More Debt, More Inflation: Japan's Counterexample

Japan has just announced a $490 billion support package to families and small businesses. This sizeable support structure is funded by more Japanese debt. While a few economists issue cries of concern about the size of the debt and the prospect of inflation, most economists and the Japanese lawmakers are unconcerned. With interest rates at 0% for 30 years, who could blame them? 

Yet the interesting part is that Japan's relative debt to GDP dwarfs that of the US. If more debt creates more inflation, why are these stimulus packages in Japan not creating more inflation? Yes, it is true that less immigration occurs in Japan and yes, it is also true that birthrates are lower. However, these factors do not seem capable of driving such an extraordinary difference in the mantra "more debt, more inflation."

Of course, no one truly knows the answer. That's part of the fun in opining on this process as opposed to advances in quantum computing or genetic engineering. However, for my part, I continue to see that more debt at some high level - such at 100% debt to GDP - slows the economy. In the famous equation that inflation equals money times velocity, it appears that increased money is thwarted by the slowing effects of massive debt on velocity numbers. The only chance of offset would be to use debt to fund productivity improvements, but increased productivity is incredibly unpopular - as we are seeing in India.

Is India the next China? The "Sacred" Productivity Problem

I have been spending more time thinking about India as a result of Modi's governance, investment observations of Indian leadership of American companies and personal interactions with Indians. As a friend of mine noted, "don't try to out trade people who invented numbers."

With that said, last weeks announcement that Prime Minister Nodi was abandoning the attempt to deregulate the agricultural sector. By bowing to the pressure of farmers, Modi has allowed incalculable damage to a people's ability to raise their standards of living. He complained that he "couldn't explain such a sacred thing to some farmers."

The phrase "sacred thing" is delightful. The truth is that gains in productivity fund increases in our standards of living. At the root of these increases are gains in agricultural productivity. While the US economy allowed the Great Depression to painfully shift employment into towns, Argentina stopped the transition. The result is that the US has gone on to gains, while Argentina has the most default-ridden of developed economies.

In the 2015 BRK annual report, Chairman Buffett writes (edited for brevity), "In 1900, America’s work force numbered 28 million. Of these, 40% worked in farming. The leading crop was corn. About 90 million acres were devoted to it and the yield was 30 bushels per acre. Then came the tractor. Today, we devote about 85 million acres to corn,but the yield is more than 150 bushels per acre - a five-fold gain. This is only half the story: The huge increases in output have been accompanied by a dramatic reduction in farmers. Today a tiny 2% of our 158-million-person work force farm - a twenty-fold gain." If farmers had been allowed to dictate (by democratic protests) this process, it is impossible to see how our standards of living would have improved without a basis in this 100-fold gain.

Interestingly, Modi was able to improve and simplify the tax system. Unlike the US which got rolled by the accounting profession into retaining nonsensical complexity, India now has a dramatically simplified system. However, without agricultural gains, India with its democracy seems a far less attractive investment space than China with its autocracy.

China Vs. US: Education

As China emphasizes "common prosperity," the leadership has cracked down on tutoring companies that provide educational advantages at great expense. The Chinese reaction to tutoring is that such education provides advantages available only to the wealthy. For such tutoring costs, families generally spend 20% of their income. 

It is interesting to see the same implicit "crackdown" occurring in the US. From the scandals around bought admissions to the removal of standardized tests, the leadership in the US is attempting to "level the playing field." Of course, admissions processes have long held a heavy hand in granting favor to those perceived to be operating at a disadvantage. 

But in China, ironically, the crackdown has impacted the private investor in tutoring companies while the changes occurring in US higher education has not affected private investment. The reason for this is that higher education has been purified of the private sector interests. 

It is clear to me that both systems are trying to emphasize a "meritocracy" approach and that the conviction of a system's worth has become a moral one - an increasingly murky distinction where self-rationalization and justification may be leading the way. Despite the structural weakness of the "meritocracy" thesis, its appeal is a potent force for investors and politicians. In this way, I am finding China and the US more common than different.

The "Real World" - more Meta?

For the past year, I have been emphasizing a movement from "physical" real estate to "digital" real estate. When I originally studied and valued Home Depot stock, I spent time studying the locations, the structures and the private valuations of those. This "physical" real estate anchored my understanding, valuation and analysis.

Since then, I have moved to the value of "digital" real estate, preferring digital real estate because of its scalability. Physical real estate became valuable due to its toll road nature, but that limitation also became a limitation in value. Digital real estate is expandable with little limitation on scale. This scalability creates an amazing "winner take all" characteristic powerful network effects drive a financially virtuous cycle of growth.

All of this converges with a growing sense that the "real world" is made up of an interplay between the two. This convergence has hit me as recently I have been considering the sale of my home. I received a beautifully written note from a realtor expressing interest in my "stunning, magical and picturesque" property and, based on her poetically stated interest, agreed to meet. 

I originally selected the property because of its connectivity in an active and busy area of town. However, as I watch the development of the digital world from Zoom to Instagram to LinkedIn to emails, I find that my main connectivity, especially during Covid-19, to be through the digital venue and my physical location was less significant. Perhaps the flight path of the jets of Love Field as well as my neighbor's daily obsession with gas-powered leaf dampened my ardor. Now I grapple with what is my best life?

