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Good Reading -- May 2012

Sorry for another email so soon, but there has been a deluge of good stuff recently and I wanted to get this out before it got any bigger. I promise no more until June. Safe travels to everyone going to Omaha. Facts and Figures

  • According to the February Case-Shiller data*, real home prices are back to their late-1990s levels. All of the price gains of the 2000s have been erased by subsequent price declines and inflation.

  • The U.S. had one million more households in March 2012 than it did a year earlier, a rate of growth not seen since 2006. The U.S. home ownership rate fell to 65.4% in March, the same level as in March 1997 (it peaked at 69.2% in 2004). Meanwhile, rental properties had a vacancy rate of 8.8%, the lowest in a decade. The homeowner vacancy rate (i.e., non-rental homes that are empty) fell to 2.2% from 2.6% -- that's still well above historical averages but the lowest since 2006. (Source: Census Bureau)

  • A 100-sqft. garage in a great location in Knightsbridge, London just went on the market for £525,000. The country's average home price is £160,000, down 0.6% in the past year. (Source, which I hope is accurate...)

* Case-Shiller tracks national home price data and adjusts for inflation by taking CPI less "Shelter" costs. The "National" index is back to 4Q98 levels and the "Composite 20" index is back to January 2000 levels. On a price-to-rent basis, the National index is back to October 1998 levels and the Composite 20 index is back to February 2000 levels


  • "101 Spectacular Nonfiction Stories" -- I haven't read the vast majority of these, but it looks like there is a lot of good reading on this list. The "Science & Nature" and "Business & Economics" sections look especially good.

  • "Beware of [Benjamin] Franklin's Gambit in making decisions" -- John Kay on "the process of making or finding a reason for what one already has a mind to do."

  • "Derivatives Lobby Has U.S. Regulators on the Run" -- Roger Lowenstein's great overview of the mess that is derivatives regulations.

  • "Finding the Culprits of the Crisis" -- a look at the problem from another, far more aggressive angle by derivatives expert Janet Tavakoli. I appreciate the lack of equivocation and I do agree that crimes were committed and the absence of indictments and convictions is stunning. (Note that she later corrected the comment about AIG's counterparty -- it was Calyon, not Credit Suisse.)

  • "The Challenges in Hedging Tail Risk" -- some timely and useful thoughts on portfolio hedging, particularly regarding puts. "As we continue to experience bouts of volatility in the market, investors will keep searching (unsuccessfully) for the “silver bullet” for hedging tail risk in the financial markets. But when volatility is high, like it was last year, and options become expensive, investors need to pay attention to the costs of protection they are buying. Otherwise, they risk paying too much."

  • "Sears -- Where America Shopped" -- this is a good history of Sears from the local (Chicago) Crain's. The coverage of Lampert is thin and not unique, and the purchase price of his holdings is dead wrong (ignores all the buybacks*), but otherwise it's pretty interesting.

  • "The Population Boon" -- an optimistic look at human productivity and prosperity. "What has Malthus been wrong so far?"

  • "To Win Big, It Helps to Be a Little Nuts" -- a brief but good profile of Fastenal, the market's best-performing stock since of the past 25 years. The underlying lessons are worthwhile if you can get past all the management platitudes.

  • "Value Investing: Investing for Grown Ups?" -- I actually took a "class" taught by Prof. Damodoran (he was a hired gun for Wall Street analyst classes' valuation training back in the day), and I was never sure what to make of him. CAPM academic? Practitioner and closeted value investor? I've since read his blog and a bunch of papers, and I'm still not sure. This paper doesn't help my confusion. It reads more like an earnest college student's senior honor thesis: parts of it are benignly naive, parts of it are factually incorrect or misinformed, and parts are somewhat interesting.

  • "The Costco Craze: Inside the Warehouse Giant" -- an interesting article and TV feature from CNBC (no, those concepts aren't always mutually exclusive, but it's close).

  • "Haste Makes Waste: How Investors are Led Astray by Their Irrational Biases" -- some tidbits about behavioral economics and investing, as well as commentary from Prof. Andrew Lo of MIT who was recently quoted as saying, "Buy and hold investing is dead." As usual, some good ideas in here along with some that fall short.

