While the stock market is behaving fearfully, we want to examine the thesis that the human capacity for innovation is an inexhaustible source of power that routinely topples seemingly intractable challenges. Our genius for betterment has flourished in the social arrangement known as democratic, free-market capitalism. Its promise of rewards for our efforts tends to subdue our baser instincts of fear and envy, and to stimulate the powerful creativity with which we are endowed. Capitalism has raised the standard of living wherever it's been tried.
No people in history have embraced the promise of capitalism as long and as enthusiastically as Americans. Variations are being experimented with on every continent, and are so successful that global trade is a record 20% of world GDP. At FAI, we are encouraged by the evidence of history and by the breakthroughs of modern research that are happening in healthcare, power generation, agricultural sciences, mining, communications, distribution, banking, electronics and every field you can name ... encouraged enough to invest our hard-earned savings in the power of innovation. Move over, Fear; make way for Genius!
Let's not make the Malthus mistake. Thomas Malthus began publishing his Essays on the Principles of Population in 1798, when democratic capitalism and the industrial revolution were both in their infancy. A core thesis of his still widely-read essays is that population growth will overrun the planet's capacity to provide sustenance, resulting in starvation, disease and inhumane behavior. His recommendation: "We need to get young people to postpone marriage!"
We've read a lot of grim economic commentaries in recent months, and even written a few ourselves! And we've met a number of investors who are so worried about the world economy that they sound as hopeless as Malthus. You know, "Get me out before I lose everything!" To be sure, there are some very serious structural concerns that absolutely have to be dealt with; and to restore financial stability in the developed world might take a few years. But the creative powers of free human beings will be at work the whole time. That's the part that Malthus was missing.
It's been 213 years since he promulgated his bleak outlook; planet Earth was supporting less than 1 billion people at the time,and not all that sumptuously, either. Today, of course, there are almost 7 billion of us walking about, more than 6 billion of whom have adequate diets, even according to World Hunger Education Services; that's a human triumph that Rev. Malthus apparently could not imagine.
While Malthus was circulating his fearful vision, other thinkers and doers were publishing their ideas for a bright future based on human potential. The Reverend Malthus could have read, for example, Adam Smith's The Wealth of Nations (1776), in which the Scottish economist and moral philosopher outlined a vision of limited government and competitive markets. But if Malthus did read it, he was unmoved by its powerful optimism. To the chagrin of Britain's colonialist elite of the time, Adam Smith proposed free markets as the most reliable arrangement by which the working poor might improve their skills and living standards. "Let each person and each nation pursue its economic advantage," he taught, "and prosperity will come to all layers of society."
Nor, it seems, did Malthus much appreciate the explosive potential for human betterment implicit in Thomas Jefferson's 1776 Declaration of Independence. All of England was obviously quite aware of America's separation from the Empire; we know Malthus disapproved of the whole thing since he wrote 20 years later in opposition to Jean-Jacques Rousseau's philosophy of democratic government. Too bad.
The "inalienable right to the pursuit of happiness" espoused by the Declaration of Independence was a poignant distillation of Adam Smith's similar observation that a "most sacred right of mankind is the right to make all that they can of every part of their own produce, and to employ their stock and industry in the way that they judge most advantageous to themselves." This notion of personal freedom and the right to enjoy the fruits of one's labor and investments is the very essence of the free market capitalism that has nurtured the creative genius of countless men and women who've put the lie to Malthusian pessimism over the past 200 years.
The Inventors
Let's look at a few standout examples. Over his lifetime, Thomas Edison personally accumulated 1,093 U.S. patents, including a filament that made light bulbs practical, the phonograph, movie camera, car battery, and central electric generating plants. Think, too, of Scottish inventor James Watt's steam engine improvements that propelled the industrial revolution; and Cyrus McCormick's reaper that "moved the line of civilization westward thirty miles each year" to make room for farms big enough to really benefit from the power of mechanization. Former slave George Washington Carver is celebrated as one of the 20th century's outstanding scientists; he's best known for developing crop rotation methods for soil conservation and discovering hundreds of uses for peanuts, pecans and sweet potatoes, which revitalized agriculture in the southern states. And the first controlled, powered and sustained human flight was as recent as 1903; our thanks to Orville and Wilbur Wright!
