lent to the private sector.

But nobody thought about what happens to an economy when the third and fourth regimes appear. These regimes are unprecedented and characterised by the absence of borrowers (investors). For instance, there have been savers in Japan for the past few decades, but the private sector has no motivation to borrow for investments. What can be done in this case? In the 2008-2009 crisis, there were no savers as well as borrowers in the Western economies. Savers were already absent when the crisis happened. In the US, the private sector was mired in a state of technical bankruptcy because asset prices were falling heavily while there were essentially no savers. At the same time, there were no investment opportunities in Europe. Even after a few rounds of QE and the massive supply of base currencies, nobody was willing to invest – there were simply no opportunities to invest in the economy. When people got hold of capital, they in essence returned the capital to banks via negative interest rates. This situation was unprecedented.

The key contributions to the body of economic knowledge by Gu Chao Ming’s framework relates to a better understanding of what happens in the third and fourth regimes where borrowers are absent. Let’s take Japan for example. It is in the third regime, where there are savers but no borrowers. He thinks that the Japanese government should take up the mantle of being the borrower of last resort in this situation and use fiscal policy to conduct direct investments. A failure to do so will lead to a contraction in the economy, since the private sector is unwilling to borrow. And once the economy contracts, a vicious cycle will form, potentially causing widespread unemployment and economic activity to decline by half. The societal consequences are unthinkable. We know that Hitler’s rise to power in the 1930s and a revival in Japanese militarism in the same era both had direct links to the economic depression prevalent back then.

The fourth regime, one where savers and borrowers are both absent, describes the 2008-2009 crisis. When a fourth regime arises, the government should assume the roles of both provider of capital of last resort, and borrower of last resort. In the US during the 2008-2009 crisis, the Federal Reserve issued currency while the Treasury department used the TARP (Troubled Asset Relief Program) Act to directly inject capital into systematically important commercial and investment banks. The actions of both the Fed and the Treasury stabilised the economy by simultaneously solving the problems of a lack of savers and borrowers. Till this day, Western Europe is possibly still trapped in the third or maybe even the fourth regime. There are no savers or borrowers. Structural issues in the Eurozone make matters worse. Countries in the Eurozone can only make use of monetary policy, since they – especially the countries in Southern Europe – are restricted from using fiscal policy to boost domestic demand. These constraints within Europe could lead to catastrophic consequences in the future.

Gu Chao Ming used the aforementioned framework to analyse the unique problems facing the global economy today (the appearance of the third and fourth regimes). He also provided his own views on the current economic policies of developed nations.

He considered the following questions: Why did both Western Europe and the US lumber toward asset bubbles? In addition, why were they unable to discover the path that leads to a return to growth (the US did return to growth, but it is anaemic) after their asset bubbles burst? To answer these questions, Gu Chao Ming provided what I think is his second unique perspective, which is meaningful for the China of today. He shared that an economy will have three different stages of development under the backdrop of globalised trade.

Let me first introduce an important concept in development economics –  the Lewis Turning Point. In the early days of urban industrialisation, surplus rural workers are constantly attracted by it. But as industrialisation progresses to a certain scale, the surplus of workers in the rural areas now becomes a shortage, leading to the economy entering a state of full employment. This is the Lewis Turning Point, which was first articulated by British economist W. Arthur Lewis in the 1950s.

Gu Chao Ming’s first stage of development refers to the early days of urban industrialisation, before the Lewis Turning Point is reached. The second stage happens when the economy has moved past the Lewis Turning Point and is in a phase where savings, investments, and consumption are all in a state of intertwined growth. This is also known as the Golden Era. In the third stage of development – a unique stage that Gu Chao Ming brought up – the economy enters a state of being chased, after it passes a mature growth phase and becomes an advanced economy. Why does this happen? That’s because investing overseas in developing countries becomes more advantageous as the cost of domestic production reaches a certain level. In the earlier days, the advantages of investing overseas in developing countries are not clear because of cultural and institutional obstacles. But as domestic production costs rises to a certain height, while other countries are simultaneously strengthening their infrastructure to absorb foreign investments, it becomes significantly more attractive to invest overseas compared to domestically. At this point, capital stops being invested in the country, and domestic wages start to stagnate.

