Jim Grant — Lifelong Observer

Winter 2014

James Grant is the founder and editor of Grant’s Interest Rate Observer, a twice-monthly journal of the financial markets. After graduating from Indiana University with a degree in economics and Phi Beta Kappa accolades and earning a degree in international affairs from Columbia University, he began his journalistic career as a reporter for The Baltimore Sun and Barron’s. In 1983, he set out on his own, founding Grant’s. He has written several financial histories, biographies, and collections of Grant’s articles, as well as the introduction to the Sixth Edition of Security Analysis. In 2013, Grant was inducted into the Fixed Income Analysts Society Hall of Fame.

He is also a member of the Council on Foreign Relations and a trustee of the New York Historical Society.

Graham & Doddsville (G&D): What first drew you to the world of economics and what led you to pursue a career in journalism?

Jim Grant (JG): Circuitously, is how I arrived here. I was a serious teenage French horn player — serious and almost good enough to play professionally. Using a baseball analogy, I was just good enough to play in the Cape Cod League. So I went to Ithaca College to become a music teacher. I quit after one semester, served in the Navy, returned to civilian life as a clerk on a Wall Street bond desk, and went back to college, this time to study economics at Indiana University.

When the time came to get a job, I joined the staff of The Baltimore Sun — this was in 1972 — where I met my wife, Patricia, and discovered my vocation.

Financial news at The Baltimore Sun was the least prestigious job on the paper, a sure dead end. I didn’t know the phrase “contrary opinion” but I seemed to have had a bent for it. I took that job and a couple of years later went to Barron’s. That was in 1975. I was there about eight years. I wrote some editorials and originated the credit markets column, “Current Yield.” I quit in 1983 to found Grant’s.

G&D: What prompted you to start Grant’s?

JG: I picked the wrong side in an intramural argument at Barron’s. I had to leave. The question was, Where could I go? I decided to start my own paper rather than working for someone else’s. I had no idea what a brave plan that was. I started Grant’s with the $75,000 I’d accumulated in my Dow Jones profit-sharing plan.

That lasted just about 8 months. Subscribers were scarce, very scarce. It seems the world had enough to read even without Grant’s. I’d just published my first book, a biography of the investor Bernard Baruch, which did not set the world of literature on fire. Nor did Grant’s set the world of journalism on fire. Nothing was going well. We had two kids and not much money. My wife, a banker at Lehman Brothers, had all the courage I needed. She said, “Well, let’s persist,” and we did. We were lucky enough to find an angel investor named John Holman, now known on these premises as St. John. He invested $35,000 and that was all we needed. I must say, he made a pretty good investment. That was in 1984. My friend Lew Lehrman, a successful entrepreneur and a good investor, says that you’re not a true entrepreneur unless you nearly go broke twice. I’m still waiting for number two, but the first time was enough for me.

G&D: Who do you consider to be some of the main influences in your economic philosophy?

JG: In college, I loved the writing of John Kenneth Galbraith. My junior year at Indiana, I went to the American Economics Association annual meeting in Manhattan. I walked into a room and at the end of the room was an elevator. And in that elevator stood John Kenneth Galbraith himself, about seven feet tall. I was awestruck. Before very long, I am pleased to say, my tastes matured. I got interested in free market literature, laissez-faire literature, the Austrian approach — Hayek, Mises, Röpke, and the rest.

Good financial writing, to me, is good writing. I have tried to emulate the masters. Walter Bagehot, the great Victorian editor of The Economist, is one. I used to read old bound copies of The Economist in the New York Public Library, just glorying in Bagehot’s writing. Another is Frederic Bastiat, who urged his readers to look beyond that “which is seen” to that “which is not seen” — in other words, to imagine the unintended consequences of human action. I have learned from Henry Hazlitt, who wrote free-market editorials for The New York Times, if you can imagine that; John Brooks, author of Once in Golconda; and Bray Hammond, author of a wonderful history entitled Banks and Politics in America. Then there’s the great Fred Schwed, Jr., author of Where Are The Customers’ Yachts? It’s delightful, word for word among the wisest books ever written about Wall Street.

G&D: You mentioned Hayek and Mises. Why do you think the Austrians seem to be a source of controversy these days? Mainstream academia seems to write them off while others take them very seriously. What’s your take on Austrian economics and where do you think it is better or worse than traditional economics?