And, of course, there's Edison's close friend, Henry Ford, and his moving-assembly-line innovation that gave us the first durable, mass-produced automobile, and made possible the suburbanization of Post-WWII America. In the early years of the 20th century, Tom Watson's tabulating machines performed data processing tasks using electro-mechanical punch card readers; his company evolved into computing giant IBM which currently employs 425,000 people worldwide.
In the late 1950s, Robert Noyce helped introduce the integrated circuit which went on to reduce the cost of electronic functions by a factor of a million to one! Noyce's Intel, now the world's largest semiconductor chip maker, has been a serial innovator that provides rewarding work for over 100,000 people today. Fast forwarding to 2011, we have to celebrate Steve Jobs, Apple's inimitable CEO who died recently at just 56. His co-development of the first personal computer in 1976, his phenomenal success with film animation at Pixar, and his iPod, iPhone, iPad, and iTunes which revolutionized several whole industries and enhance millions of people's lives every day. Thank you, Steve.
In a recent Wall Street Journal article, former Wall-Streeter Andy Kessler wrote a testimony to Wilson Greatbatch, who died recently at the age of 92. A regular, working family man, Greatbatch invented the pacemaker in 1958 at the age of 39. He went on to become quite wealthy by licensing (to Medtronic) the fabulous invention that has since extended and improved millions of people's lives. Noted in the same article were Google's founders Larry Page and Sergei Brin, both multi-billionaires today, whose search engine concept has saved all of us untold billions of hours of research and driving around, worth far more than these founders' financial rewards. These and many other famous innovators achieved considerable personal wealth while creating millions of well-paying jobs and improving the standard of living for all of us. Many of them formed publicly owned businesses in which ordinary people could invest their savings and share in the financial rewards of ownership.
And the innovations keep bubbling up from the vast ocean of human ingenuity. According to a 2004 MIT study, a modern worker accomplishes in 11 hours what took 40 hours as recently as 1950! This amazing outcome is result of productivity gains compounding at just 2.4% a year. That is the fruit of relentless innovation that benefits all of us; it's what happens in a free market culture that promises personal rewards for working hard and taking risks.
Writing when King George III reigned over England's mercantilist colonial empire, Reverend Malthus was unable to imagine the wonders of human innovation that democracy would unleash; hence his unabashed pessimism. But for those of us who have experienced innovation's blessings, long-term optimism for our economic future seems entirely natural.
Let's look at two enormous and essential industries that worry people today, and see what causes there are for optimism.
Energy And Food
I was prompted to begin this article with reference to the Malthusian thesis by an investment thinker I have admired for years, Jeremy Grantham. An Englishman with a Harvard MBA, and chairman of Boston-based global investor, GMO, he recently published an investment report that loudly echoes the concerns expressed in Malthus' Essays.
Grantham writes that the world is undergoing a "paradigm shift" in which the number of people on Earth has finally and permanently outstripped the planet's ability to support us. He concludes that the phenomenon of ever more humans using a finite supply of natural resources cannot continue forever ... and that the prices of metals, fossil fuels and food are beginning to reflect that permanent shortage. The era of abundance and reasonable commodity prices, Grantham maintains, is over for good!
Missing from Grantham's appraisal of the future is any enthusiasm for mankind's long-demonstrated ability to brighten a gloomy outlook through innovation. Regarding food, he allowed as how there is almost no available land suitable for farming and that we have already maximized the benefits of fertilization. That sounds grim, alright, but it lacks the depth and breadth of thinking I have always associated with GMO and Grantham in particular. So we thought it would be instructive to survey the possibilities that innovation might offer in the food and energy businesses.
