mispricing itself can change reality to some extent. Thus, investing itself can change the fundamental values. If this statement were true, reality would be shaped by the interests of financial markets as well as the other way around.That is what George Soros calls reflexivity. The momentum effect as a persistent market anomaly plays the role of an advocate diabolist and might help further researches to bet on the right horse and to develop a theory that improves the efficient allocation of capital in the interest of the whole economy. Finally, we must learn to be aware of our own fallibility. The progress of knowledge is framed not just by what we know, but also by gaining a better understanding of what we cannot know.

UNITED WE STAND: a strong EU for a better (economic) future

by Alberto Zaffaroni, 13th August 2011

The world’s largest professional services firm, PriceWaterhouseCoopers (Pwc) has recently published a paper, suggestively named “The world in 2050”, in which they forecast the paths that major world economies will follow in the next 40 years , in terms of GDP.

Largely expected, we’ll have to get used soon to the idea that US will no longer be on the edge of world economy, giving way to new industrial “monsters” as China and India. According to GDP data forecasts, China will overtake US approximately in 2018 and no later than 2045 it’ll be the turn of India to do the same. These historic over takings raise some first interesting questions about, for example, what changes they’ll bring in our lives and ways of looking at the world or, still, how US will interpret its new role in the world economic sphere.

But the research by Pwc goes further, showing the projections for other major economies’ performances. We can easily notice that China and India do not represent the only rollovers of the economic world as we know it. Brazil, Japan, Russia, Mexico and Indonesia will take the place of most European countries in the “top-10 GDP chart” by 2050. Brazil will overtake France and Great Britain in the next few years, following it will come the turn of Russia on Germany, then it’ll be up to Mexico on Italy and so on and so forth.

Clearly we must be prepared to this massive reversal of the “order of things” we’re now used to and somehow accept the new, marginal role that each European country, considered individually, will play on the stage of world economy.

But here’s the point. Naturally, if we consider each European country as an entity on its own, it will look like a gnome in front of giants as US, China, India or the other emerging economies. However, this is not the case if we apply the old adage “united we stand” to the European contest. In other words, if we take the GDP levels of the major European economies, as calculated by Pwc, and add them all up, the final data will lead to totally different conclusions.

Have a look at the following chart for a deeper persuasion:

As we can see, the last may not be the first this time, but surely they’ll still have something to say in the economic panorama. How to get this, then?

GDP LEVELS in 2050 (in billions of Dollars, according to Pwc’s research)

China: 59.475

India: 43.180

USA: 37.876

Main EU Countries: 20.477

Germany: 5.707

GB: 5.628

France: 5.344

Italy:3.798

Brazil: 9.762  

Japan: 7.664

Russia: 7.559

The answer’s to be found in something already existing, but maybe undervalued or culpably denied and its name is European Union. “United we stand”: the main European countries, a long long time ago, have already laid the foundations for this ambitious project of union, a marvelous machine, except refusing to give it the necessary fuel for an effective existence, i.e. sovereignty.

This is the time for strong and brave decisions, for the present, and most important, for the future. The chronicle of these black days for world and, especially, European economy is giving somehow a great chance and stimulus to European countries. It’s clear that nobody, at least in Europe, can stand alone the pressure of the moment on public finances and sovereign debt. Then, I personally welcome the strong intervention of the ECB in the last days with special reference to Italy and Spain, as an involuntary thrust in the direction that European country should take, based on two main pillars:

1) “Do what we didn’t want to some decades ago”, i.e. it’s time for European national governments to bravely but gradually give away more and more of their power so to pave the way for a true, unified, effective EU’s government, in charge of making homogeneous decisions for all the members.

2) “A EU ministry for economy and finance”. It seems that having a unique monetary policy but several fiscal policies leads to costs and obstacles higher than expected. Then, the only way to get out of this “impasse” may be to definitely give the power of decisions on European policies (both monetary and fiscal) to a superior, independent organism, responsible for the good health of all EU economy.

If we want to survive in the ocean of world economy, populated by fishes much bigger than us, than we have to make ourselves bigger and stronger too.

“United we stand” be our motto, politically and, above all, economically.

Alberto Zaffaroni 13/08/2011 Sources: Il Sole 24Ore and “The world in 2050” by Pwc

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September 6, 2009 How Did Economists Get It So Wrong?

By PAUL KRUGMAN I. MISTAKING BEAUTY FOR TRUTH

It’s hard to believe now, but not long ago economists were congratulating themselves over the success of their field. Those successes — or so they believed — were both theoretical and practical, leading to a golden era for the profession. On the theoretical side, they thought that they had resolved their internal disputes. Thus, in a 2008 paper titled “The State of Macro” (that is, macroeconomics, the study of big-picture issues like recessions), Olivier Blanchard of M.I.T., now the chief economist at the International Monetary Fund, declared that “the state of macro is good.” The battles of yesteryear, he said, were over, and there had been a “broad convergence of vision.” And in the real world, economists believed they had things under control: the “central problem of depression-prevention has been solved,” declared Robert Lucas of the University of Chicago in his 2003 presidential address to the American Economic Association. In 2004, Ben Bernanke, a former Princeton professor who is now the chairman of the Federal Reserve Board, celebrated the Great Moderation in economic performance over the previous two decades, which he attributed in part to improved economic policy making.

Last year, everything came apart.

Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy. During the golden years, financial economists came to believe that markets were inherently stable — indeed, that stocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year. Meanwhile, macroeconomists were divided in their views. But the main division was between those who insisted that free-market economies never go astray and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful Fed. Neither side was prepared to cope with an economy that went off the rails despite the Fed’s best efforts.

And in the wake of the crisis, the fault lines in the economics profession have yawned wider than ever. Lucas says the Obama administration’s stimulus plans are “schlock economics,” and his Chicago colleague John Cochrane says they’re based on discredited “fairy tales.” In response, Brad DeLong of the University of California, Berkeley, writes of the “intellectual collapse” of the Chicago School, and I myself have written that comments from Chicago economists are the product of a Dark Age of macroeconomics in which hard-won knowledge has been forgotten.

What happened to the economics profession? And where does it go from here?

As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. Until the Great Depression, most economists clung to a vision of capitalism as a perfect or nearly perfect system. That vision wasn’t sustainable in the face of mass unemployment, but as memories of the Depression faded, economists fell back

in love with the old, idealized vision of an economy in which rational individuals interact in

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in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with fancy equations. The renewed romance with the idealized market was, to be sure, partly a response to shifting political winds, partly a response to financial incentives. But while sabbaticals at the Hoover Institution and job opportunities on Wall Street are nothing to sneeze at, the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.

It’s much harder to say where the economics profession goes from here. But what’s almost certain is that economists will have to learn to live with messiness. That is, they will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic “theory of everything” is a long way off. In practical terms, this will translate into more cautious policy advice — and a reduced willingness to dismantle economic safeguards in the faith that markets will solve all problems.

II. FROM SMITH TO KEYNES AND BACK

The birth of economics as a discipline is usually credited to Adam Smith, who published “The Wealth of Nations” in 1776. Over the next 160 years an extensive body of economic theory was developed, whose central message was: Trust the market. Yes, economists admitted that there were cases in which markets might fail, of which the most important was the case of “externalities” — costs that people impose on others without paying the price, like traffic congestion or pollution. But the basic presumption of “neoclassical” economics (named after the late-19th-century theorists who elaborated on the concepts of their “classical” predecessors) was that we should have faith in the market system.

This faith was, however, shattered by the Great Depression. Actually, even in the face of total collapse some economists insisted that whatever happens in a market economy must be right: “Depressions are not simply evils,” declared Joseph Schumpeter in 1934 — 1934! They are, he added, “forms of something which has to be done.” But many, and eventually most, economists turned to the insights of John Maynard Keynes for both an explanation of what had happened and a solution to future depressions.

Keynes did not, despite what you may have heard, want the government to run the economy. He described his analysis in his 1936 masterwork, “The General Theory of Employment, Interest and Money,” as “moderately conservative in its implications.” He wanted to fix capitalism, not replace it. But he did challenge the notion that free-market economies can function without a minder, expressing particular contempt for financial markets, which he viewed as being dominated by short-term speculation with little regard for fundamentals. And he called for active government intervention — printing more money and, if necessary, spending heavily on public works — to fight unemployment during slumps.

It’s important to understand that Keynes did much more than make bold assertions. “The General

Theory” is a work of profound, deep analysis — analysis that persuaded the best young economists

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Theory” is a work of profound, deep analysis — analysis that persuaded the best young economists of the day. Yet the story of economics over the past half century is, to a large degree, the story of a retreat from Keynesianism and a return to neoclassicism. The neoclassical revival was initially led by Milton Friedman of the University of Chicago, who asserted as early as 1953 that neoclassical economics works well enough as a description of the way the economy actually functions to be “both extremely fruitful and deserving of much confidence.” But what about depressions?

Friedman’s counterattack against Keynes began with the doctrine known as monetarism. Monetarists didn’t disagree in principle with the idea that a market economy needs deliberate stabilization. “We are all Keynesians now,” Friedman once said, although he later claimed he was quoted out of context. Monetarists asserted, however, that a very limited, circumscribed form of government intervention — namely, instructing central banks to keep the nation’s money supply, the sum of cash in circulation and bank deposits, growing on a steady path — is all that’s required to prevent depressions. Famously, Friedman and his collaborator, Anna Schwartz, argued that if the Federal Reserve had done its job properly, the Great Depression would not have happened. Later, Friedman made a compelling case against any deliberate effort by government to push unemployment below its “natural” level (currently thought to be about 4.8 percent in the United States): excessively expansionary policies, he predicted, would lead to a combination of inflation and high unemployment — a prediction that was borne out by the stagflation of the 1970s, which greatly advanced the credibility of the anti-Keynesian movement.

Eventually, however, the anti-Keynesian counterrevolution went far beyond Friedman’s position, which came to seem relatively moderate compared with what his successors were saying. Among financial economists, Keynes’s disparaging vision of financial markets as a “casino” was replaced by “efficient market” theory, which asserted that financial markets always get asset prices right given the available information. Meanwhile, many macroeconomists completely rejected Keynes’s framework for understanding economic slumps. Some returned to the view of Schumpeter and other apologists for the Great Depression, viewing recessions as a good thing, part of the economy’s adjustment to change. And even those not willing to go that far argued that any attempt to fight an economic slump would do more harm than good.

Not all macroeconomists were willing to go down this road: many became self-described New Keynesians, who continued to believe in an active role for the government. Yet even they mostly accepted the notion that investors and consumers are rational and that markets generally get it right.

Of course, there were exceptions to these trends: a few economists challenged the assumption of rational behavior, questioned the belief that financial markets can be trusted and pointed to the long history of financial crises that had devastating economic consequences. But they were swimming against the tide, unable to make much headway against a pervasive and, in retrospect, foolish complacency.

III. PANGLOSSIAN FINANCE

In the 1930s, financial markets, for obvious reasons, didn’t get much respect. Keynes compared them to “those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those that he thinks likeliest to catch the fancy of the other competitors.”

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And Keynes considered it a very bad idea to let such markets, in which speculators spent their time chasing one another’s tails, dictate important business decisions: “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

By 1970 or so, however, the study of financial markets seemed to have been taken over by Voltaire’s Dr. Pangloss, who insisted that we live in the best of all possible worlds. Discussion of investor irrationality, of bubbles, of destructive speculation had virtually disappeared from academic discourse. The field was dominated by the “efficient-market hypothesis,” promulgated by Eugene Fama of the University of Chicago, which claims that financial markets price assets precisely at their intrinsic worth given all publicly available information. (The price of a company’s stock, for example, always accurately reflects the company’s value given the information available on the company’s earnings, its business prospects and so on.) And by the 1980s, finance economists, notably Michael Jensen of the Harvard Business School, were arguing that because financial markets always get prices right, the best thing corporate chieftains can do, not just for themselves but for the sake of the economy, is to maximize their stock prices. In other words, finance economists believed that we should put the capital development of the nation in the hands of what Keynes had called a “casino.”

It’s hard to argue that this transformation in the profession was driven by events. True, the memory of 1929 was gradually receding, but there continued to be bull markets, with widespread tales of speculative excess, followed by bear markets. In 1973-4, for example, stocks lost 48 percent of their value. And the 1987 stock crash, in which the Dow plunged nearly 23 percent in a day for no clear reason, should have raised at least a few doubts about market rationality.

These events, however, which Keynes would have considered evidence of the unreliability of markets, did little to blunt the force of a beautiful idea. The theoretical model that finance economists developed by assuming that every investor rationally balances risk against reward — the so-called Capital Asset Pricing Model, or CAPM (pronounced cap-em) — is wonderfully elegant. And if you accept its premises it’s also extremely useful. CAPM not only tells you how to choose your portfolio — even more important from the financial industry’s point of view, it tells you how to put a price on financial derivatives, claims on claims. The elegance and apparent usefulness of the new theory led to a string of Nobel prizes for its creators, and many of the theory’s adepts also received more mundane rewards: Armed with their new models and formidable math skills — the more arcane uses of CAPM require physicist-level computations — mild-mannered business-school professors could and did become Wall Street rocket scientists, earning Wall Street paychecks.

To be fair, finance theorists didn’t accept the efficient-market hypothesis merely because it was elegant, convenient and lucrative. They also produced a great deal of statistical evidence, which at first seemed strongly supportive. But this evidence was of an oddly limited form. Finance economists rarely asked the seemingly obvious (though not easily answered) question of whether asset prices made sense given real-world fundamentals like earnings. Instead, they asked only whether asset prices made sense given other asset prices. Larry Summers, now the top economic adviser in the Obama administration, once mocked finance professors with a parable about “ketchup economists” who “have shown that two-quart bottles of ketchup invariably sell for exactly twice as much as one-quart bottles of ketchup,” and conclude from this that the ketchup market is perfectly efficient.

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But neither this mockery nor more polite critiques from economists like Robert Shiller of Yale had much effect. Finance theorists continued to believe that their models were essentially right, and so did many people making real-world decisions. Not least among these was Alan Greenspan, who was then the Fed chairman and a long-time supporter of financial deregulation whose rejection of calls to rein in subprime lending or address the ever-inflating housing bubble rested in large part on the belief that modern financial economics had everything under control. There was a telling moment in 2005, at a conference held to honor Greenspan’s tenure at the Fed. One brave attendee, Raghuram Rajan (of the University of Chicago, surprisingly), presented a paper warning that the financial system was taking on potentially dangerous levels of risk. He was mocked by almost all present — including, by the way, Larry Summers, who dismissed his warnings as “misguided.”

By October of last year, however, Greenspan was admitting that he was in a state of “shocked disbelief,” because “the whole intellectual edifice” had “collapsed.” Since this collapse of the intellectual edifice was also a collapse of real-world markets, the result was a severe recession — the worst, by many measures, since the Great Depression. What should policy makers do? Unfortunately, macroeconomics, which should have been providing clear guidance about how to address the slumping economy, was in its own state of disarray.

IV. THE TROUBLE WITH MACRO

“We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time — perhaps for a long time.” So wrote John Maynard Keynes in an essay titled “The Great Slump of 1930,” in which he tried to explain the catastrophe then overtaking the world. And the world’s possibilities of wealth did indeed run to waste for a long time; it took World War II to bring the Great Depression to a definitive end.

Why was Keynes’s diagnosis of the Great Depression as a “colossal muddle” so compelling at first? And why did economics, circa 1975, divide into opposing camps over the value of Keynes’s views?

I like to explain the essence of Keynesian economics with a true story that also serves as a parable, a small-scale version of the messes that can afflict entire economies. Consider the travails of the Capitol Hill Baby-Sitting Co-op.

This co-op, whose problems were recounted in a 1977 article in The Journal of Money, Credit and Banking, was an association of about 150 young couples who agreed to help one another by baby- sitting for one another’s children when parents wanted a night out. To ensure that every couple did its fair share of baby-sitting, the co-op introduced a form of scrip: coupons made out of heavy pieces of paper, each entitling the bearer to one half-hour of sitting time. Initially, members received 20 coupons on joining and were required to return the same amount on departing the group.

Unfortunately, it turned out that the co-op’s members, on average, wanted to hold a reserve of more than 20 coupons, perhaps, in case they should want to go out several times in a row. As a result, relatively few people wanted to spend their scrip and go out, while many wanted to baby-sit so they could add to their hoard. But since baby-sitting opportunities arise only when someone goes out for the night, this meant that baby-sitting jobs were hard to find, which made members of the co-op even more reluctant to go out, making baby-sitting jobs even scarcer. . . .

In short, the co-op fell into a recession.

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O.K., what do you think of this story? Don’t dismiss it as silly and trivial: economists have used small-scale examples to shed light on big questions ever since Adam Smith saw the roots of economic progress in a pin factory, and they’re right to do so. The question is whether this particular example, in which a recession is a problem of inadequate demand — there isn’t enough demand for baby-sitting to provide jobs for everyone who wants one — gets at the essence of what happens in a recession.

Forty years ago most economists would have agreed with this interpretation. But since then macroeconomics has divided into two great factions: “saltwater” economists (mainly in coastal U.S. universities), who have a more or less Keynesian vision of what recessions are all about; and “freshwater” economists (mainly at inland schools), who consider that vision nonsense.

Freshwater economists are, essentially, neoclassical purists. They believe that all worthwhile economic analysis starts from the premise that people are rational and markets work, a premise violated by the story of the baby-sitting co-op. As they see it, a general lack of sufficient demand isn’t possible, because prices always move to match supply with demand. If people want more baby-sitting coupons, the value of those coupons will rise, so that they’re worth, say, 40 minutes of baby-sitting rather than half an hour — or, equivalently, the cost of an hours’ baby-sitting would fall from 2 coupons to 1.5. And that would solve the problem: the purchasing power of the coupons in circulation would have risen, so that people would feel no need to hoard more, and there would be no recession.

But don’t recessions look like periods in which there just isn’t enough demand to employ everyone willing to work? Appearances can be deceiving, say the freshwater theorists. Sound economics, in their view, says that overall failures of demand can’t happen — and that means that they don’t. Keynesian economics has been “proved false,” Cochrane, of the University of Chicago, says.