JG: First, let me say that no single canon of economic thought has all the answers. The Austrians preach freedom and the price mechanism, each of which is a fine cause. Then, too, Austrian doctrine puts interest rates at the center of the theory of the business cycle. Certainly, that rings a bell for someone whose publication has “interest rate” in its name.

G&D: In your “increasingly famous” cartoons, you frequently reference Ben Graham’s concept of Mr.

Market. How important to

you are Graham’s lessons and how do they apply in the modern world?

JG: Graham reminds us that markets are just as efficient as the people who operate in them. They — the people — overreact. They underreact. They try to follow their heads but they often follow their hearts. They ought to buy low and sell high, but they tend to wind up doing the opposite. Graham knew all about the emotional side of investing. Between the top of the stock market in 1929 and the bottom in 1932, his hedge fund was down by 70%. He picked himself up, dusted himself off, and wrote his magnum opus, Security Analysis. He might have given up, but he didn’t. By the way, Graham was a wonderful writer as well as an analyst. Security Analysis is a model of expository prose.

G&D: A lot of value investors have begun to fancy themselves macroeconomists of late. What do you think about value investors who are trying to be macroeconomists?

JG: Let me tell you first about the ones who refused to fancy themselves macroeconomists. Investors who turned a blind eye to credit — to monetary policy, to the Federal Reserve — didn’t notice the stupendous buildup of bad debt through 2007. They tended to own a lot of optically cheap financial stocks that got cheaper and cheaper until they weren’t there anymore. Seth Klarman, a renowned value investor, says that run-of-the-mill talk about the macroeconomic future reminds him of sports radio. Everyone has an opinion, and every opinion is equally valid, or invalid, or vapid. We can’t know the future. But we can observe the present. Sometimes interest rates and credit and the cycles of credit are more important than stock selection. That was true in 2007 and 2008, and it will no doubt be true again at some point.

Allow me to suggest a book on a related subject. It’s Oscar Morgenstern’s On the Accuracy of Economic Observations. The second edition came out fifty years ago. In it, Morgenstern exposes the errors and fallacies that riddle macroeconomic data. Don’t settle for what the data say, urges Morgenstern in so many words; ask what they mean. Marty Whitman, founder of the Third Avenue funds, has the same message for users of corporate financial information.

To take an example, the CPI says that prices are rising by a little less than 2% a year. Which prices? The ones in the index, of course. More specifically, the seasonally- adjusted and hedonically- adjusted ones in the index. It’s no easy thing to build a price index — the compilers must make all kinds of choices that may or may not comport with your own ideas of relevance and fairness. It’s no easy thing to interpret a price index, either. We shouldn’t be so quick to accept these figures at face value.

G&D: Howard Marks emphasizes not forecasting but simply knowing where you are in the economy.

JG: Exactly! We should be more like Henry Singleton, the CEO of Teledyne in the 1950s and 1960s. Singleton baffled his critics by doing what hadn’t been done before. For instance, he would purchase his own stock in the market when he judged it was unreasonably cheap. His critics demanded that he present a long-range corporate plan. Singleton replied that he had no plan and wanted none — the future was too full of surprises. His only plan, said the visionary, was to come to work in the morning with an open mind.

G&D: You have a whole team of analysts at Grant’s. How is the work organized and how does an issue of Grant’s come together?

JG: I sometimes wonder myself. Ideas come into the office; finished copy goes out. I write all the copy but by no means generate all of the ideas.

Our readers contribute some of our best ideas. In 2006, Alan Fournier, managing member of Pennant Capital Management, suggested that we look into mortgage derivatives. We did, under the somewhat uninviting page one headline, “Inside ACE Securities’ HEL Trust, Series 2005-HES.” It was the first of what proved to be many bearish stories on structured finance, mortgage derivatives and the like. By 2008, our readers were awfully glad we’d published them. I’ll be forever grateful to Alan for the idea and to Dan Gertner, a Grant’s analyst at the time, for doing the hard work. Dan was a chemical engineer by training. He had no experience with mortgage-backed securities. But he knew a bad idea when he saw one. It actually helped, I think, that he was not an expert in derivatives or structured finance. It was the mortgage experts who tried to tout us off the story. Nobody at Grant’s is an expert. We’re all generalists.

G&D: Do you prefer team members who come from economics or finance backgrounds?

