Tag Archives: Reisman

Understand Why Profit Margins Will Collapse

CP and GDP

Today, staring fixedly back at the road they just traveled, most investors have rosy expectations. A … survey released in July shows that the least experienced investors – those who have invested for less than five years – expect annual returns over the next ten years of 22.6%. Even those who have invested for more than 20 years are expecting 12.9%. Now, I’d like to argue that we can’t come even remotely close to that 12.9% … In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. … Maybe you’d like to argue a different case. Fair enough. But give me your assumptions.

If you think the American public is going to make 12% a year in stocks, I think you have to say, for example, “Well, that’s because I expect GDP to grow at 10% a year, dividends to add two percentage points to returns, and interest rates to stay at a constant level.” Or you’ve got to rearrange these key variables in some other manner. The Tinker Bell approach – clap if you believe – just won’t cut it. — Warren Buffett

“Mr Buffett on the Stock Market” (Fortune, 22 November 1999)

Buffett_on_1999_Stock_Market_-_Fortune_Article & 2008 Market Call

A reader, Ruben, kindly pointed out Reisman’s book, Capitalism (see link below) and Chapter 16, The Net-Consumption/Net-Investment Theory of Profit and Interest.  

I have recommended the book, but I had not read Chapter 16. Thank heavens for the heads up. Now I am clear why HIGH profits are negative for the economy and why–unless deficit spending, money printing or QE INCREASE–then corporate profit margins will collapse, perhaps violently like in 2008/09–see chart above. You can understand the decision of CEOs not to invest much in the future while taking on debt to buy-in their shares.

From Chris Leithner’s letter on profit margins: http://www.leithner.com.au/newsletter/feb13_newsletter.pdf

Why is profit presently at a record high?

Because private domestic fixed investment stands at an all-time (since 1947) low; the supply of money as a percentage of GDP has reached a 40-year high; the government’s deficit has scaled unprecedented heights; and the government’s debt relative to GDP has returned to a level unknown since the Second World War. In short, the sickness – and NOT the strength – of the U.S. economy explains why profit has attained an unparalleled level. Capitalists’ saving, investment and pursuit of profit is the key to a higher standard of living. Their achievement of very high profits, on the other hand, reflects their fear of the future, particularly of the actions of the state (which Robert Higgs dubs regime uncertainty).

Reisman shows that a high rate of profit does not reflect a healthy pace of economic growth. Quite the contrary: it is a consequence of harmful circumstances – particularly unprecedented doses of the state’s monetary interventionism and fiscal profligacy. The mainstream does not grasp the fact that the existence of high profits is not (from the point of view of society as a whole) economically beneficial. It does not realise that to a significant extent the profits of recent decades are – because they derive from the government’s deficits and inflation – artificial and fraudulent (see pp. 26-27, 514-517, 927-928 and 957-963 in Capitalism by Reisman).

Implications for Investors

If (1) Reisman is correct, (2) I have understood him correctly and (3) deficits and debt cannot rise forever, then (4) at some point profits will cease to rise ever further into the stratosphere. The critical question is: will they plateau, recede gradually (i.e., as a result of the Fed’s astute “withdrawal of stimulus” and a “grand bargain” in the Congress) or abruptly (i.e., through a crisis)? Whether gradual or sudden, the end of unprecedented monetary and fiscal interventionism implies poorer profits; and if earnings drive stocks’ prices, as the mainstream stoutly maintains (they’ll likely change their mind if and when profits change course), then significantly smaller profits mean considerably lower prices. Perhaps shrunken profits and prices will encourage the mainstream finally to recognize the egregious errors they have committed for decades. In Marshall Auerback’s words (Are US Corporate Profits Inflated by Fraud? 18 January 2013), “it may be that investors will never know or care that U.S. corporate profits are greatly inflated by … fraud. But it is possible that such a reality may matter someday. It would be a negative for U.S. equity prices.” That’s putting it mildly.

If you only learn one thing this month let it be the concepts in Chapter 16 in – George Reisman’s book Capitalism: http://mises.org/books/capitalism.pdf

You can also read the partially flawed (See Leithner’s critique) – James Montier’s chapters 43-44: http://www.wertpapier-forum.de/index.phpapp=core&module=attach&section=attach&attach_id=76874n on corporate profit margins.