Yet recessions do happen. Why? In the 1970s the leading freshwater macroeconomist, the Nobel laureate Robert Lucas, argued that recessions were caused by temporary confusion: workers and companies had trouble distinguishing overall changes in the level of prices because of inflation or deflation from changes in their own particular business situation. And Lucas warned that any attempt to fight the business cycle would be counterproductive: activist policies, he argued, would just add to the confusion.

By the 1980s, however, even this severely limited acceptance of the idea that recessions are bad things had been rejected by many freshwater economists. Instead, the new leaders of the movement, especially Edward Prescott, who was then at the University of Minnesota (you can see where the freshwater moniker comes from), argued that price fluctuations and changes in demand actually had nothing to do with the business cycle. Rather, the business cycle reflects fluctuations in the rate of technological progress, which are amplified by the rational response of workers, who voluntarily work more when the environment is favorable and less when it’s unfavorable. Unemployment is a deliberate decision by workers to take time off.

Put baldly like that, this theory sounds foolish — was the Great Depression really the Great Vacation? And to be honest, I think it really is silly. But the basic premise of Prescott’s “real business cycle” theory was embedded in ingeniously constructed mathematical models, which were mapped onto real data using sophisticated statistical techniques, and the theory came to dominate the teaching of macroeconomics in many university departments. In 2004, reflecting the theory’s influence, Prescott shared a Nobel with Finn Kydland of Carnegie Mellon University.

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Meanwhile, saltwater economists balked. Where the freshwater economists were purists, saltwater economists were pragmatists. While economists like N. Gregory Mankiw at Harvard, Olivier Blanchard at M.I.T. and David Romer at the University of California, Berkeley, acknowledged that it was hard to reconcile a Keynesian demand-side view of recessions with neoclassical theory, they found the evidence that recessions are, in fact, demand-driven too compelling to reject. So they were willing to deviate from the assumption of perfect markets or perfect rationality, or both, adding enough imperfections to accommodate a more or less Keynesian view of recessions. And in the saltwater view, active policy to fight recessions remained desirable.

But the self-described New Keynesian economists weren’t immune to the charms of rational individuals and perfect markets. They tried to keep their deviations from neoclassical orthodoxy as limited as possible. This meant that there was no room in the prevailing models for such things as bubbles and banking-system collapse. The fact that such things continued to happen in the real world — there was a terrible financial and macroeconomic crisis in much of Asia in 1997-8 and a depression-level slump in Argentina in 2002 — wasn’t reflected in the mainstream of New Keynesian thinking.

Even so, you might have thought that the differing worldviews of freshwater and saltwater economists would have put them constantly at loggerheads over economic policy. Somewhat surprisingly, however, between around 1985 and 2007 the disputes between freshwater and saltwater economists were mainly about theory, not action. The reason, I believe, is that New Keynesians, unlike the original Keynesians, didn’t think fiscal policy — changes in government spending or taxes — was needed to fight recessions. They believed that monetary policy, administered by the technocrats at the Fed, could provide whatever remedies the economy needed. At a 90th birthday celebration for Milton Friedman, Ben Bernanke, formerly a more or less New Keynesian professor at Princeton, and by then a member of the Fed’s governing board, declared of the Great Depression: “You’re right. We did it. We’re very sorry. But thanks to you, it won’t happen again.” The clear message was that all you need to avoid depressions is a smarter Fed.

And as long as macroeconomic policy was left in the hands of the maestro Greenspan, without Keynesian-type stimulus programs, freshwater economists found little to complain about. (They didn’t believe that monetary policy did any good, but they didn’t believe it did any harm, either.)

It would take a crisis to reveal both how little common ground there was and how Panglossian even New Keynesian economics had become.

V. NOBODY COULD HAVE PREDICTED . . .

In recent, rueful economics discussions, an all-purpose punch line has become “nobody could have predicted. . . .” It’s what you say with regard to disasters that could have been predicted, should have been predicted and actually were predicted by a few economists who were scoffed at for their pains.

Take, for example, the precipitous rise and fall of housing prices. Some economists, notably Robert Shiller, did identify the bubble and warn of painful consequences if it were to burst. Yet key policy makers failed to see the obvious. In 2004, Alan Greenspan dismissed talk of a housing bubble: “a national severe price distortion,” he declared, was “most unlikely.” Home-price increases, Ben Bernanke said in 2005, “largely reflect strong economic fundamentals.”

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How did they miss the bubble? To be fair, interest rates were unusually low, possibly explaining part of the price rise. It may be that Greenspan and Bernanke also wanted to celebrate the Fed’s success in pulling the economy out of the 2001 recession; conceding that much of that success rested on the creation of a monstrous bubble would have placed a damper on the festivities.

But there was something else going on: a general belief that bubbles just don’t happen. What’s striking, when you reread Greenspan’s assurances, is that they weren’t based on evidence — they were based on the a priori assertion that there simply can’t be a bubble in housing. And the finance theorists were even more adamant on this point. In a 2007 interview, Eugene Fama, the father of the efficient-market hypothesis, declared that “the word ‘bubble’ drives me nuts,” and went on to explain why we can trust the housing market: “Housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.”

Indeed, home buyers generally do carefully compare prices — that is, they compare the price of their potential purchase with the prices of other houses. But this says nothing about whether the overall price of houses is justified. It’s ketchup economics, again: because a two-quart bottle of ketchup costs twice as much as a one-quart bottle, finance theorists declare that the price of ketchup must be right.

In short, the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place.

Now that the undiagnosed bubble has burst, the true riskiness of supposedly safe assets has been revealed and the financial system has demonstrated its fragility. U.S. households have seen $13 trillion in wealth evaporate. More than six million jobs have been lost, and the unemployment rate appears headed for its highest level since 1940. So what guidance does modern economics have to offer in our current predicament? And should we trust it?

VI. THE STIMULUS SQUABBLE

Between 1985 and 2007 a false peace settled over the field of macroeconomics. There hadn’t been any real convergence of views between the saltwater and freshwater factions. But these were the years of the Great Moderation — an extended period during which inflation was subdued and recessions were relatively mild. Saltwater economists believed that the Federal Reserve had everything under control. Freshwater economists didn’t think the Fed’s actions were actually beneficial, but they were willing to let matters lie.

But the crisis ended the phony peace. Suddenly the narrow, technocratic policies both sides were willing to accept were no longer sufficient — and the need for a broader policy response brought the old conflicts out into the open, fiercer than ever.

Why weren’t those narrow, technocratic policies sufficient? The answer, in a word, is zero.

During a normal recession, the Fed responds by buying Treasury bills — short-term government debt — from banks. This drives interest rates on government debt down; investors seeking a higher rate of return move into other assets, driving other interest rates down as well; and normally these lower interest rates eventually lead to an economic bounceback. The Fed dealt with the recession that began in 1990 by driving short-term interest rates from 9 percent down to

3 percent. It dealt with the recession that began in 2001 by driving rates from 6.5 percent to 1

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3 percent. It dealt with the recession that began in 2001 by driving rates from 6.5 percent to 1 percent. And it tried to deal with the current recession by driving rates down from 5.25 percent to zero.

But zero, it turned out, isn’t low enough to end this recession. And the Fed can’t push rates below zero, since at near-zero rates investors simply hoard cash rather than lending it out. So by late 2008, with interest rates basically at what macroeconomists call the “zero lower bound” even as the recession continued to deepen, conventional monetary policy had lost all traction.

Now what? This is the second time America has been up against the zero lower bound, the previous occasion being the Great Depression. And it was precisely the observation that there’s a lower bound to interest rates that led Keynes to advocate higher government spending: when monetary policy is ineffective and the private sector can’t be persuaded to spend more, the public sector must take its place in supporting the economy. Fiscal stimulus is the Keynesian answer to the kind of depression-type economic situation we’re currently in.

Such Keynesian thinking underlies the Obama administration’s economic policies — and the freshwater economists are furious. For 25 or so years they tolerated the Fed’s efforts to manage the economy, but a full-blown Keynesian resurgence was something entirely different. Back in 1980, Lucas, of the University of Chicago, wrote that Keynesian economics was so ludicrous that “at research seminars, people don’t take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another.” Admitting that Keynes was largely right, after all, would be too humiliating a comedown.

And so Chicago’s Cochrane, outraged at the idea that government spending could mitigate the latest recession, declared: “It’s not part of what anybody has taught graduate students since the 1960s. They [Keynesian ideas] are fairy tales that have been proved false. It is very comforting in times of stress to go back to the fairy tales we heard as children, but it doesn’t make them less false.” (It’s a mark of how deep the division between saltwater and freshwater runs that Cochrane doesn’t believe that “anybody” teaches ideas that are, in fact, taught in places like Princeton, M.I.T. and Harvard.)

Meanwhile, saltwater economists, who had comforted themselves with the belief that the great divide in macroeconomics was narrowing, were shocked to realize that freshwater economists hadn’t been listening at all. Freshwater economists who inveighed against the stimulus didn’t sound like scholars who had weighed Keynesian arguments and found them wanting. Rather, they sounded like people who had no idea what Keynesian economics was about, who were resurrecting pre-1930 fallacies in the belief that they were saying something new and profound.

And it wasn’t just Keynes whose ideas seemed to have been forgotten. As Brad DeLong of the University of California, Berkeley, has pointed out in his laments about the Chicago school’s “intellectual collapse,” the school’s current stance amounts to a wholesale rejection of Milton Friedman’s ideas, as well. Friedman believed that Fed policy rather than changes in government spending should be used to stabilize the economy, but he never asserted that an increase in government spending cannot, under any circumstances, increase employment. In fact, rereading Friedman’s 1970 summary of his ideas, “A Theoretical Framework for Monetary Analysis,” what’s striking is how Keynesian it seems.

And Friedman certainly never bought into the idea that mass unemployment represents a voluntary reduction in work effort or the idea that recessions are actually good for the economy.

Yet the current generation of freshwater economists has been making both arguments. Thus

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Yet the current generation of freshwater economists has been making both arguments. Thus Chicago’s Casey Mulligan suggests that unemployment is so high because many workers are choosing not to take jobs: “Employees face financial incentives that encourage them not to work . . . decreased employment is explained more by reductions in the supply of labor (the willingness of people to work) and less by the demand for labor (the number of workers that employers need to hire).” Mulligan has suggested, in particular, that workers are choosing to remain unemployed because that improves their odds of receiving mortgage relief. And Cochrane declares that high unemployment is actually good: “We should have a recession. People who spend their lives pounding nails in Nevada need something else to do.”

Personally, I think this is crazy. Why should it take mass unemployment across the whole nation to get carpenters to move out of Nevada? Can anyone seriously claim that we’ve lost 6.7 million jobs because fewer Americans want to work? But it was inevitable that freshwater economists would find themselves trapped in this cul-de-sac: if you start from the assumption that people are perfectly rational and markets are perfectly efficient, you have to conclude that unemployment is voluntary and recessions are desirable.

Yet if the crisis has pushed freshwater economists into absurdity, it has also created a lot of soul- searching among saltwater economists. Their framework, unlike that of the Chicago School, both allows for the possibility of involuntary unemployment and considers it a bad thing. But the New Keynesian models that have come to dominate teaching and research assume that people are perfectly rational and financial markets are perfectly efficient. To get anything like the current slump into their models, New Keynesians are forced to introduce some kind of fudge factor that for reasons unspecified temporarily depresses private spending. (I’ve done exactly that in some of my own work.) And if the analysis of where we are now rests on this fudge factor, how much confidence can we have in the models’ predictions about where we are going?

The state of macro, in short, is not good. So where does the profession go from here?

VII. FLAWS AND FRICTIONS

Economics, as a field, got in trouble because economists were seduced by the vision of a perfect, frictionless market system. If the profession is to redeem itself, it will have to reconcile itself to a less alluring vision — that of a market economy that has many virtues but that is also shot through with flaws and frictions. The good news is that we don’t have to start from scratch. Even during the heyday of perfect-market economics, there was a lot of work done on the ways in which the real economy deviated from the theoretical ideal. What’s probably going to happen now — in fact, it’s already happening — is that flaws-and-frictions economics will move from the periphery of economic analysis to its center.

There’s already a fairly well developed example of the kind of economics I have in mind: the school of thought known as behavioral finance. Practitioners of this approach emphasize two things. First, many real-world investors bear little resemblance to the cool calculators of efficient- market theory: they’re all too subject to herd behavior, to bouts of irrational exuberance and unwarranted panic. Second, even those who try to base their decisions on cool calculation often find that they can’t, that problems of trust, credibility and limited collateral force them to run with the herd.

On the first point: even during the heyday of the efficient-market hypothesis, it seemed obvious that many real-world investors aren’t as rational as the prevailing models assumed. Larry

Summers once began a paper on finance by declaring: “THERE ARE IDIOTS. Look around.” But

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Summers once began a paper on finance by declaring: “THERE ARE IDIOTS. Look around.” But what kind of idiots (the preferred term in the academic literature, actually, is “noise traders”) are we talking about? Behavioral finance, drawing on the broader movement known as behavioral economics, tries to answer that question by relating the apparent irrationality of investors to known biases in human cognition, like the tendency to care more about small losses than small gains or the tendency to extrapolate too readily from small samples (e.g., assuming that because home prices rose in the past few years, they’ll keep on rising).

Until the crisis, efficient-market advocates like Eugene Fama dismissed the evidence produced on behalf of behavioral finance as a collection of “curiosity items” of no real importance. That’s a much harder position to maintain now that the collapse of a vast bubble — a bubble correctly diagnosed by behavioral economists like Robert Shiller of Yale, who related it to past episodes of “irrational exuberance” — has brought the world economy to its knees.

On the second point: suppose that there are, indeed, idiots. How much do they matter? Not much, argued Milton Friedman in an influential 1953 paper: smart investors will make money by buying when the idiots sell and selling when they buy and will stabilize markets in the process. But the second strand of behavioral finance says that Friedman was wrong, that financial markets are sometimes highly unstable, and right now that view seems hard to reject.

Probably the most influential paper in this vein was a 1997 publication by Andrei Shleifer of Harvard and Robert Vishny of Chicago, which amounted to a formalization of the old line that “the market can stay irrational longer than you can stay solvent.” As they pointed out, arbitrageurs — the people who are supposed to buy low and sell high — need capital to do their jobs. And a severe plunge in asset prices, even if it makes no sense in terms of fundamentals, tends to deplete that capital. As a result, the smart money is forced out of the market, and prices may go into a downward spiral.

The spread of the current financial crisis seemed almost like an object lesson in the perils of financial instability. And the general ideas underlying models of financial instability have proved highly relevant to economic policy: a focus on the depleted capital of financial institutions helped guide policy actions taken after the fall of Lehman, and it looks (cross your fingers) as if these actions successfully headed off an even bigger financial collapse.

Meanwhile, what about macroeconomics? Recent events have pretty decisively refuted the idea that recessions are an optimal response to fluctuations in the rate of technological progress; a more or less Keynesian view is the only plausible game in town. Yet standard New Keynesian models left no room for a crisis like the one we’re having, because those models generally accepted the efficient-market view of the financial sector.

There were some exceptions. One line of work, pioneered by none other than Ben Bernanke working with Mark Gertler of New York University, emphasized the way the lack of sufficient collateral can hinder the ability of businesses to raise funds and pursue investment opportunities. A related line of work, largely established by my Princeton colleague Nobuhiro Kiyotaki and John Moore of the London School of Economics, argued that prices of assets such as real estate can suffer self-reinforcing plunges that in turn depress the economy as a whole. But until now the impact of dysfunctional finance hasn’t been at the core even of Keynesian economics. Clearly, that has to change.

VIII. RE-EMBRACING KEYNES

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So here’s what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit — and this will be very hard for the people who giggled and whispered over Keynes — that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they’ll have to do their best to incorporate the realities of finance into macroeconomics.

Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: “There is always an easy solution to every human problem — neat, plausible and wrong.”

When it comes to the all-too-human problem of recessions and depressions, economists need to abandon the neat but wrong solution of assuming that everyone is rational and markets work perfectly. The vision that emerges as the profession rethinks its foundations may not be all that clear; it certainly won’t be neat; but we can hope that it will have the virtue of being at least partly right.

Paul Krugman is a Times Op-Ed columnist and winner of the 2008 Nobel Memorial Prize in Economic Science. His latest book is “The Return of Depression Economics and the Crisis of 2008.”

This article has been revised to reflect the following correction:

Correction: September 6, 2009 Because of an editing error, an article on Page 36 this weekend about the failure of economists to anticipate the latest recession misquotes the economist John Maynard Keynes, who compared the financial markets of the 1930s to newspaper beauty contests in which readers tried to correctly pick all six eventual winners. Keynes noted that a competitor did not have to pick “those faces which he himself finds prettiest, but those that he thinks likeliest to catch the fancy of the other competitors.” He did not say, “nor even those that he thinks likeliest to catch the fancy of other competitors.”

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BULL markets are about more than just rising prices. They create their own momentum, not to mention their own intellectual rationale (remember the “new era” talk of the late 1990s). When bull markets stop, those effects tend very quickly to go into reverse. The greater the excesses of the boom, the longer and deeper the reaction is likely to be.

The best known of these feedback loops is the use of borrowed money to buy assets. Rising prices make banks more willing to lend, creating more demand for the assets in question, pushing up prices even further and thereby appearing to ratify the original lending decisions of the banks. When markets fall this leverage works the other way, as could be seen when investors offloaded assets at fire-sale prices last year.

There are many other positive-feedback processes. Take share buy-backs, for instance. Companies used their cash (or borrowed money) to reduce their share capital. Markets might have treated this as evidence of a lack of imagination, or a paucity of profitable projects. Instead, they saw it as evidence that the managers were focusing on “shareholder value” and boosting earnings per share, however ephemeral that might have been.

