崩溃！全球能力危机

GMO QUARTERLY LETTER July 2008 Meltdown! The Global Competence Crisis Jeremy Grantham “Nobody up there understands American capitalism.” Hyman Minsky1 The Confessions of an Optimist has arisen as a consequence. The Fed’s primary job I thought things would be bad enough but they turned out is really quite simple: Protect the integrity of the U.S. to be a lot worse. I thought a year ago we were looking at financial system. In this they have sadly failed. the “first truly global bubble” in asset prices. The credit The Fed and the Treasury have moved to bail out crisis looked to be so predictably powerful and unstoppable large financial corporations under the smoke screen then that I likened the experience to “watching a slow of a liquidity crisis. As is increasingly realized, it motion train wreck,” and I predicted that “one major bank was not a liquidity crisis primarily, but a solvency (broadly defined) will fail within 5 years,” for which I got crisis. Marked to market 6 months ago, Bear Stearns considerable grief as a doomsayer, as the less optimistic and Lehman were bankrupt as are Fannie and Freddie strategists usually do. Well a year later one bank failure today. The bailouts are really providing what amounts looks positively quaint as a prediction. Ironically for a to capital to insolvent firms as opposed to preventing “perma bear,” I underestimated in almost every way how the classic run on a bank as occurred in “It’s a badly economic and financial fundamentals would turn Wonderful Life,” where a bank goes bust through no out. Events must now be disturbing to everyone, and I for fault of its own. These bailouts permit a shameful one am officially scared! lack of accountability for reckless behavior.

A lot of this worsening situation was unpredictable, 2. Other central bankers and financial authorities also but some of our optimism I fear was caused by that old underperformed. The British dithered in crisis and, bugaboo, career risk, because our asset forecasts were together with the European Central Bank (ECB), more pessimistic than others and only half-believed by failed to move early against housing prices in the clients. Our low return forecasts only required that above U.K., Spain, and Ireland that rose far higher than average profit margins and P/E ratios revert to normal. those in the U.S.

The forecasts did not need any help from a very weak economy other than a slow unraveling of the credit boom. 3. China and several other emerging countries, by In our experience, the U.S. economy usually stepped allowing currency underpricing and huge trade around the land mines, but this time it has not been so surpluses, almost guaranteed eventual inflation, which lucky. These are some of the unexpected surprises: is now exported.

1. The Fed has lost more credibility and lost it faster 4. I had offered the price of oil as a probable paradigm than expected. Misreading or not seeing bubbles shift and suggested not going seriously short until at all was a key. It is becoming increasingly clear $100 in the January 2005 Barron’s when oil had just that extreme asset price surges are too dangerous to broken $50. Well, there is a big gap between “might” ignore. Greenspan’s self-serving drivel also did not reach $100 and actually reaching $150. Such high help. Nor did over-zealous bailouts or Bernanke’s and sustained prices act as a dangerously high tax underestimation – in world opinion – of inflation. The on consumers, particularly in the U.S., which is risk of international loss of confidence in the dollar shamefully only half as energy efficient per unit of 1 Hyman P. Minsky, “Can ‘It’ Happen Again?” Essays on Instability and Finance (Armonk, NY: M.E. Sharpe, 1982) 202.

GDP as Europe and Japan. The growing surpluses companies, instruments represented as cash-like, and of oil countries must be recycled, and this can be former stalwarts of prudence such as Citibank, UBS, destabilizing. and The Royal Bank of Scotland.

5. Almost all other commodities have also soared in 9. The emergence of Iran as a latent military target has price, transferring income to farmers and miners and become a potentially destabilizing factor, especially taking more buying power from consumers. for oil prices (or even oil availability) and the U.S.’s image globally.

6. Congress behaved at the lower end of its range of effectiveness. It overestimated corn-based ethanol, 10. A year ago I thought that the credit crisis would which is a minuscule help to gasoline but a strong drastically reduce the availability of “soft” loans with push on corn and other grain prices. Since ethanol few lender rights. I expected this to be a major threat creates more carbon dioxide than pumping oil, the to silly overleveraged deals such as 2006-07 vintage ethanol program is mainly another testimonial to the private equity. But second quarter loan growth did not agribusiness lobby. merely slow; it declined at an annualized rate of over 6%, the worst since consistent records started in the 7. China’s ability to sustain rapid growth and avoid a early 1970s. This threatens the well-being of not just serious stumble has become an article of faith that flaky companies but also more ordinary companies, in I was buying into without much skepticism.