In the first stage of development (the pre-Lewis Turning Point phase), owners of capital have absolute control. This is because rural areas are still supplying plenty of labour, and so the labour force is generally in a weak position to bargain and does not have much pricing power. Companies tend to exploit workers when there are many people looking for work.

In the second stage of development (when the economy is past the Lewis Turning Point and enters a mature growth phase), companies need to rely on investing in productivity to raise their output. At the same time, companies need to satisfy the demands of the labour force, such as increasing their wages, improving their working environment, providing them with better equipment, and more. In this stage, economic growth will lead to higher wages, because shortages are starting to appear in the labour supply. A positive cycle will form, where a rise in wages will lead to higher consumption levels, driving savings and investments higher, and ultimately higher profits for companies. During the second stage, nearly every member of society can enjoy the fruits of economic development. Meanwhile, a consumer society led by the middle class will be formed. Living standards for each level in society are improving – wages are rising even for people with low education levels. This is why the second stage of development is also known as the Golden Era.

Changes in society start to appear in the third stage of development. For the labour force, only those in highly-skilled roles (such as in science and technology, finance, and trade etc.) will continue to receive good returns from their jobs. Wages in traditional manufacturing jobs that require low levels of education will gradually decline. Wealth-inequality in society will widen. Domestic economic and investment conditions will deteriorate, and investors will increasingly look to foreign shores for opportunities. At this juncture, GDP growth will rely on continuous improvements in technology. Countries that excel in this area (like the US for example) will continue to enjoy GDP growth, albeit at a low pace; countries with a weaker ability to innovate (such as Europe and Japan) will experience poor economic growth, and investments will shift toward foreign or speculative opportunities. 

Gu Chao Ming thinks that the Western economies had entered the third stage of development in the 1970s. Back then, they were being chased mainly by Japan and Asia’s Four Dragons. Fast forward to the 1980s and China had started to open itself to the international economy while Japan entered the phase of being chased. While being chased, a country’s domestic economic growth opportunities tend to decrease sharply. At the same time, any pockets of economic growth tend to form into frothy bubbles. It was the case in Japan, the US, and Western Europe. Capital flowed into real estate, stocks, bonds, and financial derivatives, forming massive bubbles and their subsequent bursting. Even after a bubble bursts, the country’s economic growth opportunities and potential remain extremely limited. As a result, the economy’s ultimate goal shifts from maximising profits to minimising liabilities. That’s because on one hand, the private sector has nowhere to invest domestically, while on the other, it wants to repair its balance sheet. In this way, predictions that are based on traditional economic theories will fail.

Gu Chao Ming pointed out that the functions of a government’s macro policies should change depending on what stage of development the economy is at. And so, different policy tools are needed. This view has meaningful implications for China today.

In the early phases of industrialisation, economic growth will rely heavily on manufacturing, exports, and the formation of capital etc. At this juncture, the government’s fiscal policies can play a huge role. Through fiscal policies, the government can gather scarce resources and invest them into basic infrastructure, resources, and export-related services etc. These help emerging countries to industrialise rapidly. Nearly every country that was in this stage of development saw their governments implement policies that promote active governmental support.

In the second stage of development, the twin engines of economic growth are rising wages and consumer spending. The economy is already in a state of full employment, so an increase in wages in any sector or field will inevitably lead to higher wages in other areas. Rising wages lead to higher spending and savings, and companies will use these savings to invest in productivity to improve output. In turn, profits will grow, leading to companies having an even stronger ability to raise wages to attract labour. All these combine to create a positive feedback loop of economic growth. Such growth comes mainly from internal sources in the domestic economy. Entrepreneurs, personal and household investing behaviour, and consumer spending patterns are the decisive players in promoting economic growth, since they are able to nimbly grasp business opportunities in the shifting economic landscape. Monetary policies are the most effective tool in this phase, compared to fiscal policies, for a few reasons. First, fiscal policies and private-sector investing both tap on a finite pool of savings. Second, conflicts could arise between the private sector’s investing activities and the government’s if poorly thought-out fiscal policies are implemented, leading to unnecessary competition for resources and opportunities.