Innovations In Energy
On September 17, The Wall Street Journal published an optimistic article about the future of energy titled "There Will Be Oil." It begins by noting that a fear of falling oil production has pervaded the industry for several decades. In the body of the article, well-known oil consultant Daniel Yergin tears into M. King Hubbert's famous "Peak Oil" proposition which correctly predicted in 1956 that U.S. oil production would top out by 1970. He looked like a prophet in the 1970s when this country first became an oil importer and fell prey to OPEC's supply manipulations. But Hubbert had gone on to predict that global oil production would fall precipitously and that children born in 1965 would see all of the world's oil used up in their lifetime. Sound like anybody we've mentioned?
As it turned out, he greatly underestimated the amount of oil that would be found and produced in the U.S. Those 1965 babies are now middle-aged, and the U.S. is producing 5.5 million barrels of oil a day vs. the 1.5 million we were supposed to be producing now, according to Hubbert's gloomy forecast. The main problem with the grim predictions, according to Peter Rose, who was Hubbert's boss at the U.S. Geological Survey, is that his was a static view of the world. He had no concept, Rose said, of technological change, economics or how new resource plays actually evolve. Hubbert insisted, for example, that price doesn't matter!
If Hubbert had spent a few evenings reading Wealth of Nations, he might have discovered the free-market reality that prices give powerful signals to people about allocating resources and developing new technologies. But to Hubbert, and perhaps to Jeremy Grantham who clearly does understand classical economic theory, oil may have seemed a special case because of its finite physical cache in the ground; what the industry calls reserves.
Proved reserves, says Yergin, are an economic concept describing how much of what's in the ground can actually be recovered at current prices and with presently available technology. He points out with many examples that, "Higher prices for oil stimulate innovation and encourage people to figure out ingenious ways to increase supplies." And rising supplies, in turn, tend to limit or even depress prices.
Worldwide, there are approximately 5 trillion barrels of oil known to exist beneath the Earth's surface. Only 1.4 trillion of these are currently counted as "proved and probable reserves"; even that is about 45 times the current annual global consumption! In the U.S. alone, "proven" reserves count about 21 billion barrels. That suggests about a 10-year reserve life at current rates of domestic production, which by itself would be a cause for concern.
But to give some idea of the potential for increasing U.S. reserves, the Deptartment of the Interior estimates the total volume of undiscovered, technically recoverable oil in the U.S. to be roughly 134 billion barrels! More than half of that is believed to be in the Outer Continental Shelf. The big variables that will define when or whether these resources will be developed include: price, technological progress and, of course, government policy.
Improvements in 3-D seismic technology have increased drilling success rates in the U.S from 40% to 80%! Advances in deep-water drilling technology have enabled a huge increase in offshore Gulf of Mexico production in recent years; the Bureau of Ocean Energy Management estimates our Gulf output will rise from 418 million barrels in 2008 to 686 million by 2013, a gain of 64% in just 5 years!
Yergin says that oil production from North Dakota's Bakken formation, only 10,000 barrels a day in 2003, has soared to over 400,000 a day this year. Such "tight oil" could, he says, provide as much as 2 million barrels a day countrywide within 10 years. That's roundly 36% of our recent U.S. annual production levels! And it's all made possible by advanced drilling technologies. And we haven't even touched on the domestic natural gas industry, which offers exciting opportunities for substituting this abundant, clean, inexpensive hydrocarbon for oil in transportation and power generation. Even before shale gas began to attract billions of dollars of new capital, the U.S. had over 100 years' supply of gas at recent rates of consumption. Shale discoveries have added a third to our reserves in the last few years and that opportunity is still expanding rapidly.
And of course there are the future possibilities in "renewable" energy sources that will doubtless become cost effective as innovators push the frontiers of energy technology. What fan of Moore's law does not expect continuous gains in the efficiency of wind, hydro and solar energy conversion? Is it not probable that these and other sources will shrink our need to burn hydrocarbons long before the natural supply is exhausted?
While we agree with Grantham's observation that the era of cheap oil may well be past, and that the trend of oil and gas prices generally is probably upward as long as emerging market demand is rising, we are not at all convinced that either the availability or the cost of energy will retard the march of the world's populations toward higher and higher standards of living.