  • "Big Maconomics" -- an interesting article about McDonald's and the long-running Economist "Big Mac Index" to measure foreign currency purchasing power against the USD. Also a link to an academic paper about McDonald's and "how poor nations get rich." (I haven't read the paper yet.)

* ESL bought its initial stake at ~$16/share, but by buying back a ton of shares at much higher prices in subsequent years, took its ownership stake from <40% to >60% and raised its average cost to about $60/share.


  • Barack Obama: The Story -- a new biography of President Obama to be released later this month. Here is an interesting excerpt in Vanity Fair focusing on his youth, self-identity, girlfriends, education, and early career.


  • James Grant's Speech to the New York Federal Reserve -- for anyone who doesn't subscribe to Grant's Interest Rate Observer or hasn't read Mr. Market Miscalculates, among others, this speech from April 28, 2012 will give you a good idea of his expertise in the history of monetary policy, criticism of the Fed, and preference for a return to the gold standard. I saw him in person at a conference in Chicago recently, and his comments were very similar and he pilloried Bernanke then too, so he's nothing if not consistent. And at the least, this has some good book recommendations and a lot of great history. (Source and editor of transcript: csinvesting)

  • "The True Lessons of the Recession: The West Can't Borrow and Spend Its Way to Recovery" -- an interesting essay in Foreign Affairs by Prof. Rajan of Fault Lines fame. The prescriptions and analysis are anti-Keynesian, but the economic history is mostly neutral and as well written as anything I can remember reading, so even the Krugman fans out there have something to learn here.

  • "Keynes the Stock Market Investor" -- following up on the Keynes articles I sent recently, this is a great paper about Keynes and his investment history. My quibbles aside (this is still an academic paper), the investment analysis and focus on Keynes's experience with the King's College endowment have apparently not been analyzed elsewhere despite the enormously interesting and important implications.

  • "Revitalizing America" -- some interesting (and interestingly similar) commentary from Presidents Bill Clinton and George W. Bush at a recent event.


  • "China's Achilles [sic] Heel" [*] -- a stark reminder about the powerful demographic forces China faces, beginning next year when its workforce is likely to begin shrinking.

  • "China's Biggest Banks are Squeezed for Capital" [*] -- a good look at the circular logic of Chinese banks' capital structures and the value destruction inherent in them. The scary part is that this barely touches on the massive misallocation of capital and credit risks...

  • "Three Reasons Japan's Economic Pain is Getting Worse" [**]-- Jared Diamond (renowned author of Collapseand Guns, Germs, and Steel, both of which are highly recommended) with a very interesting column on Japan. "Since Japan’s economic problems result from its social problems, their solution will require changes in Japanese attitudes toward women’s roles, immigration and sustainable resource use. Can Japan undertake the painful reappraisals this will require?"

  • "If the Auditors Sign Off, Does That Make It Okay?" -- a fascinating article by the professor cited in the article I sent around last December about Enron's 10th "anniversary." Andy Fastow, Enron's CFO, just got out of prison, and spoke in this professor's class. "Why did he commit fraud? Why did a bright, aspiring, stereotypical MBA cross the line and misrepresent the true financial picture of Enron? According to Fastow, greed, insecurity, ego, and corporate culture all played a part. But the key was his proclivity to rationalize his actions through a narrow application of 'the rules.' Fastow's message...has two key points. First, the rules provide managers with discretion to be misleading. Second, individuals are responsible for their actions and should not justify wrongful actions simply because attorneys, accountants, or corporate boards provide approval." (Note: I think the third-to-last paragraph has some very stretched comparisons, although I agree with the underlying point.)

* A friend made a comment to me recently about my "China bashing" articles. I responded that "bashing" China is certainly not my intent; I mean it as an interesting, hopefully instructive counteragrument to the "China is going to take over the world" bullish sentiment that results in a majority of Americans thinking that China already has a bigger economy than America does. (It's actually less than half as big, and even smaller on a per capita basis.) Anyone who depends on Chinese-growth-to-the-sky is at significant risk, and unlikely the European drag on growth, that prospect seems heavily discounted. China has major obstacles in its path (see here or here for a good and reasonable overview). Over the much longer run, its continued ascent is more than likely and it's in the world's best interest. But it seems likely that it's going to be a slower and bumpier ride.