JG: Yes. Smart people fit in well, too, as do those who are curious and tireless and can write good, sound sentences. We publish every other week and have for 30 years. I’m no longer surprised that we actually manage to produce a 12- page issue of Grant’s, though I am always grateful. I’ve got to say that ours is not the most electrifying newsroom you’ve ever walked into. It’s more like the reference room of a public library.

There are seven of us, not including the copy editor or the cartoonist, who work only on the days we go to press. There are three analysts: Evan Lorenz, David Peligal and Charley Grant (the last-named being my son). Del Coleman handles circulation, John McCarthy is the production chief and Eric Whitehead is the general administrator. If a subscriber needs a little encouragement to renew his subscription, he will hear from our discreetly persuasive marketing man, John D’Alberto. A proper issue of Grant’s is a little like a bride on her wedding day: something old (a little history), something new (never hurts in journalism), something borrowed (credit is our main subject) and something blue (we’ve been known to be bearish). The analysts submit memos, from which I write articles.

G&D: Given the extensive research in your memos and the very large bookshelf in your office, how much time do you devote to reading?

JG: I read when I’m not writing. As far as that goes, I read to write. I’m usually working on a book — a hobby, not a profit center, I can assure you. My new book is a history of the depression of 1920–21. It was the last laissez-faire depression in America. In response to a collapse in prices and a surge in unemployment, the administrations of Woodrow Wilson and Warren Harding balanced the budget and, through the Federal Reserve, raised interest rates. No “stimulus,” no TARP, no QE, no ZIRP. Yet the depression did come to an end (from top to bottom, it lasted for 18 months), after which the 1920s proverbially roared. There, I’ve given away the plot. Simon & Schuster will publish it in the fall.

G&D: Do you have any favorite books that you would recommend?

JG: Besides the titles listed on the Grant’s website, I’ll mention two. One is James Boswell’s 1791 Life of Samuel Johnson, a book about life and therefore about investing, although it contains no actionable stock ideas. A true category killer, Boswell managed to write the best biography in the English language that was also the first biography in the English language. I read it over and over. The other — a little different — is Banking and the Business Cycle, by C.A. Phillips, et al. To my mind, it’s the best contemporary analysis of the Great Depression.

G&D: Given your thoughts on the Fed and the gold standard, what did you think when Ron Paul suggested that if he were elected, he would name you Chairman of the Fed?

JG: Wise choice. And I can tell what I’d do. Day One, I would open the Fed’s very first Office of Unintended Consequences.

G&D: If you were president and could not nominate yourself as Fed Chairman, who would you nominate?

JG: My friend Lew Lehrman, whom I mentioned a moment ago. He made a lot of money by building up Rite Aid, which others subsequently unbuilt. He has devoted much of his life to studying monetary questions. He is the most knowledgeable and world- wise exponent of the gold standard in America.

G&D: What do you think it would take to move back to the gold standard?

JG: A clear demonstration that the non-gold standard isn’t working. For me, I’m already persuaded, though many seem not to be. The system in place is a system of price control and market manipulation. The Fed sets interest rates. It manipulates the stock market. It materializes trillions of new dollars. Unsound, I would call it, but the system does have its beneficiaries. Washington, D.C., is one. Greenwich, Connecticut, is another. Ultra-low interest rates and fast-paced money printing facilitate federal borrowing and lubricate leveraged finance. Ergo, both the government and Wall Street have a vested interest in not changing things. These are potent constituencies. Laura Ingalls Wilder illustrates the moral side of the monetary question in one of her Little House books. This one, entitled Farmer Boy, is set in upstate New York. One day, the protagonist is at the fair, and his father gives him a 50-cent piece. The father asks him, “You know what this is?” Silence. “Well it’s money. Do you know what money is?” Again, silence. “Money, son, is work.” Here’s the question: Is money work? Or is it an instrument of public policy? The voters will ultimately have to decide.

G&D: What would happen in the economy if the US and presumably at that point, the world, moved back to a gold standard? There are a lot of arguments that it would throw a wrench in the financial system, but in your opinion, what would that scenario look like?

JG: If I were king, or chairman, I would present the gold standard to the nation as a monetary system grounded in free markets and individual responsibility. The system we have is one of command and control. Sitting at the control panel are former tenured faculty members — the cream of the economics departments of the top universities. They do what they think is best. Here at Grant’s, we call it the Ph.D. standard. The FOMC has become a kind of seat-of-the-pants economic planning bureau. The gold standard, by contrast, operates through the price mechanism.