Innovations In Food Production And Distribution
Malthus and Grantham both focused their concern on food, which of course is critical to the survival of our species. Many people today express the same concerns. We think it is important to point out that from the 1950s to the 1990s, which experienced the most dramatic increase in the human population ever, per-capita food production actually increased, thanks mainly to innovation.
Though many organizations gather and publish data on world food production, it is understandably difficult, even if you could filter out political bias, to get an accurate picture of such a complex, fragmented and often informal business. A University of Michigan study seems to echo other reports I've found in saying that arable land comprises only 10% of Earth's 150 million sq. km. landmass. If we accept that nearly all of the agriculturally viable land is already in use, then increasing the yields from current farmland, as the report says, will continue to be the key to expanding food production to both improve the quality of life in poorer areas and keep up with population increases of approximately 1% a year.
There seems to have been a burst of very successful farming innovation in the 1960s. Advances included selective plant breeding to produce higher-yielding crops, and energy-intensive changes such as greater use of fertilizer, pesticides, irrigation and farm machinery. From the 1950s to the 1980s world grain output grew a stunning 160%, roughly twice the population growth of that era!
But farming successes were geographically selective; grain production in Africa actually declined while the rest of the world was more than doubling its yield. To what extent its poor outcomes are attributable to political instability or the failure of science to focus on crop and land issues specific to that continent's conditions I can only speculate. But seeing what innovation has made possible elsewhere, it doesn't seem a stretch to believe that the application of modern methods can make a huge difference in the diets of Africa's 1 billion citizens.
Improvements in farm productivity will involve modern land management practices, better pest management, advances in fertilizer technology, more efficient irrigation methods, conservation tillage and, of course, the development of new crop species that are hardier and more nutritious.
Modern crop breeding and genetic modification have a long and prodigious history dating back to Luther Burbank's grafting, hybridization and cross breeding successes in the early 1900s. Plant science has become seriously politicized by groups that fear new varieties may represent health risks. Others, more knowledgeable than I, will have to sort that out; but the potential to help increase food production faster than the population grows is compelling, even if current science needs further improvement.
Here are two quick examples of benefits that have accrued from plant science. Genes from wild plants with inbuilt disease resistance have been used to protect coffee plantations in Brazil. And Mexican wild maize (corn) confers resistance to seven major plant diseases.
But food technology that can expand the planet's ability to support us is not limited to agricultural sciences. It is believed that something like onethird of the crops that are grown... about 1.3 billion tons a year... is wasted, never consumed; and it happens all along the supply chain. In developing countries with a less sophisticated farming industry 40% of these losses occur at the post-harvest and processing stage. In industrialized countries 40% of the losses occur at the retail and consumer level. And it seems worth mentioning that between a third and a half of America's enormous corn crop goes into our gas tanks in the form of ethanol, which seems improvident in light of the enormous energy resources that new technology is making available (see above).
Plain economics suggest that the higher food prices we have seen the past couple years will make it profitable to pay attention to the wasted calories and proteins that could be redeemed by a focus on the many processesand policies that affect food's journey from the farm to our tables. There is plenty of opportunity for even low-tech innovation. Between the advances of science and the motivation of price signals, there are plenty of reasons to expect that the world can and will supply enough food to nourish our human family. And there will be substantial opportunities
for owners of capital to fund the needed progress. It is very plain to this writer that Malthus is still wrong!
Near-Term Challenges
For more than two centuries, democratic free-market capitalism has widened it influence in the world, and proved itself a cornucopia of INNOVATION. The voice of history insists that high expectations are appropriate for long-term investors, as long as we safeguard that culture of opportunity. Yet, since none of us has the luxury of a 100-year investment horizon, we also need to be aware that the short-term and the long-term are frequently discontinuous.
During shorter periods of time, human beings have demonstrated a remarkable capacity for creating havoc. Two of our most calamitous propensities have been WAR and DEBT... especially sovereign debt. It may be instructive to note that government is the sponsor of both.
Wars typically end when one side gives up. In the best postwar scenarios (e.g. American Civil War and WWII) devastation has been followed by an era of reconstruction, relative peace and improving standards of living, even for the vanquished.