Value Investors’ Second Quarter Commentaries; Letter to Buffett

Second Quarter Manager Commentaries



Weitz Annual Leter 2012

Weitz Value on Valeant Unique Pharmaceutical Company; owned also by Sequoia

Tweedy BrowneTweedy_Fund_CommentaryQ_2

FPA: crescent-2012-q2-final

Davis Funds: Davis Funds 2011 Annual Report

Third Avenue Funds: TAF 2012 Semi Annual Report and Shareholder Letters  A good read for those interested in asset based investing. Marty discusses corporate finance.

Letter to Buffett

Reisman letter to Buffett  An interesting rebuke to Buffett’s demand to raise taxes on the rich (the result being a punishing loss for poor people due to less capital in the hands of private enterprise to raise productivity) and Buffett’s misunderstanding of his role as an investor in society.

Reisman’s main work: http://mises.org/document/1006/ Capitalism is also in the VALUE VAULT under Austrian Economics

You may disagree but interesting nonetheless.

Inflation and the Stock Market; Alice in Wonderland and the Federal Reserve; Recommended Blogs

Alice in Wonderland

“Well, in our country,” said Alice, still panting a little, “you’d generally get to somewhere else — if you ran very fast for a long time, as we’ve been doing.”

“A slow sort of country!” said the Queen. “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”
(Through the Looking Glass, Chapter 2)

Inflation and the Stock Market

It appears to me of preeminent importance to our science that we should become clear about the causal connections between goods. –Carl Menger, Principles of Economics.

A Reader asked about why I should be bullish about stocks with inflationary dangers like rising money supply numbers present and the Fed’s zero (0%) interest rate policy.

My reply is that I would rather own franchises that can pass along their costs (inflation pass-through) than just a basket of stocks. In severe inflation the goal is to lose less in real terms than holding other assets like bonds. We all lose as a society with rampant inflation, especially the poor and those on fixed incomes.  Also, in general, the context in which stocks rise is important.  See below.

The Stock Market and Inflationary Depression (page 938 in Capitalism by George Reisman—in VALUE VAULT).

The fact that inflation undermines capital formation has important implication for the performance of the stock market. In its initial phase or when it undergoes a sufficient and relatively unanticipated acceleration, inflation in the form of credit expansion can create a stock-market boom (Now in January 2012 we are seeing a NOMINAL boom not a REAL boom in stock prices). However, its longer-run effects are very different. The demand for common stocks depends on the availability of savings. In causing savings to fail to keep pace with the growth in the demand for consumer’s goods, inflation tends to prevent stock prices, as well as wage rates, from keeping pace with the rise in the prices of consumers’ goods. For a further explanation of this phenomenon go to Man, Economy and State by Murray Rothbard to read about the structure of production: pages 319 to 508 in the VALUE VAULT.  Also, The Structure of Production by Mark Skousen

The same consequence results from the fact that inflation also leads to funds being more urgently required internally by firms—to compensate for all the ways in which it causes replacement funds to become inadequate. At some point in an inflation, business firms that are normally suppliers of funds to the credit markets—in the form of time deposits, the purchase of commercial paper, the extension of receivables credit, and the like—are forced to retrench and, indeed, even to become demanders of loanable funds, in order to meet the needs of their own, internal operations. The effect of this is to reduce the availability of funds with which stocks can be purchased, and thus to cause stock prices to fall, or at least to lag all the more behind the prices of consumers’ goods.

When this situation exists in a pronounced form, it constitutes what has come to be called an “inflationary depression.” This is a state of affairs characterized by a still rapidly expanding quantity of money and rising prices and, at the same time, by an acute scarcity of capital funds. The scarcity of capital funds is manifested not only in badly lagging, or actually declining, securities markets but also in a so-called credit crunch i.e., a situation in which loanable funds become difficult or impossible to obtain. The result is wide-spread insolvencies and bankruptcies.


As a review and emphasis, read Buffett’s take on inflation and stocks: http://www.scribd.com/doc/65198264/Inflation-Swindles-the-Equity-Investor

Let’s take a step back from what you just read. If you know that money functions as a medium of exchange, then you realize in a modern society that money helps support the specialization of production and hence improves productivity. However, inflation—like dollar bills dropped into the jungle—does not per se increase savings and capital goods (stocks are titles to capital goods). Inflation, if unanticipated, artificially boosts stock prices and then eventually causes a decline because of the limited availability of real capital (bricks, trucks, machines) to reinvest (maintenance capital expenditures) into businesses AND, at the same time, consume consumer goods. In a finite world, you have to choose between mending your fishing nets or fishing to eat; you can’t do both unless you have a cache of fish saved.  Perhaps in the delusional world of a Federal Reserve bureacrat you can have your fish and eat it too–just print more.

