On The Couch

Memo to:
Oaktree Clients
From:
Howard Marks
Re:
On the Couch
I woke up early on Saturday, December 12 the morning after a day of significant declines in stocks,
credit and crude oil with enough thoughts going through my mind to keep me from going back to sleep.
Thus I moved to my desk to start a memo that would pull them together. I knew it might be a long time
between inception and eventual issuance, since every time I dealt with one thought, two more popped into
my head. In the end, it took a month to get it done.
Professor Richard Thaler of the University of Chicago is a leading expert on behavioral economics and
decision-making (in fact, hes such a significant figure in the field that he was given a cameo role in the
movie The Big Short). He opens his new book, Misbehaving, with Vilfredo Paretos assertion that the
foundation of political economy and, in general, of every social science, is evidently psychology. Id
apply that equally to the not-so-scientific field of investing.
It has been one of my constant refrains dating back all the way to Random Thoughts on the
Identification of Investment Opportunities (January 1994) that in order to be successful, an investor
has to understand not just finance, accounting and economics, but also psychology. A thorough
understanding of how investors minds work is essential if one is to figure out where a market is in its
cycle, why, and what to do about it. For me, the markets recent behavior certainly on December 11,
but also at other points in 2015 reinforces that observation.
This memo is my attempt to send the markets to the psychiatrists couch, and an exploration of what
might be learned there.
2012-14: An Uncertain World

In September 2012, I wrote a memo called On Uncertain Ground. To begin it, I observed that The
world seems more uncertain today than at any other time in my life. I went on to list the things that
worried me. Few of them are less troubling today. Certainly the period of the post-crisis recovery hasnt
been carefree. Here are the things that concerned me in 2012, as viewed from that perspective:
Macro growth It seems to be broadly accepted that overall economic growth will be slower in
the years ahead than in the latter part of the twentieth century. Do lower birth rates and slowing
gains in productivity doom us to reduced macro gains? What does this mean for everything else?
In particular, if growth remains slow, will it lead to slowing inflation, or even deflation?
Trends in the developed world Will the developed nations be able to compete in a globalized
economy? How will incomes hold up as developing nations produce goods cheaper, and as the
quality of those goods improves? As we increasingly become knowledge-based economies, will
we need as many less-educated workers as in the past? If not, what will be the ramifications for
unemployment, income inequality and society as a whole?
Consumer behavior Will consumers regain the confidence required to return to their expansive
spending behavior? Will they employ credit as in the past to perpetuate growth in consumption?
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Europe Will Europe move forward in terms of cohesion, coordination and productivity? What
happens if it doesnt? Will the ECB be able to engineer an economic recovery? Will the
departure from the European Union of Greece or new Greeces return as a worry in the future?
(And now, will the coming referendum mandate Great Britains departure? Will there be a new
referendum in Scotland with regard to remaining in the UK? Will Catalonia vote to leave Spain,
and what will that mean for its membership in the EU?)
Leadership For years I gave speeches using PowerPoint slides listing sources of uncertainty,
but where it was supposed to say dearth of leadership, someone had mistakenly typed death of
leadership . . . and nobody quibbled. Throughout the world, few countries if any have leaders on
par with historys best. Certainly thats true in the U.S. You may think its a good thing, or you
may not, but its clear that Washington is too gridlocked to accomplish much. As I wrote in On
Uncertain Ground, . . . U.S. politicians seem to value things like ideological purity (i.e.,
toeing the party line) and being reelected above real attempts at problem solving. Partisanship
and open warfare has surely reached a new zenith.
Entitlements Social Security is a locomotive rumbling down the track to ruin. The cost of
health care programs is growing rapidly, as drugs become more expensive and Americans live
longer. Defined-benefit pensions have been promised to public employees but not fully funded.
How will federal, state and city governments meet their obligations? Not only does no one know,
but also few people in government (certainly not in Washington) seem to care.
China As the worlds second-largest economy, China plays a very important role in
determining global growth. Its GDP advanced at double-digit rates over the last 20+ years
without recessions on the basis of (a) millions of people moving from farms to cities (and to
more productive roles in manufacturing), (b) the low-cost exports they produced and (c) readily
available capital and the heavy fixed-asset investment it permitted. Henceforth China will gain
less from the above and will have to transition to domestic consumption of goods and services, as
well as a slower-growing economy . . . perhaps with ups and downs like the rest of the world.
Will this result in a near-term hard landing? And what will be the impact on nations that sell
commodities and finished goods to China?
Geopolitical hotspots From the fall of the Soviet Union at the end of 1991 until the 9/11
attacks in 2001, investors positive feelings were abetted by the presence of peace in the world.
But in recent years we have faced challenges involving Iran, Israel and the rest of the Middle
East; Russia and Ukraine; China and North Korea; and terrorist threats in many places. How will
markets react to the inevitable flare-ups?
The worries listed above confronted investors throughout the period 2012 through 2014. And in the last
few months of that period, we saw a halving of the price of oil; additional slowing in China; worsening
news from the Middle East; and continuing uncertainty regarding the Feds likely action on interest rates.
Given markets abhorrence of uncertainty, we normally would expect such issues to result in low asset
prices and negative returns. But in 2012-14, despite the many negatives, we saw a cumulative return of
74% on the S&P 500, as well as strong appreciation on the part of real estate and companies that had been
the subject of buyouts. Further reflecting investor confidence, the yield spread versus Treasurys for the
average U.S. high yield bond narrowed from 706 basis points at the end of 2011 to 522 b.p. at the end of
2014, at which point the prospective yield to worst was down to 6.67%. Thus, as 2014 moved to a close,
we saw:
the litany of meaningful macro risks described above,

investors engaging in pro-risk behavior in pursuit of adequate returns in a low-return world,
as a consequence, full asset prices, and thus
little likelihood of achieving returns high enough to compensate for the risks.
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To sum up, psychology (and thus prices) were high given the fundamentals. Our world was marked by
low prospective returns and plentiful problems, a troubling combination.
Heres what I wrote in Risk Revisited in September 2014:
While investor behavior hasnt sunk to the depths seen just before the crisis (and, in my
opinion, that contributed greatly to it), in many ways it has entered the zone of
imprudence. . . .
Its the job of investors to strike a proper balance between offense and defense, and
between worrying about losing money and worrying about missing opportunity. Today I
feel its important to pay more attention to loss prevention than to the pursuit of gain. For
the last three years Oaktrees mantra has been move forward, but with caution. At this
time, in reiterating that mantra, I would increase the emphasis on those last three words:
but with caution. . . .
Although I have no idea what could make the day of reckoning come sooner rather than
later, I dont think its too early to take todays carefree market conditions into
consideration. What I do know is that those conditions are creating a degree of risk for
which there is no commensurate risk premium.
The Negatives Build

Given the many concerns, performance in the first half of 2015 was sluggish at best. Most markets eked
out positive returns, but gains came grudgingly, and few investors had a good time. Then, during the
summer, the accumulation of worries accelerated and became too much to withstand:
Growth remained flat or slowed in the U.S., Europe and Japan.

Chinas economy continued to slow.
The Fed continued to dither regarding interest rates. A potential increase caused worry, but so
did the appearance that the Fed considered growth too weak to allow an increase.
The oil price decline resumed, and other metals and commodities joined in, weakening the prices
of related stocks and bonds.
The geopolitical picture went from bad to worse:
o Syria presented a choice between (a) enabling a despot to remain and (b) ousting him and
turning over another country to instability and insurgency.
o Russia intervened, flexing its muscles and reminding us of its intransigence.
o ISIS and the flow of immigrants to Europe took on the appearance of insoluble problems;
Paris and San Bernardino showed terrorism to be a serious ongoing threat.
o An agreement was reached to limit Irans nuclear progress, but no two experts seemed to
agree on whether it was a good or bad thing.
o Iraq, Afghanistan, Israel and Palestine got no better.
o The South China Sea heated up from time to time.
There was nothing positive to say about the U.S. political situation. Partisanship and gridlock
remained the rule. The grinding two-year campaign took up increased airtime and mindshare,
without a positive consensus concerning most candidates.
Finally, a number of issues internal to the markets ranging from reduced liquidity to marketreporting glitches to the meltdown of high-risk credit funds shook investors faith.
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Somehow, market participants are able to live with uncertainties like these and retain their equanimity,
sometimes for long periods. Maybe its conviction, maybe its obliviousness, and maybe its denial.
And thats what prevailed in recent times; as Doug Kass put it in mid-2014, weve been experiencing a
bull market in complacency.
But eventually something else happens perhaps the house of cards grows too high and investors
feeling of serenity is pierced. A point is reached beyond which equanimity can no longer be maintained.
It was getting to that point that led to meaningful declines in U.S. credit markets in the latter half of 2015.
The Tipping Point

One of the most notable behavioral traits among investors is their tendency to overlook negatives or
understate their significance for a while, and then eventually to capitulate and overreact to them on
the downside. I attribute a lot of this to psychological failings and the rest to the inability to appreciate
the true significance of events.
As negatives accumulate whether they surface for the first time or just are finally recognized as
significant eventually a time comes when they can no longer be ignored, and instead they come to be
treated as being of overwhelming importance. The latest tipping point was reached last August.
Up to that point, investors had pretty much resisted the negatives, and the S&P 500 was up 3.3% in the
first seven months of the year. (The media might say investors had coped with the negatives, but of
course they hadnt dealt with them; theyd ignored them.)
But then, in August, a series of negatives occurred in China: reports of still more economic slowing; a
decline in A-share prices from June to August that reached 45%; an unexpected devaluation of the
renminbi (whose value many people complained for years had been artificially depressed); and marketsupport measures that some found ham-handed (e.g., restrictions on actions such as short selling, and
investigations of journalists writing negative articles about the stock market).
Everyone knew for years that the Chinese economy had been overstimulated with cheap
financing, and that this had led to excessive investment in fixed assets. The effect was exceptional
GDP growth, but also a large stock of unneeded buildings and infrastructure. Everyone also knew that a
hard landing a painful slowing in economic growth, and perhaps a recession was among the possible
outcomes. But it wasnt until August that investors outside China began to notice A-shares
collapse; consider the possibility that a slowdown in China could have negative ramifications for
the rest of the world; and import those worries to their own markets. Thus between August 17 and
25, the S&P 500 declined 11%. What was behind the extrapolation of Chinas woes to other markets, like
ours? Heres how I explained it in Its Not Easy, published in September on the heels of the events in
China:
Especially during downdrafts, many investors impute intelligence to the market and look
to it to tell them whats going on and what to do about it. This is one of the biggest
mistakes you can make. As Ben Graham pointed out, the day-to-day market isnt a
fundamental analyst; its a barometer of investor sentiment. You just cant take it
too seriously. Market participants have limited insight into whats really happening in
terms of fundamentals, and any intelligence that could be behind their buys and sells is
obscured by their emotional swings. It would be wrong to interpret the recent worldwide
drop as meaning the market knows tough times lay ahead. Rather, China came out
with some negative news and people panicked, especially Chinese investors who had
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bought stocks on margin and perhaps were experiencing their first serious market
correction. Their selling prompted investors in the U.S. and elsewhere to sell also,
believing that the market decline in China signaled serious implications for the Chinese
economy and others.
Whatever the reason, the bottom line for me is that whereas risk tolerance had ruled through July,
risk aversion was reawakened in August. I picture an investor whos oblivious to risk in the earlier
months and then suddenly says, Oh yeah: there are things to worry about. The tipping point finally
arrives, a sudden wake-up call to the existence and importance of risk.
Half-Full or Half-Empty?
Almost 25 years ago, in my second memo (First Quarter Performance, April 1991), I introduced the
concept of the investment pendulum:
Although the midpoint of its arc best describes the location of the pendulum on
average, it actually spends very little of its time there. Instead, it is almost always
swinging toward or away from the extremes of its arc. But whenever the pendulum is
near either extreme, it is inevitable that it will move back toward the midpoint sooner or
later.
One of the most significant factors keeping investors from reaching appropriate conclusions is their
tendency to assess the world with emotionalism rather than objectivity. Their failings take two
primary forms: selective perception and skewed interpretation. In other words, sometimes they take
note of only positive events and ignore the negative ones, and sometimes the opposite is true. And
sometimes they view events in a positive light, and sometimes its negative. But rarely are their
perceptions and interpretations balanced and neutral.
Ever since the August events in China, Ive repeatedly found myself harking back to one of the oldest
cartoons in my file, and still one of the very best:
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In 2015 we saw old problems get worse, new ones arise, and a general absence of anything to feel good
about. The sense of hopelessness regarding problems like ISIS and runaway immigration is something
investors handle particularly poorly. In August, the events in China sparked a revival of risk aversion and
fear, with effects that carried around the world for a couple of weeks. And with the door opened to
fearful interpretation, Pollyanna tolerance gave way to widespread negativism.
The bottom line is that investor psychology rarely gives equal weight to both favorable and
unfavorable developments. Likewise, investors interpretation of events is usually biased by their
emotional reaction to whatever is going on at the moment. Most developments have both helpful and
harmful aspects. But investors generally obsess about one or the other rather than consider both. And
that recalls another classic cartoon:
It all seems so obvious: investors rarely maintain objective, rational, neutral and stable positions. First
they exhibit high levels of optimism, greed, risk tolerance and credulousness, and their resulting
behavior causes asset prices to rise, potential returns to fall and risk to increase. But then, for some
reason perhaps the arrival of a tipping point they switch to pessimism, fear, risk aversion and
skepticism, and this causes asset prices to fall, prospective returns to rise and risk to decrease.
Notably, each group of phenomena tends to happen in unison, and the swing from one to the other often
goes far beyond what reason might call for.
Thats one of the crazy things: in the real world, things generally fluctuate between pretty good
and not so hot. But in the world of investing, perception often swings from flawless to
hopeless. The pendulum careens from one extreme to the other, spending almost no time at the happy
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medium and rather little in the range of reasonableness. First theres denial, and then theres
capitulation.
The Sources of Error