But fact the whole economy. why? No sooner do we finish wallowing in the idea of Soviet incompetence than we start to believe that 11. It is quite well known that much of the world has been Chinese central planners can wonderfully manage living beyond its means in a short-term financial sense a complicated economy, growing unprecedentedly by increasing its consumer debt and by benefiting from fast and transforming overnight from a rural society excessive global money supply. Less well known to a capital-intensive industrial wonder using half of is that we have been collectively living beyond the some of the world’s resources. Economic logic and planet’s means by over-consuming finite resources. history suggest that their governmental interferences The disappointment here in the U.S. has been the will be sub-optimal, and that China’s current level chronic inability of government to get this point and, of investment will turn out to be dangerously high, in particular, to develop a serious long-term energy encouraging waste.

They continue to build basic policy. (See the attached Letters to the Investment capacity on automatic pilot even as they encounter Committee XV.) dangerous times for their export-led economy, since 12. Most dangerously, all of these factors interact, creating we are all facing the rising probability of a global a broad based – even global – vulnerability in the slowdown in economic growth and trade. China also financial system. Given the growing perception of has to deal with rising energy costs in their particularly incompetence that is broadly distributed throughout energy inefficient economy. Surely they will stumble. the system, we run a serious risk of a meltdown in And if we are all unlucky, they will stumble right into confidence in leadership totally unlike anything we the global credit crisis. have seen since World War II. And with substantial 8. Didn’t we all expect at least modest competence from justification!

Why should we trust the financial most of our financial companies? I always thought system the way we used to? We should distrust the it was the Bear Stearns of the world who knew what general competence of financial management: of was going on, and that when the music stopped, the governments and of corporations and of all bankers, financial junk would be safely (from our point of whether commercial, investment, or central bankers. view) in the hands of, say, Taiwanese banks. How did the guys who put some dead rats in the pot end Global asset prices, in complete contrast to these up eating some of their own stew? (To be charitable, unpleasant surprises in fundamentals, have been more or perhaps the head chefs did not realize that the less predictable. Some, like Chinese equities, have come kitchen staff was throwing in the odd rat to increase down much faster than I expected, and some, like U.K. their Christmas bonus!)

I never realized how far it house prices, have really taken their time. Also, junky, would reach: into municipal bonds, SIVs, insurance risky stocks have toughed it out far better than I believed GMO 2 Quarterly Letter – July 2008 likely or than the rest of the financial picture would have within a very positive long-term view. (See the attached suggested – they have held their own with the blue chips Letters to the Investment Committee XV.) – but this is, after all, the stock market and some surprises are expected. Summary and Recommendations Where does this leave me? Believing that asset prices Due to a combination of spectacular mismanagement will come down to fair price and below by about 2010, a by the authorities that resulted in very excessive and belief I have held since 1999. This means about a 10% dangerous speculation and very bad luck in the timing to 15% decline in the S&P by then (to about 1100) and a of commodity problems and over-rapid expansion of similar percentage decline for EAFE; about another 10% China, the fundamental global outlook is substantially decline in U.S. housing and perhaps a 40% decline in U.K. worse than expected.

These problems lower long-term housing, which is likely to take quite a while longer than asset values by a little and increase the chances of deeper 2010 to bottom out. Critically, overruns on the downside overruns and perhaps a faster trip to the lows. Our advice for all asset prices after a bubble breaks are much more until now was very simple: take as little risk as possible the rule than the exception! except for emerging markets. Now it is even simpler: take as little risk as possible.

So, in general, the unexpectedly bad fundamentals have not dramatically changed our asset class forecasts. Yes, The more complex issues, as always, involve timing. there has been an unexpectedly large bite taken out of the Both emerging markets and commodities (especially oil) net worth of financial companies. But other than that, it have a creative tension between the negative and risky is more that the probability has increased for longer and short term (1-2 years) and the attractive long-term (5deeper overruns below fair value and the chance of a 10 years) prospects. In the short term, slowing world “meltdown” substantially more rapid than my long-held economic growth combines with credit, currency, and suggestion of a leisurely move to a low in 2010 or later. inflation problems to dominate the outlook and offer poor prospects for emerging markets and commodities.