Money is defined in law as a weight of gold. Paper dollars are convertible into gold, and vice versa, at the fixed and statutory rate. Is that a good idea? It was a good and serviceable idea for most of American history and, as far as that goes, for most of the modern commercial history of the West. You asked about the “financial system.” Under the gold standard, banks were the property of the stockholders, not of the taxpayers. If a bank became impaired or insolvent, the stockholders got a capital call (that arrangement, called “double liability,” was phased out in the 1930s). I believe that that is the direction in which our financial reforms should be headed, not toward more regulatory micromanagement and not more monetary improvisation, or “learning by doing,” as Chairman Bernanke candidly styled QE, zero percent interest rates and the rest of it.

G&D: If you were to grade Ben Bernanke’s performance as Fed Chair, how would you evaluate him?

JG: I would say A for intentions, F for theory, C for short- and intermediate- term results. By results, I mean that the world turns on its axis; America is more prosperous than, say, France; and most people who want work seem to be able to find work. It’s a far cry, though, from dynamic American prosperity. As for the long-term costs of this extraordinary monetary experiment, I expect them to be sky high. I say that because price control doesn’t work. As far as I know, it has never worked. By controlling some prices, e.g., interest rates, you invariably distort others. The Fed is trying to fool Mother Nature.

G&D: Being a proponent of the gold standard, what do you think of Bitcoin?

JG: Bitcoin is a monetary cry for help by the technological elites. They don’t like the idea of government money in general, and they disapprove of QE and zero percent interest rates in particular. Their solution is a crypto-currency that governments can’t print. As an alternative, allow me to suggest a tangible monetary asset that governments can’t print. One which has been accepted as money for millennia, which is scarce, fungible, ductile, beautiful, and universally accepted as money. Hey, Silicon Valley: You’ll never lose gold on your hard drive.

G&D: You focus a lot on risks in the economy at large. How do you think investors should look at risk and reward and how does that compare to how central bankers should think about it?

JG: The manager of one of the world’s biggest hedge funds looked into the CNBC cameras the other day and said that risk is the volatility of returns. I would say — many value investors would agree — that risk is the likelihood of the permanent impairment of capital. In the case of a central banker, risk is a little different. As Ron Paul’s prospective Fed chairman, I would define risk as the chance that market intervention in whatever form winds up doing more harm than good.

G&D: Given the current state of the economy and the low interest rate environment, it sounds like you perceive risks that others do not. What facts, measures, or indications bother you most?

JG: Here’s a fact: China’s banking assets represent one-third of world GDP, whereas China’s economic output represents only 12% of world GDP. Never before has the world seen the likes of China’s credit bubble. It’s a clear and present danger for us all. And here’s a sign of the times: Amazon, with a trailing P/E multiple of more than 1,000, is preparing to build a new corporate headquarters in Seattle that may absorb more than 100% of cumulative net income since the company’s founding in 1994. Now, there are always things to worry about. Different today is the monetary policy backdrop. Which values are true? Which are inflated? In a time of zero percent interest rates, it’s not always easy to tell.

G&D: Where can the average investor find income?

JG: The average, risk-averse investor can’t. There’s none to be had, at least none in natural form. To generate yield, you must apply leverage. This is the stuff of businessman’s risk. A pair of examples: Annaly Capital Management (NYSE:NLY), a mortgage real estate investment trust, which changes hands at 83% of book value to yield 11.4%; and Blackstone Mortgage Trust (NYSE:BXMT), a new real estate finance company, which trades at 113% of book value to yield 6.43%. We judge both to be reasonable risks. More speculative, but — we think, also priced appropriately for the risk — are long-dated Puerto Rico general obligation bonds. The 5s of 2041 trade at 65.40 to yield a triple tax-exempt 8.18%. Widows and orphans stand clear.

G&D: What about the great debate over tapering?

JG: Grant’s is on record as saying that the Fed won’t taper. Or, that if it does taper, it will likely de- taper — i.e., reverse course to intervene once more — because the economic patient is hooked on stimulus.