To explain why these bipolar episodes occur, I want to spend a little time on some of the factors behind
investor psychology. For the most part theyre easily observed and dissected, and not mysterious. I
discussed some of them in Its Not Easy:
Emotion is one of the investors greatest enemies. Fear makes it hard to remain
optimistic about holdings whose prices are plummeting, just as envy makes it hard to
refrain from buying the appreciating assets that everyone else is enjoying owning.
Confidence is one of the key emotions, and I attribute a lot of the markets recent
volatility to a swing from too much of it a short while ago to too little more recently. The
swing may [result] from disillusionment: its particularly painful when investors
recognize that they know far less than they had thought about how the world works.
Its important to remain moderate as to confidence, but instead its usually the case that
confidence like other emotions swings radically.
While China was the proximate cause of the recent volatility, other things often
contribute, and last month was no exception. The word that always comes to mind for
me is confluence. Investors can usually keep their heads in the face of one
negative. But when they face more than one simultaneously, they often lose their
cool. One additional negative last month was the glitch in Bank of New York Mellons
SunGard software, and the banks consequent inability to price 1,200 mutual funds and
ETFs that it administers. It was another dose of disillusionment: no one enjoys learning
that the market mechanisms they need to work cant be depended on.
Another area of error be it the result of flawed perception or inadequate insight and analysis
can be seen in investors repeated failure to understand the potential for ramifications and secondorder consequences. One instance was the general lack of concern about contagion from sub-prime
mortgage backed securities that prevailed between early 2007 when mortgages began to default in large
numbers and the tumultuous events of mid/late 2008. Most people overlooked the potential for
contagion, and thus (for example), as of May 2008 the S&P 500 was essentially unchanged from the first
quarter of 2007. Yet sub-prime mortgage defaults contributed significantly to the subsequent bank
collapses and bailouts, the bankruptcy filing of Lehman Brothers, and the late-2008 emergence of fear of
a financial system meltdown. As a consequence, between May 2008 and March 2009 the S&P lost 52%.
The events that produced such extreme distress in late 2008 and early 2009 were unforeseen and
unimagined just a few months before . . . even though the clues had been there for a year.
There are many more ways in which non-objective, non-rational quirks commonly affect behavior. As
Carol Tavris points out in her May 15, 2015 Wall Street Journal review of Professor Thalers book:
As a social psychologist, I have long been amused by economists and their curiously
delusional notion of the rational man. Rational? Where do these folks live? Even 50
years ago, experimental studies were demonstrating that people stay with clearly wrong
decisions rather than change them, throw good money after bad, justify failed predictions
rather than admit they were wrong, and resist, distort or actively reject information that
disputes their beliefs.
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The difficulty of understanding events, their significance and their potential ramifications comes in
good part from the kinks in investors psyches, and it contributes to and feeds back to exacerbate
investors responses. Thus investors tend to emphasize just the positives or the negatives much more
often than they take a balanced, objective approach. And they tend to become optimistic and eager to buy
when good news, positively interpreted, has forced prices up . . . and vice versa. All of this is obvious
(especially in retrospect), and thus equally obviously, understanding and dealing with it presents a
potential way to improve results.
Notions of market efficiency the idea that most assets are priced right are based on belief in
investor rationality and objectivity. But certainly those traits are little seen in real life.
Inefficiencies in everyday language, mispricings stem from biases against one asset or in favor of
another: legal, cultural, informational, and especially behavioral and emotional. The first three of these
exist much less nowadays than they did 30 or 40 years ago, but the latter two still rear their head from
time to time. And Im sure they always will.
Case In Point Oil
On December 12, as I began to write this memo, the Financial Times provided several examples of the
negative thinking being applied. Here are some excerpts from an article about the recent market action:
Oil prices fell sharply to a seven-year low, rattling stock markets at the end of a choppy
week. . . . The price of Brent crude, the global energy benchmark, was down 5.6% to
$37.49 . . . after Opec at its meeting a week ago failed to agree output cuts, leaving
prices at the mercy of a global glut.
Lower oil prices are here to stay.
The CBOE Oil Vix is holding above the 54 level . . . as investors pay up to protect
themselves [against], or speculate upon, further sharp moves in crude.
That all sounds very serious. But is it? Does it make any sense? Whats the real significance of
declining oil prices?
The bottom line for me is that, if you arent an oil company or a net oil-producing country, low oil prices
arent necessarily a bad thing. For net oil importers like the U.S., Europe, Japan and China, the drop
weve seen in the price of oil is analogous to a multi-hundred-billion-dollar tax cut, adding to consumers
disposable income. It can also increase an importer nations cost-competitiveness.
The U.S. is both a producer of oil and an importer. That means the macro economy will enjoy the benefit
of cost reduction and income enhancement, but domestic oil companies and those who provide them with
products and services will gain less from production than had been expected, and some state and local
governments will be hard-hit. (And I must add that, thus far, the indicators fail to suggest a salutary
impact on the broad economy.) Eighteen months ago I thought the ability to produce oil through fracking
at a cost of $40-60 per barrel would give the U.S. a cost advantage in manufacturing; thats no longer
likely, at least for now.
But the one thing thats beyond doubt is that the impact of the fall in the price of oil is far from all bad. In
fact, Id say that its positive on balance for the U.S. and an unmitigated boon for the UK, Europe and
East Asia. So why did the FT attribute market weakness to it? First, the media have taken on the
unpleasant task of telling us why the markets went up or down each day, and the falling oil price is an
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easy answer . . . until you give it any real thought. Second, though, as the FT went on to explain, some
worry might be appropriate regarding what it connotes:
The fall in commodity prices is causing market anxiety because investors are worried that
it signals a slowdown in global demand, and that any economic benefit from cheaper
costs for consumers and businesses is being counteracted by the cutting of investments
and jobs by the resources sector.
In other words, theyre inferring that the price of oil declined because demand is off, and that this signals
economic weakness. But economic growth is what it is; we dont need the oil price to tell us its weak.
And the price of oil is off another third in the last few months, even though world GDP is still growing.
The important thing isnt what the oil price decline tells us about today. Its what it says about tomorrow.
And to me, everything else being equal, I think low energy prices today will contribute to better economic
growth tomorrow. (Low prices today probably also imply higher prices eventually, through their impact
on supply and demand.) Its just that everybodys interpreting everything negatively these days.
Case In Point Interest Rates
The FT also pointed out that investors were reacting to the likelihood the Fed would raise interest rates,
even though that should have been a foregone conclusion:
Next week, the Federal Reserve will raise interest rates. That at least now appears likely.
Anything else would be the biggest shock of a year in which markets and monetary
authorities have had serious misgivings. Let us assume for now that it happens.
This will be the longest-awaited and most-previewed tightening of monetary policy in
history.
Theres something wrong if an event that has been widely anticipated for years and considered a
near certainty for months can be thought capable of significantly impacting the market when it
becomes a fact. Peoples expectations should be incorporated into the prices they assign to assets. So a
negative reaction to the imminence of a widely heralded interest-rate increase must imply that either (a)
investors are too dense to have incorporated it into prices before this, (b) the increase will be a bigger deal
than people thought, or (c) the market is irrational.
On December 15, Dow Jones published the following quote:
Its been more shoot first, ask questions later in the shares of large asset managers, said
Kenneth Hill, an analyst at Barclays PLC. The concern is largely that as rates move
higher, investors think returns will move lower and there will be some rotation out of
fixed income. People are anxious to see how that plays out, he added.
When Mr. Hill said that, more than two and a half years had passed since May 2013, when Ben Bernanke
foreshadowed a tapering of bond purchases and the possibility of higher interest rates. How can
investors not have had enough time to adjust to the possibility of higher rates and incorporate it into asset
prices? Indeed, the increase that was just days away should have been mostly a non-event, and the idea
that it was a significant contributor to the declines on December 11 makes no apparent sense.
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Over the years since Bernankes statement in 2013, the question Ive been asked more often than any
other has been, What month will the Fed begin to raise interest rates? My response has been consistent:
I have no idea, and why do you care? If someone tells me hell do one thing if he thinks the Feds
going to raise rates in March and something different if its going to happen in January, what hes
demonstrated is that he doesnt understand how asset prices incorporate expectations. The difference in
timing should have little effect on the choice of a course of action. What matters is how far rates will go,
and how fast. I dont expect much of either from this dovish and cautious Fed . . . unless the economy
surprises on the upside. And that would be good news, wouldnt it?
While on the subject of interest rates, I want to mention the thing about them that most annoys me these
days. People who acted one way when rates were unchanged (even though everyone knew they wouldnt
remain that way for long) are acting very differently now that theres been a quarter-point increase. This,
they say, is because were in a rising-rate environment. But the issue of interest rates, like most others,
shouldnt be viewed as binary . . . black or white . . . flat rates or rising. The essential questions are,
how much will rates rise? and when the series of increases is over, will rates be high enough to
meaningfully alter behavior? Thats what counts.
Yesterday, The Wall Street Journal wrote as follows: Analysts and investors attribute the [auto stocks
recent greater-than-market] declines to worries that rising U.S. interest rates could crimp auto finance and
to fears that auto sales may have peaked. Does the interest rate outlook really mean significantly fewer
cars will be sold . . . especially given that low gas prices are making consumers richer and driving
cheaper? I think people may have jumped to an unwarranted and negatively tinged conclusion.
Case In Point Third Avenue
In terms of investor reaction, I find the announcement that Third Avenues Focused Credit Fund would
liquidate to be the most interesting recent event. According to the FT:
The liquidation of the biggest US mutual fund since 2008 has intensified concern for the
health of the US corporate bond market.
Some distinguished between a risk to the system, where issues at one fund trigger
redemptions from others, and so-called idiosyncratic problems related to a single fund.
Corporate bonds sold off again yesterday in the wake of the FCF liquidation
announcement and many investors rushed to buy default insurance contracts on junk debt.
There isnt much to be in doubt about in the meltdown of the Focused Credit Fund; clearly it reflected
problems peculiar to that fund alone. In 2014, while a $3 billion fund, it had substantial holdings in
particularly-high-risk, illiquid debt. Then it encountered snowballing capital withdrawals at a time of
reduced market liquidity. Under circumstances like these, portfolio managers generally raise cash by
liquidating their most salable holdings, causing the quality and liquidity of the remaining portfolio to
decline. Continuing withdrawals took FCFs assets below $800 million in December 2015, and I hear it
was down to 20 or fewer holdings, all of extremely low quality. Further redemptions would have forced
the manager to sell those, realizing extremely low prices, eliminating any liquidity that may have been
present, and leaving investors who hadnt redeemed holding the bag.
The fault certainly lies with the funds managers. Risky, illiquid investments may be appropriate for
closed-end funds whose capital is secure, but probably not for mutual funds or other vehicles subject to
daily redemptions. Its debatable whether a fund should be expected to be able to handle both an 80%
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loss of AUM and a substantial decline in liquidity. But, as I wrote in Liquidity (March 2015), no
investor should shoulder more illiquidity than its realities permit and, in particular, no investment
vehicle should promise more liquidity than is afforded by its underlying assets. Illiquid assets and the
possibility of capital flight: there are few surer recipes for investment disaster.
Investors lacking strong emotional and analytical foundations might have been scared into believing that
FCFs problems connoted or presaged widespread weakness among high yield bonds and other forms
of risky debt. Those who were a bit less panicky might have understood that high yield bonds in general
were probably secure but still feared that illiquidity would combine with cascading redemptions to cause
a chain reaction of capital withdrawals from other funds, forced sales, and collapsing bond prices. But
those with adequate emotional and analytical resources would have recognized that FCFs problems were
more endogenous and idiosyncratic than a function of high yield bonds broadly, and that adequate
creditworthiness provides the debtholders ultimate protection against chaos in the market.
Recent Developments
Behavioral economics and its younger cousin, behavioral investing, arent theoretical. In fact, theyre the
essence of practical: theyre about how human foibles cause real-life behavior to deviate from what
theory might dictate.
In recent months weve had occasion to watch how mood swings can alter the investment environment.
Ill describe below the events that have occurred in the market for distressed debt.
In the U.S., the years 2010-14 were characterized by gradual economic improvement, increasing
corporate profits, a dramatic switch of the credit markets to accommodativeness, and because of all this
some of the lowest default rates in history on low-grade debt. As a result, there was a paucity of
distressed debt. Further, the little that was available was concentrated in just a few areas: European
NPLs, real estate, shipping and power companies. Put these factors together, and Oaktree found itself
unable to assemble large or thoroughly diversified distressed debt portfolios. Noting this, we followed up
our record $10.9 billion fund raised in 2007-08 (and largely invested in the quarter following Lehman
Brothers bankruptcy filing) with one of $5.5 billion in 2010 and then another of $2.7 billion in 2011. In
other words, we halved our investable capital and then halved it again.
There is no immediate connection (other than for companies doing business there) between the slowdown
in China or the price decline in the oil patch, on one hand, and the general creditworthiness and
desirability of high-risk debt on the other. And yet, over the last few months, pronounced changes have
occurred in the market for distressed debt:
After a period of very stable prices even for iffy debt some securities have gapped down
in the last few months (i.e., fallen several points at a time rather than correcting gradually). In
particular, investors have become highly intolerant of bad corporate news.
For the first time since 2008-09, the debt of some companies outside of energy and mining has
fallen from 90 to 60, and others from 50 to 20.
There is a general sense among my colleagues that investors have gone from evaluating
securities based on the attractiveness of their yield (with company fundamentals viewed
optimistically) to judging them on the basis of the likely recovery in a restructuring (with
fundamentals viewed pessimistically).
The capital markets have begun the swing from generous toward tight, as is their habit. Thus,
whereas they used to find it easy to refinance debt in order to extend maturities or secure rescue
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financing, now its hard for companies especially those experiencing any degree of difficulty
to obtain capital.
On December 7, Oaktree held a dinner in New York for equity analysts who follow our publicly traded
units. Bob OLeary, a co-portfolio manager of our distressed debt funds, planned to be among the hosts.
But he called me on December 3 with a question I hadnt heard in a long time from my distressed debt
colleagues: Would you mind if I dont come? Theres too much going on for me to leave the office.
The change in investor attitudes had created investment opportunities where they hadnt existed just a few
months before in some cases out of proportion to the change in fundamentals.
Developments like these are indicative of rising pessimism, skepticism and fear. Theyre largely what
Oaktree hopes for, since everything else being equal they make for vastly improved buying
opportunities. But note that we may be just in the early stages of a downward spiral in corporate
performance and credit market behavior. Thus, while this may be a time to buy, Im far from
suggesting its the time.
My Prescription
To help investors deal with their potential for human error, this shrink would prescribe a number of
elements that can help with the task:
The first essential element in coping with markets irrationality is understanding. The
importance of psychology and its influence on markets must be recognized and dealt with.
The second key lies in controlling ones emotions. An investor who is as subject as the crowd to
emotional error is unlikely to do a superior job of surviving the markets swings. Thus it is
absolutely essential to keep optimism and fear in the appropriate balance.
Emotional self-control isnt enough. Its also important to have control over ones
circumstances. For professionals, that primarily means structuring ones environment so as to
limit the impact on them of other peoples emotional swings. Examples include inflows to and
outflows from funds, fluctuations in market liquidity, and pressure for short-term performance.
At Oaktree we never fail to appreciate the benefit we enjoy from being able to reject hot money
and limit our funds redemption provisions.
And finally theres contrarianism, which can convert other investors emotional swings from a
menace into a tool. Going beyond just fending off emotional fluctuation, its highly desirable to
become more optimistic when others become more fearful, and vice versa.
Im lucky to have received many gifts of investment insight early in my career. Perhaps foremost among
them is one I picked up in New York about 40 years ago, at a lunch meeting of what we called the Third
Thursday Group. It concerned the three stages of a bull market:
the first, when only a few especially insightful people suspect improvement might occur,
the second, when most people accept that improvement is actually taking place, and
the third, when everyone concludes that things are sure to improve forever.
Between the first stage and the last, nothing has to have changed in terms of fundamentals. The
difference lies in the perspective investors are bringing to their decisions. But clearly, its great to be
a buyer in the first stage and essential not to be in the last.
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We know investors swing from rejecting all possibilities to drinking the Kool-Aid, just as the three stages
say. Thus at Oaktree we want to buy when theyre pessimistic, not when theyre eager participants. If I
could know only one thing about an investment Im contemplating, it might be how much optimism
is embodied in the price. In the first stage of the bull market, no optimism is present, and that makes for
great bargains. In the last stage, the level of optimism is terribly high, and thus so are purchase prices
relative to fundamentals. I want to buy when I can benefit from the herds neuroses, not when theyll
penalize me just as they do everyone else.
As I mentioned above, since the middle of 2011 by which time the quest for return had resulted in rather
full prices for debt, over-generous capital markets and pro-risk investor behavior Oaktrees mantra has
been move forward, but with caution. Weve felt it was right to invest in our markets, but also that our
investments had to reflect a healthy dose of prudence. Except for the occasional air pocket, investors
didnt suffer significant negative consequences prior to the last year or so. Thus, as usual, we were early
in turning cautious. But opportunities (and returns) in the credit sphere have been only so-so since mid2011, and I dont think our caution caused us to miss much.
Now, as discussed above, investors optimism has deflated a bit, some negativity has come into the
equation, and prices have moved lower. Depending importantly on which market were talking
about and how it has fared in recent months, we consider it appropriate to move forward with a
little less caution.
While I have your attention, I want to devote a few paragraphs to the two questions Im asked most
often these days: What are the implications for the U.S. and the rest of the world of Chinas
weakness, and are we moving toward a new crisis of the magnitude of what we saw in 2008?
At a time when the environment is marked by so many potential problems, its important to figure out
which if any are likely to present real problems. Declining oil prices: the implications for non-oil
producers seem mixed at worst. A terrorist event: horrifying, but for any one person or location, Id put it
in the category of an improbable disaster. The political picture: well probably continue to muddle
through no matter whos elected.
I would say that, of all the things on the list, the possibility of a hard landing in China is of the greatest
significance when you combine magnitude, potential ramifications and the probability of it occurring. So
its important to look objectively at what it means for the U.S.
First, lets remember that China doesnt play a pivotal role in the U.S. economy (other than as a provider
of finished goods). It is estimated to account for only 1% of the combined profits of the S&P 500
companies. Exports account for about 13% of U.S. GDP, and in the first eleven months of 2015 less than
8% of our exported goods went to China ($106 billion of goods, versus an annual GDP approaching $18
trillion again, well below 1%).
Going on from there, I want to share Paul Krugmans analysis from The New York Times of January 8. (I
generally dont agree with Krugmans politics, but I dont think theyre relevant here.):
Yes, China is a big economy, accounting in particular for about a quarter of world
manufacturing, so what happens there has implications for all of us. And China buys
more than $2 trillion worth of goods and services from the rest of the world each year.
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But its a big world, with a total gross domestic product excluding China of more than
$60 trillion. Even a drastic fall in Chinese imports would be only a modest hit to world
spending.
What about financial linkages? One reason Americas subprime crisis turned global in
2008 was that foreigners in general, and European banks in particular, turned out to be
badly exposed to losses on U.S. securities. But China has capital controls that is, it
isnt very open to foreign investors so theres very little direct spillover from plunging
stocks or even domestic debt defaults.
All of this says that while China itself is in big trouble, the consequences for the rest of us
should be manageable. But I have to admit that Im not as relaxed about this as the above
analysis says I should be. If you like, I lack the courage of my complacency. Why?
Part of the answer is that business cycles across nations often seem to be more
synchronized than they should be. For example, Europe and the United States export
to each other only a small fraction of what they produce, yet they often have recessions
and recoveries at the same time. Financial linkages may be part of the story, but one also
suspects that there is psychological contagion: Good or bad news in one major economy
affects animal spirits in others.
So I worry that China may export its woes in ways back-of-the-envelope calculations
miss . . .
I want to highlight Krugmans reference to psychological contagion. Its interesting in this regard that,
last week, the worlds stock markets saw the following declines: S&P 500 6.0%, FTSE 100 5.3%,
DAX 8.3% and Nikkei 7.0%. I consider it highly unlikely that such uniform declines were the
result of independent, objective analysis of the impact of events on each economy and company.
Rather, I think they show the extent to which markets are linked by their investors shared
psychology.
So what about the likelihood of another 2008-style crash? The bottom line for me is that a rerun of the
Global Financial Crisis isnt in the cards:
We havent had a boom (either in the economy or in the stock market), so I dont think
were fated to have a bust. Because most businesses have been particularly loath to
expand their facilities, I dont think theyll be slammed if revenues flatten or turn down.
The leverage in the private sector has been reduced. This is particularly true of the banks,
where leverage has gone from the region of 30+ times equity before the crisis to very low
double digits today. And, of course, banks are now barred from investing adventurously
for their own account.
Finally, the main villain in the crisis was sub-prime mortgage backed securities. The raw
material the underlying mortgages was unsound and often fraudulent. The structured
mortgage vehicles were highly levered and absurdly highly rated. And the risky tranches
ended up in banks portfolios, causing them to require rescues. Importantly, this time
around I see no analog to sub-prime mortgages and MBS in terms of their
combination of fragility and magnitude.
I dont mean to suggest there arent a lot of things to worry about: swollen central bank balance
sheets; complete ignorance as to how they will be unwound and how interest rates will be moved higher;
the seeming inability to generate economic growth and inflation; and the many other macro negatives
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listed earlier. A hard landing and substantial devaluation in China, the worlds second largest economy,
certainly could have far-reaching effects.
Its important that investors (as well as economists) avoid using words like always, never, will,
wont, has to and cant, and I try to do just that. But its my view that the GFC and its
preconditions were highly unusual, and I dont think were heading for an encore. Remember, however,
that Im not a seer, and Oaktree and I never bet heavily on opinions regarding the future mine or anyone
elses.
Before I close, I want to make it abundantly clear that when I call for caution in 2006-07, or active buying
in late 2008, or renewed caution in 2012, or a somewhat more aggressive stance here in early 2016, I do it
with considerable uncertainty. My conclusions are the result of my reasoning, applied with the benefit of
my experience (and collaboration with my Oaktree colleagues), but I never consider them 100% likely to
be correct, or even 80%. I think theyre right, of course, but I always make my recommendations
with trepidation.
I read the same newspapers as everyone else. I see the same economic data. Im buffeted by the same
market movements. The same factors appeal to my emotions. Maybe Im a little more confident in my
reasoning, and certainly I have more experience than most. But the key is that for whatever reason
Im able to stand up to my emotions and follow my conclusions. None of them can be documented or
proved. If they could be, most intelligent people would reach the same conclusions, with the same
degree of confidence. I tell you this only to communicate my feeling that no one should fear hes not up
to the task just because hes unsure of his conclusions. These arent things about which certainty is
attainable.
Lastly, they tell me Oaktree is now on social media. That means you can follow @oaktree on Twitter to
receive updates about my memos, videos and speaking engagements, and to hear from others at the
firm. You can also subscribe to my memos on our website, oaktreecapital.com/insights.
January 14, 2016
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Memo to:
Oaktree Clients
From:
Howard Marks
Re:
What Does the Market Know?
My buddy Sandy was an airline pilot. When asked to describe his job, he always answers, hours of
boredom punctuated by moments of terror. The same can be true for investment managers, for whom
the last few weeks have been an example of the latter. Weve seen bad news and prices cascading
downward. Investors who thought stocks were priced right 20% ago and oil $70 ago now wonder if they
arent risky at their new reduced prices.
In Thursdays memo, On the Couch, I mentioned the two questions Id been getting most often: What
are the implications for the U.S. and the rest of the world of Chinas weakness, and are we moving toward
a new crisis of the magnitude of what we saw in 2008? Bloomberg invited me on the air Friday morning
to discuss the memo, and the anchors mostly asked one version or another of a third question: does the
markets decline worry you? That prompted this memo in response.
The answer lies in a question: what does the market know? Is the market smart, meaning you
should take your lead from it? Or is it dumb, meaning you should ignore it? Heres what I wrote in Its
Not Easy in September and included in On the Couch:
Especially during downdrafts, many investors impute intelligence to the market and look
to it to tell them whats going on and what to do about it. This is one of the biggest
mistakes you can make. As Ben Graham pointed out, the day-to-day market isnt a
fundamental analyst; its a barometer of investor sentiment. You just cant take it
too seriously. Market participants have limited insight into whats really happening in
terms of fundamentals, and any intelligence that could be behind their buys and sells is
obscured by their emotional swings. It would be wrong to interpret the recent worldwide
drop as meaning the market knows tough times lay ahead.
The rest of this memo will be about fleshing out this theme (meaning you can stop reading here if youve
had enough or are short on time).
The Nature of Consensus Opinion