The history of sovereign debt is actually quite similar to the war cycle. A government, heady with the imagined wisdom of its policies, borrows and spends recklessly to fund its programs; eventually its over-extension is laid bare, with serious consequences to the investor class. But the destruction of capital and disruption of prosperity is eventually followed by healing and recovery.
The pattern looks something like this: For a while the borrowed money stimulates economic activity, even as it sucks capital (the fuel of innovation) out of the private sector. In the late stages of the credit expansion, government's debt becomes unserviceable; programs are slashed and lenders suffer losses from either actual defaults or currency debasement. During the ensuing period of de-leveraging, economic activity is temporarily depressed while the private sector re-builds its resources and its optimism. Eventually, the stage is set for the next wave of innovation
and growth.
This Time Is Different, by Reinhart and Rogoff, is one of the best financial books of the last 10 years. The authors show with exquisite tables and charts that excess borrowing, default and a painful period of deleveraging have been the common characteristics of sovereign debt crises ever since the invention of money. John Mauldin's compelling tome on the same subject, End Game, focuses on the 21st century version of the age-old problem of spendthrift governments. He guides the reader through the array of possible outcomes, ranging from a worldwide depression-cum-deflation, to an extended period of malaise, and on to the other extreme of an inflationary collapse of the leading currencies. Pick your poison.
Just knowing that the current imprudent leverage of governments will stifle economic growth one way or the other does not make the prospect any less frightening to investors. Each of the various possible "end-game" scenarios would require quite different portfolio responses; so despite widespread awareness that we have a serious and imminent problem, the uncertainty lingers on.
Even here, in the land of the free and the brave, the home of Edison and Jobs, fear takes center stage from time to time. In the still-brief history of this 21st century, U.S. stock markets have already suffered not one but two price contractions of nearly 50%. And it is the fresh memory of these losses that is presently intensifying fear among American investors. They are worried about:
- Huge sovereign debts & out of-control deficit spending
- Abuse and misuse of the banking system
- Terrorism and political uprisings
- Renewed economic weakness in Europe and the U.S.
- Poor transparency in nations experimenting with hybrid versions of capitalism
- Competitive currency devaluations and hints of protectionism
Now, admittedly, that is a pretty daunting list of things to worry about! And most of these concerns have been with us during the entire past decade of stock and bond market volatility. "What's ahead?" every investor is inclined to ask. What can be done? Are there signs we should look for?
Debt & Deficit
A single stubborn reality underlies every item on our list of things that worry today's investors... DEBT. More specifically, it is the misuse of credit and the abuse of currencies.
Classical economics teaches that the legitimate and beneficial use of credit is to fund long-lived assets that are likely to enhance the productivity of human effort. When debt is taken on and the proceeds applied for this purpose it raises the return on both capital and labor. Simple examples are highly productive factories and highways that facilitate commerce.
Over the past three decades, our political leaders and we citizen taxpayers have both accelerated the use of credit, not for long-term investment, but to increase short-term consumption. When the consumer goods have vanished (like vacations) or depreciated (like cars) or decreased in value (like beach condos) the indebtedness lingers on; and with it, the debt service obligations.
The outstanding federal debt of the United States is $14.8 trillion and it is increasing by 9% a year! Next month, our gross federal debt will equal a stunning 100% of GDP, up from 57% as recently as 2000. By anyone's definition the situation is out of control and has to be addressed.
We Americans have wide-ranging and strongly-held opinions about parties and policies; so I don't want to go there any more than necessary to finish examining our simple thesis. But, whether an investor prefers CNN or FOX, I think it must be admitted that a government, especially a very large government, that's addicted to deficit spending is working against the free-market culture of innovation.
We can yell and scream among ourselves about whether the deficit should be eliminated by raising taxes or cutting spending; but the inescapable truth is that the present trajectory leads to financial hell.
The deficit is running at $1.3 trillion a year; and I am not the only one who thinks it may be even bigger in 2012. If it turns out that we cannot agree among ourselves to deal with it... or if we choose to "deal" by printing money and pretending that the global banking system is solvent... then the era of de-leveraging which has followed every governmental financial crisis will be forced upon us. And that is not a pretty prospect.