When an economy reaches the third stage of development (the stage where it’s being chased), fiscal policy regains its importance. At this stage, domestic savings are high, but the private sector is unwilling to invest domestically because the investing environment has deteriorated – domestic opportunities have dwindled, and investors can get better returns from investing overseas. The government should step in at this juncture, like what Japan did, and invest heavily in infrastructure, education, basic research and more. The returns are not high. But the government-led investments can make up for the lack of private-sector investments and the lack of consumer-spending because of excessive savings. In this way, the government can protect employment in society and prevent the formation of a vicious cycle of a decline in GDP. In contrast, monetary policy is largely ineffective in the third stage.

For China’s current development, discussions on the use of macro policies are particularly meaningful. Although there are different viewpoints, the general consensus is that China had passed the Lewis Turning Point a few years ago and entered a mature growth phase. Over the past decade, we’ve seen accelerating growth in the level of wages, consumer spending, savings, and investments. But even when an economy has entered a new stage of development, the economic policies that were in place for the previous stage of development – and that have worked well – tend to remain for some time. The lag in the formulation and implementation of new policies that are more appropriate for the current stage of development comes from the inertia inherent in government bodies. This mismatch between macro policies and the stage of development the economy is at has happened in all countries and stages. For instance, Western economies are still stuck with macro policies that are more appropriate for the Golden Era (fiscal policy). Actual data show that the current policies in the West have worked poorly. Today, many Western countries (including Japan) are issuing currencies on a large scale and have zero or even negative interest rates. But even so, these countries are still facing extremely low inflation and slow economic growth while debt levels are soaring.

In the same vein, China’s government is still relying heavily on policies that are appropriate for the first stage of development even when the country’s economy has grown beyond the Lewis Turning Point. In the past few years, we have seen a series of measures for economic reforms. Their intentions are noble, meant to fix issues that have resulted from the industrialisation and manufacturing boom that occured in the previous development stage. But in practice, the reform measures have led to the closures and bankruptcies of private enterprises on a large scale. So from an objective standpoint, the reform measures have, at some level, produced the phenomenon of an advance in the state’s fortunes, but a decline for the private sector. More importantly, it has hurt the confidence of private enterprises and caused a certain degree of societal turmoil and loss of consumer-confidence. All of these have lowered the potential for economic growth in this stage.

Today, net exports contribute negatively to China’s GDP growth while consumption has a share of 70% to 80%. Private consumption is particularly important within the consumption category, and will be the key driver for China’s future economic growth. In the Golden Era, the crucial players are entrepreneurs and individual consumers. The focus and starting point for all policies should be on the following: (1) strengthening the confidence of entrepreneurs; (2) establishing market rules that are cleaner, fairer, and more standardised; (3) reducing the control that the government has over the economy; and (4) lowering taxes and economic burdens. Monetary policy will play a crucial role at this juncture, based on the experiences of many other developed countries during their respective Golden Eras.

During the first stage of development, China’s main financial policy system was based on an indirect financing model. It’s almost a form of forced savings on a large scale, and relied on government-controlled banks to distribute capital (also at a large scale) at low interest rates to manufacturing, infrastructure, exports and other industries that were important to China’s national interests. This financial policy was successful in helping China to industrialise rapidly. 