I based the above reference to Ben Graham on his famous observation that in the long run the markets a
weighing machine, but in the short run its a voting machine. In other words, in the long term the
consensus of investors figures out what things are really worth and moves the price there. But in the short
term, the market merely reflects consensus opinion regarding an assets future popularity, something
thats highly susceptible to the ups and downs of psychology.
So, what does the market know? First its important to understand for this purpose that there really
isnt such a thing as the market. Theres just a bunch of people who participate in a market. The
market isnt more than the sum of the participants, and it doesnt know any more than their collective
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This is a very important point. If you believe the market has some special insight that exceeds the
collective insight of its participants, then you and I have a fundamental disagreement. The thinking of the
crowd isnt synergistic. In my view, the investment IQ of the market isnt any higher than the average IQ
of the participants. And everyone who transacts gets a volume-weighted vote in setting an assets price at
a given point in time.
People of all different levels of ability act together to set the price. They vary all over the lot in terms of
knowledge, experience, insight and emotionalism. The market doesnt give the ones who are superior in
these regards any more influence than the others, especially in the short run. My bottom line on this
subject is that the market price merely reflects the average insight of the market participants.
Thats point number one.
If anything, I think its emotion thats synergistic. It builds into herd behavior or mass hysteria. When
10,000 people panic, the emotion seems to snowball. People influence each other, and their emotions
compound, so that the overall level of panic in the market can be higher than the panic of any participant
in isolation. Thats something Ill return to later.
Now lets think about the first goal of investing: to buy low. We want to buy things whose price
underestimates the value of the underlying assets or earnings (value investing) or the future potential
(growth investing). In either case, were looking for instances when the market is wrong. If we
thought the market was always right the efficient market hypothesis we wouldnt spend our lives as
active investors. Since we do, wed better believe we know more than the consensus. So by definition
we must not think the market that is, the sum of all other investors knows everything, or knows
more than we do, or is always right. Thats point number two.
And that leads logically to point number three: why take instruction from a group of people who
know less than you do? In On the Couch, I wrote that it all seems obvious: investors rarely maintain
objective, rational, neutral and stable positions. Do you agree with that or not? Is the market a clinical
and rational fundamental analyst, or a barometer of investor sentiment? Does the markets behavior these
days look like something a mature adult should emulate?
It seems clear to me: the market does not have above average insight, but it often is above average
in emotionality. Thus we shouldnt follow its dictates. In fact, contrarianism is built on the premise
that we generally should do the opposite of what the crowd is doing, especially at the extremes, and I
prefer it.
A Case in Point The Crash of 2008
The year 2008 culminated in the greatest panic Ive ever seen. The events that built up to it included:
massive subprime mortgage defaults and the failure of mortgage backed vehicles,
meltdowns at funds that had invested in those vehicles, notably two Bear Stearns funds,
the collapse of Bear Stearns, necessitating its purchase by JPMorgan for almost no consideration,
rescues of Merrill Lynch by Bank of America; Wachovia by Wells Fargo; and Washington
Mutual by JPMorgan (after it was first seized by the Office of Thrift Supervision),
decisions on the part of BofA and Barclays not to acquire Lehman Brothers, and on the part of the
U.S. Treasury not to bail it out, leading to Lehmans bankruptcy filing,
the appearance that Morgan Stanley would be next if it couldnt secure additional capital, and
widespread speculation regarding other firms that might follow.
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A massive downward spiral ensued. Among the contributing factors were:
precipitous declines in the prices of bank stocks,

large-scale short selling of the stocks (the uptick rule previously mandated that a stock could
only be sold short at a price above the last trade, meaning short selling couldnt force the price
down. But the rule was repealed in 2007, so there ceased to be limits on when stocks could be
shorted. Thus short sellers could force stock prices down whether intentionally, in what in the
1920s were called bear raids, or just because they thought the stocks were right to sell),
dramatic increases in the cost to insure the debt of banks through credit default swaps.
In the environment described above, the downward spiral in bank stocks was intensified by the following
factors (whether they were intentionally manipulated, I cant say for sure):
It was easy to bet against the banks by buying credit default swaps (CDS) on their debt.
It was easy to depress bank stocks by selling them short.
The declining stock prices were taken as a sign that the banks were weakening, causing the cost
of buying CDS protection to rise.
The rising cost of CDS protection was taken as an additional negative sign, causing the stocks to
fall further.
I can tell you, it had the feel of an unstoppable vicious circle. Some compared it to the China
Syndrome: a 1979 movie with Jane Fonda and Michael Douglas in which an out-of-control nuclear
reaction threatens to propel reactor components through the earths core, from the U.S. to China. Thus
the stock of panic-ridden Morgan Stanley (for example) fell 82%, to less than $10.
But its important to note that the negative feedback loop described above was able to continue without
reference to and not necessarily in reasonable relationship to actual developments at the banks or
changes in their intrinsic value. Eventually, however, the Treasury restricted short selling in the stocks of
19 financial institutions deemed systemically important. Morgan Stanley secured a $9 billion injection
of convertible equity from Mitsubishi UFJ Financial Group. The panic subsided. The economy and
capital markets recovered. And Morgan Stanleys stock traded at $33 a year later.
Do you wish you had taken the markets instruction in 2008 and sold bank stocks? Or do you wish
you had rejected its advice and bought instead? In short, did the market know anything?
There are three possible answers:
The market was flat wrong in 2008 when it took Morgan Stanleys stock so low.
The market was right; it properly reflected the possibility of a meltdown that could have
happened but didnt.
The market was wrong in the case of Morgan Stanley in 2008, but most of the time it isnt.
I like the first, and the second is appealing as well. But while a meltdown certainly was possible, the
below-$10 price probably assigned it too high a likelihood. And, of course, Im not persuaded by the
third.
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A Case in Point Senior Loans in the Financial Crisis

While on the subject of 2008, I want to review the performance of senior loans. In the old days, banks
made corporate loans, sometimes sharing part with a syndicate of a few friendly banks but retaining the
rest. More recently the custom changed, with banks syndicating their loans widely to buyers of all types
and retaining rather little. This process has more in common with investment banks underwriting of
securities than with the commercial banks prior lending process.
Senior loans became a significant area of activity for credit investors like us. Theyre typically their
issuers senior-most debt, so theyre perceived to carry little credit risk. And since they pay interest at
floating rates, there is no interest rate risk. (Of course, with so little risk, they offer low yields.) Theyre
the highest-quality instruments Ive ever dealt in.
Because they were considered so safe, loans were widely deemed appropriate for levered investment, and
prior to the financial crisis large numbers of highly levered Collateralized Loan Obligations, or CLOs,
were formed to hold them. Borrowing at low floating rates to buy senior debt paying high floating rates
was very enticing, and the CLO business mushroomed.
Senior loans were affected dramatically by the events of 2008. Since senior loans had been used to fund
buyouts with purchase prices at high multiples of cash flow, investors became concerned about the
issuers ability to service them, and especially to refinance them when they came due (since the capital
markets had slammed shut). Loan prices fell to levels never seen before in the absence of a default;
whereas non-distressed senior loans had rarely sold below 95 in the past, now they fell to the 80s, and
then to the 60s. Because of the collapsing prices, market-value CLOs received margin calls they
couldnt meet, and banks seized portfolios and liquidated them in overnight BWIC (bid-wanted-incompetition) transactions. The indiscriminate selling put further pressure on prices, leading to more
margin calls and more BWICs: another prototypical negative feedback loop.
The senior loan index was down 29% in 2008. That exceeded the 25% decline of the high yield bond
index. Why would senior debt fall more during a crisis than junior debt? The answer is that senior loans
had been ground zero for buying with leverage (and thus for margin calls and forced selling) whereas
high yield bonds had not.
The key questions were rarely asked while things melted down: what were the loans worth, and would
they pay? That depended on the outlook for defaults, but in late 2008 few people felt they could assess it
or could take the time required to do so. And neither did they question the extent to which the price
collapses had been caused by margin calls and forced selling, rather than investment fundamentals.
They just succumbed to negativity and sold.
When 2008 ended, and with it the cycle of selling, price declines, margin calls, more selling and more
price declines, the prices of loans stopped going down. And then they went up. The senior loan index
rose 45% in 2009, meaning someone who invested on December 31, 2007 and didnt sell was up 3%
overall by December 31, 2009. What if you had taken the markets advice in the post-Lehman meltdown
and sold in response to the negative signal? Youd have a valid complaint, but whom would you blame?
The market . . . or yourself?
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What Does a Falling Market Say About Value?