** See, I'm bashing Japan too.

China’s Achilles heel

A comparison with America reveals a deep flaw in China’s model of growth

LIKE the hero of “The Iliad”, China can seem invincible. In 2010 it overtook America in terms of manufactured output, energy use and car sales. Its military spending has been growing in nominal terms by an average of 16% each year for the past 20 years. According to the IMF, China will overtake America as the world’s largest economy (at purchasing-power parity) in 2017. But when Thetis, Achilles’s mother, dipped her baby in the river Styx to give him the gift of invulnerability, she had to hold him somewhere. Alongside the other many problems it faces, China too has its deadly point of unseen weakness: demography.

Over the past 30 years, China’s total fertility rate—the number of children a woman can expect to have during her lifetime—has fallen from 2.6, well above the rate needed to hold a population steady, to 1.56, well below that rate (see table). Because very low fertility can become self-reinforcing, with children of one-child families wanting only one child themselves, China now probably faces a long period of ultra-low fertility, regardless of what happens to its one-child policy.

The government has made small adjustments to the policy (notably by allowing an only child who is married to another only child to have more than one child) and may adapt it further. But for now it is firmly in place, and very low fertility rates still prevail, especially in the richest parts of the country. Shanghai reported fertility of just 0.6 in 2010—probably the lowest level anywhere in the world. According to the UN’s population division, the nationwide fertility rate will continue to decline, reaching 1.51 in 2015-20. In contrast, America’s fertility rate is 2.08 and rising.

The difference between 1.56 and 2.08 does not sound large. But over the long term it has a huge impact on society. Between now and 2050 China’s population will fall slightly, from 1.34 billion in 2010 to just under 1.3 billion in 2050. This assumes that fertility starts to recover. If it stays low, the population will dip below 1 billion by 2060. In contrast, America’s population is set to rise by 30% in the next 40 years. China will hit its peak population in 2026. No one knows when America will hit its population peak.

The differences between the two countries are even more striking if you look at their average ages. In 1980 China’s median (the age at which half the population is younger, half older) was 22. That is characteristic of a young developing country. It is now 34.5, more like a rich country and not very different from America’s, which is 37. But China is ageing at an unprecedented pace. Because fewer children are being born as larger generations of adults are getting older, its median age will rise to 49 by 2050, nearly nine years more than America at that point. Some cities will be older still. The Shanghai Population and Family Planning Committee says that more than a third of the city’s population will be over 60 by 2020.

This trend will have profound financial and social consequences. Most obviously, it means China will have a bulge of pensioners before it has developed the means of looking after them. Unlike the rest of the developed world, China will grow old before it gets rich. Currently, 8.2% of China’s total population is over 65. The equivalent figure in America is 13%. By 2050, China’s share will be 26%, higher than in America.

In the traditional Chinese family, children, especially sons, look after their parents (though this is now changing—see story on next page). But rapid ageing also means China faces what is called the “4-2-1 phenomenon”: each only child is responsible for two parents and four grandparents. Even with high savings rates, it seems unlikely that the younger generation will be able or willing to afford such a burden. So most elderly Chinese will be obliged to rely heavily on social-security pensions.

China set up a national pensions fund in 2000, but only about 365m people have a formal pension. And the system is in crisis. The country’s unfunded pension liability is roughly 150% of GDP. Almost half the (separate) pension funds run by provinces are in the red, and local governments have sometimes reneged on payments.

But that is only part of a wider problem. Between 2010 and 2050 China’s workforce will shrink as a share of the population by 11 percentage points, from 72% to 61%—a huge contraction, even allowing for the fact that the workforce share is exceptionally large now. That means China’s old-age dependency ratio (which compares the number of people over 65 with those aged 15 to 64) will soar. At the moment the ratio is 11—roughly half America’s level of 20. But by 2050, China’s old-age ratio will have risen fourfold to 42, surpassing America’s. Even more strikingly, by 2050, the number of people coming towards the end of their working lives (ie, those in their 50s) will have risen by more than 10%. The number of those just setting out (those in their early 20s, who are usually the best educated and most productive members of society) will have halved.

Help wanted

The shift spells the end of China as the world’s factory. The apparently endless stream of cheap labour is starting to run dry. Despite pools of underemployed country-dwellers, China already faces shortages of manual workers. As the workforce starts to shrink after 2013, these problems will worsen. Sarah Harper of the Oxford Institute of Population Ageing points out that China has mapped out the age structure of its jobs, and knows for each occupation when the skills shortage will hit. It is likely to try to offset the impact by looking for workers abroad. Manpower, a business-recruitment firm, says that by 2030 China will be importing workers from outside, rather than exporting them.