I'm not sure yet, but I believe that physical real estate patterns will be affected on individual basis in the same way as retail space has been disrupted by Amazon. It seems as if the primary shift in residential will be a greater sprawl when suburban concepts are appealing. For those who are attracted to inner cities, the metrics are altered to an increase in space as office dedicated space is important. But it looks like the grind of daily suburban commutes are likely to be reduced.

A capstone of this trend is Facebook's recent pivot to the metaverse. As the physical and the digital converge, it seems clear to me that the metaverse will play a multidimensional approach like the facetime dynamic. The convenience factor will be important. Over time, there are signs that zoom, google meeting and skype are tiresome and awkward. Why not simply write a lovely note like this realtor? However, if the newly named Meta can drive interactions as easy as those between iPhone owners, then physical reality may become even less relevant and allow for an expanded suburbia.

Wage Push Inflation Sustainable?

Everyone sees the inflationary spike post-Covid (assuming that day arrives) and I think pretty much everyone assumed that it was likely to occur. However, the key phrase became "transitory" versus "permanent." I have been and am in the "transitory" camp, but have noted one flaw in my analysis.

Basically, I viewed a post-Covid world as one which returned to a pre-Covid world with significant tech improvements. These improvements are generally deflationary - greater communication, less travel and better technology (like docusigning etc). I recognized that there would be some inflationary impacts as some distancing measures and productivity losses held. 

However, my biggest blindspot was the reluctance of workers to simply return back to work. I was skeptical that subsidy checks would cause people to be reluctant to go back to work. Here I was wrong. In the 80s, I saw a strangely similar pattern. When realtors made six figure incomes in the real estate boom in the 80s, they were reluctant to work for anything less when the boom busted. Forever more, they saw themselves as six figure people.

Now a similar pattern seems to be showing up where people have received funds for no work and shifted a self-image to a much higher income to return to work. In response, businesses have simply stepped up wages and passed those on to customers - who assume these prices are temporary. I still believe that these prices are temporary and that higher wages will only drive higher productivity and a loss of some services jobs. If a wage push inflation is sustainable, bond and stock markets will be dislocated. In japan, there have been more jobs than workers for years, but inflation has not been sustainable.

Quality = Low Turnover

Increasingly I have focused my attention on the "own forever" principle. By evaluating such a permanent commitment, I am forced to focus on "quality." Quality companies are distinguished by several factors: 1) a business model that is durable, 2) an industry that is durable, 3) a strong balance sheet and 4) a willingness to suffer by making long term investments in the business. Such companies make for wonderful investment marriages when combined with a reasonable price. 

However my life is littered with a very different history. Having been trained in the school of Ben Graham, I have tended to look for that which is on sale. This excitement is the same as anyone might observe at a TJ Maxx. There is real pleasure in getting something that is genuinely needed at a significant discount. This warmth has a downside as the value is remembered long after the price is forgotten. By accumulating "sale price" goods, the investment portfolio is built of companies which grow slowly once the price has gotten to intrinsic value. The decision pathway becomes unattractive - either sell and pay taxes or keep and grow slowly. No good solution. 

I'm finding that such a pathway towards quality and low turnover is also important in every other area of my life. First of all, as a veteran of two divorces, clearly there are a set of characteristics for a quality spouse. Second, in the area of employees, there are also characteristics that make for a quality employee. Third, in terms of selecting a client base, the same can be held true. The emphasis should be the same: pay attention to the drivers of low turnover and high quality while avoiding short term excitement.

"Margin of Safety" Investment Stack

The three most important words for investing are "margin of safety." Benjamin Graham, who coined this phrase was essentially focused on the investment itself. For example, he liked an stock investment which cost less than the actual net cash of the underlying investment. This "tangible" value approach to investing was a way to preserve value through such disruptions as the Great Depression. Since then, the world has evolved away from "tangibles" to "intangibles" but the underlying principle has not changed.

Yet within investing there are several layers which create an "investment stack." The investment stack at the most fundamental is the business itself. There are a wide variety of estimating the the values, but the principle is to pay less than the value of the investment by a "margin of safety." In today's world, this is increasingly difficult and requires some conviction about the ability for rates to stay lower for longer.

The next level within the investment stack is at the portfolio level. This involves an asset class decision, such as an appropriate amount of cash, bonds and stocks. At this level, the portfolio has to exhibit a "margin of safety" so that the volatility of the portfolio performs adequately against required draw rates.

The final level within the investment stack is at the investor level. The investor is likely to experience changed requirements, such as those related to healthcare or other issues, as well as psychological issues during periods of extreme duress. If an investor is likely to get caught up in larger societal reactivity, the investor needs a "margin of safety" to address this. Reason does not win when faced with the overwhelming power of emotions. Here Socrates gave the two most important words "know thyself." 

When a "margin of safety" is the principle of construction at each level of the stack, the investment process is likely to be enjoyable as well as profitable.