What do big price declines mean? They mean market participants sense fundamental deterioration. But
what price declines say is reflective, not predictive. They tell you about the events that have occurred,
and how investors have reacted to them. They dont tell you anything that the average investor doesnt
know about future events. And, again, Im firmly convinced (a) the average investor doesnt know much,
and (b) following average opinion wont help you attain above average results.
Most of my readers want to perform better than the average investor. As Ive set out in Dare to Be Great
II (April 2014) and in the discussion of second level thinking in my book The Most Important Thing,
to accomplish that, you have to invest differently than the average investor. To do that, you have to think
differently than the average investor. And to do that, you have to consider different inputs than the
average investor, or consider inputs differently. You simply cant follow the signals their behavior
provides.
Its a matter of logic: if price movements reflect average opinion, following their supposed advice
cant help you perform above average.
Now lets think about the question of whether to sell. Here are some possible reasons to do so:
Belief that the price is high relative to the fundamentals.

Belief that while the current price may not be high relative to the current fundamentals, the
fundamentals will deteriorate in ways that arent anticipated by the price. (In other words, the
price is high relative to how the fundamentals will come to be viewed.)
Belief that the price will fall regardless of the fundamentals, meaning that by selling today you
can avert a loss and/or position yourself to profit by buying lower later.
Do you agree that these are the main reasons to sell? Are there others? Are these all legitimate?
For me the first two are compelling. This is what the skilled investor thinks about. Both of these
decisions are made relative to something called intrinsic value. Theres only one intelligent form of
investing: figure out what something's worth and see if you can buy it at or below that price. Its all
about value.
But note that the third reason to sell shown above has nothing to do with value. The price may be high,
low or fair relative to the fundamentals today or what theyre expected to be tomorrow. You just sell
because you think the price will fall.
First, does it make sense to sell something if the price is low relative to the fundamentals, just
because you fear it may fall in the short run? A long-term value investor holds or buys when price is
low relative to value. Low price relative to value is his dream. Why sell a low-priced asset just because
you think its going to fall for a while? Most people understand the challenge in dealing with twodecision stocks: you sell because you think the price may fall (even though it may be something youd
like to hold for the long term), and then you have to figure out when to buy it back. Last year Charlie
Munger complained to me that theyre really three-decision stocks: you sell it because you think the
price is full, you have to figure out when to buy it back, and in the meantime you have to come up with
something else to do with your money. In my experience, most people who are lucky enough to sell
something before it goes down get so busy patting themselves on the back that they forget to buy it
back.
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All other things being equal, as something falls in price, you should want to own it more, not less. The
buy-and-hold value investor is stalwart, ignoring price fluctuations. Even better, the contrarian moves
opposite to the market, buying when the price falls and selling when it rises.
Second, if not on the basis of fundamentals, how does one make the decision to sell for the third
reason listed above? Essentially, two things give rise to changes in asset prices: changes in the outlook
(macro or asset-specific) and changes in attitudes toward the asset. In other words, fundamentals and
valuation. Fundamentals are dealt with above. If youre going to try to benefit from changes in price that
are unrelated to changes in fundamentals, youre left having to predict investor psychology. If On the
Couch wasnt successful in convincing you this isnt possible, this memo probably wont be, either.
My bottom line is that markets dont assess intrinsic value from day to day, and certainly they dont do a
good job during crises. Thus market price movements dont say much about fundamentals. Even in the
best of times, when investors are driven by fundamentals rather than psychology, markets show
what the participants think value is, rather than what value really is. Value is something the market
doesnt know any more about than the average investor. And advice from the average investor
obviously cant help you be an above average investor.
What Does a Falling Market Say About Psychology?

Fundamentals the outlook for an economy, company or asset dont change much from day to day. As
a result, daily price changes are mostly about (a) changes in market psychology and thus (b)
changes in who wants to own something or un-own something. These two statements become
increasingly valid the more daily prices fluctuate. Big fluctuations show that psychology is changing
radically.
And, I said on page two, emotional fluctuations swings in market sentiment or psychology do seem to
be synergistic. That is, in crowd psychology, 2 + 2 = 5. While I dont think the price of an asset
reflects more wisdom than is possessed by the average of its markets members, I do believe mass
psychology will make a group swing to reach greater emotional extremes than its members would
separately. In short, people make each other crazy. And when times are bad like now they depress
each other. That was a factor in the edge enjoyed by our distressed debt team in 2008: they were able to
buy at the markets lows because they werent in New York, where everyone was trading scary stories
and getting each other down.
Again, we can gain insight through logic. We all know we want to buy (not sell) at the lows, and sell
(not buy) at the highs. So then how can it be right to sell because of a decline or buy because of a
rise? Advocates of this latter approach must think (a) declines and rises tend to continue more than they
reverse and/or (b) they can tell which declines mean buy and which mean sell. Some savants may
have that latter ability, but not many. In general, I think its ridiculous to sell something because its
down (just as it is to buy because its up).
As prices fall, there are some very genuine reasons to sell:
Some people feel rising fear and have to lighten their positions in order to retain their composure.
Some, having lost a lot of money, sell to be sure they wont experience losses they cant survive.
Some have to sell to repay demanding creditors or satisfy investor withdrawals.
These reasons are not invalid. Its just that none of them has anything to do with making money.
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Most mature investors know intellectually that short-term price fluctuations are low in fundamental
significance, and that the best results will be achieved if they hold on to their positions and ride out the
volatility. But sometimes people sell anyway, perhaps for the above reasons. Doing so has the potential
to convert a short-term fluctuation into a permanent loss by causing any subsequent recovery to be
missed. I consider this the cardinal sin in investing.
What Do the Media Know?