Large-scale immigration poses problems of its own. America is one of the rare examples of a country that has managed to use mass immigration to build a skilled labour force. But America is an open, multi-ethnic society with a long history of immigration and strong legal and political institutions. China has none of these features.

In the absence of predictable institutions, all areas of Chinese society have relied on guanxi, the web of connections that often has extended family relations at the centre. But what happens when there are fewer extended families? One result could be a move towards a more predictable legal system and (possibly) a more open political culture. And, as shifts in China’s economy lead to lower growth, Chinese leaders will have to make difficult spending choices; they will have to decide whether to buy “guns or walking sticks”.

China is not unique in facing these problems. All rich countries have rising pension costs. And China has some advantages in dealing with them, notably low tax rates (giving room for future increases) and low public expectations of welfare. Still, China is also unusual in two respects. It is much poorer than other ageing countries, and its demographic transition has been much more abrupt. It seems highly unlikely that China will be able to grow its way economically out of its population problems. Instead, those problems will weigh down its growth rate—to say nothing of the immense social challenges they will bring. China’s Achilles heel will not be fatal. But it will hobble the hero.

China's Biggest Banks Are Squeezed for Capital

China’s banks are among the biggest and most profitable financial institutions in the world.

But the state-backed banks are also starved for capital after an aggressive lending spree that was encouraged by the government.

Within the last year, seven of the biggest Chinese banks tapped the markets for 323.8 billion renminbi ($51.4 billion ) in new funds, according to Citigroup estimates. Several financial firms are expected to raise another $17.7 billion in the next few months, with China’s fifth-biggest lender, the Bank of Communications, accounting for $9 billion.

Banks around the world have been tapping investors for new funds as they struggle with slumping share prices and waning profits. But Chinese firms have maintained that their profit growth is strong and their balance sheets are solid, raising red flags among some analysts about the banks’ persistent capital needs.

The concerns were heightened after rare and blunt criticism by Prime Minister Wen Jiabao. In early April, he accused banks of reaping easy profits, and called for breaking up the monopoly held by the country’s biggest lenders.

“Frankly, our banks make profits far too easily. Why? Because a small number of major banks occupy a monopoly position, meaning one can only go to them for loans and capital,” Mr. Wen said, according to China National Radio. “That’s why right now, as we’re dealing with the issue of getting private capital into the finance sector, essentially, that means we have to break up their monopoly.”

The uncertainty introduced by Mr. Wen’s comments means China’s banks may find it harder to raise capital, especially if investors are worried about a breakup of the banks’ dominant position. But the irony is that this “monopoly” has served none better than the Chinese state.

Before they started going public a decade ago, all of China’s major banks were, in effect, lenders for government policies. Now, despite partial reforms to the broader financial system, the banks remain integral to the Chinese model of state-directed capitalism, where government-supported firms and projects enjoy preferential access to banks loans at what many analysts say are artificially low interest rates.

The current wave of bank capital-raising is partly the legacy of an unprecedented, multiyear lending boom. Beijing responded to the financial crisis with a 4 trillion renminbi national stimulus plan. The initiative relied heavily on infrastructure spending and was primarily financed with loans from the state-controlled banking industry. Local governments chipped in with additional spending of their own, which likewise depended on banks to finance projects.

This lending spree has proved to be extremely profitable for the banks, as Mr. Wen observed. The country’s four biggest lenders reported combined profits of 623 billion renminbi for 2011, up about 25 percent from 2010.

The least profitable among them — the Agricultural Bank of China [1288.HK 3.51 0.01 (+0.29%) ] — made $18.9 billion last year. That is just shy of the $19 billion that JPMorgan Chase, America’s most profitable bank, made last year.

This week, the so-called Big Four are expected to report that first-quarter profit rose 10 to 26 percent, according to Simon Ho and Paddy Ran at Citigroup in Hong Kong.