There is, though, one important change in our outlook for Longer term, the reverse is true and they look like emerging market equities. I still believe they will end the assets to own. But for those who can keep some up selling at a large P/E premium some time in the next of their powder dry, there are likely to be much better 5 years or so, for reasons outlined last quarter in “The investment opportunities in a year or two (or three) than Emerging Emerging Bubble.” What has changed is the we have seen for 20 years. Our motto should be: risk over the next couple of years. I now realize that in Don’t be brave, run away. an unexpectedly bad global economy, the combination of Live to fight another day. rising inflation, commodity dependence, and particularly high export ratios leave them more vulnerable than I had How Did Things Get So Bad? thought. Economically, most emerging countries really looked to have decoupled for 18 months as we slowed and At one level, we have spent 20 years or more digging our they did not. But in a global recession no one decouples. deep hole. We slowly and steadily lowered our financial As German, French, and British growth slowed rapidly standards and increased our debt leverage and our general in the last 6 weeks, a global slowdown looks more likely risk-taking in the ways predicted by the late but newly and more painful. To this end, we have done an about- famous Hyman Minsky. And we and a rapidly increasing face and lowered our weightings in emerging equities to number of others have commented quite bitterly on this neutral or just below. To critics of this change, I would long slide. cite the quote attributed to Keynes, caught in the same But what I think has been under analyzed is the proximate predicament: “When the facts change, I change my mind cause – the thing that really tipped us into the manure: a – what do you do, sir?” remarkable unwillingness of the authorities and financial leadership to believe that asset bubbles, however arrived Commodities do not play a very big part in our current at, always revert to normal. asset mix and more’s the pity, a clear mistake on our part.

If they did however, we would be reducing our exposure The first dramatic example of this disbelief in the and again expecting short-term 1- to 3-year price problems existence of bubbles was of course the internet and tech Quarterly Letter – July 2008 3 GMO bubble, with the market at 35x earnings (compared with frustrating. It’s almost as bad as struggling with the the 1929 and 1965 highs of 21x) and with the growth half efficient market hypothesis for 30 years, and is closely of the market at over 50x! Famously, our much praised related to it. As Kindleberger2 said, this kind of belief in Fed boss could see no bubble and respected the thousands efficiency that denies the existence of bubbles “ignores a of “well informed investors,” most of whom by then were condition for the sake of a theory.” To which I can’t resist actually playing musical chairs and momentum and could adding: Bubbles occur. They always burst. They always not have cared less about information! Having been a cause pain. Financial leaders, please wake up! cheerleader rather than a stern enforcer of standards, the Fed, as promised, rushed to provide help as that bubble The U.S. Housing Bubble and the Poor U.K. inevitably burst. This – as we all know to our cost – Well, it’s been an eventful 6 months in housing! Exhibit facilitated a much more dangerous bubble in housing. 1 shows our well-worn, but updated exhibit of the classic And again the Fed cheered the “ingenuity” of the sexy bubble in U.S. house prices that we have been showing new financial instruments, notably the asset-backed and for 3 years now. It is interesting to read how surprising subprime mortgage-backed paper. the U.S. house price decline has apparently been for If only financial lenders had understood the full many commentators. But in real life, it would have been consequences of the housing bubbles – that U.S. house far more than merely surprising, perhaps even unique, prices would decline by 25% or more and U.K. prices by if they had not declined, as our study of all similar 2-40% or more – they would have acted very differently. standard-deviation (40-year event) bubbles has indicated. Greenspan and Bernanke would have responded early and The reason house prices had never declined before was often to help shrink the volume of subprime mortgages that hitherto the U.S. housing market was very diverse, instead of emphasizing, as Bernanke did, the normalcy bubbling in one area while cooling in another. Uniquely of the market at its peak and the fact that U.S. house this time, the areas varied from red hot to merely warm, prices had never declined. If Hank Paulson had counted with the average deep in extreme bubble territory (the on a 30% decline, he would have foreseen a calamity 100-year event or 3 standard deviations from long-term for banks and related entities, since he especially must have known about the highly suspicious quality of the Exhibit 1 instruments. He would have known that Fannie and U.S. House Prices Will Continue to Decline Freddie, to be topical, at over 60x leverage obviously U.S. Median House Price/ did not have enough equity for this kind of decline. Had Median Family Income 4.0 he believed, he would have entered his job demanding Prices need to fall 17% tomorrow or immediate damage control and that much more equity stay flat for 4 years to reach fair value. 3.8 be raised rather than suggesting that all was well and 3 std dev contained. The big-wig bankers at Merrill, Citi, Lehman, 3.6 Bear Stearns, et al. could never have behaved the way 2 std dev they did had they understood the size of the likely drop 3.4 in housing values.