By shrinking the supply of shares in the market, the buy-back splurge played its own part in prolonging the bull market. In America, Smithers & Co, a consultancy, says that net corporate buying of shares peaked at an annualised rate of around $1 trillion in late 2007. Companies were buying far more of their own shares than anyone else did. But the buying spree was unsustainable. Smithers calculates that American-owned companies were paying out some 70% of their profits at the peak, if you include dividends and buy-backs. They have since slashed dividends and will have to start issuing shares as well. Instead of borrowing money to pay back shareholders, companies now need to raise equity to pay back creditors.

The shift in the supply-demand balance is not confined to America. European companies have already raised a total of €56 billion ($76 billion) in rights issues this year, according to dealReporter, an information service. Robert Buckland, a strategist at Citigroup, says that British equity supply was shrinking at 4% per annum in early 2008, and is now growing by a similar amount. That is all down to financial companies, which have had to raise capital to repair their balance-sheets; net issuance from the rest of the market is basically flat.

The recent stockmarket rally has undoubtedly helped companies successfully issue shares. But it will also tempt more businesses to sell equities, putting a potential cap on the rally. As Mr Buckland puts it: “Equity issuance soaks up money that might otherwise have been used to drive the market higher.”

Another positive-feedback loop in bull markets used to be the final-salary pension fund. As share prices rose, pension schemes would move into surplus, allowing sponsoring companies to enjoy contribution holidays. That boosted both their cashflow and their profits, giving a further uplift to share prices. American companies could include an “expected return” from pension assets in their income statements, a return that drifted higher over the life of the bull market.

But a dismal decade for equities and low bond yields have now sent many companies into deficit. In Britain, under the fairly conservative assumptions used by the Pension Protection Fund, private-sector schemes had a deficit of £188 billion ($277 billion) in April. Having an exposure to a final-salary pension scheme is now a drag on a company’s share price, not a boon. BT, for example, is almost having to double its annual pensions contribution to £525m, a move that helped prompt a 59% decline in the British telecoms giant’s annual dividend.

Tax and regulation also work in a buoyant market’s favour. Booms tend to bolster tax revenues and make the government appreciate the virtues of the finance industry; cities compete to attract banks and asset managers by offering tax advantages and minimal regulation. When the bust comes, taxes rise and regulations are tightened. Activity slows and investment is discouraged.

All these effects can take many years to gain momentum, and help explain why bull markets can last much longer than observers expect. By the same token, however, when these processes go into reverse, they can also be self-perpetuating.And that is why there will have to be a lot more evidence than a couple of months of rising share prices before one can say that a new bull market is under way.

Economist.com/blogs/Buttonwood

Theory says that the past performance of share prices is no guide to the future. Practice says otherwise

Momentum in financial markets

Jan 6th 2011 | from PRINT EDITION

WHAT goes up must come down. It is natural to assume that the law of gravity should also apply in financial markets. After all, isn’t the oldest piece of investment advice to buy low and sell high? But in 2010 European investors would have prospered by following a different rule. Anyone who bought the best-performing stocks of the previous year would have enjoyed returns more than 12 percentage points higher than someone who bought 2009’s worst performers.

This was not unusual. Since the 1980s academic studies have repeatedly shown that, on average, shares that have performed well in the recent past continue to do so for some time. Longer-term studies have confirmed that this “momentum” effect has been observable for much of the past century. Nor is the phenomenon confined to the stockmarket. Commodity prices and currencies are remarkably persistent, rising or falling for long periods.

The momentum effect drives a juggernaut through one of the tenets of finance theory, the efficient-market hypothesis. In its strongest form this states that past price movements should give no useful information about the future. Investors should have no logical reason to have preferred the winners of 2009 to the losers; both should be fairly priced already.

 

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Markets do throw up occasional anomalies—for instance, the outperformance of shares in January or their poor performance in the summer months—that may be too small or unreliable to exploit. But the momentum effect is huge. Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School (LBS) looked at the largest 100 stocks in the British market since 1900. They calculated the return from buying the 20 best performers over the past 12 months and then holding them, rebalancing the portfolio every month.

This produced an annual average of 10.3 percentage points more than a strategy of buying the previous 12 months’ worst performers. An investment of £1 in 1900 would have grown into £2.3m by the end of 2009; the same sum invested in the losers would have turned into just £49 (see chart 1).

Messrs Dimson, Marsh and Staunton applied a similar approach to 19 markets across the world and found a significant momentum effect in 18 of them, dating back to 1926 in America and 1975 in larger European markets. A study by AQR Capital Management, a hedge fund, found that the American stocks with the best momentum outperformed those with the worst by more than ten percentage points a year between 1927 and 2010 (see chart 2). AQR has set up a series of funds that attempt to exploit the momentum anomaly.

Too costly, too risky?

Even the high priests of efficient-market theory have acknowledged the momentum effect. Well-paid fund managers have spent decades trying to find ways to beat the market. But you have to wonder why they bother devoting so much money and effort to researching the fortunes of individual companies when the momentum approach appears to be easy to exploit and has been around for a long time.

Logic suggests that the effect should be arbitraged away. If the best performers of the past 12 months continue to do well, smart investors will buy them after 11 months have elapsed, reducing the returns on offer to those who wait the extra month. In turn, others will buy after ten months, then nine, eight and so on until the effect disappears.

When efficient-market theorists come across a market anomaly, they tend to dismiss it in one of three ways. The first argument is that the anomaly is a statistical quirk obtained by torturing the data; it will not persist. But the momentum effect was noticed in 1985 (by Werner de Bondt, a Belgian economist now at DePaul University in Chicago, and Richard Thaler, of the University of Chicago Booth School of Business) and has not gone away.

The second is that any gains from the strategy will be dissipated in higher trading costs. Clearly, the LBS team’s strategy of rebalancing a portfolio every month would be expensive but Mr Marsh says these would not offset an annual performance gap of over ten percentage points.

The third is that higher returns simply reflect the higher risks of the strategy. This has been used to explain away two other notable anomalies: the size and value effects. Small companies tend to do better than bigger ones in the long term, but they tend to be less diversified and therefore more risky. And shares that look cheap on conventional measures (asset value, dividend yield, price-earnings ratio) also tend to deliver above-average returns, but belong to firms that are likelier to go bust.

According to a paper by Cliff Asness, who co-founded AQR, the better performance of momentum stocks is not merely a reflection of higher risk. He finds that the momentum effect persisted even when the data were controlled for company size and value (defined as price-to-book) criteria. Another explanation is needed.

One possibility relates to timing. The efficient-market hypothesis assumes that new developments are instantly assimilated into asset prices. However, investors may be slow to adjust their opinions to fresh information. If they view a company unfavourably, they may dismiss an improvement in quarterly profits as a blip, rather than a change in trend. So momentum may simply represent the lag between beliefs and the new reality.

Once a trend is established, a share may benefit from a bandwagon effect. Professional fund managers have to prepare regular reports for clients on the progress of their portfolios. They will naturally want to demonstrate their skills by owning shares that have been rising in price and selling those that have been falling. This “window-dressing” may add to momentum. Paul Woolley of the London School of Economics has suggested that momentum might result from an agency problem. Investors reward fund managers who have recently beaten the market; such fund managers will inevitably own the most popular shares. As they get more money from clients, such managers will put more money into their favoured stocks, giving momentum an extra boost.

It is hardly a surprise that the momentum effect has been exploited by some professionals for decades. Commodity trading advisers (CTAs), also known as managed futures funds, exist to exploit the phenomenon. They take advantage of trends across a wide range of asset classes, including equities and currencies as well as raw materials. Martin Lueck was one of the three founders of AHL, one of the more successful CTAs, and now works for another trend-follower, Aspect Capital. “Trends occur because there is a disequilibrium between supply and demand,” he says. “The asset is trying to get from equilibrium price A to equilibrium price B.”

Many of the trend-following models were developed in the late 1970s and early 1980s. They were exploited by investors such as John Henry, best known outside the financial world for owning a baseball team, the Boston Red Sox, and a football club, Liverpool (which is on a downward trend of its own). One of the simplest was to buy an asset when the 20-day moving average of its price rose above its 200-day average. In a recent study Joëlle Miffre and Georgios Rallis of the Cass Business School in London found 13 profitable momentum strategies in commodity markets with an average annual return of 9.4% between 1979 and 2004.

Modern CTAs like Aspect and Winton (run by David Harding, another founder of AHL) devote a lot of effort to researching new ways of exploiting momentum. That has sometimes meant trading faster and faster, with a time horizon of milliseconds rather than months. However, not all market movements are part of a trend. Some are merely random fluctuations. “As you trade faster, it is easier to get misled by the noise,” says Mr Lueck. Trend-followers can get “whipsawed” in volatile markets, buying at the top of a short-term trend and then selling at a loss shortly afterwards.

That may be one reason why the momentum effect has not been arbitraged away: it can go horribly wrong. Just as trees do not grow to the sky, share prices do not rise for ever. The effect tends to work for the best performers over the past 12 months, but not for those that have shone for longer periods, say three or five years.

The value of value

That may be because of another anomaly, the value effect. Investors eventually get too pessimistic about struggling firms, and price their shares too cheaply. That turns them into bargains. Broadly, whereas momentum works over the short term, value is successful over longer periods. The result can be sharp reversals in markets—and nasty surprises for momentum traders. One such turning-point occurred in 2009. Investors who used a short-term momentum strategy, buying the winners of the previous six months, would have lost 46% in the British market and 53% in America, according to the LBS team. Similarly bad years were 1975, 2000 and 2003.

The momentum effect allows investors to get rich slowly. But many fund managers are impatient and thus use leverage (borrowed money) to enhance returns. Such an approach would lose so much money in bad years that clients might lose faith. “To exploit momentum, you need investors who understand the portfolio is going to be subject to a very high level of volatility,” says Mr Marsh of the LBS.

Momentum is so significant in stockmarkets that academics are starting to analyse what role it plays in professional fund managers’ returns. This is all part of the long process of removing the “magic” from financial performance. In the early days of fund management, in the 19th century, there were no stockmarket indices. Fund managers could thus claim that a positive return was down to their own brilliance, rather than a general rise of the market, and clients could not tell the difference.

After the development of benchmarks like the S&P 500, clients began to demand that fund managers proved their skill by outperforming an index. Many failed; but even some who succeeded may have done so by holding concentrated portfolios of only a few stocks. Such portfolios were more risky than the overall market. So the next step was to measure the managers’ performance after adjusting for risk. Even those managers may have done well because their investment style (value, for instance) was in fashion. So academics started to allow for that, too.

In effect, the portion of the investment return that was purely a result of fund managers’ skill was being reduced at every stage. Now, says Mr Marsh, academics are looking to see whether some outperformance is really all down to momentum.

All this analysis matters because these factors can be replicated. These days investors can not only match a benchmark through simple index-tracking funds; they can also own portfolios that exploit the value and momentum effects without paying hefty fund-management fees. The investment-management industry may become even more commoditised.

The momentum effect raises a further important issue. If markets are rational, as the efficient-market hypothesis assumed, then they will allocate capital to its most productive uses. But the momentum effect suggests that an irrationality might be at work; investors could be buying shares (and commodities) just because they have risen in price.

That would help explain why bubbles are created and why professional investors ended up allocating capital to dotcom companies with no earnings and business plans written on the back of a cigarette packet. Momentum can carry whole economies off track.