Im usually able to find something in the print or broadcast media that helps me make my point. Heres
how The New York Times led the business section on Saturday:
Concern Grows That Market Sell-off is an Early Warning of a U.S. Slowdown
It may be time for everyone to take the markets seriously again.
As stock prices started tumbling in the first trading days of the year, many Wall Street
professionals were tempted to describe the declines as the sort of adjustment that the
market has gone through in recent years before moving higher.
But that opinion evaporated this week as the selling intensified. Concerns are now
growing that the markets are signaling that the United States economy, despite its recent
bright spots, is on the verge of a slowdown.
The fear is that economic problems in China have set off negative reactions around the
world that could ultimately weigh on American households and corporations.
So the bottom-line question is simple: does the market reflect what people know, or should people
base their actions on what the market knows? And if the latter, where does the market get its
information, other than from people? For me its simple: if people follow the markets dictates, theyre
taking advice from . . . themselves!
I set a trap at the beginning of this memo, and I want to spring it now. In the first paragraph, I wrote,
Weve seen bad news and prices cascading downward. You probably glossed over it. But is it true?
Leaving aside China and the markets gyrations, have we really been seeing negative news on balance?
Isnt it just that people are fixating on bad news, ignoring good news, and tending to interpret things
negatively?
There are ways in which psychology can become real, feeding back to influence fundamentals. One is
that declining asset prices produce a negative wealth effect, making people feel poorer and causing
them to spend and invest less. And there are others. But despite the feedback influences of the market
declines, I still would say U.S. and European economic fundamentals arent negative on balance.
On Friday, in the midst of the declines, I participated in a small lunch attended by investment
professionals and current and former senior government economic and financial leaders. Ill spare you
the details: there was a lot of on one hand and on the other hand, but no one thought there
would be a recession this year. So then who are the people creating price signals to which others should
accord significance?
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I want to end by making one thing completely clear. Im not saying the market is never right when prices
go down (or up). Im merely saying the market has no special insight and conveys no consistently helpful
message. Its not that its always wrong; its that theres no reason to presume its right.
It is the goal of some investors to sell on declines when the subsequent movements will be down, but
buy the dips when the subsequent movements will be up. If you think you can tell which is which from
watching the market movements themselves, then we again have a fundamental disagreement. Future
price movements can only be predicted on the basis of the relationship between price and
fundamentals. And, given the markets short-term volatility and irrationality, this can only be done in the
long-term sense. The market has nothing useful to contribute on this subject.
January 19, 2016
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Memo to:
Oaktree Clients
From:
Howard Marks
Re:
Economic Reality
Addendum, June 13: Theres been a lot of response since the memo that follows was originally published
on May 26. In the discussions that have ensued, I realized that I should have led with something like this:
Ultimately, economics is the study of choice. Because choices range over every
imaginable aspect of human experience, so does economics. . . .
How do individuals make choices: Would you like better grades? More time to relax?
More time watching movies? Getting better grades probably requires more time
studying, and perhaps less relaxation and entertainment. Not only must we make choices
as individuals, we must make choices as a society. Do we want a cleaner environment?
Faster economic growth? Both may be desirable, but efforts to clean up the environment
may conflict with faster economic growth. Society must make choices. . . .
We would always like more and better housing, more and better education more and
better of practically everything.
If our resources were . . . unlimited, we could say yes to each of our wants and there
would be no economics. Because our resources are limited, we cannot say yes to
everything. To say yes to one thing requires that we say no to another. Whether we
like it or not, we must make choices.
Our unlimited wants are continually colliding with the limits of our resources, forcing
us to pick some activities and to reject others. Scarcity is the condition of having to
choose among alternatives. (Macroeconomics Principles, Libby Rittenberg and Tim
Tregarthen. Emphasis added)
Because of the above, we make economic choices every day. Everyone knows choices like these are
inescapable.
Everyone, that is, except for politicians. The politician promises better grades and more leisure time. A
cleaner environment and faster economic growth. Thats what caused me to write the memo: in politics
and government unlike the real world the word or often goes out the window, replaced by and.
No choices are necessary.
A few months ago I saw a cartoon featuring caricatures of two primary opponents. Under one it said
bulls**t and under the other it said free s**t. Theres bound to be a lot of the former in any election
season, but economics tells us the latter is unrealistic. I wrote this memo to help readers understand why.
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In 1977, responding to the difficult energy outlook brought on by the Arab Oil Embargo, President Jimmy
Carter created the position of Secretary of Energy and chose James Schlesinger as Americas first energy
czar. Previously Schlesinger had served as Chairman of the Atomic Energy Commission, Director of
Central Intelligence, and Secretary of Defense, and in his early days he taught economics at the
University of Virginia. I was tickled by a story undoubtedly apocryphal about his days in academia
that made the rounds when Schlesinger was in his new energy post.
As the story went, Schlesinger was such a convincing evangelist for capitalism that two students in his
economics class decided to go into business after graduation. Their plan was to borrow money from a
bank, buy a truck, and use it to pick up firewood purchased in the Virginia countryside, which they would
then sell to the grandees in Georgetown. Schlesinger wholeheartedly endorsed their entrepreneurial
leanings, and they proceeded with great enthusiasm. From the start of their venture, the former students
could barely keep up with the demand.
Thus it came as quite a shock when their banker called to tell them the balance in their account had
reached zero and the truck was about to be repossessed. They contacted Schlesinger, and he listened
attentively as they recounted their experience: they had, in fact, been able to acquire vast amounts of
wood for $50 a cord, and theyd been able to sell all they had for $40 a cord. How could they be broke?
Where had they gone wrong? Schlesinger puffed on his ever-present pipe and said: The answers
obvious: you need a bigger truck.
While it certainly wasnt the case with Schlesinger (despite what the above tale suggests), most ordinary
citizens dont have what it takes to figure out what is and isnt economically feasible. Since were in the
midst of election season, with promises of cures for our economic woes being thrown around, this seems
like a particularly appropriate time to explore what can and cant be achieved within the laws of
economics. Those laws might not work 100% of the time the way physical laws do, but they generally
tend to define the range of outcomes. Its my goal here to point out how some of the things that central
banks and governments try to do and election candidates promise to do fly in the face of those laws.
When I was in high school, one of my buddies convinced me to take a class in accounting. I found the
double-entry bookkeeping we learned to be logical, symmetrical and unambiguous. After accounting I
moved on to economics, and I found it equally logical. The die was cast for my career in business.
Like the lesson of the Schlesinger story, the rest of economics is also pretty straightforward, and its laws
are quite reliable. If you buy for $50 and sell for $40, you wont make money . . . period (or stay in
business long). That reminds me of a joke I used in bubble.com in January 2000, one my father told me
roughly 60 years ago:
I lose money on everything I sell.
Then how do you stay in business?
I make it up on volume.
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For those of us in the business world, economics defines reality. (You may think youve heard me poke
at it, but what I deride is economic forecasting, not economics. Theres a big difference.) The realities of
economics are the subject of this memo. My primary methodology will be to describe ways in which
people (and especially politicians) tend to propose things that conflict with economic reality, and explain
why theyre unlikely to work.
Lets start with central banks attempts to achieve monetary stimulus. When central banks want to help
economies grow, they take actions such as reducing the interest rates they charge on loans to banks or,
more recently, buying assets (quantitative easing). In theory, both of these will add to the funds in
circulation and encourage economic activity. The lower rates are, and the more money there is in
circulation, the more likely people and businesses will be to borrow, spend and invest. These things will
make the economy more vibrant.
But theres a catch. Central bankers cant create economic progress; they can only stimulate activity
temporarily. GDP, or national output, can be seen roughly as the amount of labor employed times
productivity, or the amount of output per unit of labor. In the long term, these things are independent of
the amount of money in circulation or the rate of interest. The level of economic activity is determined by
the nations productiveness.
Central bank actions can encourage or accelerate economic activity, but they cant create economic
activity that otherwise wouldnt occur. Much of what central banks do consists of making things happen
today that otherwise would happen sometime in the future. Its not clear that the effects are long-lasting
or anything more than an acceleration of events within the confines of a zero-sum game. What is
beneficial, however, as Professor Randall Kroszner of the Chicago Booth School of Business wrote me, is
the fact that:
[Central banks] can help to prevent a complete financial meltdown and the negative
economy-wide externalities associated with a financial collapse. In these circumstances,
and if done appropriately, their actions can do more than just move up future production
to the present by helping to avoid economic activity losses due to a panic.
In the old days, when cars often failed to start, there were fluids we could squirt into the carburetor to get
them going. But they werent fuel for long-term operation.
For example, lending people money can enable them to buy things today that they otherwise mightnt
have bought until later (if at all). If a consumer buys a boat today with money made available through a
low-interest loan, thats a boat he wont buy next year. Lending people money doesnt alter their lifetime
incomes, meaning consumers may buy fewer boats later, when the loans have to be repaid, causing
disposable income to contract.
So far, as the last seven years show, (a) central banks havent been able to generate the growth they
hoped for and (b) the impact of each successive jolt of stimulus seems to have been less powerful.
Rather than believing central banks can make economies more productive, its my bottom line that theres
a naturally occurring growth rate for each economy, and that rate dictates the long-term output, not central
bankers actions.
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What have the following places had in common in recent years: China, Ireland, Spain and Arizona? The
answers simple: large numbers of empty new homes. In the last decade-plus, governments and central
banks chose to encourage economic growth in these jurisdictions by making financing readily available
for construction. This can do wonders for an economy . . . as it did in these cases in the years leading up
to the crisis of 2007-08.
Construction increases the demand for labor, building materials, support services and ancillary
businesses. Theres only one catch: easy financing especially if sufficient to cover 100% of costs can
encourage developers to create space for which theres no demand. The process of creating unsalable
homes, unneeded office space and uneconomic infrastructure adds to GDP in the short run but burdens
the countries financial systems, especially the institutions that make the loans to builders. In the end, the
bad loans stay with the banks, perhaps necessitating bailouts.
Another example can be seen in the case of Sainty Marine, a Chinese state-owned enterprise that recently
made headlines by becoming Chinas first listed company to file for bankruptcy. Sainty Marine first
bought and sold ships and then transitioned into shipbuilding, acting on contracts that unlike elsewhere
in the industry were entered into without the benefit of financial guarantees. It needed financing in
order to build those ships, and got it from state-owned banks. But when a state-owned bank lends
money to a state-owned shipbuilder, whos making business-like decisions? Who worries about
issues like whether therell be charters for the ships and whether owning them will be profitable?
The point is that mistakes like overbuilding are always possible but theyre much more likely to occur if
no ones making decisions on an economic basis. If lending personnel are making loans without a direct
stake in their repayment, theyre less likely to say no to weak loan applicants. And if borrowers wont
be affected by a failure to repay loans, which of them will decline offers of financing?
Not all loans work. And when they dont work, both the lender and the borrower are usually affected. As
someone once said, bankruptcy is to capitalism as hell is to Catholicism. When the parties involved
arent motivated by profit or worried about loss, good economic decisions are unlikely to be made.
Riding to work the other day, I heard about protests occurring in France. Workers were complaining
about potential changes in labor regulations that would make their jobs less secure. In brief, French
workers like it the way things are: they cant be pushed beyond 35 hours a week, and employers ability
to terminate them is subject to a drawn-out, torturous and uncertain program. They also like their lengthy
vacations and the extensive benefits provided by the state. The question is where the ability to pay for
above average benefits will come from if neither the hours worked nor the productivity per hour is
above average. Governments and regulations cant produce prosperity.
In the current campaign, Bernie Sanders has called for free health care and free public college education
for all. And all the candidates have sworn to protect the current level of Social Security benefits, which
are sure to render the system insolvent absent other changes. Benefits like these have to be paid for. This
can be done either out of current earnings a share of GDP (i.e., tax revenues) or through
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borrowings. But governments cant create out of thin air the means with which to make disbursements.
In that way theyre not so different from households or businesses.
*
One way some governments think they can pull off the miracle of providing more is by raising taxes on
the rich. After all, the rich have by definition more money than they need: everyone else gets by on
much less.
Populism has been a strongly rising element in politics over the last decade. It primarily means
drawing class distinctions and claiming to be on the side of the common man. This often comes down to
playing on the resentment of the lower-earning majority toward the wealthy minority. Populism is a
particularly strong force in the U.S. presidential election now underway, fed by economic dissatisfaction
among the working class due to the effects of globalization, job outsourcing, and technological progress
with which some havent kept up. Outsider or non-establishment candidates in both parties Donald
Trump and Bernie Sanders are having a lot of success telling voters the economy isnt working for them
and appealing to resentment toward those who are doing better. Now even Hillary Clinton is saying of
the wealthy and powerful, The deck is stacked in their favor . . . my job is to reshuffle the cards.
Taxes are the main instrument for politicians to put class resentment to work. Many eventually resort to
an old saw: Were not out to soak the rich. We just want them to pay their fair share. I discussed this
subject at length in Its All Very Taxing (November 2011). In my view, however, (a) theres no way to
determine what the fair share is, (b) there are only the opinions of self-styled experts on this subject, and
(c) fair share always seems to come down to more than theyve been paying.
It makes sense to assume that most democratic societies eventually will reach the point where the
majority views the top tier as a cash cow available for unlimited milking. Lets hit them for a little
more; theres nothing they can do about it. But the truth is, this tyranny of the majority is an
unhealthy development. First, society does better when able members have strong incentive to
contribute. Second, upward aspiration and mobility will be constrained when taxes become confiscatory.
Finally, taxpayers arent necessarily powerless in the face of rising tax rates.
That brings me to an article that appeared in The New York Times on April 30, entitled One Top
Taxpayer Moved, and New Jersey Shuddered. It concerns the impact of rising rates on taxpayer
behavior, starting from the fact that New Jerseys biggest single earner had moved to Florida. (New
Jersey has raised its top income tax bracket from 6.37% in 1996 to 8.97% today, whereas Florida doesnt
have a state income tax.)
If youre making hundreds of millions of dollars and youre paying close to 10 percent
to the state of New Jersey, you do the math, said John Bramnick, the Republican leader
in the New Jersey Assembly. You can save millions a year by moving to Florida. How
can you blame him? . . .
In New York, California, Connecticut, Maryland and New Jersey, the top 1 percent pay a
third or more of total income taxes. Now a handful of billionaires or even a single individual
. . . can have a noticeable impact on state revenues and budgets. . . .
In California, 5,745 taxpayers earning $5 million or more [or only 4/100s of a percent of
the 13.6 million returns filed] generated more than $10 billion of income taxes in 2013,
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or about 19% of the states total, according to state officials. Any state that depends on
income taxes is going to get sick when one of these guys gets a cold . . .
While not everyone would change their residence to reduce their taxes, some will. Remember that seven
of the 50 states do not tax their residents incomes. Thus the bottom line on this I think the good
news in terms of fiscal responsibility is that states have no choice but to think of taxpayers as
mobile. If you raise the top tax rate by 10%, you wont collect 10% more taxes from them. A
surprisingly large number of the people Nancy and I meet in New York have their residences in Florida.
Thats a reflection of economic reality and should restrain the tendency to excessively tax the rich.
The U.S. is one of only a tiny number of countries whose citizens are taxed on all their worldwide
income, regardless of where they live or where their income is earned. Thus, Americans dont have a
good way to escape federal income taxation by moving abroad. (Technically, they can leave the U.S. tax
system by paying the taxes that would be due if they were to sell all their assets and realize all the
appreciation to date. But they also have to surrender their citizenship and sacrifice frequent visits to the
U.S., and the number of people willing to do all this is limited.)
Citizens of almost every other country have an easier way to respond when the soak-the-rich movement
arrives (see the big earners who moved away when France enacted a 75% top rate a few years ago). Thus
most governments are aware that while they can raise tax rates on people of means, in most cases
they cant make them sit still and take it.
Another way national governments can make it easier to accomplish their financial goals is by
printing money. But flooding the market with more currency debases the value of the currency.
They can increase peoples nominal incomes, but eventually theyll find their fatter wallets dont contain
any more spending power than they used to.
In The Limits to Negativism (October 2008), I discussed the fact that in Weimar Germany, the
government took the 1,000 mark note and over-stamped it One Million Marks. But it still only bought
one goat.
The mark fell from 60 to the U.S. dollar in early 1921 to 320 to the dollar in early 1922
and 8,000 to the dollar by the end of 1922. Its hard to believe, but according to
Wikipedia (user-maintained and perhaps not always the most authoritative):
In December 1923 the exchange rate was 4,200,000,000,000 Marks to 1 U.S.
dollar. In 1923, the rate of inflation hit 3.25 x 106 percent per month (prices
double every two days).
One of the firms printing these [new 100 trillion Mark] notes submitted an
invoice for 32,776,899,763,734,490,417.05 (3.28 x 1019, or 33 quintillion)
Marks. [Thats not a misprint.]
The great advantage for governments in creating inflation lies in the ability to meet obligations with
debased currency. That was the motivation behind Germanys hyperinflation in the 1920s to make it
easier to cover expenses and debts denominated in Marks.
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Today most nations want to see inflation. That would reduce the real value of their national debt and
ease repayment in real terms. Treasuries and central banks have tried to encourage inflation by cutting
interest rates and increasing the amount of money in circulation. Quantitative easing, for example,
consists of the Fed using newly printed dollars to buy outstanding debt; this should increase the amount of
money in circulation and thus raise the dollar price of goods. Voil: inflation.
But governments efforts have been strikingly unsuccessful and, so far, inflation is MIA. Inflation is a
mysterious (and, I think, largely psychological) phenomenon. The U.S. government couldnt figure out
how to stop it in the 1970s, and the nations of the world cant find a way to start it today.
Classically, inflation has resulted from (a) demand pull too many buyers for a fixed supply of goods,
or (b) cost push rapid increases in the costs of production. Neither of these causes is in evidence
today. Thus inflation is quite feeble, and thats disappointing to countries that would like to pay their
debts with cheaper currency.
A related tool for national economic betterment consists of another route toward currency debasement:
devaluation. A nation can increase its ability to deal with the rest of the world by adjusting its currencys
rates of exchange.
Lets say the U.S. wants to increase its exports of manufactured goods. One way to do this is to make the
goods cheaper. But what if the dollar costs of manufacturing cant be reduced? In that case, why not just
reduce the amount of foreign currency it takes to buy a dollars worth of goods?
For example, lets say the selling price of a U.S. widget is $100, and there are 10 Ruritanian kopeks to the
dollar. Thus a widget costs 1,000 kopeks in Ruritania. Say we change the exchange rate to 8 kopeks to
the dollar. Now that widget costs a Ruritanian buyer only 800 kopeks. The number of dollars the U.S.
seller receives is unchanged, but the number of kopeks the Ruritanian buyer has to pay for a widget is
reduced by 20%. Sales of U.S. widgets to Ruritanians skyrocket.
Of course, while a weaker currency makes a countrys exports more competitive, it also means its citizens
have to pay more of their home currency to buy imports. So, as in the case of the other things under
discussion here, theres no free pass. Theres little a country can do in terms of policy actions to
improve its situation that (a) doesnt have negative ramifications and (b) will enhance the long-run
outlook in the absence of fundamental improvement in economic efficiency.
And, by the way, heres another wrinkle: you cant just devalue your currency; you can only devalue it
against another currency. What happens when multiple countries want to devalue at the same time?
China tries to devalue the yuan versus the yen, but Japan tries to devalue the yen relative to the yuan.
This is called competitive devaluation. The one thing we can be sure of is that every country cant
simultaneously devalue versus all the others . . . try as they may.
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This discussion of devaluation and exchange rates leads eventually to the entire issue of globalization and
international competition. Globalization is one of the most important and influential topics today, and it
is shaping economic progress and political discourse.
Lets go back to the early post-World War II period. The U.S. mainland was physically and economically
intact having been spared from combat while Europe and Japan had been decimated. U.S.
corporations were performing strongly, and the prosperous U.S. consumer was the source of powerful
demand. In most fields, American products were the best in the world. Imported cars were essentially
non-existent, and the television sets, hi-fis and appliances our parents (or grandparents) bought were
produced here. Even our clothing was made in America.
In this very positive economic environment, consumers, producers and workers all thrived, and in most
regards, Americans enjoyed the highest standard of living in the world. Now that is in doubt, and this has
become a main issue in the presidential campaign. Heres how I put things in What Worries Me
(August 2008):
One of the reasons for our high standard of living is the fact that Americans have been
paid more for doing a given job than everyone else. This was fine as long as (a) the U.S.
enjoyed the benefits listed [earlier], and (b) significant barriers protected the status quo.
But why should this go on? How can it go on?
Think about two cities. City A has more jobs than people, and city B has more people
than jobs. Initially, people in city A where labor is relatively scarce will be paid more
for doing a given job than people in city B. The key to their continuing to earn more is
the existence of barriers that prevent people from moving to city A. Otherwise,
people will move from city B to city A until the ratio of people to jobs is the same in both
cities and so are the wages. Among other things, geographic inequalities are
dependent on the immobility of resources.
For much of the last century, barriers kept our pay high. Other countries output wasnt
as good as ours. Some lacked investment capital, and some were decimated by war from
time to time. Perhaps they didnt possess our ability to generate technological
advancements or our managerial skills. High transportation costs, tariffs, prejudices
(when I was a kid, Japanese transistor radio was synonymous with low quality) or
legal restrictions (e.g., keeping foreign airlines from competing freely in our markets)
may have protected American wages. International trade wasnt what it is today. But all
of these things can change over time, and its hard to see how the earnings supremacy of
U.S. workers will be sustainable. . . .
In 1949 we saw the arrival of a little car called the Volkswagen Beetle. It was odd, with its rounded
shape and the engine in the back, but boy was it cheap: roughly $1,300. The quality of foreign cars was
initially the subject of skepticism, but over time quality improved, the superior price/value bargain
overcame cultural resistance, and the share of car sales going to imports grew.
Two Volkswagens were sold in the U.S. that year, then hundreds, and then many thousand. Soon Japan
started to send over the Toyota, Datsun (now Nissan) and Honda, and they were successful, too. To put
their success into perspective versus those two Beetles in 1949, in 1981 the Japanese automakers entered
into a voluntary restraint agreement limiting the number of cars they could bring into the U.S. to 1.68
million per year. More recently Korea began sending cars to the U.S. Today foreign brands account for
more than 55% of car sales in the U.S. market. Of course a good part of the success of imports has been
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related to lower costs. (A substantial number of the foreign brand cars sold in the U.S. today are
actually made here, but in non-unionized plants at total labor costs including benefits that average
$10/hour, or $250/car, less than the U.S. carmakers unionized plants. In the past, when foreign cars were
actually made abroad, the cost differential was much more dramatic.)
U.S. automakers market share was destined to decline if foreign cars were some combination of
better and cheaper. And when it did, U.S. autoworkers income and standard of living had to start
to equalize relative to those building better-value-for-the-money cars abroad. Trade barriers, high
transportation costs, a strong union and inertia kept the U.S. worker ahead as the 20th century wore on, but
eventually reality caught up with the industry.
Heres an example: the autoworkers union had bargained for excellent benefits for auto workers, and
according to the Economic Policy Institute:
In 2005, there was a gap of $3.62 between the average hourly wage of $27.41 at Ford and
$23.79 for [foreign-owned plants]. When fringe benefits, legally required payments,
pension benefits, retiree health care, and other post-employment labor costs are added in,
the gap grew to $20.55 ($64.88 versus $44.33).
There was a limit on the ability of U.S. automakers to sell cars burdened with substantial benefit costs
while foreign car costs included much less for benefits. The bottom line is that, in a globalized world,
if people in country A will work for less than those in country B, there are only four possibilities for
manufacturers in country B:
charge a higher price for the same product and lose market share,
charge the same price for the higher-cost product and enjoy smaller profit margins (or even
suffer losses),
charge the same price for an inferior product (this probably cant be done for long), or
get the government to erect trade barriers on imported goods, such as a tariff that equalizes
selling prices or a quota that restrains competition.
Thus the operating and financial condition of U.S. automakers deteriorated such that, during the Global
Financial Crisis, General Motors and Chrysler declared bankruptcy (enabling them to cut costs and shed
benefits), and Ford underwent a thorough restructuring with the same result. Workers more modest
contracts since then have, of necessity, caused their relative standard of living to decline. This is an
example of the reasons behind the working classs current discontent.
Of course, this leads me to the idea that probably did more than any other to set the wheels in
motion for this memo: well bring back the jobs. One of Donald Trumps most emphatic promises
is that he will respond to Americas loss of manufacturing jobs to other nations by causing goods to be
made here again. Bernie Sanders opposes free trade and argues we must develop trade policies which
demand that American corporations create jobs here, and not abroad. Are these actionable positions?
(A minute for an aside: U.S. manufacturing employment of 12.3 million workers is down 37% from the
peak of 19.5 million reached in 1979. So when did the value of manufacturing output hit its peak? The
answer may surprise you: today! The current level of U.S. manufacturing output is in the vicinity of the
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all-time high and roughly double the 1979 level. Twice the output with less than 2/3 the workers means
output per worker has more than tripled. Thus, if we were producing todays output at the 1979 level of
productivity, wed be employing 25 million more workers! So while weve lost 3.2 million jobs to China
since 2001, for example, weve lost many times that to improvements in productivity. Perhaps if the
government wants to preserve jobs it should just outlaw productivity gains. That thought reminds
me of the early-19th-century Luddites, English textile workers who were unhappy about industrialization
and banded together to destroy labor-saving factory machinery. Of course, history shows its hard to hold
back economic progress by edict or force of will.)
Lets assume its possible to manufacture high-labor-content goods like cellphones much more cheaply in
China than in the U.S. (not an unreasonable assumption, since the average manufacturing worker in China
makes less than $9,000 per year). And lets assume the resulting cost to deliver a cellphone to an
American retailer is $100 if made in China versus $150 if made in the U.S. In that case, a Trump or
Sanders administration would have the following choices:
forbid imports of cellphones, requiring that they be made in the U.S. at a cost of $150,
find Americans willing to work at Chinese wages, bringing the cost down to $100, or
impose a trade tariff on Chinese imports that equalizes the U.S. retailers cost for phones at $150.
Im not aware of any other possibilities. The first probably isnt feasible in this day and age. The second
is equally unlikely, since few Americans are likely to elect to do the tedious work involved, and the
Chinese wage of less than $5 per hour would violate our federal minimum. That leaves the third option:
tariffs. And, in fact, Mr. Trump has said he would impose a 45% tariff on Chinese imports, 35% on
Mexico, and various tariffs on goods from other countries. Here are some of the problems with that:
First, such tariffs are probably barred under trade agreements that are in place. To impose them,
we would have to abrogate those agreements.
We have to wonder about retaliatory actions wouldnt other countries impose offsetting tariffs
on U.S. exports that would further harm our manufacturing base? As The New York Times wrote
on May 3, starting a trade war might be cathartic for workers who have lost jobs, but it is
unlikely to create a lot of factory work.
What would happen to our ability to refinance our perpetually growing national debt if China, our
biggest creditor, decided one day it wasnt quite as eager to participate in new Treasury
financings?
What would rising barriers do to one of the main motivations behind the broadening of U.S. trade
agreements since World War II: preventing conflict?
Finally, but most simply, what American wants to pay 50% more for a cellphone than he
does today?
What we have here is a reminder that economic common sense isnt so common. Have the voters who
think its a great idea to bring back the jobs thought about what goods manufactured at U.S. wages or
tariffs designed to bring the cost of Chinese goods up to those levels would do to their cost of living?
Id guess not. How will the interests of the 3.2 million Americans estimated to have lost their
manufacturing jobs to China be balanced against the hundreds of millions who would have to pay
considerably more for imported goods? Not an easy question.
Quotas, tariffs and subsidies are all ways for countries to protect industries that cant hold their own
against international competitors without these things. Thus theyre a good example of ways in which
policy decisions can lead to distortions. Since the industries for which tariffs and subsidies are
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established are, by definition, industries that cant compete without them, for these things to be
enacted, someone has to make a decision that (a) these industries should be kept afloat and (b)
consumers of these industries goods should be prevented from paying the lower prices that would
prevail if consumers had easy access to goods from abroad, free of tariffs.
Do we want to subsidize our farmers, or do we want to allow Americans to buy cheap crops from abroad
(and let the farmers go out of business)? Leaving aside strategic national considerations, do we want to
protect the jobs of those who work in industries where the U.S. is uncompetitive, or do we want to allow
U.S. consumers as a whole to minimize their cost of living? In each case, its one or the other . . . but
not both.
The bottom line, as with so many of the things Im discussing here, is that economic laws cannot be
ignored or magical solutions willed to appear. While its far from the entire explanation, the main reason
the U.S. has lost manufacturing jobs to foreign countries is that people there are willing to work for much
less. In this globalized world, that means Americans cant enjoy both the high-paying
manufacturing jobs they used to have and the low-cost goods theyve been buying of late. The
imposition of tariffs cant solve that conundrum. As long as American workers demand wages higher
than people elsewhere, theyre unlikely to manufacture much for the rest of the world, or for themselves,
either. This is an incredibly clear example of how economic reality makes it hard to find easy solutions to
difficult problems.
While on the subject of wages, its appropriate to mention the minimum wage. The U.S. government first
established a federal minimum wage of $0.25 an hour in the Fair Labor Standards Act of 1938. It has
been raised 22 times since then and now stands at $7.25. At the state level, theres a patchwork of
regulation. A few states dont have a minimum wage. Some have minimums that are below the federal
level. Many states use the federal minimum, and a bunch have minimums higher than the federal level.
Just this year, however, increases in the state minimum to $15 (with exceptions) have been enacted in
California (by the end of 2021, from $10 today) and in New York (by the end of 2018-19, from $9 today).
As the wages of the lowest-paid workers increase, where does their newfound prosperity come from, and
what will be the effects?
The debate over increasing the minimum wage is loud and inconclusive . . . and mainly a matter of
ideology. Conservatives and business interests are sure an increase in the minimum wage will be
disastrous for both business and workers. If higher wages drive up selling prices vis--vis competitors
who face lower labor costs, business and jobs will suffer. If selling prices and non-labor costs are
unchanged, theres a fixed pie to be divided up (between workers wages and business owners profits).
Thus, if you mandate higher pay per worker and the owners slice remains the same, the wage slice of the
pie by definition will cover fewer recipients; the result is job losses. And if instead you take the higher
wages out of the owners part of the pie, fewer businesses will start up, and some might close, again
resulting in job losses.
Liberals and labor organizations, on the other hand, insist there will be no material impact. For example,
according to a study from the National Employment Law Project, following most of the 22 federal
increases since 1938, job formation didnt slow from what it had been. And in the few cases where it did
slow, the increase took place in recessionary times, so maybe it wasnt the result of the wage increase.
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In between these polar positions (neither of which is probably completely right), there are lots of things to
think about:
Whats right for undifferentiated businesses (think fast food) in a high-minimum-wage state
abutting one where the wage is much lower?
Is the same minimum wage right for all businesses in a given state regardless of their varying
degrees of labor-intensiveness?
Is the same minimum wage right for all businesses in a state regardless of their profitability? And
what about non-profits like hospitals, with their heavy reliance on low-cost labor?
Is the same minimum wage right for all parts of a state regardless of the differences in their
economic vibrancy and cost of living?
And is a benign job-formation-impact history relevant given that were now talking about
increases of 50-100%, large changes relative to history, and given that the U.S. no longer has all
the growth potential and competitiveness that it did when the prior increases took place?
Senator Sanders has said hell enact a $15 minimum federal wage. Is it possible that $15 is an appropriate
minimum for all regions, states and cities? (Its interesting to note in this regard that the proposed
changes in New York and California treat New York City differently from Rochester, and Los Angeles
differently from Bakersfield.) And if a single minimum wage isnt right for every location, what
government commissariat will perform the impossible task of setting the right minimum for each one?
I dont mean to decide the minimum-wage issue here, but rather to say its not an easy subject. It seems
unlikely that you can make everyone better off just by mandating a higher wage. Some businesses
will become less successful or non-viable. Business formation may be discouraged. The breakeven cost
for further investment in automation will decline. (Headline from todays Washington Post: ExMcDonalds CEO says raising the minimum wage will help robots take jobs) Some workers may lose
their jobs or fail to get jobs. Remember, governments and regulators dont create wealth, they only
redistribute it. Their impact is largely a zero-sum game except in the longest-term sense.
As an avowed democratic socialist, Bernie Sanders expresses hostility toward business, especially the
financial sector The business model of Wall Street is fraud and he sounds like hed go pretty far to
regulate the economy. For instance, hes said he will break up the big banks (without much mention of
how).
Rather than go into all the economic laws his policies violate, Ill simply ask some questions I consider
relevant:
What has been behind the United States progress to the top of the worlds economic heap? (If he
doesnt attribute a lot of our success to the capitalist, free-market system, then we disagree.)
Where are the countries that have thrived under control economies? How about the U.S.S.R. and
East Germany? (Didnt the ability to watch the former East Germany and West Germany sideby-side provide a good controlled experiment?) How do average folks live in Cuba, Venezuela
and Vietnam? Why is China continually increasing its use of free-market techniques?
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How about an example of central economic control in action? Here are some excerpts from an article
about Venezuela that appeared in The Atlantic of May 12, 2016 (Ive added some emphasis and reordered
the paragraphs):
A case in point is the price controls, which have expanded to apply to more and more
goods: food and vital medicines, yes, but also car batteries, essential medical services,
deodorant, diapers, and, of course, toilet paper. The ostensible goal was to check
inflation and keep goods affordable for the poor, but anyone with a basic grasp of
economics could have foreseen the consequences: When prices are set below
production costs, sellers cant afford to keep the shelves stocked. Official prices are low,
but its a mirage: The products have disappeared.
Heres a shocker: you can set prices for goods, but you cant make people produce them. That
sounds a lot like economic reality.
These ineffective or counterproductive price controls were only one part of a huge economic mess.
How did it arise?
Not long ago, Venezuela a seemingly modern, seemingly democratic nation just a few hours flight
from the United States was wealthy and a good place to live.
Sitting atop the worlds largest reserves of oil at the tail end of a frenzied oil boom, the
government led first by [Hugo] Chavez and, since 2013, by [Nicolas] Maduro, received
over a trillion dollars in oil revenues over the last 17 years.
But then it saw the beginning of:
The experiment with 21st-century socialism as introduced by . . . Chavez, a selfdescribed champion of the poor who vowed to distribute the countrys wealth among the
masses, and instead steered the nation toward the catastrophe the world is witnessing
under his handpicked successor Maduro . . .
In the last two years Venezuela has experienced the kind of implosion that hardly ever
occurs in a middle-income country like it outside of war. Mortality rates are
skyrocketing; one public service after another is collapsing; triple-digit inflation has left
more than 70 percent of the population in poverty; an unmanageable crime wave keeps
people locked indoors at night; shoppers have to stand in line for hours to buy food;
babies die in large numbers for lack of simple, inexpensive medicines and equipment in
hospitals, as do the elderly and those suffering from chronic illnesses.
This is the fate that has befallen a once-wealthy and once-modern nation operating under central
economic control. Shall we give it a try?
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For me, the bottom line on economic reality is that, in the short run, governments theoretically have the
ability to:
a) accelerate economic activity, bringing forward to today otherwise-future activity,
b) make life better for one group of citizens at the expense of another (e.g., the rich versus the
poor), and
c) encourage one form of activity versus others (e.g., investing for capital gains versus investing
for dividends).
One could view these things as potentially helpful policy tools, or as actions that distort the
workings of the economy. By definition, they are designed to accomplish results that wouldnt
occur if the market were left free. Perhaps not all the goals are truly desirable, and some may cease
being considered desirable after theyve been enshrined in law, possibly because of unintended
consequences. Some issues for example, the question of whether income on capital should be taxed
higher or lower than income from labor are just a matter of opinion based largely on political point of
view. Some actions taken may be nothing more than patronage and rewards for voter loyalty.
In contrast to the above list of things governments can do to affect economies, theres a significant list of
things they cant do.
a) They cant create much net growth, wealth or prosperity through stimulus alone. A certain
quantum of wealth is produced by an economy. It can be moved around, but governments cant
increase it magically.
b) They cant make everyone better off simultaneously. For the most part they can only take
from one group to give to another. An example is the ability to improve the fortunes of workers
in an endangered industry through import tariffs that raise prices for the industrys customers.
c) There arent many actions they can take that wont have repercussions for people other
than the ones theyre intending to benefit, and second-order consequences for everyone.
France can enact regulations that protect current jobholders by making it difficult to lay them off,
but those same regulations will deter entrepreneurs and owners from starting or expanding
businesses and hiring new employees.
d) While governments can provide incentives and nudge people in a given direction, they cant
make economies (or the people in them) perform as desired. For example, in the 1990s the
Japanese government tried to stimulate consumption by mailing out checks (something thats
referred to today as helicopter money). But its conservative citizens put the money in the bank
rather than spend it, turning the governments action into a classic case of pushing on a string.
Fundamental improvements intelligent changes in investment incentives, the tax system or
infrastructure, for example can increase the slope of the growth curve and provide substantial net
long-term benefits for a society (although not necessarily for every individual member). Short-term
fixes simply cannot create wealth out of thin air. Ill close with something Winston Churchill said,
with some additions of my own: We contend that for a nation to try to tax [or stimulate or devalue] itself
into prosperity is like a man standing in a bucket and trying to lift himself up by the handle.
May 26, 2016
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Memo to:
Oaktree Clients
From:
Howard Marks
Re:
Political Reality
My last memo, in May, was on the subject of Economic Reality. Its goal was to describe the realities
imposed by economics and point out the many ways in which governments and, especially, candidates for
elected office ignore and promise to override them. Since then I have been struck by the way
developments have moved economic reality to center stage. Of course, foremost among them has been
the affirmative vote of June 23 on Brexit: whether the United Kingdom should leave the European Union.
I have no interest in writing a memo about Brexit itself. Theres a huge number of moving parts, too little
past experience, too many varying opinions, and zero clarity on how the departure will be handled. There
are many pundits out there telling us what the consequences of Brexit will be. The only thing Im sure of
is that most of them are wrong, and if I were to join their ranks, Id probably be wrong, too.
Economic Reality: Choices and Consequences