3.2 We now have several other big negatives that are unrelated 1 std dev (or only slightly related) to U.S. housing: commodity price 3.0 increases, rising inflation, and dollar problems. They will independently cause plenty of grief. But without the 2.8 U.S. (and soon the U.K.) housing issues, the pressure on the global financial system would have been manageable. 2.6 And without ignorant behavior around bubbles – the near certainty of their breaking and the damage they invariably 2.4 cause, especially in housing – most of our current near 1977 1981 1985 1989 1993 1997 2001 2005 disaster would have been avoided. It is all very, very Source: National Association of Realtors, U.S. Census Bureau, GMO As of 6/30/08 2 Charles P. Kindleberger, Manias, Panics, and Crashes: A History of Financial Crises (New York: John Wiley & Sons, 2005).

GMO 4 Quarterly Letter – July 2008 trend). From this extreme level, this bubble has burst Hall of Fame. It was no fantasy that the land under the quite rapidly, in fact about as rapidly as it went up, which Emperor’s palace really did equal the whole of California is also typical of large bubble events. In order for house at the peak prices. The current U.K. housing event had prices to reach normal from here, they must either decline become the biggest tease in bubble history, beginning to 17% immediately or experience 4 flat years while income decline almost 4 years ago, then putting together another catches up, or some combination. However, what we must 2-year rally before finally flagging this year. The bad worry about is the normal tendency for bubbles to overrun news is that as usual it will go all the way back to normal on the downside. Exhibit 2, my recent favorite exhibit, – which you can barely see from here – and very probably shows the dramatic differences between our housing will overrun just to rub it in. It will make our troubles look prices and those in the U.K. While the U.S. is a newcomer like a toothache to their hip replacement. Unfortunately to housing bubbles, the Brits are old pros. It’s practically for global financial well being, the U.K. is not Iceland, their national past time. They may not win at Wimbledon, but a major player in the global banking business, so the but they can do really good housing bubbles! 1973 and scale of the write-downs will produce yet another wave of 1989 were the peaks of two handsome, fairly symmetrical destabilization. housing bubbles in the U.K. Note in particular how the housing market reached fair value at trend in 1992 and In the U.K., house prices could easily decline 50% from overran considerably by 1996, which produced the lowest the peak, and at that lower level they would still be higher income multiples since the records began in 1950. We than they were in 1997 as a multiple of income! It is a had all been told that the 1989 U.K. prices were a new truly ugly thought that mortgage lenders and the guardians high plateau because they were no longer making any of the financial system seem never to have considered, at more land and certainly were not zoning any more old least until recent weeks. If prices go all the way back to land for housing. Presumably by 1997, they had decided trend, and history says that is extremely likely, then the to make some more after all. U.K. financial system will definitely need some serious bailouts and the global ripples will be substantial. Of all The U.K. housing event is probably second only to the the negative possibilities out there, and there are plenty, Japanese 1990 land bubble in the Real Estate Bubble real pain in this area is the most likely; I would say, nearly certain.

Exhibit 2 U.K. House Prices Will Really Decline! Thank Heaven for Optimists U.K. House Price George Soros has long believed in “Reflexivity,” a term he Multiple of Family Income uses to describe how even strange and irrational investment 6.5 Prices need to fall 38% tomorrow or beliefs can still impact and change reality. Seldom has stay flat for 7 years to reach fair value. this been demonstrated better than in the irrational belief 6.0 that the credit cycle’s problems were over late last year 5.5 and again in April this year. This belief allowed for two waves of capital raising by banks and related entities 5.0 from sovereign funds, institutions, and corporations, who assumed all the bad news was over and the price was 4.5 2 std dev right. Investors have been conditioned to buy the dips since 1982, because doing so was most often successful, 4.0 1 std dev notably so in the 1987 crash. But this time really is different, and the problems will be deeper and longer than 3.5 most investors even now expect. By the end, capital equal to a third of all the financial capital that existed in June 3.0 2007 may have been written off. At this level of reduced equity, the banking system could not function effectively.