At the second stage of development, the main focus should be this: How can society’s financing direction and methods be changed from one of indirect financing in the first stage to one of direct financing, so that entrepreneurs and individual consumers have the chance to play the key borrower role? We’ve seen such changes happen to some extent in the past few years. For instance, the area of consumer credit has started developing with the help of fintech. There are still questions worth pondering for the long run, such as whether property mortgages can be done better to unleash the potential for secondary mortgages. During this stage, some of the most important tools in macro policy include: Increasing the proportion of direct financing in the system; enhancing the stock market’s ability to provide financing for private enterprises; and establishing bond and equity markets. In addition, the biggest tests for the macro policies are whether the government can further reduce its power in the economy and switch its role from directing the economy to supporting and servicing it.

Over the past few years, the actual results of China’s macro policies have been poor despite the initial good intentions when they were implemented. This is because the policies were simply administrative means. The observation of the economic characteristics of China’s second stage of development also gives us new perspectives and lessons. During the Golden Era of the second stage of development, some policies could possibly have better results if they were adjusted spontaneously by market forces. In contrast, directed intervention may do more harm than good. These are the most important subjects for China today. 

Currently, Japan, Western Europe and the US are all in the third stage of development while China is in the second. This means that China’s potential for future growth is still strong. China’s GDP per capita of around US$10,000 is still a cost-advantage for developed nations in the West. At the same time, other emerging countries (such as India) have yet to form any systemic competitive advantages. It’s possible for China to remain in the Golden Era for an extended period of time. China’s GDP per capita is around US$10,000 today, but there are already more than 100 million people in the country that have a per-capita GDP of over US$20,000. These people mainly reside in the southeast coastal cities of the country. China actually does not require cutting-edge technology to help its GDP per capita make the leap from US$10,000 to US$20,000 – all it needs is to allow the living standards and lifestyles of the people in the southeast coastal cities to spread inward throughout the country. The main driver for consumption growth is the “neighbour effect” – I too want for myself what others eat and possess. Information on the lifestyles of the 100 million people in China’s southeast coastal cities can be easily disseminated to the rest of the country’s 1 billion-plus population through the use of TV, the internet, and other forms of media. In this way, China’s GDP per capita can reach US$20,000.

In the years to come, the level of China’s wages, savings, investments, and consumption will all increase and create a positive cycle of growth. Investment opportunities in the country will also remain excellent. Attempts to unleash the growth potential in China’s economy would benefit greatly if China’s government can learn from the monetary policies of the Western nations when they were in their respective Golden Eras, and make some adjustments to the relationship between itself and the market. Meanwhile, Western nations (especially Western Europe) could learn from the positive experiences of the fiscal policies of Japan and China, and allow the government to assume the role of borrower of last resort and invest in infrastructure, education, and basic research at an even larger scale. Doing so will help developed nations in the West to maintain economic growth while they are in the third stage of development (of being chased).

The idea of adjusting policies and tools as the economy enters different stages of development is a huge contribution to the world’s body of economic knowledge. Economics is not physics – there are no everlasting axioms and theories. Economics requires the study of constantly-changing economic phenomena in real life to bring forth the best policies for each period. From this viewpoint, the theoretical framework found in Gu Chao Ming’s book is a breakthrough for economic research.

Earlier, I mentioned three big questions that the world is facing today and that the book is trying to answer. They are the most intractable and pressing issues, and it is unlikely that there will be perfect answers. Gu Chao Ming has a deep understanding of Japan, so the views found in his book stem from his knowledge of the country’s economic history. But is Japan’s experience really applicable for Europe and the US? This remains to be seen. QE, currency oversupply, zero and negative interest rates, high asset prices, wealth inequality, the rise of populist politics – these phenomena that arose from developed countries will continue to plague policy makers and ordinary citizens in all countries for a long period of time.

For China, it has passed the Lewis Turning Point and is in the Golden Era. The economic policies (particularly the fiscal policies) implemented by Japan and other developed countries in the West during their respective Golden Eras represent a rich library of experience for China to learn from. It’s possible for China to unleash its massive inherent economic growth potential during this Golden Era, so long as its policymakers know clearly what stage of development the country is at, and make the appropriate policy adjustments. China’s future is still promising.

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