Starting in 1979, accounting rules required insurance companies to value the equity securities they hold at market
rather than at the lower of cost or market, which was previously the requirement. In this table, Berkshire’s results
through 1978 have been restated to conform to the changed rules. In all other respects, the results are calculated using
the numbers originally reported.
The S&P 500 numbers are pre-tax whereas the Berkshire numbers are after-tax. If a corporation such as Berkshire
were simply to have owned the S&P 500 and accrued the appropriate taxes, its results would have lagged the S&P 500
in years when that index showed a positive return, but would have exceeded the S&P 500 in years when the index
showed a negative return. Over the years, the tax costs would have caused the aggregate lag to be substantial.
2
BERKSHIRE HATHAWAY INC.
To the Shareholders of Berkshire Hathaway Inc.:
Our gain in net worth during 2009 was $21.8 billion, which increased the per-share book value of both
our Class A and Class B stock by 19.8%. Over the last 45 years (that is, since present management took over)
book value has grown from $19 to $84,487, a rate of 20.3% compounded annually.*
Berkshire’s recent acquisition of Burlington Northern Santa Fe (BNSF) has added at least 65,000
shareholders to the 500,000 or so already on our books. It’s important to Charlie Munger, my long-time partner,
and me that all of our owners understand Berkshire’s operations, goals, limitations and culture. In each annual
report, consequently, we restate the economic principles that guide us. This year these principles appear on pages
89-94 and I urge all of you – but particularly our new shareholders – to read them. Berkshire has adhered to these
principles for decades and will continue to do so long after I’m gone.
In this letter we will also review some of the basics of our business, hoping to provide both a freshman
orientation session for our BNSF newcomers and a refresher course for Berkshire veterans.
How We Measure Ourselves
Our metrics for evaluating our managerial performance are displayed on the facing page. From the start,
Charlie and I have believed in having a rational and unbending standard for measuring what we have – or have
not – accomplished. That keeps us from the temptation of seeing where the arrow of performance lands and then
painting the bull’s eye around it.
Selecting the S&P 500 as our bogey was an easy choice because our shareholders, at virtually no cost, can
match its performance by holding an index fund. Why should they pay us for merely duplicating that result?
A more difficult decision for us was how to measure the progress of Berkshire versus the S&P. There are
good arguments for simply using the change in our stock price. Over an extended period of time, in fact, that is
the best test. But year-to-year market prices can be extraordinarily erratic. Even evaluations covering as long as a
decade can be greatly distorted by foolishly high or low prices at the beginning or end of the measurement
period. Steve Ballmer, of Microsoft, and Jeff Immelt, of GE, can tell you about that problem, suffering as they do
from the nosebleed prices at which their stocks traded when they were handed the managerial baton.
The ideal standard for measuring our yearly progress would be the change in Berkshire’s per-share intrinsic
value. Alas, that value cannot be calculated with anything close to precision, so we instead use a crude proxy for
it: per-share book value. Relying on this yardstick has its shortcomings, which we discuss on pages 92 and 93.
Additionally, book value at most companies understates intrinsic value, and that is certainly the case at
Berkshire. In aggregate, our businesses are worth considerably more than the values at which they are carried on
our books. In our all-important insurance business, moreover, the difference is huge. Even so, Charlie and I
believe that our book value – understated though it is – supplies the most useful tracking device for changes in
intrinsic value. By this measurement, as the opening paragraph of this letter states, our book value since the start
of fiscal 1965 has grown at a rate of 20.3% compounded annually.
*All per-share figures used in this report apply to Berkshire’s A shares. Figures for the B shares are
1/1500th of those shown for A.
3
We should note that had we instead chosen market prices as our yardstick, Berkshire’s results would
look better, showing a gain since the start of fiscal 1965 of 22% compounded annually. Surprisingly, this modest
difference in annual compounding rate leads to an 801,516% market-value gain for the entire 45-year period
compared to the book-value gain of 434,057% (shown on page 2). Our market gain is better because in 1965
Berkshire shares sold at an appropriate discount to the book value of its underearning textile assets, whereas
today Berkshire shares regularly sell at a premium to the accounting values of its first-class businesses.
Summed up, the table on page 2 conveys three messages, two positive and one hugely negative. First,
we have never had any five-year period beginning with 1965-69 and ending with 2005-09 – and there have been
41 of these – during which our gain in book value did not exceed the S&P’s gain. Second, though we have lagged
the S&P in some years that were positive for the market, we have consistently done better than the S&P in the
eleven years during which it delivered negative results. In other words, our defense has been better than our
offense, and that’s likely to continue.
The big minus is that our performance advantage has shrunk dramatically as our size has grown, an
unpleasant trend that is certain to continue. To be sure, Berkshire has many outstanding businesses and a cadre of
truly great managers, operating within an unusual corporate culture that lets them maximize their talents. Charlie
and I believe these factors will continue to produce better-than-average results over time. But huge sums forge
their own anchor and our future advantage, if any, will be a small fraction of our historical edge.
What We Don’t Do
Long ago, Charlie laid out his strongest ambition: “All I want to know is where I’m going to die, so I’ll
never go there.” That bit of wisdom was inspired by Jacobi, the great Prussian mathematician, who counseled
“Invert, always invert” as an aid to solving difficult problems. (I can report as well that this inversion approach
works on a less lofty level: Sing a country song in reverse, and you will quickly recover your car, house and
wife.)
Here are a few examples of how we apply Charlie’s thinking at Berkshire:
• Charlie and I avoid businesses whose futures we can’t evaluate, no matter how exciting their
products may be. In the past, it required no brilliance for people to foresee the fabulous growth
that awaited such industries as autos (in 1910), aircraft (in 1930) and television sets (in 1950). But
the future then also included competitive dynamics that would decimate almost all of the
companies entering those industries. Even the survivors tended to come away bleeding.
Just because Charlie and I can clearly see dramatic growth ahead for an industry does not mean
we can judge what its profit margins and returns on capital will be as a host of competitors battle
for supremacy. At Berkshire we will stick with businesses whose profit picture for decades to
come seems reasonably predictable. Even then, we will make plenty of mistakes.
• We will never become dependent on the kindness of strangers. Too-big-to-fail is not a fallback
position at Berkshire. Instead, we will always arrange our affairs so that any requirements for cash
we may conceivably have will be dwarfed by our own liquidity. Moreover, that liquidity will be
constantly refreshed by a gusher of earnings from our many and diverse businesses.
When the financial system went into cardiac arrest in September 2008, Berkshire was a supplier
of liquidity and capital to the system, not a supplicant. At the very peak of the crisis, we poured
$15.5 billion into a business world that could otherwise look only to the federal government for
help. Of that, $9 billion went to bolster capital at three highly-regarded and previously-secure
American businesses that needed – without delay – our tangible vote of confidence. The remaining
$6.5 billion satisfied our commitment to help fund the purchase of Wrigley, a deal that was
completed without pause while, elsewhere, panic reigned.
4
We pay a steep price to maintain our premier financial strength. The $20 billion-plus of cashequivalent
assets that we customarily hold is earning a pittance at present. But we sleep well.
• We tend to let our many subsidiaries operate on their own, without our supervising and
monitoring them to any degree. That means we are sometimes late in spotting management
problems and that both operating and capital decisions are occasionally made with which Charlie
and I would have disagreed had we been consulted. Most of our managers, however, use the
independence we grant them magnificently, rewarding our confidence by maintaining an owneroriented
attitude that is invaluable and too seldom found in huge organizations. We would rather
suffer the visible costs of a few bad decisions than incur the many invisible costs that come from
decisions made too slowly – or not at all – because of a stifling bureaucracy.
With our acquisition of BNSF, we now have about 257,000 employees and literally hundreds of
different operating units. We hope to have many more of each. But we will never allow Berkshire
to become some monolith that is overrun with committees, budget presentations and multiple
layers of management. Instead, we plan to operate as a collection of separately-managed mediumsized
and large businesses, most of whose decision-making occurs at the operating level. Charlie
and I will limit ourselves to allocating capital, controlling enterprise risk, choosing managers and
setting their compensation.
• We make no attempt to woo Wall Street. Investors who buy and sell based upon media or analyst
commentary are not for us. Instead we want partners who join us at Berkshire because they wish
to make a long-term investment in a business they themselves understand and because it’s one that
follows policies with which they concur. If Charlie and I were to go into a small venture with a
few partners, we would seek individuals in sync with us, knowing that common goals and a shared
destiny make for a happy business “marriage” between owners and managers. Scaling up to giant
size doesn’t change that truth.
To build a compatible shareholder population, we try to communicate with our owners directly
and informatively. Our goal is to tell you what we would like to know if our positions were
reversed. Additionally, we try to post our quarterly and annual financial information on the
Internet early on weekends, thereby giving you and other investors plenty of time during a
non-trading period to digest just what has happened at our multi-faceted enterprise. (Occasionally,
SEC deadlines force a non-Friday disclosure.) These matters simply can’t be adequately
summarized in a few paragraphs, nor do they lend themselves to the kind of catchy headline that
journalists sometimes seek.
Last year we saw, in one instance, how sound-bite reporting can go wrong. Among the 12,830
words in the annual letter was this sentence: “We are certain, for example, that the economy will
be in shambles throughout 2009 – and probably well beyond – but that conclusion does not tell us
whether the market will rise or fall.” Many news organizations reported – indeed, blared – the first
part of the sentence while making no mention whatsoever of its ending. I regard this as terrible
journalism: Misinformed readers or viewers may well have thought that Charlie and I were
forecasting bad things for the stock market, though we had not only in that sentence, but also
elsewhere, made it clear we weren’t predicting the market at all. Any investors who were misled
by the sensationalists paid a big price: The Dow closed the day of the letter at 7,063 and finished
the year at 10,428.
Given a few experiences we’ve had like that, you can understand why I prefer that our
communications with you remain as direct and unabridged as possible.
* * * * * * * * * * * *
Let’s move to the specifics of Berkshire’s operations. We have four major operating sectors, each
differing from the others in balance sheet and income account characteristics. Therefore, lumping them together,
as is standard in financial statements, impedes analysis. So we’ll present them as four separate businesses, which
is how Charlie and I view them.
5
Insurance
Our property-casualty (P/C) insurance business has been the engine behind Berkshire’s growth and will
continue to be. It has worked wonders for us. We carry our P/C companies on our books at $15.5 billion more
than their net tangible assets, an amount lodged in our “Goodwill” account. These companies, however, are
worth far more than their carrying value – and the following look at the economic model of the P/C industry will
tell you why.
Insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from
certain workers’ compensation accidents, payments can stretch over decades. This collect-now, pay-later model
leaves us holding large sums – money we call “float” – that will eventually go to others. Meanwhile, we get to
invest this float for Berkshire’s benefit. Though individual policies and claims come and go, the amount of float
we hold remains remarkably stable in relation to premium volume. Consequently, as our business grows, so does
our float.
If premiums exceed the total of expenses and eventual losses, we register an underwriting profit that
adds to the investment income produced from the float. This combination allows us to enjoy the use of free
money – and, better yet, get paid for holding it. Alas, the hope of this happy result attracts intense competition,
so vigorous in most years as to cause the P/C industry as a whole to operate at a significant underwriting loss.
This loss, in effect, is what the industry pays to hold its float. Usually this cost is fairly low, but in some
catastrophe-ridden years the cost from underwriting losses more than eats up the income derived from use of
float.
In my perhaps biased view, Berkshire has the best large insurance operation in the world. And I will
absolutely state that we have the best managers. Our float has grown from $16 million in 1967, when we entered
the business, to $62 billion at the end of 2009. Moreover, we have now operated at an underwriting profit for
seven consecutive years. I believe it likely that we will continue to underwrite profitably in most – though
certainly not all – future years. If we do so, our float will be cost-free, much as if someone deposited $62 billion
with us that we could invest for our own benefit without the payment of interest.
Let me emphasize again that cost-free float is not a result to be expected for the P/C industry as a
whole: In most years, premiums have been inadequate to cover claims plus expenses. Consequently, the
industry’s overall return on tangible equity has for many decades fallen far short of that achieved by the S&P
500. Outstanding economics exist at Berkshire only because we have some outstanding managers running some
unusual businesses. Our insurance CEOs deserve your thanks, having added many billions of dollars to
Berkshire’s value. It’s a pleasure for me to tell you about these all-stars.
* * * * * * * * * * * *
Let’s start at GEICO, which is known to all of you because of its $800 million annual advertising
budget (close to twice that of the runner-up advertiser in the auto insurance field). GEICO is managed by Tony
Nicely, who joined the company at 18. Now 66, Tony still tap-dances to the office every day, just as I do at 79.
We both feel lucky to work at a business we love.
GEICO’s customers have warm feelings toward the company as well. Here’s proof: Since Berkshire
acquired control of GEICO in 1996, its market share has increased from 2.5% to 8.1%, a gain reflecting the net
addition of seven million policyholders. Perhaps they contacted us because they thought our gecko was cute, but
they bought from us to save important money. (Maybe you can as well; call 1-800-847-7536 or go to
www.GEICO.com.) And they’ve stayed with us because they like our service as well as our price.
Berkshire acquired GEICO in two stages. In 1976-80 we bought about one-third of the company’s
stock for $47 million. Over the years, large repurchases by the company of its own shares caused our position to
grow to about 50% without our having bought any more shares. Then, on January 2, 1996, we acquired the
remaining 50% of GEICO for $2.3 billion in cash, about 50 times the cost of our original purchase.
6
An old Wall Street joke gets close to our experience:
Customer: Thanks for putting me in XYZ stock at 5. I hear it’s up to 18.
Broker: Yes, and that’s just the beginning. In fact, the company is doing so well now,
that it’s an even better buy at 18 than it was when you made your purchase.
Customer: Damn, I knew I should have waited.
GEICO’s growth may slow in 2010. U.S. vehicle registrations are actually down because of slumping
auto sales. Moreover, high unemployment is causing a growing number of drivers to go uninsured. (That’s illegal
almost everywhere, but if you’ve lost your job and still want to drive . . .) Our “low-cost producer” status,
however, is sure to give us significant gains in the future. In 1995, GEICO was the country’s sixth largest auto
insurer; now we are number three. The company’s float has grown from $2.7 billion to $9.6 billion. Equally
important, GEICO has operated at an underwriting profit in 13 of the 14 years Berkshire has owned it.
I became excited about GEICO in January 1951, when I first visited the company as a 20-year-old
student. Thanks to Tony, I’m even more excited today.
* * * * * * * * * * * *
A hugely important event in Berkshire’s history occurred on a Saturday in 1985. Ajit Jain came into
our office in Omaha – and I immediately knew we had found a superstar. (He had been discovered by Mike
Goldberg, now elevated to St. Mike.)
We immediately put Ajit in charge of National Indemnity’s small and struggling reinsurance operation.
Over the years, he has built this business into a one-of-a-kind giant in the insurance world.
Staffed today by only 30 people, Ajit’s operation has set records for transaction size in several areas of
insurance. Ajit writes billion-dollar limits – and then keeps every dime of the risk instead of laying it off with
other insurers. Three years ago, he took over huge liabilities from Lloyds, allowing it to clean up its relationship
with 27,972 participants (“names”) who had written problem-ridden policies that at one point threatened the
survival of this 322-year-old institution. The premium for that single contract was $7.1 billion. During 2009, he
negotiated a life reinsurance contract that could produce $50 billion of premium for us over the next 50 or so
years.
Ajit’s business is just the opposite of GEICO’s. At that company, we have millions of small policies
that largely renew year after year. Ajit writes relatively few policies, and the mix changes significantly from year
to year. Throughout the world, he is known as the man to call when something both very large and unusual needs
to be insured.
If Charlie, I and Ajit are ever in a sinking boat – and you can only save one of us – swim to Ajit.
* * * * * * * * * * * *
Our third insurance powerhouse is General Re. Some years back this operation was troubled; now it is
a gleaming jewel in our insurance crown.
Under the leadership of Tad Montross, General Re had an outstanding underwriting year in 2009, while
also delivering us unusually large amounts of float per dollar of premium volume. Alongside General Re’s P/C
business, Tad and his associates have developed a major life reinsurance operation that has grown increasingly
valuable.
Last year General Re finally attained 100% ownership of Cologne Re, which since 1995 has been a
key – though only partially-owned – part of our presence around the world. Tad and I will be visiting Cologne in
September to thank its managers for their important contribution to Berkshire.
7
Finally, we own a group of smaller companies, most of them specializing in odd corners of the
insurance world. In aggregate, their results have consistently been profitable and, as the table below shows, the
float they provide us is substantial. Charlie and I treasure these companies and their managers.
Here is the record of all four segments of our property-casualty and life insurance businesses:
Underwriting Profit Yearend Float
(in millions)
Insurance Operations 2009 2008 2009 2008
General Re . . . . . . . . . . . . . . . . . . . . . . $ 477 $ 342 $21,014 $21,074
BH Reinsurance . . . . . . . . . . . . . . . . . . 349 1,324 26,223 24,221
GEICO . . . . . . . . . . . . . . . . . . . . . . . . . 649 916 9,613 8,454
Other Primary . . . . . . . . . . . . . . . . . . . 84 210 5,061 4,739
$1,559 $2,792 $61,911 $58,488
* * * * * * * * * * * *
And now a painful confession: Last year your chairman closed the book on a very expensive business
fiasco entirely of his own making.
For many years I had struggled to think of side products that we could offer our millions of loyal
GEICO customers. Unfortunately, I finally succeeded, coming up with a brilliant insight that we should market
our own credit card. I reasoned that GEICO policyholders were likely to be good credit risks and, assuming we
offered an attractive card, would likely favor us with their business. We got business all right – but of the wrong
type.
Our pre-tax losses from credit-card operations came to about $6.3 million before I finally woke up. We
then sold our $98 million portfolio of troubled receivables for 55¢ on the dollar, losing an additional $44 million.
GEICO’s managers, it should be emphasized, were never enthusiastic about my idea. They warned me
that instead of getting the cream of GEICO’s customers we would get the – – – – – well, let’s call it the
non-cream. I subtly indicated that I was older and wiser.
I was just older.
Regulated Utility Business
Berkshire has an 89.5% interest in MidAmerican Energy Holdings, which owns a wide variety of
utility operations. The largest of these are (1) Yorkshire Electricity and Northern Electric, whose 3.8 million end
users make it the U.K.’s third largest distributor of electricity; (2) MidAmerican Energy, which serves 725,000
electric customers, primarily in Iowa; (3) Pacific Power and Rocky Mountain Power, serving about 1.7 million
electric customers in six western states; and (4) Kern River and Northern Natural pipelines, which carry about
8% of the natural gas consumed in the U.S.
MidAmerican has two terrific managers, Dave Sokol and Greg Abel. In addition, my long-time friend,
Walter Scott, along with his family, has a major ownership position in the company. Walter brings extraordinary
business savvy to any operation. Ten years of working with Dave, Greg and Walter have reinforced my original
belief: Berkshire couldn’t have better partners. They are truly a dream team.
Somewhat incongruously, MidAmerican also owns the second largest real estate brokerage firm in the
U.S., HomeServices of America. This company operates through 21 locally-branded firms that have 16,000
agents. Though last year was again a terrible year for home sales, HomeServices earned a modest sum. It also
acquired a firm in Chicago and will add other quality brokerage operations when they are available at sensible
prices. A decade from now, HomeServices is likely to be much larger.
8
Here are some key figures on MidAmerican’s operations:
Earnings (in millions)
2009 2008
U.K. utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 248 $ 339
Iowa utility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285 425
Western utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 788 703
Pipelines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 457 595
HomeServices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 (45)
Other (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 186
Operating earnings before corporate interest and taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,846 2,203
Constellation Energy * . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — 1,092
Interest, other than to Berkshire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (318) (332)
Interest on Berkshire junior debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (58) (111)
Income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (313) (1,002)
Net earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,157 $ 1,850
Earnings applicable to Berkshire ** . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,071 $ 1,704
Debt owed to others . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,579 19,145
Debt owed to Berkshire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 1,087
*Consists of a breakup fee of $175 million and a profit on our investment of $917 million.
**Includes interest earned by Berkshire (net of related income taxes) of $38 in 2009 and $72 in 2008.
Our regulated electric utilities, offering monopoly service in most cases, operate in a symbiotic manner
with the customers in their service areas, with those users depending on us to provide first-class service and
invest for their future needs. Permitting and construction periods for generation and major transmission facilities
stretch way out, so it is incumbent on us to be far-sighted. We, in turn, look to our utilities’ regulators (acting on
behalf of our customers) to allow us an appropriate return on the huge amounts of capital we must deploy to meet
future needs. We shouldn’t expect our regulators to live up to their end of the bargain unless we live up to ours.
Dave and Greg make sure we do just that. National research companies consistently rank our Iowa and
Western utilities at or near the top of their industry. Similarly, among the 43 U.S. pipelines ranked by a firm
named Mastio, our Kern River and Northern Natural properties tied for second place.
Moreover, we continue to pour huge sums of money into our operations so as to not only prepare for
the future but also make these operations more environmentally friendly. Since we purchased MidAmerican ten
years ago, it has never paid a dividend. We have instead used earnings to improve and expand our properties in
each of the territories we serve. As one dramatic example, in the last three years our Iowa and Western utilities
have earned $2.5 billion, while in this same period spending $3 billion on wind generation facilities.
MidAmerican has consistently kept its end of the bargain with society and, to society’s credit, it has
reciprocated: With few exceptions, our regulators have promptly allowed us to earn a fair return on the everincreasing
sums of capital we must invest. Going forward, we will do whatever it takes to serve our territories in
the manner they expect. We believe that, in turn, we will be allowed the return we deserve on the funds we
invest.
In earlier days, Charlie and I shunned capital-intensive businesses such as public utilities. Indeed, the
best businesses by far for owners continue to be those that have high returns on capital and that require little
incremental investment to grow. We are fortunate to own a number of such businesses, and we would love to buy
more. Anticipating, however, that Berkshire will generate ever-increasing amounts of cash, we are today quite
willing to enter businesses that regularly require large capital expenditures. We expect only that these businesses
have reasonable expectations of earning decent returns on the incremental sums they invest. If our expectations
are met – and we believe that they will be – Berkshire’s ever-growing collection of good to great businesses
should produce above-average, though certainly not spectacular, returns in the decades ahead.
9
Our BNSF operation, it should be noted, has certain important economic characteristics that resemble
those of our electric utilities. In both cases we provide fundamental services that are, and will remain, essential to
the economic well-being of our customers, the communities we serve, and indeed the nation. Both will require
heavy investment that greatly exceeds depreciation allowances for decades to come. Both must also plan far
ahead to satisfy demand that is expected to outstrip the needs of the past. Finally, both require wise regulators
who will provide certainty about allowable returns so that we can confidently make the huge investments
required to maintain, replace and expand the plant.
We see a “social compact” existing between the public and our railroad business, just as is the case
with our utilities. If either side shirks its obligations, both sides will inevitably suffer. Therefore, both parties to
the compact should – and we believe will – understand the benefit of behaving in a way that encourages good
behavior by the other. It is inconceivable that our country will realize anything close to its full economic
potential without its possessing first-class electricity and railroad systems. We will do our part to see that they
exist.
In the future, BNSF results will be included in this “regulated utility” section. Aside from the two
businesses having similar underlying economic characteristics, both are logical users of substantial amounts of
debt that is not guaranteed by Berkshire. Both will retain most of their earnings. Both will earn and invest large
sums in good times or bad, though the railroad will display the greater cyclicality. Overall, we expect this
regulated sector to deliver significantly increased earnings over time, albeit at the cost of our investing many tens
– yes, tens – of billions of dollars of incremental equity capital.
Manufacturing, Service and Retailing Operations
Our activities in this part of Berkshire cover the waterfront. Let’s look, though, at a summary balance
sheet and earnings statement for the entire group.
Balance Sheet 12/31/09 (in millions)
Assets
Cash and equivalents . . . . . . . . . . . . . . . . . $ 3,018
Accounts and notes receivable . . . . . . . . . . 5,066
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 6,147
Other current assets . . . . . . . . . . . . . . . . . . 625
Total current assets . . . . . . . . . . . . . . . . . . . 14,856
Goodwill and other intangibles . . . . . . . . . 16,499
Fixed assets . . . . . . . . . . . . . . . . . . . . . . . . 15,374
Other assets . . . . . . . . . . . . . . . . . . . . . . . . 2,070
$48,799
Liabilities and Equity
Notes payable . . . . . . . . . . . . . . . . . . . . . . . $ 1,842
Other current liabilities . . . . . . . . . . . . . . . 7,414
Total current liabilities . . . . . . . . . . . . . . . . 9,256
Deferred taxes . . . . . . . . . . . . . . . . . . . . . . 2,834
Term debt and other liabilities . . . . . . . . . . 6,240
Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,469
$48,799
Earnings Statement (in millions)
2009 2008 2007
Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $61,665 $66,099 $59,100
Operating expenses (including depreciation of $1,422 in 2009, $1,280 in 2008
and $955 in 2007) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59,509 61,937 55,026
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 139 127
Pre-tax earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,058* 4,023* 3,947*
Income taxes and minority interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 945 1,740 1,594
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,113 $ 2,283 $ 2,353
*Does not include purchase-accounting adjustments.
10
Almost all of the many and widely-diverse operations in this sector suffered to one degree or another
from 2009’s severe recession. The major exception was McLane, our distributor of groceries, confections and
non-food items to thousands of retail outlets, the largest by far Wal-Mart.
Grady Rosier led McLane to record pre-tax earnings of $344 million, which even so amounted to only
slightly more than one cent per dollar on its huge sales of $31.2 billion. McLane employs a vast array of physical
assets – practically all of which it owns – including 3,242 trailers, 2,309 tractors and 55 distribution centers with
15.2 million square feet of space. McLane’s prime asset, however, is Grady.
We had a number of companies at which profits improved even as sales contracted, always an
exceptional managerial achievement. Here are the CEOs who made it happen:
COMPANY CEO
Benjamin Moore (paint) Denis Abrams
Borsheims (jewelry retailing) Susan Jacques
H. H. Brown (manufacturing and retailing of shoes) Jim Issler
CTB (agricultural equipment) Vic Mancinelli
Dairy Queen John Gainor
Nebraska Furniture Mart (furniture retailing) Ron and Irv Blumkin
Pampered Chef (direct sales of kitchen tools) Marla Gottschalk
See’s (manufacturing and retailing of candy) Brad Kinstler
Star Furniture (furniture retailing) Bill Kimbrell
Among the businesses we own that have major exposure to the depressed industrial sector, both
Marmon and Iscar turned in relatively strong performances. Frank Ptak’s Marmon delivered a 13.5% pre-tax
profit margin, a record high. Though the company’s sales were down 27%, Frank’s cost-conscious management
mitigated the decline in earnings.
Nothing stops Israel-based Iscar – not wars, recessions or competitors. The world’s two other leading
suppliers of small cutting tools both had very difficult years, each operating at a loss throughout much of the
year. Though Iscar’s results were down significantly from 2008, the company regularly reported profits, even
while it was integrating and rationalizing Tungaloy, the large Japanese acquisition that we told you about last
year. When manufacturing rebounds, Iscar will set new records. Its incredible managerial team of Eitan
Wertheimer, Jacob Harpaz and Danny Goldman will see to that.
Every business we own that is connected to residential and commercial construction suffered severely
in 2009. Combined pre-tax earnings of Shaw, Johns Manville, Acme Brick, and MiTek were $227 million, an
82.5% decline from $1.295 billion in 2006, when construction activity was booming. These businesses continue
to bump along the bottom, though their competitive positions remain undented.
The major problem for Berkshire last year was NetJets, an aviation operation that offers fractional