Do not blindly believe inflation is “good” for stocks.

Other Views on Inflation and Stocks



Alice in Wonderland and the Federal Reserve


“The Federal Reserve, declaring that the economy would need help for years to come, said Wednesday it would extend by 18 months the period that it plans to hold down interest rates in an effort to spur growth.” (New York Times)

Illogic 101: Artificially low interest rates helped produce the crisis. Therefore the Fed will fix the economy by holding down interest rates for the foreseeable future.  (Give the drunk more booze to cure the hangover!)

The article below will help clarify the points made at the beginning of this post.

Interest Rates and the business cycle: http://www.thefreemanonline.org/columns/interest-rates-and-the-business-cycle/

by Glen Tenney • November 1994 • Vol. 44/Issue 11

The cause of the business cycle has long been debated by professional economists. Recurring successions of boom and bust have also mystified the lay person. Many questions persist. Are recessions caused by under consumption as the Keynesians would have us believe? If so, what causes masses of people to quit spending all at the same time? Or are recessions caused by too little money in the economy, as the monetarists teach? And how do we know how much money is too much or too little? Perhaps more importantly, are periodic recessions an inevitable consequence of a capitalist economy? Must we accept the horrors associated with recessions and depressions as a necessary part of living in a highly industrialized society?


New Money Gives a False Signal

Money is primarily a medium of exchange in the economy; and as such, its quantity does not have anything to do with the real quantity of employment and output in the economy. Of course, with more money in the economy, the prices of goods, services, and wages, will be higher; but the real quantities of the goods and services, and the real value of the wages will not necessarily change with an increase of money in the overall economy. But it is a mistake to think that a sudden increase in the supply of money would have no effect at all on economic activity. As Nobel Laureate Friedrich A. Hayek explained:

Everything depends on the point where the additional money is injected into circulation (or where the money is withdrawn from circulation), and the effects may be quite opposite according as the additional money comes first into the hands of traders and manufacturers or directly into the hands of salaried people employed by the state.2 [2]

Because the new money enters the market in a manner which is less than exactly proportional to existing money holdings and consumption/savings ratios, a monetary expansion in the economy does not affect all sectors of the economy at the same time or to the same degree. If the new money enters the market through the banking system or through the credit markets, interest rates will decline below the level that coordinates with the savings of individuals in the economy. Businessmen, who use the interest rate in determining the profitability of various investments, will anxiously take advantage of the lower interest rate by increasing investments in projects that were perceived as unprofitable using higher rates of interest.

The great Austrian economist Ludwig von Mises describes the increase in business activity as follows:

The lowering of the rate of interest stimulates economic activity. Projects which would not have been thought “profitable” if the rate of interest had not been influenced by the manipulation of the banks, and which, therefore, would not have been undertaken, are nevertheless found “profitable” and can be initiated.3 [3]

The word “profitable” was undoubtedly put in quotes by Mises because it is a mistake to think that government actions can actually increase overall profitability in the economy in such a manner. The folly of this situation is apparent when we realize that the lower interest rate was not the result of increased savings in the economy. The lower interest rate was a false signal. The consumption/ saving ratios of individuals and families in the economy have not necessarily changed, and so the total mount of total savings available for investment purposes has not necessarily increased, although it appears to businessmen that they have. Because the lower interest rate is a false indicator of more available capital, investments will be made in projects that are doomed to failure as the new money works its way through the economy.

Eventually, prices in general will rise in response to the new money. Firms that made investments in capital projects by relying on the bad information provided by the artificially low interest rate will find that they cannot complete their projects because of a lack of capital. As Murray Rothbard states:

The banks’ credit expansion had tampered with that indispensable “signal”-the interest rate—that tells businessmen how much savings are available and what length of projects will be profitable . . . . The situation is analogous to that of a contractor misled into believing that he has more building material than he really has and then awakening to find that he has used up all his material on a capacious foundation, with no material left to complete the house. Clearly, bank credit expansion cannot increase capital investment by one iota. Investment can still come only from savings.4 [4]

Capital-intensive industries are hurt the most under such a scenario, because small changes in interest rates make a big difference in profitability calculations due to the extended time element involved.

It is important to note that it is neither the amount of money in the economy, nor the general price level in the economy, that causes the problem. Professor Richard Ebeling describes the real problem as follows:

Now in fact, the relevant decisions market participants must make pertain not to changes in the “price level” but, instead, relate to the various relative prices that enter into production and consumption choices. But monetary increases have their peculiar effects precisely because they do not affect all prices simultaneously and proportionally.5 [5]

The fact that it takes time for the increase in the money supply to affect the various sectors of the economy causes the malinvestments which result in what is known as the business cycle.