But banks’ balance sheets have ballooned as a result. Last month, China’s four biggest lenders — Industrial and Commercial Bank of China [1398.HK 5.14 -0.02 (-0.39%) ], the Bank of China [3988.HK 3.22 --- UNCH ], China Construction Bank [0939.HK 5.95 0.03 (+0.51%) ] and Agricultural Bank of China — reported a combined 14 percent increase in total assets, to 51.3 trillion renminbi. That is roughly the size of the German, French and British economies combined.

So far, the banks appear to have emerged unscathed. The Big Four lenders all showed declining levels of nonperforming loans last year. On average, such troubled loans at the four banks fell in 2011 to 1.15 percent of total lending, down from 1.34 percent in 2010.

But the worry is that, over time, the massive infrastructure, real estate and other projects that were the products of China’s stimulus-driven lending binge will fail to turn a profit. Borrowers, including local governments, may then fall behind on their interest payments and could default on their loans. Much concern has centered on local-level governments, which had racked up a debt pile of 10.7 trillion renminbi by the end of 2010, according to official estimates.

Analysts say a wave of souring loans will have a magnified effect on the Chinese banking industry, given its historically weakened capital position.

“For the first time, a large number of Chinese banks are beginning to face cash pressures,” Charlene Chu, a banking analyst at Fitch Ratings, wrote in a research report. “It is because of this cash constraint that the forthcoming wave of asset quality issues has the potential to become uglier and more destabilizing than in previous episodes of loan portfolio deterioration.”

The potential risks on banks’ loan books can be unpredictable.

China’s ambitious plans to construct a nationwide high-speed rail network, for example, have been praised by politicians from Shanghai to Sacramento as the kind of aggressive stimulus spending that yields instant and tangible economic benefits. But a collision between two trains on a high-speed rail line in eastern China in July, which killed 39 people and injured more than 200 others, has prompted some rethinking in Beijing. Now, analysts question whether the Ministry of Railways can continue servicing the more than 2 trillion renminbi in debt that it amassed before the accident.

The systemic risks of a bad debt bubble bursting are not lost on Chinese banking regulators, who are trying to require banks to bolster their reserves. Under a new set of rules, the country’s biggest lenders will need to increase their capital levels to 11.5 percent of assets by the end of 2013. Their core Tier 1 capital ratio, the strictest measure of a bank’s ability to withstand financial shocks, will need to be at least 9.5 percent. These requirements are more rigorous than the rules that apply to American and European banks.

But increasing regulatory capital may not be enough, because that only focuses on the loans that banks keep on the books. In late 2010, financial regulators in China started cracking down on new loan growth in order to fight inflation. Seeking to comply with regulators, but also to continue chasing profits, banks responded by pursuing newer and more creative forms of off-balance-sheet lending. A GaveKal researcher, Joyce Poon, who is based in Hong Kong, has estimated that outstanding off-balance-sheet lending rose to around 12 trillion renminbi by the first half of 2011, doubling since the end of 2009.

“China’s conservative turn in financial regulation, while understandable given the global excesses that led to the 2008 financial crisis, meant that financial institutions’ search for profits increasingly led them into regulatory gray areas,” Ms. Poon wrote in a research report.

China’s leading banks have another reason for devouring capital. They need to maintain big dividend payouts to their biggest shareholder: the state.

The firms’ recapitalization programs are “largely due to massively excess dividends the banks have paid in recent years,” said Nicholas Lardy, an expert on the Chinese financial system and a fellow at the Peterson Institute for International Economics in Washington.

The problem is that paying out high dividends blows holes in their base capital. Thus, banks need to continue tapping the markets for fresh funds, often diluting minority shareholders by issuing new shares. The finance ministry, the banks’ ultimate controlling shareholder, always buys in, keeping its stakes topped up.

The amount of cash that is churned in the process is staggering. In 2010, China’s five biggest banks (the Big Four plus the Bank of Communications) paid more than 144 billion renminbi in dividends and raised more than 199 billion renminbi on the capital markets, according to GaveKal.

“This is the nonsense of it,” says Fraser Howie, a managing director at CLSA Asia-Pacific Markets, who is based in Singapore and is a co-author of “Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise.” “There’s an awful lot of money just going round and round from one pocket to another, giving the appearance of strength when it’s really not there.”

Three Reasons Japan’s Economic Pain Is Getting Worse

By Jared Diamond - Apr 25, 2012

Japan’s economic problems are serious and getting worse. Foremost among them is the crushing burden of government debt.

