The Innovator, the Imitator and the Idiot

The idiot phase of an economy is when financial disasters strike. It’s when the market reveals all the mistakes of the prior boom. It’s when all these supposedly smart people running billion-dollar financial firms get their heads handed to them. Guess which phase we’re in. Chris Mayer explains…

While in Vienna last week, I grabbed hold of the international edition of The Wall Street Journal. Over a classic Viennese breakfast of coffee, a boiled egg and pastry, I stumbled across an interview with Ted Forstmann, titled, "The Credit Crisis Is Going to Get Worse."

I hadn’t seen Forstmann’s name in years. He once lorded over one of the world’s most famous private equity firms, Forstmann Little. For a time, it was, as the Journal notes, "the most successful private equity firm in the world, renowned for both its outsized returns and its caution." When things got a little too crazy, Forstmann chose not to play. For two years, he sat on $2 billion of uninvested funds. That’s discipline you don’t find often, in any era.

Ted Forstmann’s caution saved his firm a lot of pain when the private equity market collapsed later. As the interview made plain, old Forstmann has that bad feeling again. "Buffett once told me," he said, "there are thee ‘I’s’ in every cycle. The ‘innovator,’ that’s the first ‘I.’ After the innovator comes the ‘imitator.’ And after the imitator in the cycle comes the ‘idiot.’" We’re in the idiot phase now, he says.

The idiot phase is when financial disasters strike. It’s when the market reveals all the mistakes of the prior boom. It’s when all these supposedly smart people running billion-dollar financial firms get their heads handed to them. "The creation of much too much money caused all of this excess," he says.

He would’ve found agreeable company in Vienna last week. The inaugural meeting of the Society for Austrian Economic Thought took place in the elegant salons of the Hotel Imperial. Here, a motley crew of entrepreneurs, philosophers and economists from all over the world met to discuss the world’s troubles.

Austrian Economics, in case you don’t know, refers to a school of thought originating largely in Vienna in the late 19th and early 20th centuries. Its great thinkers include Ludwig von Mises, for instance, who was actually born in what today is Ukraine. (As an aside, this sort of thing happened a lot, as the old Austro-Hungarian Empire’s borders shifted in later years. Carl Menger, another founding Austrian thinker, was actually born in what is today Poland.)

Nowadays, the term "Austrian" in economic circles refers to anybody who holds to the theories of this group. The late Murray Rothbard, another famous practitioner and my favorite of the lot, was an American, for instance. I used to write for the Mises Institute and spent several years studying the Austrians. It’s the economic framework I still use.

Anyway, I’m getting off track. One definite theme of the meeting was the sick monetary systems of the world’s economies. Dr. Andre Homberg, a friend, reader and the organizer of the event, laid it out as the 5 "D"s:

– Delusions – the notion that "the welfare state can provide everyone with a free lunch and a reliable pension and health care"
– Deficits and Debts – the accumulation of enormous fiscal imbalances, particularly in the public sector
– Dollars – the debasement of the dollar and reckless credit expansion
– Derivatives – Dr. Homberg pointed out that the notional value of derivatives topped $1,000 trillion, as per a recent IBS report. "This excessive leverage could implode anytime and make the U.S. subprime debacle look like a day at the beach," he said.

The end result of all this? Dr. Homberg happily explained: "The prices of everything that you must have will escalate at a speed that you will not believe. The prices of energy and fuel will continue to spiral higher. Food and water prices will accelerate upward and will result in a lower standard of living for yourself, your family and your loved ones."

It was a cheery afternoon, let me tell you. There’s nothing quite like sitting under crystal chandeliers in a decadent 100-plus-year-old salon, spooning your weichsel-chily kaltschale mit gebratener Steingarnele – a sort of cold soup with sour cherries, chili and roasted prawn – while also matter-of-factly chatting about the end of the world as we know it.

There are plenty of reasons to feel gloomy. But even Dr. Homberg allowed that there would be great opportunities to make a lot of money. "At least for the ones that understand the forces involved," he added, "and have the courage to grab the opportunities that this process will create." Homberg is financially independent, in large part owing to his deft investing since 2000. I’m proud to count him as a loyal reader.

Going forward, I think it will be important to stick with real assets during these inflationary times. I’ve got two very interesting ideas I’m researching now. Both of them are quirky oddball opportunities rich in tangible inflation-beating assets.

Also, in thinking back to the "I" cycle, the idiots eventually make way for the innovators, the winners in the next up cycle. Among the innovators in this cycle will be those who solve or ease the high cost of oil.

I’m currently reading an interesting book, Engines That Move Markets by Alasdair Nairn. It’s all about the history-making shifts of various innovations – canals, railroads, telephones, etc. In particular, the book focuses on their impacts on markets and investing. One early lesson is how people misread key events and missed great investments in the process.

One early quote stands out. The Quarterly Review in March 1825, noted: "What could be more palpably absurd than the prospect held of locomotives traveling twice as fast as stagecoaches?" Stagecoach and canal investors who doubted the power of the trains lost a lot of money. While the losers are easy to spot in retrospect, they’re not usually so obvious to investors at the time, as The Quarterly Review comment shows.

As far as identifying the winners of this process, that was also not obvious. The railroads proved poor investments for most. By the mid-1870s, 40% of American railroad bonds were in default. The real winners were the people who enjoyed the lower cost of freight – traders and merchants expanding into new markets. So, too, the winners in this crisis might not be so obvious.