Government Externalizes Uncertainty

Professor Roger Garrison has noted another way that government policy causes distortions in the economy by falsifying the interest rate.6 [6] In a situation where excessive government spending creates budget deficits, uncertainty in the economy is increased due to the fact that it is impossible for market participants to know how the budget shortfall will be financed. The government can either issue more debt, create more money by monetizing the debt, or raise taxes in some manner. Each of these approaches will redistribute wealth in society in different ways, but there is no way to know in advance which of these methods will be chosen.

One would think that this kind of increase in uncertainty in the market would increase the risk premium built into loan rates. But these additional risks, in the form of either price inflation or increased taxation are borne by all members of society rather than by just the holders of government securities. Because both the government’s ability to monetize the debt and its ability to tax generate burdens to all market participants in general rather than government bond holders alone, the yields on government securities do not accurately reflect these additional risks. These risks are effectively passed on or externalized to those who are not a part of the borrowing/lending transactions in which the government deals. The FDIC, which guarantees deposit accounts at taxpayer expense, further exacerbates the situation by leading savers to believe their savings are risk-free.

For our purposes here, the key concept to realize is the important function of interest rates in this whole scenario. Interest rates serve as a regulator in the economy in the sense that the height of the rates helps businessmen determine the proper level of investment to undertake. Anything in the economy that tends to lower the interest rate artificially will promote investments in projects that are not really profitable based upon the amount of capital being provided by savers who are the ones that forgo consumption because they deem it in their best interest to do so. This wedge that is driven between the natural rate of interest and the market rate of interest as reflected in loan rates can be the result of increases in the supply of fiat money or increases in uncertainty in the market which is not accurately reflected in loan rates. The manipulation of the interest rate is significant in both cases, and an artificial boom and subsequent bust is inevitably the result.


Changes in the supply of money in the economy do have an effect on real economic activity. This effect works through the medium of interest rates in causing fluctuations in business activity. When fiat money is provided to the market in the form of credit expansion through the banking system, business firms erroneously view this as an increase in the supply of capital. Due to the decreased interest rate in the loan market brought about by the fictitious “increase” in capital, businesses increase their investments in long-range projects that appear profitable. In addition, other factors as well can cause a discrepancy between the natural rate of interest and the rate which is paid in the loan market. Government policies with regard to debt creation, monetization, bank deposit guarantees, and taxation, can effectively externalize the risk associated with running budget deficits, thus artificially lowering loan rates in the market.

Either of these two influences on interest rates, or a combination of the two, can and do influence economic activity by inducing businesses to make investments that would otherwise not be made. Since real savings in the economy, however, do not increase due to these interventionist measures, the production structure is weakened and the business boom must ultimately give way to a bust. []

  1. For a detailed discussion of the phenomenon of interest and the corresponding relationship to the business cycle, see Ludwig you Mises, Human Action, 3d rev. ed. (Chicago: Contemporary Books, 1966), chapters 19-20; Murray N. Rothbard, Man, Economy, and State (Los Angeles: Nash Publishing Corporation, 1970), chapter 6 in Value Vault; and Mark Skousen, The Structure of Production (New York: New York University Press, 1990), chapter 9.
  2. Friedrich A. Hayek, Prices and Production, 2d ed. (London: George Routledge, 1931; Repr. New York: Augustus M. Kelley, 1967), p. 11.
  3. Ludwig von Mises, The Austrian Theory of the Trade Cycle (Auburn, Ala,: The Ludwig von Mises Institute, 1983), pp. 2-3.
  4. Rothbard, Man, Economy, and State, p. 857.
  5. Richard Ebeling, preface to The Austrian Theory of the Trade Cycle by Ludwig von Mises, Gottfried Haberler, Murray N. Rothbard, and Friedrich A. Hayek (Auburn, Ala.: The Ludwig von Mises Institute, 1983).
  6. Roger W. Garrison, “The Roaring 20s and the Bullish 80s: The Role of Government in Boom and Bust,” Critical Review 7, no. 2-3 (Spring-Summer 1993), pp. 259-276.

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Here is an investor who has the guts to put his work in the public domain. This is one way to track your thinking and investment progress.


For those who want to dig deeper, here are notes on Competition Demystified from an “Austrian” Value Investor.