ownership of jets. Over the years, it has been enormously successful in establishing itself as the premier company
in its industry, with the value of its fleet far exceeding that of its three major competitors combined. Overall, our
dominance in the field remains unchallenged.
NetJets’ business operation, however, has been another story. In the eleven years that we have owned
the company, it has recorded an aggregate pre-tax loss of $157 million. Moreover, the company’s debt has soared
from $102 million at the time of purchase to $1.9 billion in April of last year. Without Berkshire’s guarantee of
this debt, NetJets would have been out of business. It’s clear that I failed you in letting NetJets descend into this
condition. But, luckily, I have been bailed out.
11
Dave Sokol, the enormously talented builder and operator of MidAmerican Energy, became CEO of
NetJets in August. His leadership has been transforming: Debt has already been reduced to $1.4 billion, and, after
suffering a staggering loss of $711 million in 2009, the company is now solidly profitable.
Most important, none of the changes wrought by Dave have in any way undercut the top-of-the-line
standards for safety and service that Rich Santulli, NetJets’ previous CEO and the father of the fractionalownership
industry, insisted upon. Dave and I have the strongest possible personal interest in maintaining these
standards because we and our families use NetJets for almost all of our flying, as do many of our directors and
managers. None of us are assigned special planes nor crews. We receive exactly the same treatment as any other
owner, meaning we pay the same prices as everyone else does when we are using our personal contracts. In short,
we eat our own cooking. In the aviation business, no other testimonial means more.
Finance and Financial Products
Our largest operation in this sector is Clayton Homes, the country’s leading producer of modular and
manufactured homes. Clayton was not always number one: A decade ago the three leading manufacturers were
Fleetwood, Champion and Oakwood, which together accounted for 44% of the output of the industry. All have
since gone bankrupt. Total industry output, meanwhile, has fallen from 382,000 units in 1999 to 60,000 units in
2009.
The industry is in shambles for two reasons, the first of which must be lived with if the U.S. economy
is to recover. This reason concerns U.S. housing starts (including apartment units). In 2009, starts were 554,000,
by far the lowest number in the 50 years for which we have data. Paradoxically, this is good news.
People thought it was good news a few years back when housing starts – the supply side of the picture
– were running about two million annually. But household formations – the demand side – only amounted to
about 1.2 million. After a few years of such imbalances, the country unsurprisingly ended up with far too many
houses.
There were three ways to cure this overhang: (1) blow up a lot of houses, a tactic similar to the
destruction of autos that occurred with the “cash-for-clunkers” program; (2) speed up household formations by,
say, encouraging teenagers to cohabitate, a program not likely to suffer from a lack of volunteers or; (3) reduce
new housing starts to a number far below the rate of household formations.
Our country has wisely selected the third option, which means that within a year or so residential
housing problems should largely be behind us, the exceptions being only high-value houses and those in certain
localities where overbuilding was particularly egregious. Prices will remain far below “bubble” levels, of course,
but for every seller (or lender) hurt by this there will be a buyer who benefits. Indeed, many families that couldn’t
afford to buy an appropriate home a few years ago now find it well within their means because the bubble burst.
The second reason that manufactured housing is troubled is specific to the industry: the punitive
differential in mortgage rates between factory-built homes and site-built homes. Before you read further, let me
underscore the obvious: Berkshire has a dog in this fight, and you should therefore assess the commentary that
follows with special care. That warning made, however, let me explain why the rate differential causes problems
for both large numbers of lower-income Americans and Clayton.
The residential mortgage market is shaped by government rules that are expressed by FHA, Freddie
Mac and Fannie Mae. Their lending standards are all-powerful because the mortgages they insure can typically
be securitized and turned into what, in effect, is an obligation of the U.S. government. Currently buyers of
conventional site-built homes who qualify for these guarantees can obtain a 30-year loan at about 51⁄4%. In
addition, these are mortgages that have recently been purchased in massive amounts by the Federal Reserve, an
action that also helped to keep rates at bargain-basement levels.
In contrast, very few factory-built homes qualify for agency-insured mortgages. Therefore, a
meritorious buyer of a factory-built home must pay about 9% on his loan. For the all-cash buyer, Clayton’s
homes offer terrific value. If the buyer needs mortgage financing, however – and, of course, most buyers do – the
difference in financing costs too often negates the attractive price of a factory-built home.
12
Last year I told you why our buyers – generally people with low incomes – performed so well as credit
risks. Their attitude was all-important: They signed up to live in the home, not resell or refinance it.
Consequently, our buyers usually took out loans with payments geared to their verified incomes (we weren’t
making “liar’s loans”) and looked forward to the day they could burn their mortgage. If they lost their jobs, had
health problems or got divorced, we could of course expect defaults. But they seldom walked away simply
because house values had fallen. Even today, though job-loss troubles have grown, Clayton’s delinquencies and
defaults remain reasonable and will not cause us significant problems.
We have tried to qualify more of our customers’ loans for treatment similar to those available on the
site-built product. So far we have had only token success. Many families with modest incomes but responsible
habits have therefore had to forego home ownership simply because the financing differential attached to the
factory-built product makes monthly payments too expensive. If qualifications aren’t broadened, so as to open
low-cost financing to all who meet down-payment and income standards, the manufactured-home industry seems
destined to struggle and dwindle.
Even under these conditions, I believe Clayton will operate profitably in coming years, though well
below its potential. We couldn’t have a better manager than CEO Kevin Clayton, who treats Berkshire’s interests
as if they were his own. Our product is first-class, inexpensive and constantly being improved. Moreover, we will
continue to use Berkshire’s credit to support Clayton’s mortgage program, convinced as we are of its soundness.
Even so, Berkshire can’t borrow at a rate approaching that available to government agencies. This handicap will
limit sales, hurting both Clayton and a multitude of worthy families who long for a low-cost home.
In the following table, Clayton’s earnings are net of the company’s payment to Berkshire for the use of
its credit. Offsetting this cost to Clayton is an identical amount of income credited to Berkshire’s finance
operation and included in “Other Income.” The cost and income amount was $116 million in 2009 and $92
million in 2008.
The table also illustrates how severely our furniture (CORT) and trailer (XTRA) leasing operations
have been hit by the recession. Though their competitive positions remain as strong as ever, we have yet to see
any bounce in these businesses.
Pre-Tax Earnings
(in millions)
2009 2008
Net investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $278 $330
Life and annuity operation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116 23
Leasing operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 87
Manufactured-housing finance (Clayton) . . . . . . . . . . . . . . . . . . . . . . . . 187 206
Other income * . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186 141
Income before investment and derivatives gains or losses . . . . . . . . . . . $781 $787
*Includes $116 million in 2009 and $92 million in 2008 of fees that Berkshire charges Clayton for the
use of Berkshire’s credit.
* * * * * * * * * * * *
At the end of 2009, we became a 50% owner of Berkadia Commercial Mortgage (formerly known as
Capmark), the country’s third-largest servicer of commercial mortgages. In addition to servicing a $235 billion
portfolio, the company is an important originator of mortgages, having 25 offices spread around the country.
Though commercial real estate will face major problems in the next few years, long-term opportunities for
Berkadia are significant.
13
Our partner in this operation is Leucadia, run by Joe Steinberg and Ian Cumming, with whom we had a
terrific experience some years back when Berkshire joined with them to purchase Finova, a troubled finance
business. In resolving that situation, Joe and Ian did far more than their share of the work, an arrangement I
always encourage. Naturally, I was delighted when they called me to partner again in the Capmark purchase.
Our first venture was also christened Berkadia. So let’s call this one Son of Berkadia. Someday I’ll be
writing you about Grandson of Berkadia.
Investments
Below we show our common stock investments that at yearend had a market value of more than $1 billion.
12/31/09
Shares Company
Percentage of
Company
Owned Cost * Market
(in millions)
151,610,700 American Express Company . . . . . . . . . . . . . . . . . . . . . . . . 12.7 $ 1,287 $ 6,143
225,000,000 BYD Company, Ltd. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.9 232 1,986
200,000,000 The Coca-Cola Company . . . . . . . . . . . . . . . . . . . . . . . . . . 8.6 1,299 11,400
37,711,330 ConocoPhillips . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5 2,741 1,926
28,530,467 Johnson & Johnson . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.0 1,724 1,838
130,272,500 Kraft Foods Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.8 4,330 3,541
3,947,554 POSCO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.2 768 2,092
83,128,411 The Procter & Gamble Company . . . . . . . . . . . . . . . . . . . . 2.9 533 5,040
25,108,967 Sanofi-Aventis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.9 2,027 1,979
234,247,373 Tesco plc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.0 1,367 1,620
76,633,426 U.S. Bancorp . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.0 2,371 1,725
39,037,142 Wal-Mart Stores, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.0 1,893 2,087
334,235,585 Wells Fargo & Company . . . . . . . . . . . . . . . . . . . . . . . . . . 6.5 7,394 9,021
Others . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,680 8,636
Total Common Stocks Carried at Market . . . . . . . . . . . . . . $34,646 $59,034
*This is our actual purchase price and also our tax basis; GAAP “cost” differs in a few cases because of
write-ups or write-downs that have been required.
In addition, we own positions in non-traded securities of Dow Chemical, General Electric, Goldman
Sachs, Swiss Re and Wrigley with an aggregate cost of $21.1 billion and a carrying value of $26.0 billion. We
purchased these five positions in the last 18 months. Setting aside the significant equity potential they provide us,
these holdings deliver us an aggregate of $2.1 billion annually in dividends and interest. Finally, we owned
76,777,029 shares (22.5%) of BNSF at yearend, which we then carried at $85.78 per share, but which have
subsequently been melded into our purchase of the entire company.
In 2009, our largest sales were in ConocoPhillips, Moody’s, Procter & Gamble and Johnson & Johnson
(sales of the latter occurring after we had built our position earlier in the year). Charlie and I believe that all of
these stocks will likely trade higher in the future. We made some sales early in 2009 to raise cash for our Dow
and Swiss Re purchases and late in the year made other sales in anticipation of our BNSF purchase.
14
We told you last year that very unusual conditions then existed in the corporate and municipal bond
markets and that these securities were ridiculously cheap relative to U.S. Treasuries. We backed this view with
some purchases, but I should have done far more. Big opportunities come infrequently. When it’s raining gold,
reach for a bucket, not a thimble.
We entered 2008 with $44.3 billion of cash-equivalents, and we have since retained operating earnings
of $17 billion. Nevertheless, at yearend 2009, our cash was down to $30.6 billion (with $8 billion earmarked for
the BNSF acquisition). We’ve put a lot of money to work during the chaos of the last two years. It’s been an
ideal period for investors: A climate of fear is their best friend. Those who invest only when commentators are
upbeat end up paying a heavy price for meaningless reassurance. In the end, what counts in investing is what you
pay for a business – through the purchase of a small piece of it in the stock market – and what that business earns
in the succeeding decade or two.
* * * * * * * * * * * *
Last year I wrote extensively about our derivatives contracts, which were then the subject of both
controversy and misunderstanding. For that discussion, please go to www.berkshirehathaway.com.
We have since changed only a few of our positions. Some credit contracts have run off. The terms of
about 10% of our equity put contracts have also changed: Maturities have been shortened and strike prices
materially reduced. In these modifications, no money changed hands.
A few points from last year’s discussion are worth repeating:
(1) Though it’s no sure thing, I expect our contracts in aggregate to deliver us a profit over their lifetime,
even when investment income on the huge amount of float they provide us is excluded in the
calculation. Our derivatives float – which is not included in the $62 billion of insurance float I
described earlier – was about $6.3 billion at yearend.
(2) Only a handful of our contracts require us to post collateral under any circumstances. At last year’s low
point in the stock and credit markets, our posting requirement was $1.7 billion, a small fraction of the
derivatives-related float we held. When we do post collateral, let me add, the securities we put up
continue to earn money for our account.
(3) Finally, you should expect large swings in the carrying value of these contracts, items that can affect
our reported quarterly earnings in a huge way but that do not affect our cash or investment holdings.
That thought certainly fit 2009’s circumstances. Here are the pre-tax quarterly gains and losses from
derivatives valuations that were part of our reported earnings last year:
Quarter $ Gain (Loss) in Billions
1 (1.517)
2 2.357
3 1.732
4 1.052
As we’ve explained, these wild swings neither cheer nor bother Charlie and me. When we report to
you, we will continue to separate out these figures (as we do realized investment gains and losses) so that you can
more clearly view the earnings of our operating businesses. We are delighted that we hold the derivatives
contracts that we do. To date we have significantly profited from the float they provide. We expect also to earn
further investment income over the life of our contracts.
15
We have long invested in derivatives contracts that Charlie and I think are mispriced, just as we try to
invest in mispriced stocks and bonds. Indeed, we first reported to you that we held such contracts in early 1998.
The dangers that derivatives pose for both participants and society – dangers of which we’ve long warned, and
that can be dynamite – arise when these contracts lead to leverage and/or counterparty risk that is extreme. At
Berkshire nothing like that has occurred – nor will it.
It’s my job to keep Berkshire far away from such problems. Charlie and I believe that a CEO must not
delegate risk control. It’s simply too important. At Berkshire, I both initiate and monitor every derivatives
contract on our books, with the exception of operations-related contracts at a few of our subsidiaries, such as
MidAmerican, and the minor runoff contracts at General Re. If Berkshire ever gets in trouble, it will be my fault.
It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.
* * * * * * * * * * * *
In my view a board of directors of a huge financial institution is derelict if it does not insist that its
CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other
employment. And if he fails at it – with the government thereupon required to step in with funds or guarantees –
the financial consequences for him and his board should be severe.
It has not been shareholders who have botched the operations of some of our country’s largest financial
institutions. Yet they have borne the burden, with 90% or more of the value of their holdings wiped out in most
cases of failure. Collectively, they have lost more than $500 billion in just the four largest financial fiascos of the
last two years. To say these owners have been “bailed-out” is to make a mockery of the term.
The CEOs and directors of the failed companies, however, have largely gone unscathed. Their fortunes may
have been diminished by the disasters they oversaw, but they still live in grand style. It is the behavior of these
CEOs and directors that needs to be changed: If their institutions and the country are harmed by their
recklessness, they should pay a heavy price – one not reimbursable by the companies they’ve damaged nor by
insurance. CEOs and, in many cases, directors have long benefitted from oversized financial carrots; some
meaningful sticks now need to be part of their employment picture as well.
An Inconvenient Truth (Boardroom Overheating)
Our subsidiaries made a few small “bolt-on” acquisitions last year for cash, but our blockbuster deal
with BNSF required us to issue about 95,000 Berkshire shares that amounted to 6.1% of those previously
outstanding. Charlie and I enjoy issuing Berkshire stock about as much as we relish prepping for a colonoscopy.
The reason for our distaste is simple. If we wouldn’t dream of selling Berkshire in its entirety at the
current market price, why in the world should we “sell” a significant part of the company at that same inadequate
price by issuing our stock in a merger?
In evaluating a stock-for-stock offer, shareholders of the target company quite understandably focus on
the market price of the acquirer’s shares that are to be given them. But they also expect the transaction to deliver
them the intrinsic value of their own shares – the ones they are giving up. If shares of a prospective acquirer are
selling below their intrinsic value, it’s impossible for that buyer to make a sensible deal in an all-stock deal. You
simply can’t exchange an undervalued stock for a fully-valued one without hurting your shareholders.
Imagine, if you will, Company A and Company B, of equal size and both with businesses intrinsically
worth $100 per share. Both of their stocks, however, sell for $80 per share. The CEO of A, long on confidence
and short on smarts, offers 11⁄4 shares of A for each share of B, correctly telling his directors that B is worth $100
per share. He will neglect to explain, though, that what he is giving will cost his shareholders $125 in intrinsic
value. If the directors are mathematically challenged as well, and a deal is therefore completed, the shareholders
of B will end up owning 55.6% of A & B’s combined assets and A’s shareholders will own 44.4%. Not everyone
at A, it should be noted, is a loser from this nonsensical transaction. Its CEO now runs a company twice as large
as his original domain, in a world where size tends to correlate with both prestige and compensation.
16
If an acquirer’s stock is overvalued, it’s a different story: Using it as a currency works to the acquirer’s
advantage. That’s why bubbles in various areas of the stock market have invariably led to serial issuances of
stock by sly promoters. Going by the market value of their stock, they can afford to overpay because they are, in
effect, using counterfeit money. Periodically, many air-for-assets acquisitions have taken place, the late 1960s
having been a particularly obscene period for such chicanery. Indeed, certain large companies were built in this
way. (No one involved, of course, ever publicly acknowledges the reality of what is going on, though there is
plenty of private snickering.)
In our BNSF acquisition, the selling shareholders quite properly evaluated our offer at $100 per share.
The cost to us, however, was somewhat higher since 40% of the $100 was delivered in our shares, which Charlie
and I believed to be worth more than their market value. Fortunately, we had long owned a substantial amount of
BNSF stock that we purchased in the market for cash. All told, therefore, only about 30% of our cost overall was
paid with Berkshire shares.
In the end, Charlie and I decided that the disadvantage of paying 30% of the price through stock was
offset by the opportunity the acquisition gave us to deploy $22 billion of cash in a business we understood and
liked for the long term. It has the additional virtue of being run by Matt Rose, whom we trust and admire. We
also like the prospect of investing additional billions over the years at reasonable rates of return. But the final
decision was a close one. If we had needed to use more stock to make the acquisition, it would in fact have made
no sense. We would have then been giving up more than we were getting.
* * * * * * * * * * * *
I have been in dozens of board meetings in which acquisitions have been deliberated, often with the
directors being instructed by high-priced investment bankers (are there any other kind?). Invariably, the bankers
give the board a detailed assessment of the value of the company being purchased, with emphasis on why it is
worth far more than its market price. In more than fifty years of board memberships, however, never have I heard
the investment bankers (or management!) discuss the true value of what is being given. When a deal involved the
issuance of the acquirer’s stock, they simply used market value to measure the cost. They did this even though
they would have argued that the acquirer’s stock price was woefully inadequate – absolutely no indicator of its
real value – had a takeover bid for the acquirer instead been the subject up for discussion.
When stock is the currency being contemplated in an acquisition and when directors are hearing from
an advisor, it appears to me that there is only one way to get a rational and balanced discussion. Directors should
hire a second advisor to make the case against the proposed acquisition, with its fee contingent on the deal not
going through. Absent this drastic remedy, our recommendation in respect to the use of advisors remains: “Don’t
ask the barber whether you need a haircut.”
* * * * * * * * * * * *
I can’t resist telling you a true story from long ago. We owned stock in a large well-run bank that for
decades had been statutorily prevented from acquisitions. Eventually, the law was changed and our bank
immediately began looking for possible purchases. Its managers – fine people and able bankers – not
unexpectedly began to behave like teenage boys who had just discovered girls.
They soon focused on a much smaller bank, also well-run and having similar financial characteristics
in such areas as return on equity, interest margin, loan quality, etc. Our bank sold at a modest price (that’s why
we had bought into it), hovering near book value and possessing a very low price/earnings ratio. Alongside,
though, the small-bank owner was being wooed by other large banks in the state and was holding out for a price
close to three times book value. Moreover, he wanted stock, not cash.
Naturally, our fellows caved in and agreed to this value-destroying deal. “We need to show that we are
in the hunt. Besides, it’s only a small deal,” they said, as if only major harm to shareholders would have been a
legitimate reason for holding back. Charlie’s reaction at the time: “Are we supposed to applaud because the dog
that fouls our lawn is a Chihuahua rather than a Saint Bernard?”
17
The seller of the smaller bank – no fool – then delivered one final demand in his negotiations. “After
the merger,” he in effect said, perhaps using words that were phrased more diplomatically than these, “I’m going
to be a large shareholder of your bank, and it will represent a huge portion of my net worth. You have to promise
me, therefore, that you’ll never again do a deal this dumb.”
Yes, the merger went through. The owner of the small bank became richer, we became poorer, and the
managers of the big bank – newly bigger – lived happily ever after.
The Annual Meeting
Our best guess is that 35,000 people attended the annual meeting last year (up from 12 – no zeros
omitted – in 1981). With our shareholder population much expanded, we expect even more this year. Therefore,
we will have to make a few changes in the usual routine. There will be no change, however, in our enthusiasm
for having you attend. Charlie and I like to meet you, answer your questions and – best of all – have you buy lots
of goods from our businesses.
The meeting this year will be held on Saturday, May 1st. As always, the doors will open at the Qwest
Center at 7 a.m., and a new Berkshire movie will be shown at 8:30. At 9:30 we will go directly to the
question-and-answer period, which (with a break for lunch at the Qwest’s stands) will last until 3:30. After a
short recess, Charlie and I will convene the annual meeting at 3:45. If you decide to leave during the day’s
question periods, please do so while Charlie is talking. (Act fast; he can be terse.)
The best reason to exit, of course, is to shop. We will help you do that by filling the 194,300-squarefoot
hall that adjoins the meeting area with products from dozens of Berkshire subsidiaries. Last year, you did
your part, and most locations racked up record sales. But you can do better. (A friendly warning: If I find sales
are lagging, I get testy and lock the exits.)
GEICO will have a booth staffed by a number of its top counselors from around the country, all of
them ready to supply you with auto insurance quotes. In most cases, GEICO will be able to give you a
shareholder discount (usually 8%). This special offer is permitted by 44 of the 51 jurisdictions in which we
operate. (One supplemental point: The discount is not additive if you qualify for another, such as that given
certain groups.) Bring the details of your existing insurance and check out whether we can save you money. For
at least 50% of you, I believe we can.
Be sure to visit the Bookworm. Among the more than 30 books and DVDs it will offer are two new
books by my sons: Howard’s Fragile, a volume filled with photos and commentary about lives of struggle
around the globe and Peter’s Life Is What You Make It. Completing the family trilogy will be the debut of my
sister Doris’s biography, a story focusing on her remarkable philanthropic activities. Also available will be Poor
Charlie’s Almanack, the story of my partner. This book is something of a publishing miracle – never advertised,
yet year after year selling many thousands of copies from its Internet site. (Should you need to ship your book
purchases, a nearby shipping service will be available.)
If you are a big spender – or, for that matter, merely a gawker – visit Elliott Aviation on the east side of
the Omaha airport between noon and 5:00 p.m. on Saturday. There we will have a fleet of NetJets aircraft that
will get your pulse racing.
An attachment to the proxy material that is enclosed with this report explains how you can obtain the
credential you will need for admission to the meeting and other events. As for plane, hotel and car reservations,
we have again signed up American Express (800-799-6634) to give you special help. Carol Pedersen, who
handles these matters, does a terrific job for us each year, and I thank her for it. Hotel rooms can be hard to find,
but work with Carol and you will get one.
18
At Nebraska Furniture Mart, located on a 77-acre site on 72nd Street between Dodge and Pacific, we
will again be having “Berkshire Weekend” discount pricing. To obtain the Berkshire discount, you must make
your purchases between Thursday, April 29th and Monday, May 3rd inclusive, and also present your meeting
credential. The period’s special pricing will even apply to the products of several prestigious manufacturers that
normally have ironclad rules against discounting but which, in the spirit of our shareholder weekend, have made
an exception for you. We appreciate their cooperation. NFM is open from 10 a.m. to 9 p.m. Monday through
Saturday, and 10 a.m. to 6 p.m. on Sunday. On Saturday this year, from 5:30 p.m. to 8 p.m., NFM is having a
Berkyville BBQ to which you are all invited.
At Borsheims, we will again have two shareholder-only events. The first will be a cocktail reception
from 6 p.m. to 10 p.m. on Friday, April 30th. The second, the main gala, will be held on Sunday, May 2nd, from 9
a.m. to 4 p.m. On Saturday, we will be open until 6 p.m.
We will have huge crowds at Borsheims throughout the weekend. For your convenience, therefore,
shareholder prices will be available from Monday, April 26th through Saturday, May 8th. During that period,
please identify yourself as a shareholder by presenting your meeting credentials or a brokerage statement that
shows you are a Berkshire holder. Enter with rhinestones; leave with diamonds. My daughter tells me that the
more you buy, the more you save (kids say the darnedest things).
On Sunday, in the mall outside of Borsheims, a blindfolded Patrick Wolff, twice U.S. chess champion,
will take on all comers – who will have their eyes wide open – in groups of six. Nearby, Norman Beck, a
remarkable magician from Dallas, will bewilder onlookers.
Our special treat for shareholders this year will be the return of my friend, Ariel Hsing, the country’s
top-ranked junior table tennis player (and a good bet to win at the Olympics some day). Now 14, Ariel came to
the annual meeting four years ago and demolished all comers, including me. (You can witness my humiliating
defeat on YouTube; just type in Ariel Hsing Berkshire.)
Naturally, I’ve been plotting a comeback and will take her on outside of Borsheims at 1:00 p.m. on
Sunday. It will be a three-point match, and after I soften her up, all shareholders are invited to try their luck at
similar three-point contests. Winners will be given a box of See’s candy. We will have equipment available, but
bring your own paddle if you think it will help. (It won’t.)
Gorat’s will again be open exclusively for Berkshire shareholders on Sunday, May 2nd, and will be
serving from 1 p.m. until 10 p.m. Last year, though, it was overwhelmed by demand. With many more diners
expected this year, I’ve asked my friend, Donna Sheehan, at Piccolo’s – another favorite restaurant of mine – to
serve shareholders on Sunday as well. (Piccolo’s giant root beer float is mandatory for any fan of fine dining.) I
plan to eat at both restaurants: All of the weekend action makes me really hungry, and I have favorite dishes at
each spot. Remember: To make a reservation at Gorat’s, call 402-551-3733 on April 1st (but not before) and at
Piccolo’s call 402-342-9038.
Regrettably, we will not be able to have a reception for international visitors this year. Our count grew
to about 800 last year, and my simply signing one item per person took about 21⁄2 hours. Since we expect even
more international visitors this year, Charlie and I decided we must drop this function. But be assured, we
welcome every international visitor who comes.
Last year we changed our method of determining what questions would be asked at the meeting and
received many dozens of letters applauding the new arrangement. We will therefore again have the same three
financial journalists lead the question-and-answer period, asking Charlie and me questions that shareholders have
submitted to them by e-mail.
19
The journalists and their e-mail addresses are: Carol Loomis, of Fortune, who may be e-mailed at
cloomis@fortunemail.com; Becky Quick, of CNBC, at BerkshireQuestions@cnbc.com, and Andrew Ross
Sorkin, of The New York Times, at arsorkin@nytimes.com. From the questions submitted, each journalist will
choose the dozen or so he or she decides are the most interesting and important. The journalists have told me
your question has the best chance of being selected if you keep it concise and include no more than two questions
in any e-mail you send them. (In your e-mail, let the journalist know if you would like your name mentioned if
your question is selected.)
Neither Charlie nor I will get so much as a clue about the questions to be asked. We know the
journalists will pick some tough ones and that’s the way we like it.
We will again have a drawing at 8:15 on Saturday at each of 13 microphones for those shareholders
wishing to ask questions themselves. At the meeting, I will alternate the questions asked by the journalists with
those from the winning shareholders. We’ve added 30 minutes to the question time and will probably have time
for about 30 questions from each group.
* * * * * * * * * * *
At 86 and 79, Charlie and I remain lucky beyond our dreams. We were born in America; had terrific
parents who saw that we got good educations; have enjoyed wonderful families and great health; and came
equipped with a “business” gene that allows us to prosper in a manner hugely disproportionate to that
experienced by many people who contribute as much or more to our society’s well-being. Moreover, we have
long had jobs that we love, in which we are helped in countless ways by talented and cheerful associates. Indeed,
over the years, our work has become ever more fascinating; no wonder we tap-dance to work. If pushed, we
would gladly pay substantial sums to have our jobs (but don’t tell the Comp Committee).
Nothing, however, is more fun for us than getting together with our shareholder-partners at Berkshire’s
annual meeting. So join us on May 1st at the Qwest for our annual Woodstock for Capitalists. We’ll see you
there.
February 26, 2010 Warren E. Buffett
Chairman of the Board
P.S. Come by rail.
20