The May memo described the ways in which economics defines and constrains reality in business,
investing and everyday life. Economics establishes the rules of the game and the boundaries of the
playing field, and these things cant be ignored. They can be altered, but not without consequences.
The realities of economics are stark and consistent, but also logical. They arent absolute, like the laws of
physics (e.g., gravity), but they reliably establish tendencies and limits. If the price of something goes up,
the amount consumed is likely to go down. If wages rise, the number of people employed for a task is
likely to decline. If tax rates go up, theres likely to come a point at which theres less incentive to work,
and thus less output. If a government spends more, to pay the bills it has to either print money (which
tends to be inflationary), raise taxes or borrow.
Shortly after publishing Economic Reality, I added a new section to the version appearing on Oaktrees
website, saying economics is largely the study of choice. If you only have $10, do you want to buy a
$10 book or two $5 hamburgers, or make a $10 gift, or add $10 to your savings? The only thing we know
you cant do is do them all. Further, decisions and actions have consequences. For example, spending
can provide us with enjoyment, but it will also make us poorer.
Reality in Politics
Ive always gotten a kick out of oxymorons phrases that are internally contradictory such as jumbo
shrimp and common sense. Ill add political reality to the list. The world of politics has its own,
altered reality, in which economic reality often seems not to impinge. No choices need be made:
candidates can promise it all. And there are no consequences. If something might have negative
consequences in the real world, politicians seem to feel free to ignore them. If someone annoying, like a
journalist or an opposing candidate, asks about potential consequences, its easy these days to
misrepresent them or deny they exist. And if it turns out that costs or consequences were willfully
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ignored, no redress is available: election victories based on unmet promises cant be rescinded, and
candidates cant be sued over falsehoods on the stump.
In the addendum to Economic Reality, I pointed out that candidates rarely talk about choice. Instead,
theyre likely to promise all of the above. And rarely if ever do they mention the cost that will be
attached to something, or the downside, as in Ill give you A, but youll have to give up B. I imagine
page one of The Politicians Handbook must say never deliver an unpleasant message.
In What Worries Me (August 2008), I wrote:
Imagine two candidates for president. One says, Im going to give you eight years of
discipline and denial of higher taxes and lower spending but Ill leave the country in
better shape. The other says, I have a secret plan that will solve all of our problems
without requiring any sacrifice on your part. Who do you think would win?
How about a real-world example? In 1984, Walter Mondale was the Democratic candidate for president,
running against Republican incumbent Ronald Reagan. Mondale became famous for his candor in
accepting his partys nomination:
Whoever is inaugurated in January, the American people will have to pay Mr. Reagans
bills. The budget will be squeezed. Taxes will go up. And anyone who says they wont
is not telling the truth to the American people. . . . Mr. Reagan will raise taxes, and so
will I. He wont tell you. I just did.
The result? Mondale lost in a landslide, with the popular vote of 59% to 41% representing the seventhbiggest percentage deficit in presidential election history. Far worse, of the 538 electoral votes, he won
only 13 (the District of Columbia and his home state of Minnesota). That stands as the second-lowest
electoral total for a presidential runner-up since 1824. So much for the benefits of candor.
Today many politicians promise to safeguard the Social Security system, but rarely do we hear anyone
talk about (a) reduced benefits, (b) higher Social Security tax rates, (c) a higher ceiling on wages taxed,
(d) delayed onset of benefits, or (e) means-testing for recipients. And yet, either some combination of
these or the insolvency of the system is an actuarial certainty. Instead, we get the candidates mantra:
more for all, with no cost or consequences . . . and, in the case of Social Security, a complete absence of
progress.
Brexit: Political Reality in Action