Investment Response
Going back to the range of possible outcomes for the credit crisis, we could encounter:
1) A deflationary depression à la 1929
2) A generation of economic malaise and gradual wasting of assets
3) Runaway inflation; "soft default" by servicing the debt with cheap dollars
4) If we have the courage to eliminate the government deficit before it blows up, we could grow our way out of the debt problem. This, of course, is the textbook capitalist answer to the dilemma... face the problem and deal with it. But the clock is ticking on this option.
Obviously these are hugely different outcomes. Just as obviously, nobody knows how the soap opera finally ends. So, how does an investor manage this range of uncertainty? Our response is to diversify as though each outcome is possible, but tilt the portfolio in favor of the more likely scenarios. Then, monitor the developments in the real world and adjust the portfolio's emphasis as the unfolding facts give us greater conviction about the probable outcome.
Our best and brightest hope is scenario number 4: Bite the bullet, stop the fiscal hemorrhaging and right-size the nation's balance sheet for the next era of growth. But to actually do this, we'll need to summon the appropriate political courage within a year or two. It's anyone's guess whether that can happen! Oh, and a warning seems appropriate: an abrupt elimination of the deficit (by any combination of cutting spending or raising taxes) will almost surely give us the dreaded "double dip." My personal conviction is that getting the pain behind us as soon as possible is the healthiest approach in the long run.
Scenario number 3 seems to be the path preferred by the Federal Reserve and the Administration, so it has the political wind at its back. Many politicians prefer this option because they think it is the most favorable to debtors... and Uncle Sam is the biggest debtor of all! But runaway inflation is ruinous to savers, retirees on fixed incomes, long-term lenders and to any investments without inflation protection.
Whichever way our present credit crisis resolves itself, past periods of deleveraging show us several good things that happen during the uncomfortable process of adjustment.
- Bureaucracies become less intrusive and market influence grows.
- Occasional panic selling creates extraordinary investment values.
- Eventually volatility diminishes, trading "noise" is reduced and value is revealed.
- Credit defaults raise interest rates to rational levels.
- Creative destruction clears the dead wood for a new beginning.
Our Optimistic Summary
As democracy and capitalism gathered momentum over the last 200 years, human creativity has managed to feed, clothe and house seven times the population that poor ol' Malthus thought had already outrun Earth's sources. he inventiveness of our race has been a persistent phenomenon that makes long-term optimism completely appropriate.
In Europe, the United States and Japan, the use of credit has been overdone, especially in the last ten years, and balance has to be restored. De-leveraging is not a painless process, but neither is it terminal. This is not civilization's first experience with bad debt.
The stabilization process will be intensely political because a) most of the debt has been incurred by government and b) our expectations of government may have gotten a bit unrealistic. They say democracy is messy; and daily exposure to the political turmoil can be disheartening. But western history reminds us just how productive freedom and self-government really have been over the years. No social arrangement has worked nearly as well; several totalitarian alternatives have failed spectacularly in the last century. We think the track ecord justifies confidence that free people can and will solve our current national policy challenges as surely as they have delivered manned flight, hip replacements and streaming video!
As long as we safeguard our democratic free-market culture that has been so productive, human ingenuity gives us every reason to be confident about the future; there will be enough food and energy, so let's not be afraid of starving in the dark!
If we need to pass through an investment winter, it might help to stop occasionally and appreciate the unprecedented prosperity we ordinary folks already enjoy in the developed countries. It's not going to kill us for the economy to take a deep breath while we put our financial house back in order for the next wave of innovation. It may take a few years, but so what? There are always opportunities!
The fuel of modern economies (and those seeking modernity) is capital that is invested. From month to month, the market prices of securities will reflect the ebb and flow of emotions, but over time a iversified portfolio will earn a return appropriate to something so essential and so scarce. Fear not. Stay the course. Life is good!
J. Michael Martin, CFP, JD, is president and chief investment officer of Financial Advantage Inc., in Columbia, Md.