Chris Mayer
for The Daily Reckoning
July 23, 2008

This essay was taken from a recent issue of Capital & Crisis.

Chris is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer’s essays have appeared in a wide variety of publications, from the Daily Article series to here in The Daily Reckoning. He is the editor of Mayer’s Special Situations and Capital & Crisis – formerly the Fleet Street Letter.

Chris also recently wrote a book: Invest Like a Dealmaker: Secrets from a Former Banking Insider.

Yesterday was the first day of speeches at the Agora Financial Investment Symposium. We heard from quite a few DR familiar faces, and by and large, the theme of the first day’s speeches was a simple one: when it comes to investing, understand what you’re doing. We’ll get to a recap of yesterday’s events in a moment. First, let’s take a look at the happenings in the financial media.

The big news this morning is that President Bush has dropped his threat of a veto for the housing bill that will bail both Fannie Mae and Freddie Mac out, and also offer relief to homeowners that have gotten in over their heads and now run the risk of foreclosure. reports that the legislation would allow the Federal Housing Agency to insure up to "$300 billion in new 30-year fixed rate mortgages for at-risk borrowers in owner-occupied homes if their lenders agree to write-down their loan balances to 90% of the current appraised value of their homes…The cost of the FHA program – which would begin on October 1 and be in place for just a few years – would be funded by fees from Fannie and Freddie."

And of course, since Fannie and Freddie are seriously ill-equipped to offer up those kinds of funds at the present moment, the bill would allow the Treasury broad powers that would provide the mortgage giants with liquidity and a "capital background" – basically an unlimited line of credit. It is generally understood that this will leave U.S. taxpayers with a gigantic bill to pay – in fact, yesterday the CBO estimated the cost of the "rescue" at $25 billion, and said there is a chance that it could end up costing the U.S. government $100 billion in the long term. Does the term "hemorrhaging money" mean anything to you, dear reader?

*** Zimbabwe is just a mess. Due to the nationalization of their agriculture sector and food shortages caused by hyperinflation, millions of the country’s citizens face starvation. The inflation rate in this southern African country is at an unbelievable 2.2 million percent – and economists think that this is actually understated, and that the actual inflation rate may be running between 10 million and 15 million percent. Because of this, and a major cash shortage, the Zimbabwean government has introduced a $100 billion bank note.

In the United States, points out Bill, we look at countries like Zimbabwe and shake our heads in disbelief. It seems almost like slapstick comedy to us.

As Milton Friedman once said, "If you let the government run the Sahara Desert, soon there will be a shortage of sand." And in the U.S., we have Fannie and Freddie, who represent a huge nationalization event in the United States.

"This is a remarkable thing for the supposedly most ‘free market’ country in the world," continues Bill. "Nationalizing their biggest industry, the mortgage industry. Johnson trying to pretty up the nation’s account, so he took Fannie and turned it into a private business."

This added a whole new innovation to the history of nationalizations. The United States created a company where the profits were private, but the losses were to be funded by the government.

"Nationalization is a great milestone in our economic lives," Bill said to the 1,000 attendees. "Adjusted for the price of gasoline, no one has made money in stocks for 40 years. When you adjust American wages for inflation, you’ll see that they’ve gone nowhere for the past 40 years, either. No one has been getting rich. How is this possible? you have to ask this to find out what’s going on, where it leads and what we’ll do about it.

"We take for granted that economics matter. We have only been thinking of this for the last 25 years. This idea of capitalism brought to us in the 80s was fatally flawed. People got the idea that to be rich you need a free market and free trade. But really, you don’t get rich because of those things – those are just the circumstances that allow you to get rich… if you do the right thing. If you do the wrong thing, it will allow you to go broke. You can’t get rich on consumption, as Dr. Richebächer used to say. You need capital formation. Save your money and invest it in productive enterprises."

*** Rick Rule, who is clearly the ‘rock star’ of the AF Symposium each year, also had some very straightforward advice for the conference attendees: only invest in things you understand very well. And for him, that understanding lies within the commodities and natural resource markets.

Rick believes the resource bull market still has a way to go. Resource stocks, in his opinion, seem to be an asset that is more popular when they are overpriced than when they are cheap. These assets will be headed lower in the coming months.

"Its better to be a contrarian than it is to be a victim," says Rick, echoing his theme of his speech that he gave last year. "If you are of a contrarian mind-frame, and you are solvent enough that you can use volatility as a tool rather than being victimized by it, these [resource] markets could work for you. Use your head. When stuff becomes less expensive, stuff becomes more desirable. Don’t be afraid of price declines – take advantage, rationally, of these opportunities as they present themselves.

"Within the resource and commodities markets, investors haven’t been discriminating between the good, the bad and the ugly. They took them all up. When they decline in price, you don’t have to buy the bad and the ugly. You are educating yourself to what the good sectors are."

This is just a taste of what’s to come from the Agora Financial Investment Symposium. We’ll be reporting on the speeches for the rest of the week for those of you who weren’t able to join us this year. And once again, we will be offering a complete set of CDs of every major speaker’s presentation at the 2008 Agora Financial "View From the Peak" Symposium. This year, however, we’re doing it a little differently – you can choose to either get the CD’s – or you can purchase them in MP3 format, so if you want to listen to our speakers on your iPod, you’re covered.

Until tomorrow,

Short Fuse
The Daily Reckoning