Being in Europe at the time of the Brexit vote gave me an opportunity to see the imperfections of political
reality in action. Ill review a few:
The decision to conduct the referendum was a matter of political expediency (defined as the
quality of being convenient and practical despite possibly being improper or immoral). A
schism in the Conservative Party between the pro-Europe faction and the Euro-sceptics
(pronounced skeptics) as well as opposition from the UK Independence Party, or UKIP
threatened to hand Britains 2015 election to the Labour Party. To put down this threat,
Conservative Party leader David Cameron promised in 2013 to put the issue of membership in the
European Union to a popular vote. We often see politicians paper over a problem with promises
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today, preferring to put off the possible consequences until tomorrow (they seem to assume
tomorrow will never come see page 4). This is a very practical stratagem, since elected
officials often leave office well before consequences appear, and at any rate, theres no
consolation prize for losing an election, so a candidate might as well do everything he can to win.
Potential consequences are often overlooked or not understood. Of course, the ramifications
of a Brexit referendum couldnt be known in 2013; even now in 2016 no one knows what theyll
be, although the decision to leave is a fait accompli. It was a glaring error to leave a decision of
this importance and permanence up to a simple majority of those going to the polls. The
referendum could have been structured so that a decision to leave required a supermajority of
those voting, or a majority of registered voters (whether they voted or not). Since neither of
these was required, the decision was made to take the UK out of the EU possibly tearing the
country asunder (e.g., Scotland may well secede from the UK, since it was tempted to do so
before and strongly wishes to be part of the EU) because 37% of registered voters said thats
what they wanted (whereas 35% voted to Remain and the other 28% didnt vote).
The decision was likely influenced by factual inaccuracies and false promises. For example,
probably most importantly, Leave voters were told that exiting the EU would enable Britain to
gain control over its borders and thus exclude immigrants. Further, voters were told the UK was
sending 350 million weekly to the EU, and leaving would enable that to be spent on the National
Health Service instead. Within days after the election, however, some of those who had made the
promises admitted that (a) maintaining unfettered access to the European market and its 500
million consumers will probably make it impossible to close Britains borders to immigrants
from Europe; (b) the 350 million was a gross figure that ignored the money the EU sent back to
subsidize British farmers, and the real net figure was closer to 200 million per week; and (c) no
one really thought the whole savings could go to the NHS maybe just a good part.
It became clear soon afterward that winning the election and implementing the decision are
two different things. Britain soon saw that (a) no one had a plan for how the departure would
take place and (b) implementing wouldnt be as much fun as campaigning. Thus:
o
David Cameron (who had urged a vote to Remain) announced the next day that, since he
wasnt the right person to engineer a departure, he would resign as Prime Minister and head
of the Conservative Party.
Ex-London Mayor Boris Johnson, a leading Conservative agitator for Leave, who it was
widely assumed would become the next Prime Minister, walked away after his unsuitability
was made clear in something of a coup.
Jeremy Corbyn, the head of the Labour Party, whose tepid effort failed to reflect his party
members strong support for Europe, was the subject of a 172-40 no-confidence vote by the
Labour members of the House of Commons.
The leader of UKIP, Nigel Farage, stepped down, saying he wanted his life back after many
years of advocating for Britains departure from Europe.
Thus, two weeks after the referendum, no one knew who would lead any of these parties. (Since
then Theresa May has ascended, surprisingly quickly, as Prime Minister and head of the majority
Conservatives.)
The English have a great expression: a dogs breakfast. The meaning is simple: a complete mess. I
think thats an apt way to describe the Brexit referendum.
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To pull this part of the memo together, I cant overstate my appreciation for the way Thomas Friedman
described the UKs situation in The New York Times on June 29:
A major European power, a long-time defender of liberal democracy, pluralism and free
markets, falls under the sway of a few cynical politicians who see a chance to exploit
public fears of immigration to advance their careers. They create a stark, binary choice
on an incredibly complex issue, of which few people understand the full scope stay or
quit the E.U.
These politicians assume that the dog will never catch the car and they will have the
best of both worlds opposing something unpopular but not having to deal with the
implications of the public actually voting to get rid of it. But they so dumb down the
debate with lies, fear-mongering and misdirection, and with only a simple majority
required to win, that the leave-the-E.U. crowd carries the day by a small margin. The dog
catches the car. And, of course, it has no idea what to do with this car. There is no plan.
There is just barking.
The Voting Booth

Now lets think about the nature of elections. In The Intelligent Investor, Ben Graham described the stock
market as a weighing machine in the long run but a voting machine in the short run. What he meant by
the latter reference was that in the short run, intrinsic value is often ignored and the stocks that do best are
usually the ones capable of winning a popularity contest.
I believe that, over time, elections have become more like popularity contests. The successful
campaign speech isnt one that does the best job of analyzing the challenges and supplying optimal
solutions. Its one that most provides what people want to hear.
In business and investing, people invariably compare the benefits and costs of A against the benefits and
costs of B. Then they select the alternative with the better expected net result (and hopefully one whose
bad outcomes are survivable). A lot of mistakes may be made, and the process is sometimes misguided,
but the effort to make good economic decisions is undeniably there. Decisions usually have clear
consequences, and they are likely to become known before the people responsible depart.
In contrast, politicians tend to believe the best decision is the one that is most likely to lead to election or
reelection. Responsibility for outcomes is highly diffused, and the results may only become clear years
or decades after the elections are held and the decisions are made. Few voters have the ability to assess
the reasonableness of candidates promises, and given the time lags mentioned just above it can be
difficult to judge candidates for reelection on the basis of their performance on the job.
Time for an aside: I dont claim that people in the private sector do Gods work. But we generally pull
together to work for the collective good when the incentives are aligned properly. While everyone at
Oaktree wants to advance his or her own financial position, status and career potential, Im certain they
also want Oaktree and its clients to succeed, as that is a prerequisite for and will be a prime contributor
to each individuals own success. In Washington, on the other hand, many elected officials
(Republicans and Democrats alike) give the impression that the success of the government and the
country takes a backseat to making sure that (a) they and their fellow party members are elected and
reelected and (b) members of the other party arent. To this end, some members of party A seem to
consider it more important to ensure that party B is unable to claim any accomplishments, than it is that
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party A actually gets something done. I saw a political advisor interviewed on TV, and when asked what
makes a politician successful, he answered, getting reelected by his or her constituents. He quickly
amended that to getting legislation done, but the message was clear.
The Quality of Debate

Its only hesitantly that I use the above section heading to describe what I want to cover here. First, it
seems theres little of quality in political speech today, and second, I dont see a lot of debate (in the sense
of a method of formally presenting an argument in a disciplined manner Wikipedia).
Rather than organized point and counterpoint, voters today certainly in the U.S. are subjected
to sound bites, insults and assertions that arent in response to anything. During a presidential
debate in 2012 (which in retrospect seems so prim and well-mannered compared to today), one
candidate when told by the moderator that he hadnt answered the question said you asked
the question you wanted to ask; I answered the question I wanted to answer.
Unlike earlier years, there do not seem to be any rules governing what some people will say, or
subjects that are off-limits.
Some candidates seem to believe the truth is dispensable. In past elections, candidates could be
heavily damaged if it could be shown that theyd said something inaccurate or untrue. This time
around, the truth doesnt seem to be accorded a universally high priority. According to PolitiFact,
an independent fact-checking outlet, 28% of Hillary Clinton statements that theyve checked are
Mostly False or worse. In Donald Trumps case, its an astounding 70%.
In fact, it seems to me that, among certain portions of the electorate, theres little concern for
whats said just how its said. Over and over I hear people on TV say, I like Trump because
he tells it like it is. Theyre not necessarily commenting on his policies or the accuracy of his
statements; more likely its his outspokenness and disdain for political correctness. In recent
decades, it seems this is someone Id like to have a beer with has taken the place of this is the
person whos best qualified to lead the country.
Ive thought for the last year that the Republican primary debates had the feeling, more than anything
else, of the professional wrestling matches I watched on television when I was a boy. Each wrestler had a
persona that appealed to a certain segment of the crowd, and the fans of the villains would scream their
support, faces contorted in rage. Dirty tricks and cheating didnt push away these fans in fact, these
things just stirred their bloodlust. That certainly seems to be the case with some of todays campaign
moments. The parallels between politics and pro wrestling might even extend to attempts to rig the
outcome. Just last month, the head of the Democratic National Committee was forced to resign because
of staffers leaked emails proposing that it favor one candidate over another.
Ignoring Economic Reality

I listed above some of the false promises that led to the victory for Leave in the Brexit referendum. I
also mentioned that there was a lot of backtracking on those promises in the weeks following the vote.
Now I want to discuss a few questionable statements that have been made in the lead-up to the U.S.
presidential election.
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Some of Donald Trumps most prominent economic pronouncements have been with regard
to imports, job losses and the balance of trade.
o
He says of China, theyre killing us. But trade is a two-way street. Barring unfair
competition, when we run trade deficits meaning we buy more from other countries than
they buy from us its for one main reason: they provide a better price/value proposition than
we do. They sell products (and take jobs), but we get bargains. China isnt winning in that
case, and the U.S. isnt losing: its a win for both countries. Of course its also true that
while the result may be positive for the countries overall, there still can be negative
consequences for individuals. For example, people may lose their jobs because of cheap
imports, and society should take steps to ease their loss. Ill return to this later.
Trump cites unfair competition from China as a main source of our loss of manufacturing
jobs. As I pointed out in Economic Reality, however, in recent decades the U.S. has lost
roughly ten times as many potential jobs to increased productivity, mechanization and
automation as it has actual jobs to low-cost competition from China.
Trump blames part of Chinas ability to sell cheap goods on the fact that it has held its
currency artificially low versus the dollar. But its interesting to note that when China
recently made its exchange rate less rigid, the yuan declined rather than rose, suggesting that
perhaps it hadnt been held artificially low.
As for economic reality, never has Trump said anything like this: We may be able to
increase manufacturing jobs by imposing protective tariffs, but that would require all
consumers to pay higher prices for their purchases of goods from abroad. What would the
average Americans everyday shopping experience be if imported goods were barred,
discouraged or heavily taxed?
Further, Trump doesnt point out that, in response to the adoption of protectionist
measures by the U.S., other countries could retaliate with increased tariffs on U.S.-made
goods, costing some Americans their jobs. Heres what Moodys Analytics says about his
original economic agenda (I havent yet seen analysis of the plan he announced on August 8):
Broadly, Mr. Trumps economic proposals would result in a more isolated U.S.
economy. Cross-border trade and immigration will be significantly diminished,
and with less trade and immigration, foreign direct investment will also be
reduced. While globalization has created winners and losers in the U.S. economy
in recent decades, it contributes substantially to the ongoing growth of the U.S.
economy. Pulling back from globalization, as Mr. Trump is proposing, will thus
diminish the nations growth prospects.
Trumps campaign is mainly targeting people who fear being left behind by globalization, and
ignoring the individual winners and positive overall effects (much as Leave campaigners did in
the UK).
Trump claims his expertise and experience in business would enable him to put the U.S.
economy on a better track. Heres Moodys take on the original plan:
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Mr. Trumps economic proposals will also result in larger federal government
deficits and a heavier debt load. His personal and corporate tax cuts are massive
and his proposals to expand spending on veterans and the military are significant.
Given his stated opposition to changing entitlement programs such as Social
Security and Medicare, this mix of much lower tax revenues and few cuts in
spending can only be financed by substantially more government borrowing.
According to Moodys, Trumps program would cause the federal budget deficit to increase from
$640 billion today to $3,151 billion in 2026 (rather than $1,289 billion under current law), and
federal government debt to increase from $14 trillion today to over $37 trillion in 2026 (versus
about $24 trillion under current law all figures in 2009 dollars, adjusted for inflation).
Finally, Ill mention Trumps most unrealistic claim: that he could trim the federal debt by
negotiating the ability to pay it off at a reduced amount. He built his net worth in part by
borrowing money and not paying it back, and he seems proud of his companies repeated use of
bankruptcy as a strategic tool. But Trump doesnt have an ongoing need to tap the world capital
markets, as the U.S. does (he now operates under an asset-lite business model that emphasizes
licensing fees rather than asset ownership; perhaps this is because his multiple defaults have
caused the credit window to be closed to him). The United States could refuse to pay its debts
in full thats called rescheduling or default but wed be unlikely to have the same
access to the credit markets, and we would certainly cease to enjoy the benefits of a high
credit rating and resulting low interest rates.
As for my picking on Trump here: Im quick to point out that Clinton has her own shortcomings as a
candidate and potential president. Her use of a private email server while Secretary of State is just one
prime example. And she has embraced positions, such as opposition to the Trans-Pacific Partnership and
her promise of free public college at certain income levels, that seem intended simply to help her compete
against Bernie Sanders in the primaries and win over his supporters in the general election. But I think
its fair to say that she hasnt been anywhere near as guilty as Trump of defying economic reality on the
campaign trail, and thats my subject here.
The Sources of Todays Division

One prominent characteristic of the political arena today is the rise in discontent, much of it based
on economics. The world is changing in ways that are uncomfortable for many, especially those
lacking the ability to change with it. Heres some of what I wrote in What Worries Me (August
2008):
In many ways, including materially, Americans have enjoyed a wonderful standard of
living over the last hundred years. Considering creature comforts such as housing, food,
sanitation, healthcare, leisure and luxuries, ours may have been the highest standard of
living in the world. That raises three questions:
Why should we continue to enjoy the highest standard of living?