2.5 Mar- 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08 I believe that realistic investors should have held back Source: Datastream from investing in weakened financial companies and As of 6/30/08 mostly still should. But we all need the financial system Quarterly Letter – July 2008 5 GMO to survive and function effectively, and to do this it needs roaring back. By May, most of our equity strategies were more capital. We have all benefited from the generous, down against their benchmarks. Reality, however, began if misguided, investments that have already taken place to bite in June and most of our equity strategies nosed and the increasingly reluctant ones that will continue to ahead and continued to run in early July. For the year, be made. So, to all you sovereign funds, private equity our Emerging and International Active strategies were funds, Bank of Americas, and shareholders who threw slightly behind, U.S. Core and Quality very slightly ahead, your money into overpriced banking stocks to provide and International Quant about 2 points ahead. Asset new capital, a heartfelt “Thank you!” from all of us. Allocation’s long-only strategies such as global balanced were slightly ahead, and our hedge strategies performed Recent Performance well in a difficult period. Multi-Strategy was up 6.5% for the year. We continue to have high expectations from our This year has not been without unexpected problems for very conservative disposition in equities, hedge strategies, us. Our fixed income difficulties from last year continued, and asset allocation. but now we believe, given higher yields on our asset-backed paper and the likelihood of being paid off, that Footnote: GMO’s 10-year Forecast from June 1998 we will get back over the coming months at least most of what we lost this year. There have been very good times and very bad times over the last decade, so it’s a reasonably appropriate moment In equities, all measures of value have had a very tough to look at the 10-year forecast we put out in June 1998. time globally, and the expected move to fundamental As you can see from Table 1, U.S. equity performance quality and away from riskier stocks has been very slight came in dead last out of 10 asset categories, as we and uneven, which is remarkable given the heightened suggested it would, but it was still 1.3% a year ahead of risk awareness in fixed income. The first week of the year our expectations. All of this outperformance resulted was phenomenally good in this respect, but in the months from profit margins that in June were still well above the following the Fed’s string of bailouts, risky stocks came long-term average, in our view unsustainably so. If profit Table 1 GMO 10-Year Forecasts for June 30, 1998 Forecasts from June 30, 1998 vs. actual as of June 30, 2008 GMO 10-Yr Forecast June '98 Estimated (% Real Actual Actual Asset Class Rank Return/Yr) 10-Yr Return* Rank Emerging Market Equities 1 7.0 13.4 1 U.S. REITs 2 5.2 7.4 2 Emerging Country Debt 3 4.9 6.9 3 International Small Cap 4 4.9 6.5 4 U.S. TIPS 5 3.8 4.8 5 Lehman Aggregate 6 2.6 2.7 7 EAFE 7 2.5 2.9 6 U.S. T-Bills 8 2.1 0.6 9 Foreign Bonds 9 2.0 2.2 8 S&P 500 10 -1.3 0.0 10 *Actual real index returns are for 6/30/98 to 6/30/08 period. Source: GMO GMO 6 Quarterly Letter – July 2008 margins were normal today, even with no shift in P/E to be raised to 7.0% – and the actual performance on the ratios, the last 10 years’ returns would have been 0.6% a NCREIF Timberland index came in at 6.0%, handsomely year behind our estimate. EAFE equities came in 0.4% ahead of the major asset classes.) a year ahead of expectations. Emerging equities that we ranked in first place indeed came in first, outperforming We so-called “perma bears” are criticized because – bless them – by 6.4% a year, ahead of our already strong negativity is unpleasant and off-putting to most investors. estimate. Although we were a little pessimistic in general, Most strategists, through this dismal 10 years for U.S. accounted for by remarkably strong ending margins, we equities, have been more or less “perma bulls.” Back in nailed the rankings with none of the 10 categories being 1998, they were arguing for a normal long-term return, more than 1 place from the correct ranking. (Forestry was that is to say about 7-8% real. If we feel that we have not a serious asset class 10 years ago but, for the record, been unduly optimistic, what must they feel? They really our forestry estimate was 5.0% real – shortly after that date do get away with murder!

Disclaimer: The views expressed are the views of Jeremy Grantham through the period ending July 25, 2008, and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.

Copyright © 2008 by GMO LLC. All rights reserved.

Quarterly Letter – July 2008 7 GMO GMO SPECIAL TOPIC July 2008 Letters to the Investment Committee XV* Living Beyond Our Means: Entering the Age of Limitations Jeremy Grantham “Wolf! Wolf!” Our current faith, though, is based on impressive data.