Japan’s ratio of government debt to gross domestic product, currently about 2.28, is by far the highest in the industrial world, almost double that of even Greece and Italy, and steadily growing. Already, the combined costs of interest on that debt and social security are approximately equal to total government tax revenue.

Japan’s trade balance is about to go negative for the first time since 1980. Land values and Nikkei stock values have fallen to about 30 percent of 1989 levels. Now, educated young Japanese women are emigrating, Japanese companies are shifting production overseas (even to the U.S.), national politics are in gridlock (six prime ministers in the past five years), and last year Japan experienced its first mass street protests in decades.

The economic troubles are symptoms of at least three sets of deeper social problems. Regardless of what policies Japan now adopts, its troubles can only increase unless those social problems are solved. While all three of these also beset other industrial societies, certain local attitudes make them more severe in Japan.

Marriage and Babies

Throughout the industrial world, birth rates are falling, and fewer people are marrying. Japan’s rate (7.31 births per year per 1,000 people), already the world’s lowest, is still dropping. If its rate of decrease over the past two years is extrapolated, it reaches zero by 2017. Naturally, this dire outcome won’t actually happen, but the calculation does emphasize that the problem is increasing.

In the U.S. and most European countries, in contrast, birth rates are still more than 10 per year per 1,000 people, and in Nigeria and Tanzania, they are more than 40.

Japan’s marriage rate is low, too, even by industrial-world standards: 5.8 marriages per year per 1,000 people, compared with 9.8 in the U.S. The average age of marriage in Japan is now 31, and 18 percent of Japanese women 35 to 39 have never been married.

These numbers don’t reveal whether the reluctance to marry and to have children is on the part of men, women or both. In the absence of rigorous sociological polling, I’ll summarize interviews that Japanese friends have conducted for me. They report that most single adult Japanese still live with their parents, because it’s comfortable to live at home and expensive to leave.

Young Japanese feel more comfortable communicating with each other electronically than by phone or in person. “Over the years that the formerly widespread practice of arranged marriage almost completely disappeared,” one person explained to me, “the digital revolution made it increasingly difficult for Japanese to develop the social skills necessary to woo a potential spouse themselves.” Among men, the biggest reasons given for not marrying are worries about their economic future and their ability to bear the responsibility for a family.

Married women tend to manage the household finances and take care of both their own and their husbands’ parents, and many of them now swear they will be the last generation to be saddled with those burdens. Career women, who find strength in their education, jobs and earning power, are capable of supporting themselves in the style to which they aspire, and are buying condominiums and planning for their own retirements. If they do want to marry, they find that their age is an obstacle, because Japanese men over the age of 40 want much younger women. If they do want children, Japanese societal support for working mothers is low. Hence they either forgo children, or leave the workforce or even leave Japan, and that represents a big loss of human capital for the country.

Much of what I have just said about marriage and babies applies to some degree around the industrial world. Why should these issues be acute in Japan? In most other countries, women’s new opportunities are creating tension between men and women, but it has been manageable because male society has made some accommodation. Japan is the industrial country where women’s roles were, until recently, most stereotyped; hence male resistance to women’s expectations is still the greatest there.

Old People, Immigrants

Again throughout the industrial world, falling birth rates and improved medical care have resulted in aging populations, making it harder to fund retirement systems over the long term. Those trends reach their extreme in Japan because of its record- low birth rate and relatively healthy lifestyles. It is the country with the largest share of population (22 percent) over 65 years of age. Except for Monaco, it also has the longest life expectancy, 84 years.

But numbers alone don’t indicate the extent of the problems. After all, the percentage of the population over 65 in other First World countries is between 14 percent and 20 percent. What makes the problem so serious in Japan is the country’s refusal to do what other countries have done: admit massive immigration of younger people from overseas. It is very difficult to immigrate to Japan, and (having immigrated) even harder to obtain citizenship. Japan is the world’s most homogeneous large country.

This rejection of immigration not only bodes ill for the future of Japan’s retirement system, but also deprives the country of the pool of workers, artists, scientists and inventors that immigrants represent for the U.S., Western Europe and Australia. Many notable Americans have been immigrants or their children. The long list includes, in recent times, Albert Einstein, Sergei Rachmaninoff, Vladimir Nabokov, Wernher von Braun, Henry Kissinger and our current president. Differences in immigration policies contribute directly to the big gap between the U.S. and Japan in Nobel Prizes. The U.S. leads the world in those awards, while Japan wins few despite high government outlays for science.