We simply do not know!

John Gray

• Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism by George Akerlof and Robert Shiller
  Princeton, 230 pp, £16.95, February 2009, ISBN 978 0 691 14233 3

The last two years, in which capitalism has suffered one of its periodic shocks, have given John Maynard Keynes a new lease of life. Events have demonstrated the limits of the theory that economies can be relied on to be stable if they are lightly regulated and otherwise left to themselves. There is now much talk of the paradox of thrift, whereby the rational choices of individuals can prove collectively ruinous, and of the need for government to counteract the inherently anarchic tendencies of markets. Keynes has been revived because he understood that markets are very often irrational. Unfortunately, few of those who urge that we go back to him seem to have understood why he believed this.

Apart from a brief postscript to one of the chapters and a few remarks in the preface, George Akerlof and Robert Shiller’s Animal Spirits was written before the current crisis. Yet, based on research undertaken over many years, it can be read as prefiguring the current disillusionment with economics. The trouble with prevailing theories, in Akerlof and Shiller’s view, is that they assume human beings are more rational than they actually are. ‘This book, which draws on an emerging field called behavioural economics, describes how the economy really works,’ they claim. ‘It accounts for how it works when people really are human, that is, possessed of all-too-human animal spirits.’

They point to five different ways in which these ‘animal spirits’ can affect economic behaviour. First, the state of the economy depends on the level of confidence we feel about the future, but confidence ‘is not just a rational prediction. It is the first and most crucial of our animal spirits.’ Second, a concern for fairness ‘can trump economic motivations’: elementary economics teaches that a rise in demand for shovels after a snowstorm should result in higher prices for shovels; but most people – 82 per cent of correspondents in a survey conducted by two behavioural economists – believe that raising the price would be unfair. Third, the actions of predatory corporations can have an impact on the entire economy: the belief that Enron had acted in bad faith led to people being ‘fed up with financial markets in general’, a shift of a kind that is ‘clearly within the realm of pure animal spirits’. Fourth, people make many of their economic decisions without taking account of inflation: instead of acting to maximise their real (inflation-adjusted) income, they succumb to ‘money illusion’. Finally, human behaviour is heavily influenced by stories, narratives with a dramatic logic that drives people to action. The internet boom at the start of the millennium was not just a response to the development of a new technology; it expressed a view of the world, including the belief that a new era had arrived in which the economic cycles of the past had ceased to operate.

As Akerlof and Shiller represent them, each of these manifestations of animal spirits shows behaviour being driven by forces other than reason. None of them offers rational grounds for action in any sense that most economists would recognise. Even so, the authors insist, these responses must enter into any account of how economies actually work. If economists have failed to explain repeated crises, it is because they have interpreted economic activity through an unreal model of rational decision-making. Thinking of human behaviour in this way allows them to claim a high degree of precision for their discipline, which is presented as a kind of applied mathematics. But they have left psychology out of their equations.

A cogent critique of the theoretical excesses of mainstream economics, Animal Spirits is well argued and also – no small virtue among economists – pleasingly written. At the same time, it is hardly the revolution in thinking that its authors claim. The observation that markets are prone to violent swings of emotion, recurrent illusions and powerful stories is a piece of perennial wisdom that was summarised in Charles Mackay’s Memories of Extraordinary Popular Delusions and the Madness of Crowds, published in 1841. More recently, George Soros has insisted that market behaviour is a reflexive process intrinsically liable to lead to cycles of boom and bust, as the beliefs and decisions of participants are reinforced by a desire to go with the trend until the market becomes unsustainable.

The fact that markets are flawed seems novel only in the context of the economic orthodoxy that prevailed between the wars, and in the run-up to the recent crisis. It is wrong to imply, as Akerlof and Shiller do, that the classical economists believed otherwise. ‘Just as Adam Smith’s invisible hand is the keynote of classical economics,’ they write, ‘Keynes’s animal spirits are the keynote to a different view of the economy – a view that explains the underlying instabilities of capitalism.’ Here they are endorsing the caricature of Smith propagated by neoliberal ideologues anxious to confer a distinguished patrimony on an illegitimate intellectual offspring. Certainly, the ‘invisible hand’ is one of Smith’s central ideas, but he never saw it as working in a mechanical fashion. A network of hidden adjustments whereby conflicting interests could be reconciled, in a complex process that always involved human emotions, the invisible hand was neither all-powerful nor uniformly benign. It could be thwarted by collusion among businessmen, and when given free rein its social effects could be seriously harmful. Like other thinkers of the Scottish Enlightenment, Smith understood the imperfectability of human institutions. He was concerned about the ways in which free markets detached people from communities, and some of these worries fed into the theory of alienation developed by that other celebrated classical economist, Karl Marx.