How many times over the last 200 years have gloomy Every commodity (with the clear exception of wood, economists predicted limitations to growth? And always and the possible exception of oil) has declined in real they were wrong. Science and human ingenuity always price for 200 years. These prices have fallen despite the came to the rescue. Instead of rising steadily in price, raw obvious truth that we try to use the most fertile soil first materials and food fell in real terms. And since hourly and find the shallowest oil, the thickest coal seams, and income rose, raw materials became ever more affordable the richest ores. Offsetting this pressure from naturally as the specter of starvation, although always around, rising marginal costs was a steady rise in technological steadily retreated. Food, for example, fell from 70% of progress: it became cheaper to drill ever deeper wells a typical American’s budget 200 years ago to about 10% because techniques for both locating and drilling oil today. And, every time a warning was redundant, the idea improved. And so it was with corn and copper and that science always wins and that the human brain and everything else. But it was not a natural law that this talent are boundless and can conquer all took deeper root. trend would continue indefinitely. It happened because We have learned in the stock market not to underestimate of the accidental confluence of favorable factors. As the power of repeated events to create a consensus. the world entered the technological and agricultural Humans are just plain eager to see patterns, and 200 years revolutions led by Britain in the 18th century, productivity of increasing plenty in the face of recurrent pessimism surged. Britain’s per capita wealth doubled in 100 years, is serious reinforcement indeed. It is hardly surprising, equaling the growth of at least the previous 1000 years. therefore, to find ourselves in a position where faith in our This doubling occurred in Germany in 70 years, and ability to rise above the planet’s limitations is complete. then eventually in Japan in 40, in South Korea in 30, and finally in China in 10 or 12. This acceleration reflected the It is believed today by just about everyone, smart or not, growing accumulation of advanced techniques that were well informed or not. And so it probably was with the exploited by the latest arrivals. The accumulated body of Mayans, whose civilization withstood the limitations science and technology was applied in each new country imposed by the local environment and other stresses for to economic and agricultural systems that had changed almost 1000 years. Yes, there were close calls, dreadful only slightly for the mass of people in thousands of droughts and wars, but with their boundless ingenuity years. This created a mass of low-hanging fruit and, with and a few human sacrifices, they scraped through over these easy pick-ups, populations could expand and grow and over again. A millennium must have left the Mayans wealthier simultaneously. The new arrivals to economic feeling that their prosperity was divinely endowed. But take-off helped sustain the momentum of the more mature eventually, despite their time-baked confidence, they countries such as the U.S. and European nations that were leaned a little too hard on their resources, the droughts growing at the boundaries of technology. Almost too lasted a little too long, and it all ended. good to be true, cumulative technological progress was a * The Letters to the Investment Committee series is designed for a very focused market: members of institutional committees who are well informed but non-investment professionals.

little faster than the increasing marginal costs of a world where a closely related culture existed for 3000 years. And now growing at a remarkable 3% a year. The real price let us assume, to simplify, that wealth could be defined as of commodities, defying the doomsayers, fell about 1.5% tangible, as the cubic capacity of possessions. If Ancient a year, a number that sounds small but is large enough to Egypt had started in 3000 BC with just 1 cubic meter of steadily increase global wealth. possessions and had grown them at 4.5% a year, sustained by technology and the unbounded inventiveness of man’s There were however, at least two worms in the apple. The brain, then man’s brain would have a major parking first is that if enough people enter economic take-off at problem to deal with. Egypt’s wealth would have grown approximately the same time, as 2.3 billion Chinese and from 1 cubic meter to 1067 cubic meters, an amount so vast Indians have now done, then the pressure on resources it could not be squeezed into the entire known universe! might happen to increase marginal costs slightly faster So let’s reverse engineer it. What growth could have been than technology could offset them. The second worm, sustained? At a lowly 1%, Egypt’s physical wealth would though, is much more serious: the developed world’s great have increased by more than 9 trillion times. Even at growth spurt has been facilitated by and sustained only at 1/10 of a percent, Egypt’s wealth would have multiplied the cost of eating through our patrimony, the incredibly by 20 times, very much more than they accomplished fortunate set of unique but finite resources that our planet but at least a level of growth in physical assets that the inherited utterly by chance: underground water resources planet could probably sustain for another 5000 or 10,000 that currently sustain some of our most productive land years. Not however, the kind of growth to which we but like a metronome tick off a reduction of several feet think we are entitled, and even then only possible if there each year; rain-fed waters that, although renewable, are were no simultaneous population growth. For the long-finite and already so overused that previously valuable term growth consequences for population are the same. lakes retreat to sometimes disastrous local effects and The world’s population, which is thought to have been river volumes, once seemingly limitless, are now fought about 15 million in 3000 BC, would have become 1.5 x over; subsoil, which took thousands of years to form, is 1020 at 1% growth or almost 150 million times 1 trillion depleted through casual use (In the Midwest, for every people by the time of Christ! And remember, this is a bushel of wheat produced, it is said that a bushel of subsoil growth rate in global population far less than the 1.5% in is lost. Our farmers are in the mining business! Yes, the my lifetime, and indeed close to that which Malthus was soil is incredibly deep, but it is still finite.); high-grade seeing when he wrote his famous “Essay on the Principle mineral ores are fully developed, the very best are long of Population” in 1798. gone, and all are irreplaceable; previously fertile land has often been overgrazed and turned into desert. I like to say that of course Malthus was right; he merely got his timing wrong. And even that comment might At the end of this list is the one we usually worry about be unfair. He argued that if population compounded the most: hydrocarbons. Here technology has remarkably at that rate in 1800, it would eventually get ahead of kept the life of resources from imploding. But there food supply. With the vision of quadrillions of people are limits, and we have reached them. Since 1974 the before us, after 3000 years at a mere 1%, it should be U.S., despite all investments and improved technology, easy to buy his argument. There would be nowhere to has steadily reduced oil output. Now the entire world stand, let alone grow food. Impatient as ever, we wanted routinely adds less oil to reserves than it pumps.