Scientific advances are essential to a technology-based economy. Thus, while immigration creates big problems, lack of it creates bigger ones.

Non-Sustainable Resources

No industrialized country is self-sufficient in renewable natural resources, especially forest products and seafood. Some must be imported.

If the world’s forests and fisheries were well managed, forest products and seafood could be harvested sustainably in perpetuity. Unfortunately, most harvesting is destructive and non-sustainable. Most of the world’s major fisheries are declining or have already collapsed.

Hence many government agencies and nongovernmental organizations around the world are working toward sustainability. One might naively predict that Japan, a small country that is one of the most dependent on resource imports, would be the world’s leading promoter of sustainability. But the reverse is true: Japan may be the First World country most opposed to sustainable policies. Its imports of illegally sourced and unsustainably harvested forest products are much higher than those of the U.S. or European Union countries, whether calculated on a per-capita basis or as a percentage of total forest product imports.

And Japan is a world leader in opposing prudent regulation of fishing and whaling. Incredibly, in 2010, Japan saw it as a great diplomatic triumph that it blocked international protection for Atlantic/Mediterranean bluefin tuna -- even though the fish, whose stocks are declining, is especially prized and widely consumed in Japan.

Even my Japanese friends are puzzled by this stance. They suggest three explanations. First, Japanese people see themselves as living in harmony with nature, and until recently they did expertly manage their own forests -- though not the overseas forests and fisheries that they exploit. Second, national pride causes the Japanese to dislike bowing to international pressure. The country especially does not want to give in to the anti-whaling campaign of the Sea Shepherd conservation organization, even though few Japanese eat whale meat; the whaling industry operates at a big loss; and tsunami relief funds have had to be diverted to subsidize whaling escort ships.

Finally, because Japan is aware of its own limited home resources, it has for the past 140 years maintained at all costs, as the core of its national security, its right of unrestricted access to the world’s natural resources. In today’s times of declining availability, that insistence is no longer viable.

To an outside admirer of Japan like me, its opposition to sustainable resource use seems sad and self-destructive. Unrealistic quests for resources drove the country to self- destructive behavior once before, when it made war simultaneously on China, the U.S., the U.K., Australia, New Zealand and the Netherlands. Defeat today is as inevitable as it was then -- this time, not by military conquest, but by exhaustion of both renewable and nonrenewable natural resources. If I were the evil dictator of another country who hated Japan and wanted to ruin it without resort to war, I would do exactly what Japan is now doing to itself: destroy the overseas resource bases on which it depends.

The Future

Since Japan’s economic problems result from its social problems, their solution will require changes in Japanese attitudes toward women’s roles, immigration and sustainable resource use. Can Japan undertake the painful reappraisals this will require?

One cause for cautious optimism is the country’s history. Twice in modern times, Japan has accomplished selective change. The most drastic example came with the Meiji Restoration that began in 1868. The forced opening of ports by Commodore Perry in 1853-54 raised the specter that Japan might be taken over by Western powers. But the country saved itself with a crash program: It ended its isolation from the outside world and jettisoned its shogun leader, its samurai class, its feudal land system and its ban on guns. It adopted a constitution, a cabinet government, a national army, industrialization, a European-style banking system, a new school system and much Western clothing, food and music.

At the same time, it retained its emperor, language, writing system and most of its culture. Japan thereby not only preserved its independence, but also became the first non- Western country to rival the West in wealth and power.

Again, after World War II, Japan made drastic selective changes, abandoning its military tradition and its notion of a divine emperor in favor of adopting democracy and developing an export economy.

Once again, Japan can selectively reappraise its core values, let go of those that no longer make sense, and retain the ones that still do and that give the country strength.

So far, however, this doesn’t seem to be happening.

(Jared Diamond, a professor of geography at the University of California, Los Angeles, is the author of “Guns, Germs and Steel” and “Collapse.” The opinions expressed are his own.)

If the Auditors Sign Off, Does That Make It Okay?