The source of the Fed’s problem (which, of course, is everyone’s problem) is that there ought to be deflation. In a time of technological wonder, prices ought to fall, as they fell in the final quarter of the 19th century. As it costs less to produce things (and services), so it should cost less to buy them. In an attempt to force the price level higher by an arbitrary 2% a year, the central bank inevitably creates too much money. Those redundant dollars don’t disappear. They inflate something — and that something, these days, is investment assets. The Fed doesn’t seem to mind; higher stock prices are part and parcel of the central bankers’ recovery program. But when markets crash, the Fed returns to do more of what levitated those markets in the first place.

The central bank did it in the early 2000s to bind up the wounds of the dot-com crash; and, of course, it’s repeated the treatment, only with much heavier does, from 2009 to date. Observe that ultra-low interest rates encourage debt formation. The trouble with debt is that it tends to be deflationary. Leveraged firms tend to overproduce in order to generate the revenue with which to remain solvent. Overproduction presses down on prices. Easy access to speculative credit prolongs the life of marginal firms. They don’t go broke but continue to produce, thereby adding to the physical volume of production and so to the overhead weight on prices. Debt is deflationary the more it drives production or the more it inhibits consumption. You see the problem. The Fed is egging on inflation with one hand but suppressing it with the other. It materializes the dollars that drive some prices higher. It fosters the debt that drives other prices lower. What it refuses to do is let markets clear.

G&D: Do you think there’s a multi-year playbook that they’re following or is it more day- to-day?

JG: Well, if they’re “data- dependent,” as they insist they are, they’re just as good as the quality of their data. And they’re just as good as the soundness of their theories. In short — by my lights — they’re not very good.

G&D: Where in the world do you see there being attractive investment opportunities right now?

JG: We are finding it harder to find good long ideas, easier to find good short ideas. Years ago, when I believed I could predict the future, I would have answered your question by declaring that the top is in: Sell everything! Older and — maybe — wiser, I know that I don’t know that the top is in. What I think I know is that risk increasingly overshadows reward in stocks and bonds alike.

G&D: Have you tracked the returns of the investment ideas that you include in Grant’s?

JG: No. I’m not sure which is harder, investing or writing about investing. What I do know is that they are different. For a decade and more, Alex Porter and I were the general partners of Nippon Partners, a long- only partnership that invested in Japan. We worked hard at securities analysis and portfolio management, but we didn’t have to publish our findings, in scintillating prose (complete with a funny cartoon) every two weeks. At Grant’s, we analyze securities and we comment on credit and on China and on the prices of modern art and on anything else that strikes our fancy. But we manage no portfolios. We size no positions. We hedge no currencies. I don’t track our returns because they wouldn’t be returns. They would a journalist’s idea of returns.

G&D: There are some who compare journalism and investing. In fact there’s the notion that being an investor is like being an editorialist because you have to find the facts and then connect them to form an argument or opinion.

JG: Plenty of people leave journalism to go to Wall Street and find that investing is not as easy as it seemed while they were writing about it. And there are plenty of people who invest for a living whose annual letters are fun to read only because the first paragraph says, “Dear investor, we were up 46% this year.” Beautiful prose.

G&D: How do you manage to maintain a healthy skepticism without becoming overly cynical?

JG: It can be hard. To anyone who was bearish on the dot-com mania, as I was, the year 1998 lasted for about 6 years; 1999 dragged on, seemingly, for another 15 years. But then, blessedly, came the year 2000. You start rooting for bad things. A friend of mine and a fine investor, Frederick E. “Shad” Rowe, calls himself a recovering short seller. Shad was bearish with the rest of us skeptics and cynics in the late 1980s and very early 1990s. Then he turned bullish, did very well, and became much happier. His mother was the inspiration for one of my favorite Grant’s cartoons. A married couple is seen in the family kitchen. They happen to be bears. She is laying a paw consolingly over his shoulder. Obviously, the market has been soaring. “Don’t worry cupcake,” she is saying. “I just know something terrible is going to happen.”

I am cyclically bearish and permanently — temperamentally — skeptical. But one has to navigate this terrain between cynicism and skepticism. One cannot be bearish on life, and I’m happy to say that I’m not.

G&D: What advice do you have for students or investors in the early stages of their career?

JG: See the older gent walking down the street, the one not checking a mobile device? He has money, security, position. In short, he possesses everything you don’t have and desperately want. But do you know something? The elderly gent would give his money, security and position for your bounding energy, full head of hair and limitless prospects. You should enjoy them!

G&D: Thank you very much for your time, Mr. Grant.