Malthus to be right immediately rather than realizing And you, of course, have heard it all before and dismiss that his argument draws its power from its inevitability, it. Well, let me give you a thought experiment to mentally not its immediacy. But, let’s look at Malthus’ argument chew on. For the last 2 years the world’s growth (of in more detail for a few minutes. From the 15 million goods and services) has grown at 4.5% a year. Since inhabitants of 3000 BC, population about doubled every we can convince ourselves that services like haircuts 1000 years with some spurts and setbacks until 1000 AD, that were once 50¢ (or $5 in today’s currency) are now when the world’s population was about 250 million. This “worth” $25 for an identical service, we had better limit 4000-year growth rate was coincidentally just a shade ourselves to goods, for they are what sustain us: food, over 0.1% a year.

It continued to grow at just over that clothing, housing, and vehicles. Let us imagine a long- rate, and by 1700 had doubled again in those 700 years. lived civilization. The longest lived is probably in Egypt, Then as the Industrial Revolution kicked in, observed by GMO 2 Letters to the Investment Committee XV, July 2008 Malthus, global population exploded: up over 10 times in Whatever the reasons, it looks increasingly as if global birth 300 years, more than the prior 3000 years had produced. rates will slow for a long time, and that before the end of Even in this explosive phase, it started relatively slowly, this century, and perhaps much sooner, global population at about 0.4% for the first 150 years and accelerated to will start to fall until once again we are below the long-0.8% for the second 150 years. And that was not the end, term sustainable capacity of Earth.

The critical period for in the last 70 years, it averaged over 1% and actually is precisely this century. We are living in a thoroughly peaked at over 2% – or at least we must pray it peaked – a dangerous and interesting phase where we determine how few years ago! much irreversible and semi-permanent damage we do to our planet and test our previously modest abilities to Malthus recognized that man’s ingenuity could increase cooperate and defer gratification for the greater good of agricultural output, as well he might, since he lived our future. through England’s agricultural revolution with “Turnip Townshend” and other gentlemen-scientist-farmers of In the meantime, we are living increasingly beyond our that era who pioneered crop rotation, fallow years, and means, and Mr. Market is about to help us reconsider nitrogen-fixing crops. On the positive side of the equation, our behavior.

This century will likely see the end of the he did not foresee what might be called “The Hydrocarbon Industrial Revolution and the age of “limitless resources.” Revolution,” in which a bountiful store of energy and Higher prices and (hopefully) voluntary improved behavior fertilizer could be unexpectedly used to muscle multiples will together usher in the post-Industrial Revolution phase of the output that mere brainpower could achieve. To be of limited resources and frugality. We will all modify our fair though, he also missed the comparable increases from behavior and probably quite fast. We will all re-adopt human engineered improved crops. On the negative side, Yankee virtues (or Yorkshire virtues, I might add) of his barely imagined worst nightmare of an accelerating “waste not, want not,” and get accustomed to using our growth in human population was exactly what came to brains instead of our hydrocarbon brawn. pass.

And, at anything like current or recent growth rates The prices of commodities are likely to crack short term in population, we will of course – guaranteed beyond (see first section of this letter), but this will be just a tease. all doubt – outrun all of our resources including simply In the next decades, the prices of all future raw materials the space to put ourselves, let alone our burgeoning will be priced as just what they are: irreplaceable. Oil, possessions. Indeed, if we were to try and go down that for example, will never again be priced on the marginal path, we would also guarantee the destruction of a great cost of pumping a marginal barrel from some giant Saudi majority of the planet’s diversity, quite probably including oil field, as has been the practice for most of the last 100 ourselves. years of oil production.

Real cost is always replacement Malthus’ second edition urged voluntary (“moral”) checks cost and oil, a precious feedstock for chemicals and on population growth but, since he considered man’s fertilizers, simply cannot be replaced. Using marginal sexual desire and fertility to be a given, he cannot have cost as a substitute was ignorant and conducive to wasteful been too confident. So Malthus expected that it was more consumption of scarce energy resources. It also enabled likely that humans, like rats, would multiply right up to us to put our collective head in the sand and ignore the the boundary of food supply and permanently stay there. growing need for an enlightened long-term energy and Into this ugly Malthus-was-right world, however, entered climate policy. a positive and unforeseen factor: a voluntary reduction in Relatively quickly, in 100 years or so, we will run out birth rate caused by two completely different reasons.