11:12 AM Tuesday May 1, 2012 by Lawrence Weiss

Andrew Fastow, the former chief financial officer of Enron, recently completed a six-year prison sentence for his part in the scandalous deception that hid Enron's financial troubles from investors. After I was quoted late last year in an article on the 10th anniversary of the Enron debacle, Fastow contacted me and offered to speak to the Financial Statement Accounting class I teach at Tufts University's Fletcher School of Law and Diplomacy.

Last month, Fastow made good on his offer. Why did he commit fraud? Why did a bright, aspiring, stereotypical MBA cross the line and misrepresent the true financial picture of Enron? According to Fastow, greed, insecurity, ego, and corporate culture all played a part. But the key was his proclivity to rationalize his actions through a narrow application of "the rules."

Fastow's message, an important one for all managers and potential managers, has two key points. First, the rules provide managers with discretion to be misleading. Second, individuals are responsible for their actions and should not justify wrongful actions simply because attorneys, accountants, or corporate boards provide approval.

After his guilty plea for fraud, Fastow forfeited $23.8 million in cash and property. He has helped the Enron Trust recover over $27 billion, of which $6 billion has gone to shareholders. (And he was not compensated for his presentation to my class.)

He began the presentation by admitting he committed fraud and taking full responsibility for his actions. He made a heartfelt detailed apology and expressed remorse for having hurt so many people. He admitted making technical violations and taking wrongful actions that, while approved, were misleading. He said he knew what he was doing was wrong. But he rationalized those actions in his mind at the time, because the result was higher leverage, a higher return on equity, and a higher stock price. Further, he convinced himself that his actions were acceptable because they had been signed off by the firm's lawyers, accountants, and board and were disclosed in the financial reports. He told himself his actions were systemic, it is the way the game is played. All who cared to know knew. As Fastow rhetorically asked my students:

"If the internal and external auditors and lawyers sign off on it, does that make it okay?"

The problem is that attorneys, accountants, managers, boards, and bankers are not gatekeepers; rather, they are there to help businesses execute deals. They are enablers. In the case of Enron, these outside advisers played an active role in structuring and disclosing the deals, and the board approved them, but managers were still responsible for their own actions. Thus, technically following the rules as interpreted by these advisers, even if theirs is the best expertise money can buy, does not make a given action "right." Fastow emphasized that enablers are not an excuse: each individual is his or her own and only gatekeeper.

Fastow suggested that to avoid falling into an ethical trap he should have asked himself the right questions: Am I only following the rules or am I following the principles? If this were a private partnership, would I do the same deal?

Regulation has not prevented fraud. In fact, it may have exacerbated the problem. Enron viewed the complexity or ambiguity of rules as an opportunity to game the system.

Compare Enron's deals with the structured finance innovations we've seen since the passage of the Sarbanes-Oxley Act: Enron's prepays (circular commodity sales which moved debt off the balance sheet and generated funds flow) look very similar to Lehman's Repo 105s (short-term loans secured with a transfer of securities treated as a sale of securities). The mispriced investments and derivatives at Enron look similar to mortgage-backed securities at banks or companies with a disproportionate amount of Level 3 fair-value assets (illiquid assets with highly subjective estimated values). Enron's $35 billion in off-balance sheet debt looks puny compared to the $1.1 trillion of off-balance sheet debt at Citi in 2007. Enron did not pay income taxes in four of its last five years, and GE pays little today. Banks are now engaging in "capital relief" deals that inflate regulatory capital in advance of the new Basel standards. Are these deals true risk transfers or are they cosmetic?

If regulation is not the answer, then how can corporations and society prevent fraud in the future? Fastow said we can begin by understanding that structured finance is like steroids: a little can cure many illnesses, but a lot can destroy your organs. Its use needs to be limited, and investments in firms that use structured vehicles without a clear business reason should be avoided. Mark-to-market accounting can lead to more transparent financial statements but, if abused, can put a company in a hole that it can't climb out of. The market must value transparency. Companies with the fairest disclosures must be rewarded, not placed at a disadvantage as is now the case. Finally, executives must ask whether a transaction is consistent with the principle and not just the rules. Are they doing it for window dressing or for valid business purposes?

It is critical for analysts, directors, and managers to maintain a certain sense of humility and to understand how human nature, competitive pressures, and a lack of clear guidelines can lead to potentially disastrous choices. And it is not just corporations that engage in these practices. Yes, Enron hid debt in derivatives. So did Greece.

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