If Akerlof and Shiller’s grip on the history of economic thought is shaky, they also fail to grasp why Keynes rejected the idea that markets are self-stabilising. Throughout Animal Spirits they portray him as reintegrating psychology with economic theory. No doubt this was one of Keynes’s goals, but it is not his most fundamental revision of economic orthodoxy. Among his other accomplishments he was the author of A Treatise on Probability (1921), in which he tried to develop a theory of ‘rational degrees of belief’. By his own account he failed, and in his canonical General Theory of Employment, Interest and Money (1936) he concluded that there was no way anyone could make forecasts. Future interest rates and prices, new inventions and the likelihood of a European war cannot be predicted: there is no ‘basis on which to form any calculable probability whatever. We simply do not know!’ For Keynes, markets are unstable less because they are driven by emotion than because the future is unknowable. To suggest that the source of market volatility is unreason is to imply that if people were fully rational markets could be stable. But even if people were affectless calculating machines they would still be ignorant of the future, and markets would still be volatile. The root cause of market instability is the insuperable limitation of human knowledge.

Later economists have made much of a distinction between risk, which can be assessed in terms of quantifiable likelihood, and uncertainty, where probabilities cannot be attached to possible outcomes. The trouble is that when attempting to forecast the course of the economy we often cannot confidently distinguish between the two. Even our list of possible outcomes may turn out to have omitted the ones that are most important in shaping events. Such an omission was one of the factors that led Long-Term Capital Management, a highly leveraged hedge fund set up by two Nobel Prize winning economists, to fail in 1998-2000. The information used in applying the formula did not include the possibility of such events as the Asian financial crisis and Russia’s default on its sovereign debt, which destabilised global financial markets and helped destroy the fund. The orthodoxy that came unstuck with the collapse of LTCM was not faulty because it neglected the vagaries of human moods; its mistake was to think that the unknown future could be turned into a set of calculable risks and, in effect, conjured out of existence, which was impossible. Several centuries earlier, Pascal – one of the founders of probability theory – had come to the same conclusion, when in the Pensées he asks ironically: ‘Is it probable that probability brings certainty?’

The central flaw of the economic orthodoxy against which Keynes fought in the 1930s was to imagine that an insoluble problem – human ignorance of the future – had been solved. The error was repeated in the 1990s, when economists came to believe that complex mathematical formulae could tame uncertainty in the murky world of derivatives. Steeped in history as they were, this was a delusion that none of the classical economists entertained. It began to shape economics only towards the end of the 19th century, with the rise of Positivism, according to which the natural sciences are the only legitimate repository of human knowledge. It was the formative influence of this philosophy on the Chicago School that enabled the orthodoxy of the 1930s to re-emerge triumphant, and the result was an immense boost to the prestige of economics as a discipline. Economists could claim to be scientists, who with the aid of their mathematical magic could pierce the veil that conceals the future.

The hegemony of Positivism in economics obscured Keynes’s scepticism about probabilistic knowledge, his most important contribution to the discipline. G.L.S. Shackle set Keynes’s argument out systematically in his neglected masterpiece Epistemics and Economics: A Critique of Economic Doctrines (1972). Shackle is probably the only significant economist to have been influenced both by Keynes and by his arch-rival, F.A. Hayek. He knew both of them well, but argued that neither had digested the full implications for economics of our ignorance of the future. Hayek said that governments could never know enough to plan the economy successfully – a claim vindicated by the miserable record of central planning in Communist countries. At the same time, he attributed near omniscience to markets, and never doubted that if left to its own devices the economy would liquidate mistaken investments and return to equilibrium. Against this, Keynes had shown that there is no market mechanism that ensures revival; economic contraction can be self-reinforcing, and only government action can then create a way out.

Shackle took Keynes’s argument a step further, and showed that no economic policy can ensure economic stability indefinitely. ‘Keynesian’ policies are no exception to this rule. Deficit financing and monetary expansion may have worked well in the conditions that existed after the Second World War. It is not clear that they will be so effective today, when globalisation has brought a freedom of capital movements that did not exist then. The lesson of Shackle is that we must be resourceful in devising new remedies, while not losing sight of the fact that none of them works for long.

Akerlof and Shiller claim that their account of the role of psychology helps to explain the financial crisis. ‘Our theory of animal spirits,’ they say, ‘provides an answer to a conundrum: why did most of us utterly fail to foresee the current economic crisis? How can we understand this crisis when it seems to have come out of the blue with no cause?’ They are right that part of the answer lies in an intellectual default within economics, but they seem oblivious of the role of ideology in producing this default. The deformation of economics was not the result only of factors internal to the discipline, it was also part of the short-lived Western triumphalism that followed the end of the Cold War.

Those were the years when slackers throughout the world were enjoined to submit themselves to the rigours of ‘the Washington consensus’ – a mix of dogmatic policy prescriptions and hypocritical rhetoric that enjoyed the support of the great majority of economists. According to that consensus, the market regime that was installed in Britain, the US and a few other countries from the 1980s onwards could not only ensure stability and promote steady growth there but was a model – the only possible model – for countries everywhere. The one truly rational economic regime, free market capitalism, was also the most productive. As such it was bound to drive every other system out of existence, and would eventually be adopted worldwide. This faith in the universal spread of free markets animated much of the thinking of the American-led institutions overseeing the world economy, such as the IMF. Along with economists in university departments in much of the world, these institutions succumbed to a quasi-religious belief that the free market was the germ of a single, universal economic system.

Not everyone swallowed this creed. It was not accepted in China, which then as now displayed a well-founded contempt for Western advice – an attitude that has much to do with its astonishing economic success. Whether in the face of global recession China can continue to grow at the same rate is unclear – as Keynes would have put it, we simply don’t know. Nonetheless, its emergence as an economic superpower poses questions for economics that are harder to answer than is generally recognised. Economists do not always take the neoliberal party line, according to which growth can be sustained only in a regime of deregulated capitalism; the evidence of history precludes any such simple-minded view. Liberal capitalism has achieved striking results (though in the US, often against the background of trade protection), but so have many varieties of dirigisme, from rapid growth in late tsarist Russia to Asian market economies in the decades after 1945. Economic historians whose minds are not befogged by ideology accept that there are many routes to growth. At the same time, nearly all Western-trained economists insist that sustained growth is impossible in the absence of a legal system that allows the independent rule of law and secure rights to private property. Without this framework, they believe, there will not be the incentives required for long-term saving and investment.

But China has achieved the largest and fastest industrialisation in history without having such a legal system. Until recently, Western economists, along with other Western observers, were adamant that China would continue to be successful only to the extent that it mimicked Western practice. Now that Western economies are in trouble this confidence has been shaken, and China is once again being perceived as alien and dangerous. There is no real attempt to try to understand the sources of its success. Like other branches of the study of society, economics remains culturally parochial, and its underlying concepts based on a few centuries of Western experience.

To their credit, Akerlof and Shiller do discuss how motives not normally regarded as economic have contributed to China’s growth. An appeal to patriotism helped persuade villagers to contribute to the regime’s plans for economic growth in the 1970s, so that ‘a national story began to grip the imagination of the people of China, a story of individual effort and sacrifice.’ One may doubt whether this is the whole story, but it is suggestive, because it illustrates the unreality of the notion that the behaviour of markets is governed by strictly ‘economic’ motivations. Much of Akerlof and Shiller’s analysis is an implicit criticism of this notion, and yet – in conformity with the narrow explanatory model of market behaviour they aim to criticise – they invoke it whenever they suggest that deviations from economic rationality account for instability in markets. They don’t appear to realise that the assumption of a categorical distinction between ‘economic’ and ‘non-economic’ motives is one of the chief reasons recent economic theory has been so consistently remote from reality.

Keynes and the classical economists before him knew that there is no realm of market exchange that obeys laws of the kind that can be formulated in the natural sciences. Economics and politics are not separate branches of human activity, and economic life cannot be studied independently of social divisions and political conflicts among populations, along with their cultures and religions. Familiar to Keynes and most of the economists of his generation, these truisms have been forgotten, or rejected, by many economists today. The result is an economic imperialism that tries to explain every human activity in terms of a conception of rational action that does not work even when applied to the behaviour of markets.

Of course, there is a standard response to these observations, which is that unrealism in economic theories doesn’t matter. As developed by Milton Friedman, among others, this is in effect a version of instrumentalism, a tenable position in the philosophy of science. For instrumentalists, the goal of science is not a true representation of the world; it is to organise our observations into a theoretical framework that serves practical goals, such as prediction and control. But what practical goals have been served by the type of economics dominant over the past two decades? It has been useful neither in making predictions nor in responding to unforeseen developments.

Akerlof and Shiller intend their analysis to contribute to an intellectual reformation in economics, as a consequence of which the discipline will become more useful to policy-makers. It must be doubted, though, that the authors will succeed in persuading economists of the inadequacy of the conception of rational action. The profession is one of the few areas of human activity in which that conception is applicable. In its intra-academic varieties, at any rate, economics is insulated from the world not only by its narrow explanatory methodology but also because it rewards the mathematical modelling that resulted in nearly all of its members failing to anticipate the financial crisis. As institutionalised in universities, the notion of rational decision-making is self-perpetuating. Economics as currently practised may have only a slight grip on market behaviour, but it seems to be powerfully predictive of the behaviour of economists.

Führung

Entscheiden in chaotischen Zeiten

Von Mary E. Boone und David J. Snowden

Viele der bewährten Managementkonzepte taugen nur für geordnete Verhältnisse. Führungskräfte stehen jedoch immer häufiger komplexen Situationen gegenüber, die völlig andere Reaktionen erfordern. So stellen Sie sich auf die Umstände ein.

Im Januar 1993 erschoss ein Mann sieben Menschen in einem Fast-Food-Restaurant in Palatine, einem Vorort von Chicago. Der für den Fall zuständige Deputy Chief Walter Gasior stand vor einem Problem. In seiner Doppelrolle als leitender Verwaltungsangestellter und Sprecher der Polizeibehörde musste er mehrere Situationen gleichzeitig meistern. Gasior sollte sich um die trauernden Angehörigen und die verängstigten Bürger kümmern, dafür sorgen, dass der Routinebetrieb auf dem völlig überlasteten Revier weiterlief, und die Fragen der Medien beantworten, deren Reporter und Filmteams die Stadt überschwemmten. "Da kamen buchstäblich vier Personen gleichzeitig auf mich zu, mit logistischen Fragen und Problemen mit den Medien", erinnerte er sich. "Und in diesem ganzen Durcheinander mussten wir dafür sorgen, dass das Tagesgeschäft auf dem Revier reibungslos weiterlief."

Durcheinander: Im Chaos greifen bewährte Führungskonzepte nicht mehr

© Corbis

Walter Gasior war dieser Aufgabe letztlich gewachsen. Doch nicht alle Führungskräfte erreichen die von ihnen angestrebten Ergebnisse, wenn sie mit Situationen konfrontiert sind, die zahlreiche unterschiedliche Entscheidungen und Reaktionen von ihnen erfordern. Manager verlassen sich allzu oft auf allgemeine Führungskonzepte, die unter bestimmten Umständen erfolgreich sind, unter anderen jedoch nicht.

Warum scheitern diese Konzepte, obwohl sie rein logisch betrachtet Erfolg haben sollten? Die Antwort liegt in der grundlegenden Annahme der Organisationstheorie und -praxis, dass in unserer Welt ein gewisses Maß an Berechenbarkeit und Ordnung herrsche. Diese Annahme geht auf das newtonsche Weltbild zurück, das die Grundlagen für die Lehre der wissenschaftlichen Betriebsführung bildet. Sie bestärkt uns Menschen darin, zu vereinfachen - was bei geordneten Umständen auch sinnvoll ist. Doch wenn sich die Umstände ändern und ihre Komplexität zunimmt, können Vereinfachungen scheitern. Nicht in jeder Situation lassen sich deshalb dieselben Führungsprinzipien anwenden.

Unserer Meinung nach sollte der traditionelle Ansatz für Führungs- und Entscheidungsprozesse erweitert werden. Es ist Zeit, eine neue Sichtweise einzuführen, die auf der Komplexitätswissenschaft beruht (siehe Komplexität verstehen). In den vergangenen zehn Jahren haben wir die Prinzipien dieser Wissenschaft auf Regierungen und Unternehmen aus einem breiten Spektrum unterschiedlicher Branchen angewendet. In Zusammenarbeit mit weiteren Kollegen haben wir das Cynefin-Modell für Führungskräfte entwickelt, mit dessen Hilfe sie Sachverhalte aus anderen Blickwinkeln betrachten, komplexe Konzepte verstehen und sich mit realen Problemen und Chancen auseinandersetzen können. (Das Wort Cynefin stammt aus dem Walisischen und bezeichnet die zahlreichen Faktoren in unserer Umgebung und unserer Erfahrungswelt, die uns beeinflussen, ohne dass wir es merken.) Wenn Führungskräfte dieses Konzept anwenden, lernen sie, das Modell unter Zuhilfenahme von Beispielen aus der Vergangenheit ihres Unternehmens und Szenarios seiner möglichen Zukunft zu definieren. Dies verbessert nicht nur die Kommunikation innerhalb des Unternehmens, sondern hilft den Managern auch sehr schnell, den Kontext einer Situation oder eines Problems zu erkennen

>

brand eins 10/2008

Die Kraft des Mittelfingers

Text: Steffan Heuer

Foto: William Widmer

"Such dir einen Feind! "

(alle Zitate aus dem Buch "Getting Real" von 37 Signals)

David Heinemeier Hansson ist vulgär, und das ganz bewusst. Seine "Fuck you! "- und "That's bullshit"-Sprüche setzt er dosiert ein, wenn er Gesprächspartnern seine Sicht der Dinge nahebringt. Der Däne mit Wohnsitz Chicago hält nichts von harmonischem Gesülze, aber das sieht man ihm nicht an. Hoch gegeltes Haar, Designerjeans, Apple MacBook Air. Eigentlich alles Symbole für "Hello, how are you? Fine?"

Nix da. Hansson sagt, sein Fluchen sei ein "Aufnahmeknopf fürs Hirn". Sonst hört einem ja heute keiner mehr zu. Dösende Angestellte werden wachgerüttelt. Investoren, die Hansson schlicht "Geldsäcke" nennt, merken auf. Dass der raue Umgangston nicht nur eine persönliche Marotte Hanssons ist, sondern Programm, merken sie spätestens, wenn sein Partner Jason Fried dazukommt.

Die Chefs der Webdesign-Firma 37 Signals sind Stars. Nicht deshalb sind sie so ungehobelt, nein, das waren sie schon zuvor. Den Ruhm verdanken sie ihrem Engagement bei Web-2.0-Entwicklungen und vor allem einem programmatischen Text, der Furore macht. Er trägt den Titel "Getting Real", zu Deutsch: "Zur Sache" oder "Im Ernst". Das ist eine Art Cluetrain-Manifest (vgl. brand eins 03/2000) der zweiten Web-Generation. Und weit weniger harmonisch als die 95 Cluetrain-Thesen, die 1999 durchs Internet gingen.

"Getting Real" ist eine Streitschrift. Kurz. Simpel. Trocken. Bissig. Kooperation? Gemeinsames Nachdenken?

Ach was. Fuck you. In "Getting Real" steht das anders:

"Meetings sind Gift. Leute brauchen ihre Ruhe, um Dinge zu erledigen."

Mag sein, dass das ein wenig mit dem Standort Chicago zu tun hat, der nicht so fein ist, nicht so politisch korrekt wie das Silicon Valley und seine Ach-das-finde-ich-aber-sehr interessant-Kultur. Chicago ist ein alter Industriestandort. Rau, hart, erdig. Direkt wie die Sprache von 37 Signals. In all dem freundlichen Gesäusel im Web ist das für nicht wenige eine Wohltat. Und "Bullshit", erklärt Fried grinsend, sage er nur deshalb so oft, weil dadurch klar werde, dass 37 Signals relativ wenig Bullshit predige. Sondern fürs Rustikale eintrete, für Dinge mit Nutzen. Webdesign für Leute, die auch gern mal zum Trucker-Treffen fahren.

Nicht weit von dem Backsteingebäude, in dem 37 Signals seinen Sitz hat, erstreckt sich das alte Zentrum des Fleischgroßhandels. Zwischen Laderampen und Plakaten für 1A-Schweinehälften und gut abgehangene Steaks werden Industriebauten in Galerien und Lofts umgewandelt oder stehen einfach leer. Wer die tiefen Schlaglöcher auf der West Lake Avenue umkurvt, während über dem Kopf die aus Filmen berühmte Hochbahn rumpelt, kann erahnen, wo Hansson und Fried ihre Wut auf die geleckten Technik-Freaks von der Westküste hernehmen.

"Tu weniger als die Konkurrenz, um sie zu schlagen."

"Es gibt immer wieder Leute, die behaupten, man muss an einem bestimmten Ort wie etwa im Silicon Valley sein, um Besonderes zu leisten", sagt der dänische Programmierer. Eine durchschnittliche Umgebung dagegen führe zu durchschnittlicher Arbeit "völliger Schwachsinn! ". 37 Signals hat gerade einmal zehn Angestellte, von denen nur fünf in Chicago sind, der Rest arbeitet irgendwo in den USA und Kanada, zum Beispiel im wenig glamourösen Idaho. "Wenn es hochkommt, treffen wir uns einmal im Jahr. Ich war bestimmt seit zwei Monaten nicht mehr in diesem Büro", sagt Hansson. Am Firmensitz gibt es lediglich einige Schreibtische zur Untermiete und einen Telefonanschluss. Die Nummer sucht man auf der Web-Seite von 37 Signals vergeblich, den Hörer nimmt ohnehin so gut wie nie jemand ab.

Was Jason Fried und sein 28-jähriger Geschäftspartner leisten, geschieht weitgehend virtuell. 37 Signals begann 1999 als Web-design-Firma mit eigenwilliger Agenda: keine marktschreierische Web-Seite mit Referenzen und Portfolio-Projekten, keine Farben und Flash-Animationen. Nackt und schwarz-weiß. Fried ließ sich lieber darüber aus, wie gutes Design auszusehen hat. Wem es nicht passte, der sollte sich eine andere Designfirma suchen. Nach vier Jahren fehlte ihm die richtige Software, um die wachsende Liste eigener Projekte zu verwalten. Die Rettung kam in Gestalt von Hansson, der in Kopenhagen gerade seinen Master of Business Administration machte, leidenschaftlich mit Fried korrespondierte und die relativ unbekannte Programmiersprache Ruby benutzte. Per E-Mail stellte Fried ihn an, um zunächst auf Stundenbasis eine Art Rahmen zu basteln, mit dem sich Web-Anwendungen nach dem Baukastenprinzip erstellen ließen. Hansson nannte das Ruby on Rails, frei übersetzt: Programmieren mit Stützrädern.