For of oil, underground water, and most non-fully-renewable agrarian societies, as abject poverty decreases, so does resources. At current rates, we will do it very, very fast. the need for the old age insurance that having 10 children A major complication now, though, is that we have been used to provide. Even more unexpectedly, for developed brainwashed by repetition to reject this whole idea as economies the second variable is the love of the good life. irretrievably pessimistic and defeatist, and just well ... What a delicious irony that the very factor that causes us thoroughly un-American. so much trouble in resource depletion and climate change will through a similar motive lead to fewer inconvenient One of the most unfortunate features of our sustained and expensive children! ability to overcome presumed limitations by applying Letters to the Investment Committee XV, July 2008 3 GMO technology is in the dangerous overconfidence it has been a critical difference between the Toyotas leading the given us, particularly in our casual and profligate use consumers and the GMs following them. of resources.

Starting now, higher prices will steadily overcome our optimistic assumptions and change our The American genius suited the era of the Industrial wasteful behavior. We must remember that, after all, in Revolution. As the Confederate General Forrest would the wolf story, the wolf finally comes. say, victory goes to those who get there first with the most. An age of limitations will be more like the “Tragedy of the Investment Implications Commons,” where uncontrolled and uncooperative access Looking ahead to the next several decades, investors to the common land resulted in sheep destroying grazing should be particularly interested in all finite raw land. The American hard-driving way has historically materials, especially land useful for farming or forestry, been to get the most darned sheep on the common first. and preferably in those emerging countries where one can Going forward, the types of problems we will have to deal stand the legal risks.

I would include water rights and with include climate change, environmental pollution, and water treatment in this category as well. resource limitation. They need broad-ranging thinking that must be long term and must put the common good There will also be a bottomless pit of investment above corporate interests. Unfettered capitalism, however opportunities in new technologies that address energy desirable in principle, can never handle these problems! It conservation, alternative energy (including nuclear), can never prevent over-grazing or over-fishing of common carbon extraction, and agricultural improvements property any more than it can handle over-carbonizing of (including new farming techniques that conserve land our common atmosphere. Whether the think tanks and and limit resource-intensive fertilizer as well as designer libertarians like it or not, tragedies of the commons need grains). enlightened government, cooperation, and leadership.

Those who are moving early on these issues are sending Other developed countries seemed to start this era a very positive signal to investors. They are showing a with more suitable predispositions for dealing with the willingness to think long term in a world increasingly problems we all face. Recent history in the U.S., with no fixated by next quarter’s earnings. They are, in my opinion sensible energy policy and failure of leadership in climate at least, flagging that they are quicker on the uptake and problems (including the lack of government assistance for simply better suited for success in the new era. That some alternative energy research), means we start the new race investors have shorter horizons than these progressive a few steps off the pace. The French famously derive companies do will almost certainly turn out to be a failing a nearly 8 times larger share of electricity from nuclear of investors and not the corporations! power than the U.S. The Germans have well over 8 Redesigning corporations for a resource-limited world times our share from solar and wind, in which they have will not be easy. They have been conditioned by a 25- become leaders. We must either change quickly, or we year credit expansion to think ... well, expansively. With will fall behind. The change will not be easy, for our faith this attitude, declining commodity prices for the first 20 in American ingenuity conquering all – if unfettered by years was strong reinforcement. “Top-line growth at all government – is very substantial, and we have not been in costs” and “the devil take the hindmost” were the slogans. the mood to make hard choices for some time. Congress’ And now, you can hear the gears grinding as the early attempt to scapegoat buyers of commodity futures as the handful realize the game has changed to careful, frugal, cause of the rise in oil prices, rather than their own vacuous and profitable growth. and weak-kneed lack of a long-term energy policy, is not a promising start. Nor is the fact that at the end of this This is not to say that all fault lies with corporations. year, Congress will have allowed subsidies for alternative Mostly the profligacy has been on the part of consumers, energy to expire while retaining subsidies for oil and gas. with their McMansions and Hummers, but there has still That’s right: they really don’t get it yet. But they will.

Disclaimer: The foregoing does not constitute an offer of any securities for sale. Past performance is not indicative of future results. The views expressed herein are those of Jeremy Grantham and GMO and are not intended as investment advice.

Copyright © 2008 by GMO LLC. All rights reserved.

GMO 4 Letters to the Investment Committee XV, July 2008