Statt der freien Wahl gibt es feste Gleise oder Vorlagen, die für ein hohes Entwicklungstempo und Narrensicherheit sorgen. Selbst ein durchschnittlich begabter Anfänger konnte dank Ruby on Rails plötzlich an einem Nachmittag eine voll funktionsfähige, professionelle Web-Seite basteln. Das Projekt für den Hausgebrauch war nicht nur das perfekte Beispiel für Frieds neuen Minimalismus, sondern wurde zugleich zum ersten Produkt namens Basecamp, das die Firma fortan im Abonnement verkaufte. Dafür zahlen heute eine halbe Million Nutzer Monat für Monat bis zu 149 Dollar.

Dazu sind im Laufe der Jahre vier weitere Abo-Programme mit Namen wie Highrise oder Campfire hinzugekommen, die allesamt Alltagsprobleme kleiner bis mittelgroßer Unternehmen lösen. Man loggt sich ein, tippt die Kreditkartennummer in ein Feld und kann loslegen. Mit den Web-Diensten aus Chicago lassen sich etwa Projekte verwalten, Arbeitszeiten verfolgen oder Kontakte pflegen. Das ist an sich nichts Ungewöhnliches, denn Software für den besseren Betriebsablauf kann man inzwischen an allen Ecken und Enden mieten oder sogar gratis nutzen.

"Am Anfang immer Nein sagen! "

Was Fried und Hanssons gebührenpflichtige Produktpalette zum Kult gemacht hat, ist ihre unverschämte Art und Weise, Programme mit so wenigen Funktionen wie möglich als Geniestreich zu verkaufen. Prioritäten von eins bis fünf? Unsinn, alles ist gleich wichtig. Zeiterfassung im 15-Minuten-Takt? Nicht notwendig, richtige Kreative arbeiten zielorientiert. Projektmanagement für mehr als eine Person oder weniger als das gesamte Team? Muss nicht sein. Entweder tragen alle Verantwortung oder keiner!

Nicht, dass ihre Kunden solche Funktionen nicht wollten und immer wieder verlangten, gratis, versteht sich. "Solche , Verbesserungsvorschläge' kommen ständig rein. Man liest sie und schmeißt sie am besten weg", sagt Fried. "Genau Buch zu führen lenkt nur ab. Auf Dauer schieben sich die wirklich relevanten Dinge in den Vordergrund, da muss man keine schlauen Listen anlegen."

Der Rest der Welt mag vorgeben, am liebsten "den Kunden zuzuhören", und dazu grandiose Blogs einrichten, in denen der Chef den verständnisvollen Therapeuten gibt - 37 Signals glaubt nicht, dass der Kunde immer recht hat. Fried drückt das so aus: "Nutzer schlagen Lösungen vor, wenn sie eigentlich ihr Problem beschreiben sollten. Das ist ein großer Unterschied. Wer ein wirklich gutes Produkt haben will, handelt im Interesse seiner Kunden, aber er lässt sich nicht von jedem Wunsch in tausend Richtungen gleichzeitig ziehen. Sonst ist man nach ein paar Deals nicht mehr Herr seiner eigenen Produkte." Und sein Partner Hanson ergänzt: "Ich schreibe meine Software für uns und freue mich, wenn andere sie auch benutzen wollen."

Als arrogant wollen die beiden aber nicht verstanden werden. Sie hätten lediglich ein gesundes Selbstvertrauen, das sich aus Erfolg speise. Hilfreich ist sicherlich, dass Hansson von Google und dem einflussreichen Technik-Verlag O'Reilly Media zum "Hacker des Jahres" gekürt wurde. Der Firmenname ist auch nicht gerade ein Zeichen der Bescheidenheit, denn 37 Signals spielt auf geheimnisvolle Signale aus dem Weltall an, die Astronomen nicht zweifelsfrei als normales Himmelsrauschen abtun konnten und die vielleicht Anzeichen für außerirdische Intelligenz sind.

Abgehoben ist Hanssons und Frieds Arbeit dennoch nicht. Einige Programmierer kritisieren allerdings die mangelnde Flexibilität ihres Denkens und der daraus resultierenden Software, die sich zu wenig anpassen lasse. Das Programm Ruby on Rails etwa sei zu wenig ausbaufähig, um einem plötzlichen Nutzeransturm gewachsen zu sein - so wie der Mikroblogging-Dienst Twitter, der wegen wachsender Beliebtheit regelmäßig zusammenbricht. Und Harper Reed, Cheftechniker des T-Shirt-Händlers Threadless und Kunde von 37 Signals, bemängelt: "So sehr ich die beiden schätze - wenn ich nur dann ans Ausbauen dächte, wenn der große Ansturm kommt, bricht meine Web-Seite zusammen, und wir verlieren Kunden. Man muss im Voraus planen und kann nicht nur für den Augenblick improvisieren." Threadless sitzt auch in Chicago und wurde als Pionier des Crowdsourcing bekannt.

Fried und Hansson aber halten unbeirrbar am kleinen Rahmen fest und lehnen Wachstum um seiner selbst willen konsequent ab. Rechner wie Personal auf Vorrat zu halten, ist für sie pure Verschwendung. 37 Signals hat seine Abo-Gebühren sogar erhöht, während andere Firmen ähnliche Dienste verschenken, um viele Kunden anzulocken und zu binden. "Kostenlos bringt nichts. Das kann man machen, wenn man jede Menge Spielgeld hat. Aber wir betreiben ein Geschäft, kein Start-up", sagt Fried. "Wir wollen nicht mit irgendwelchen Experimenten unsere Zeit und anderer Leute Kapital verschwenden, sondern eine langfristige Beziehung zu unseren Kunden aufbauen und Geld verdienen. Wer unsere Ideen nicht versteht und nicht zahlen will, der kann ruhig wieder gehen! " Aber das ist offenbar nicht das Problem von 37 Signals - das Duo verweist darauf, dass sich der Umsatz seit der Anhebung der Abo-Gebühren erhöht habe.

Ebenso unorthodox ist die Haltung der beiden zu Wagniskapital, ohne das im Silicon Valley so gut wie nichts geht. Dass sich Innovation mit fremdem Geld beschleunigen lässt, glauben Fried und Hanson nicht. Außer einer Investition in ungenannter Höhe von Amazon-Boss Jeff Bezos im Jahr 2006 haben die beiden bislang jede Offerte von Wagniskapitalfirmen abgelehnt.

"Freu dich über Sachzwänge! "

Der Rummel um Risikokapital und wer am schnellsten eine Milliarde Dollar einsackt, das ist für Fried und Hansson das große Problem des Silicon Valley. "Die wenigsten Leute, die diese tollen Geschichten hören, kapieren, dass die Chancen so gering sind wie ein Sechser im Lotto", sagt Hansson. Das will niemand hören, das widerspricht dem Mythos, dem alle nachjagen - und genau deswegen ist das sein Thema bei jeder Konferenz, zu der er als Programmier-Genie und Quertreiber eingeladen wird. Sein Partner Fried, der bereits als Student Programme verkaufte, hat daraus eine Management-Maxime gemacht: "Die meisten Firmen kommen zu leicht an zu viel Geld heran und schmeißen es für Marketing und neue Stellen raus. Ich stelle lieber so wenige Leute wie möglich und so spät wie möglich ein. Am besten holt man sich die faulsten Leute, denn die sind bestrebt, alles schnell und effizient zu erledigen."

Und wie finden die beiden fähige und faule Mitarbeiter? Indem sie sich die Beiträge jedes Bewerbers zu Open-Source-Software anschauen und ihn zum Test ein aktuelles Problem lösen lassen. Die Transparenz der weltweiten Open-Source-Gemeinschaft erlaubt solche Recherchen.

"Suche und feiere kleine Siege! "

Die Statistiken von Dow Jones VentureSource verzeichnen für den Großraum Chicago zwischen 2002 und 2008 jährlich zwischen 38 bis 45 Risikokapital-Beteiligungen im Wert von 270 bis 400 Millionen Dollar. Die Hälfte davon entfiel auf Firmen, die sich mit Informationstechnik befassen. In Großraum Silicon Valley zog allein die Halbinsel südlich von San Francisco im selben Zeitraum jährlich mehr als 600 Deals im Wert von bis zu sieben Milliarden Dollar an.

Für die beiden professionellen Provokateure von 37 Signals ist dieser Geldregen Wahnsinn. Die Risikokapitalgeber spekulierten auf überdurchschnittliches Wachstum junger Firmen und verleiteten die Gründer dazu, diesen fiebrigen Fantasien hinterherzuhetzen. Ihr Alternativprogramm beschreiben Hanson und Fried so: "Ich kann sehr gut mit fünf guten Leuten fünf Millionen Dollar im Jahr umsetzen. Alle gehen zu vernünftigen Zeiten nach Hause und haben ein gutes Leben. Was ist daran auszusetzen? Die Zahl der Mitarbeiter diktiert, wie groß mein Projekt wird - nicht umgekehrt."

"Glücklich und durchschnittlich ist besser als brillant und frustriert."

Dass diese hemdsärmelige Bescheidenheit auch für Firmen in anderen Städten und sogar für große Organisationen mit mehreren Hundert oder Tausend Mitarbeitern funktionieren kann, wollen die beiden mit "Getting Real" beweisen. Eigentlich richtet sich die broschierte Fibel mit schwarzem Einband an Entwickler in kleinen Klitschen wie ihrer eigenen. Aber viele der darin enthaltenen Ratschläge, die sie aus ihren Blog-Beiträgen zusammengestellt haben, lassen sich in der Tat übertragen. Denn in dem Manifest geht es nicht um Software, sondern um gesunden Menschenverstand.

"Zufriedenheit ist optimierbar"

Die Botschaft scheint anzukommen: Die beiden Autoren verkaufen ihr Büchlein im Eigenverlag über einen Print-on-Demand-Versand und in elektronischer Form, derzeit monatlich rund 3000 Exemplare, insgesamt bereits mehr als 30 000 Stück. Und um sicherzugehen, dass die Botschaft weite Kreise zieht, arbeiten Fried und Hansson gerade an einem zweiten Buch, das den Minimalismus mit ausgestrecktem Mittelfinger auf weniger als 100 Seiten als Management-Theorie darlegt.

Dicke Wirtschaftsbücher gebe es ohnehin zu viele, sagt Fried, deswegen schwebt ihm eine Serie dünner Publikationen vor. Zudem organisieren er und sein Kompagnon eine jährliche Konferenz namens "Seed" für "Design, Unternehmertum und Inspiration". Die dritte Veranstaltung fand diesen Juni passenderweise in der Crown Hall in Chicago statt, die der Ober-Minimalist Mies van der Rohe entworfen hat. "Wir stopfen euch die Köpfe voll mit Wissen, das ihr nutzen könnt. Keine Theorie, sondern Praxis", verkündeten Fried und Hansson vollmundig in der Einladung.

Beeinflusst sind die beiden von rebellischen Unternehmern wie Richard Branson und dem Apple-Gründer Steve Jobs bis zum Management-Anarchisten Ricardo Semler, der die vom Vater geerbte Firma Semco gnadenlos umkrempelte und darüber ein Buch schrieb. "Das Semco-System" (im Original lautet der Titel wörtlich übersetzt: "Den eigenen Spieß umdrehen") wurde Anfang der neunziger Jahre zum bestverkauften Sachtitel Brasiliens. Darin beschreibt er ein basisdemokratisches Unternehmen, in dem die Belegschaft die Bosse einstellt, völlige Transparenz herrscht und Arbeit wirklich nur das halbe Leben ausmacht. So weit allerdings will Fried nicht gehen: "Einige seiner Vorstellungen sind selbst für meinen Geschmack zu extrem - etwa ein Fünftel des Gewinnes an die Mitarbeiter zu verteilen."

Überhaupt mögen die beiden Bosse klare Verhältnisse: "Ich sehe uns als Chefköche. Wir zeigen den Leuten mit einem Kochbuch, wie die Rezepte aussehen und wie man's macht. Köche sind schlau. Sie verraten zwar die Zutaten und die Zubereitung, verkaufen aber trotzdem noch eine Menge drum herum: Fernsehshows, Kochtöpfe und so weiter. Das ist geniales Merchandising." Und klare Machtverhältnisse liegen dem Webdesigner sowieso: "Der Chefkoch entscheidet, und die Kunden essen. Deswegen kommen sie. Niemand geht in eine Restaurantküche und lässt sich das Rezept vorlesen oder würzt nach. Da sagt der Starkoch nur: "Fuck off! " -

Getting Real - The smarter, faster, easier way to build a successful web application. 2006, online gratis zu lesen. PDF oder Buch für 20 Dollar bei http://gettingreal.37signals.com/

Signal vs. Noise, der Blog von 37 Signals: www.37signals.com/svn/

Correction Appended

A banking system in crisis after the collapse of a housing bubble. An economy hemorrhaging jobs. A market-oriented government struggling to stem the panic. Sound familiar?

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Swedish National Debt Office

Bo Lundgren, deputy minister of finance during the 1992 crisis.

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It does to Sweden. The country was so far in the hole in 1992 — after years of imprudent regulation, short-sighted economic policy and the end of its property boom — that its banking system was, for all practical purposes, insolvent.

But Sweden took a different course than the one now being proposed by the United States Treasury. And Swedish officials say there are lessons from their own nightmare that Washington may be missing.

Sweden did not just bail out its financial institutions by having the government take over the bad debts. It extracted pounds of flesh from bank shareholders before writing checks. Banks had to write down losses and issue warrants to the government.

That strategy held banks responsible and turned the government into an owner. When distressed assets were sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies as well.

“If I go into a bank,” said Bo Lundgren, who was Sweden’s deputy minister of finance at the time, “I’d rather get equity so that there is some upside for the taxpayer.”

Sweden spent 4 percent of its gross domestic product, or 65 billion kronor, the equivalent of $11.7 billion at the time, or $18.3 billion in today’s dollars, to rescue ailing banks. That is slightly less, proportionate to the national economy, than the $700 billion, or roughly 5 percent of gross domestic product, that the Bush administration estimates its own move will cost in the United States.

But the final cost to Sweden ended up being less than 2 percent of its G.D.P. Some officials say they believe it was closer to zero, depending on how certain rates of return are calculated.

The tumultuous events of the last few weeks have produced a lot of tight-lipped nods in Stockholm. Mr. Lundgren even made the rounds in New York in early September, explaining what the country did in the early 1990s.

A few American commentators have proposed that the United States government extract equity from banks as a price for their rescue. But it does not seem to be under serious consideration yet in the Bush administration or Congress.

The reason is not quite clear. The government has already swapped its sovereign guarantee for equity in Fannie Mae and Freddie Mac, the mortgage finance institutions, and the American International Group, the global insurance giant.

Putting taxpayers on the hook without anything in return could be a mistake, said Urban Backstrom, a senior Swedish finance ministry official at the time. “The public will not support a plan if you leave the former shareholders with anything,” he said.

The Swedish crisis had strikingly similar origins to the American one, and its neighbors, Norway and Finland, were hobbled to the point of needing a government bailout to escape the morass as well.

Financial deregulation in the 1980s fed a frenzy of real estate lending by Sweden’s banks, which did not worry enough about whether the value of their collateral might evaporate in tougher times.

Property prices imploded. The bubble deflated fast in 1991 and 1992. A vain effort to defend Sweden’s currency, the krona, caused overnight interest rates to spike at one point to 500 percent. The Swedish economy contracted for two consecutive years after a long expansion, and unemployment, at 3 percent in 1990, quadrupled in three years.

After a series of bank failures and ad hoc solutions, the moment of truth arrived in September 1992, when the government of Prime Minister Carl Bildt decided it was time to clear the decks.

Standing shoulder-to-shoulder with the opposition center-left, Mr. Bildt’s conservative government announced that the Swedish state would guarantee all bank deposits and creditors of the nation’s 114 banks. Sweden formed a new agency to supervise institutions that needed recapitalization, and another that sold off the assets, mainly real estate, that the banks held as collateral.

Sweden told its banks to write down their losses promptly before coming to the state for recapitalization. Facing its own problem later in the decade, Japan made the mistake of dragging this process out, delaying a solution for years.

Then came the imperative to bleed shareholders first. Mr. Lundgren recalls a conversation with Peter Wallenberg, at the time chairman of SEB, Sweden’s largest bank. Mr. Wallenberg, the scion of the country’s most famous family and steward of large chunks of its economy, heard that there would be no sacred cows.

The Wallenbergs turned around and arranged a recapitalization on their own, obviating the need for a bailout. SEB turned a profit the following year, 1993.

“For every krona we put into the bank, we wanted the same influence,” Mr. Lundgren said. “That ensured that we did not have to go into certain banks at all.”

By the end of the crisis, the Swedish government had seized a vast portion of the banking sector, and the agency had mostly fulfilled its hard-nosed mandate to drain share capital before injecting cash. When markets stabilized, the Swedish state then reaped the benefits by taking the banks public again.

More money may yet come into official coffers. The government still owns 19.9 percent of Nordea, a Stockholm bank that was fully nationalized and is now a highly regarded giant in Scandinavia and the Baltic Sea region.

The politics of Sweden’s crisis management were similarly tough-minded, though much quieter.

Soon after the plan was announced, the Swedish government found that international confidence returned more quickly than expected, easing pressure on its currency and bringing money back into the country. The center-left opposition, while wary that the government might yet let the banks off the hook, made its points about penalizing shareholders privately.

“The only thing that held back an avalanche was the hope that the system was holding,” said Leif Pagrotzky, a senior member of the opposition at the time. “In public we stuck together 100 percent, but we fought behind the scenes.”