Why should it continue to improve?
And why should the rate of improvement outpace that of the rest of the world?
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We often see poll results showing that increasing numbers of Americans doubt their
children will live better than they do. Wed like them to, but why should they? Other
than technological improvements which doubtless will continue to make life better for
everyone, why should our standard of living improve monotonically? And improve
relative to the rest of the world? Certainly the advantage in this regard can shift to other
countries, just as it shifted to us in the past.
One of the reasons for our high standard of living is the fact that Americans have been
paid more for doing a given job than everyone else. This was fine as long as (a) the U.S.
enjoyed significant post-war competitive advantages and (b) significant barriers protected
the status quo. But why should this go on? How can it go on?
Think about two cities. City A has more jobs than people, and city B has more people
than jobs. Initially, people in city A where labor is relatively scarce will be paid more
for doing a given job than people in city B. The key to their continuing to earn more is
the existence of barriers that prevent people from moving to city A. Otherwise, people
will move from city B to city A until the ratio of people to jobs is the same in both cities
and so are the wages. Among other things, geographic inequalities are dependent on the
immobility of resources.
For much of the last century, barriers kept our pay high. Other countries output wasnt
as good as ours. Some lacked investment capital, and some were decimated by war from
time to time. Perhaps they didnt possess our ability to generate technological
advancements or our managerial skills. High transportation costs, tariffs, prejudices
(when I was a kid, Japanese transistor radio was considered synonymous with low
quality) or legal restrictions (e.g., keeping foreign airlines from competing freely in our
markets) may have protected American wages. International trade wasnt what it is
today. But all of these things can change over time, and its hard to see how the
earnings supremacy of U.S. workers will be sustainable. (Emphasis added)
Unfortunately, these 2008 observations, and especially the final sentence, proved to be on target. And the
central issue globalization of trade, or the opening of national borders for the free movement of goods
has raised serious issues and become a source of controversy in the current election.
The good news about free trade is that an overwhelming majority of economists believe it contributes to
economic progress. For example:
A study by the Peterson Institute found that past trade liberalization laws added between
$7,100 to $12,900 in additional income to the average household. A study by Peter Petri
and Michael Plummer estimates that the Trans-Pacific Partnership, which Trump opposes
and Clinton sort of opposes, would boost American incomes by $131 billion. (David
Brooks, The New York Times, July 1)
Whats the source of these gains? They come primarily from specialization. When borders are closed,
each country has to produce all the goods it needs. But when borders are open, each country will produce
the goods it can make best or cheapest. Each will sell some of its output to other nations that cant make
those things as well or as cheaply, and each will buy from other nations that which it cant produce as
well.
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There are good reasons for international specialization, and by and large Americans have
benefited tremendously. Do we really want to produce T-shirts here and pay $60 for
something that now costs $15? (Professor Gregory Mankiw, chairman of the Council of
Economic Advisers under President George W. Bush, in The New York Times, July 15)
Clearly this process makes the overall global production system more efficient everything is made
where it can be done best to the enrichment of all nations . . . but not all people. The benefits to
date have been far from evenly distributed. In the U.S. they have gone overwhelmingly to those who are
better educated and technologically adept or who own the companies that profit. Real incomes for people
in the lower portion of the distribution have been stagnant at best, and the percentage of Americans
participating in the work force either employed or looking for a job has declined.
As I described in 2008, Americans historically have been paid more than their counterparts around the
globe. This creates incentives to both manufacture abroad and automate at home. (It also creates a
condition that attracts immigrants some illegal who are willing to work for less.) Manufacturing
employment is down a third since 1979, despite economic growth and increased manufacturing output.
Americans who lack education and thus are suited only for manual work who may have found jobs
in agriculture a hundred years ago or in auto and appliance plants fifty years ago now face declining
income trends . . . to some degree in absolute terms, and significantly when compared to (a)
Americans with the education required for higher incomes and (b) the way things used to be,
especially for their parents.
In the past, in addition to the fact that incomes werent so enormous at the top, the
income gap was narrowed by the fact that people could do pretty well at the bottom.
Millions of menial and blue-collar jobs were created as our economy expanded.
Even without much education, people could enjoy the good things in life, including cars,
TVs and vacations, along with good public school educations for their kids and the
possibility that most of those kids would have better jobs than their parents. Which of
those elements is equally true today? (What Worries Me)
I remember first becoming aware of income inequality and certainly of unequal quality of life during
my first business trip in 1970, which was to Los Angeles. As a kid who grew up in Queens, New York, I
had never seen anything like the verdant neighborhoods and beach communities of Southern California.
Now the divergent trends in income are tearing at our society and influencing political events. A
deteriorating income outlook and increasing income disparity have led to frustration, resentment,
economic nationalism, protectionism and xenophobia among those affected.
As The New York Times put it on July 13:
In the years that followed [the mid-1990s], the number of immigrants living in the United
States illegally would double and then triple before leveling off under the Obama
administration around 11 million. Deindustrialization, driven in part by global trade,
would devastate the economic fortunes of white men accustomed to making a decent
living without a college degree.
The economic reality is that these trends international specialization, automation, rising
productivity, job losses, the need for education, and a feeling of hopelessness among those affected
negatively are real and powerfully influential. Whether we like them or not, theyre here to stay.
Theyre economic reality, and they cannot be ignored or refuted.
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Ill move toward summing up on the causes of todays conditions by quoting from Thomas Friedman in
The International New York Times of June 30. I think he did a great job of capturing the situation:
Its the story of our time: The pace of change in technology, globalization and climate
have started to outrun the ability of our political systems to build the social,
educational, community, workplace and political innovations needed for some
citizens to keep up.
We have globalized trade and manufacturing, and we have introduced robots and
artificial intelligent systems, far faster than we have designed the social safety nets, trade
surge protectors and educational advancement options that would allow people caught in
this transition to have the time, space and tools to thrive. Its left a lot of people dizzy
and dislocated.
Friedmans statements appeal to me very strongly and remind me of Future Shock, a book written by
Alvin Toffler in 1970. Toffler defined future shock which he viewed as destabilizing our society very
simply: too much change in too short a period of time.
Arthur M. Schlesinger, Jr. discussed the results of economic decline and dissatisfaction in The Politics of
Upheaval (cited in The New York Times of June 20):
The followers of the demagogues mostly came from the old lower-middle classes, now in
an unprecedented stage of frustration and fear, menaced by humiliation, dispossession
and poverty. . . . They came from provincial and traditionally non-political groups in the
population, jolted from apathy into near-hysteria by the shock of economic collapse. . . .
Old America [is] in resentful revolt against contemporary politics and contemporary
economics.
These words do an excellent job of summing up current conditions. But Schlesinger, who died in 2007,
obviously didnt write them for that purpose, but rather in 1960, to describe the Great Depression. The
populism were seeing today is not a unique phenomenon, but rather a standard occurrence in periods of
economic difficulty. Populism has a record of giving rise to very destructive leaders and movements.
The combination of productivity improvements and foreign competition has been very hard on unskilled
and semi-skilled labor whats called the working class. People employed in uncompetitive
industries at the time globalization takes place are particularly disadvantaged. Their incomes
decline at a minimum, and they may lose their jobs and be unable to find new ones. Society should
cushion the blow on these people. Heres one proposal:
Last March, the ranks of the incensed included 78 percent of Bernie Sanderss supporters
and a whopping 98 percent of those backing Donald J. Trump.
More than half of voters including 61 percent of Mr. Trumps supporters feel they are
not keeping up with the cost of living. Three quarters of Mr. Trumps supporters feel that
life for people like them is worse than it was 50 years ago.
Some of this is due to irreversible forces. The days when white men kept an
uncontested hold on political power, when young adults without a college degree
could easily find a well-paid job, are not coming back. . . .
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Last month, four academics Jeff Madrick from the Century Foundation, Jon Bakija of
Williams College, Lane Kenworthy of the University of California, San Diego, and Peter
Lindert of the University of California, Davis published a manual of sorts. It is titled
How Big Should Our Government Be?. . .
The scholars laid out four important tasks: improving the nations productivity, bolstering
workers economic security, investing in education to close the opportunity deficit of
low-income families, and ensuring that Middle America reaps a larger share of the spoils
of growth.
The strategy includes more investment in the nations buckling infrastructure and
expanding unemployment and health insurance. It calls for paid sick leave, parental
leave and wage insurance for workers who suffer a pay cut when changing jobs. And
they argue for more resources for poor families with children and universal early
childhood education. (The International New York Times, August 3, emphasis added)
This is a very liberal agenda, and many Americans would say the whole and many of its parts constitute
undesirable government intervention. What, then if anything should be done to arrest the trends
described above? If we dont do something, its likely that the income and wealth gap will continue to
grow; the downside of globalization will continue to be felt; and our political process will continue to be
riven by widespread dissatisfaction.
Eduardo Porter, an economics columnist, summed up succinctly in The New York Times of May 25:
We shouldnt try to stop globalization, even if we could. But if we dont do a better job
managing a changing world economy, it seems clear that it will end badly . . .
The trends discussed above and resentment over experiencing them, fear of doing so, and anger upon
seeing them at work in ones community have been big contributors to Trumps popularity over the last
year, and also to Sanderss appeal to large numbers of Democratic primary voters. Similar sentiment
played a big part in the Brexit vote to Leave and is on the rise in Europe. The issues wont end with this
years presidential election. Rather, I believe they are likely to prove long-lasting and difficult to resolve.
They and the non-economic forces at play in this election are likely to have significant influence on U.S.
politics for years to come.
The Implications for Politics in the Future

The historical alignment of the two main parties was quite stable for a long time. For most of my
life, the Democrats have stood for the working class; a bigger and more active government; more
taxation, spending and wealth redistribution; and more-liberal social policies. The Republicans, on the
other hand, have been considered the party of big business and economically better-off Americans, and
they have fought for free enterprise; smaller, less-activist government; lower taxes; a muscular defense
posture and foreign intervention; conservative social policies; free trade; and supply-side (trickle-down)
economics. The two parties and their candidates and voters generally have stuck to these ideologies.
Ive seen the parties evolve from the above positions, but only modestly and gradually:
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The Democratic Party swung toward support for civil rights and became the primary party for
non-whites. And when Bill Clintons administration adopted a more centrist, less-liberal
approach, it stood less for welfare and economic redistribution and was more sympathetic to big
business and free trade.
The Republicans, on the other hand, attracted rural whites antagonized by the Democrats support
for desegregation. The party became more motivated by religion, morality and personal freedom,
more socially conservative, and less concerned with maintaining military strength and (outside of
the Tea Party faction) shrinking government and reforming entitlements.
In the current presidential race, Donald Trump and Bernie Sanders both outsiders to the traditional
parties have fared quite well thanks to support from millions of voters who are unhappy with the
historic political arrangement and how it deals with todays conditions. Thus change appears to have
accelerated, and theres talk of political revolution.
Given the events of 2016, the positions described above may well be realigned. There may be a party in
the future built largely around:
economic disadvantage and discontent,

cultural grievances and disregard for political correctness, experts, establishments, and
economic, social, political and media elites,
fear of terrorism, xenophobia, law and order, nativism, protectionism, closed borders, and
isolationism, and
pragmatism and self-interest (national and individual) as opposed to philosophy and ideology.
The above factors, which Trump sums up as America First and Make America Great Again,
may well rearrange or supplant the traditional positions of the parties. Depending in part on the
outcome of the current election, it may turn out as many people are saying that the Republican
establishment of the past has lost control of its party. Thus the party described above may be what today
is called Republican, or it may be something brand new. While the Democratic Party establishment
remains in control at present, Sanders shook it, assembling a substantial minority attracted to his socialist
principles.
It is particularly intriguing to consider the possibility of a reshuffling of the historical blocs into three
parties rather than two. Will a party of the Dissatisfieds be formed from todays Trump supporters to
compete against both the Republicans and the Democrats? Might they be joined by Sanders supporters,
with their own dislike of free trade, banks and big money; hostility toward elites and the Washington
establishment; preference for economic redistribution; and disappointment with their economic prospects?
Can the glue of alienation and dissatisfaction overcome these two groups vast political, demographic and
cultural differences? If Trump loses this year, will this group fade away or become institutionalized
under the leadership of more conventional politicians? These things will become clear over time.
Heres a particularly provocative potential issue to consider: Our constitution calls for election of the
president by a majority of the electoral college. But if there come to be three major parties, its easy to
imagine no candidate getting a majority. What happens then?
Few Americans may have known the answer a year ago, but I think many have begun to research it, and
still more are likely to do so in the years ahead. Ill give you the answer: in the absence of an electoral
majority, the president is chosen through a vote of the House of Representatives, with each state having
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one vote. Thus, theoretically, the 26 least-populous states containing just 17% of Americas
people and, by definition, almost none of its big cities could choose the president. For me,
regardless of the political makeup of the House, the loss of proportional election is of great concern,
particularly given the way the House is elected (see below).
My Prescriptions
I like and admire many of the politicians I meet of both parties. I just dont like the actions (or inaction)
the system produces collectively. So I want to make it clear that my reservations about politicians in
general are not as sweeping as I may make them sound above. Heres what I said in What Worries Me:
Condemnation of politicians neednt be universal. There actually are some I like. More
than anything else, theyre marked by a spirit of bipartisanship. Rather than consider
politics a blood sport in which the only important goals are to embarrass the other side
and win elections, they want to solve our nations problems.
Nevertheless, despite the above, the bottom line is that I find myself more worried than optimistic (also
from What Worries Me):
I confess that I feel the deck is stacked against government getting better. Less attention
paid to newspapers and TV news, declining interest in national and international affairs,
the rising role of the sound bite, generally shorter attention spans, a vanishing spirit of
self-sacrifice, rising me-first-ism . . . where would optimism come from in this regard?
We can hope, but Im not that hopeful. The truth is that most people vote for the
candidate who looks and sounds best in TV ads, who says what they want to hear, and
who they think will put money in their pocketbooks today and brighten their lives
tomorrow.
To the above I would add a very powerful force: the decline of balance in the media. Unlike the
days of my youth, in which broadcasters operated under the fairness doctrine, today there are networks
(as well as newspapers and websites) that act more like spokespeople for one party or the other than like
impartial journalists. That enables people who follow election news through these outlets to hear only
one partys rhetoric and avoid all exposure to the other sides case. This encourages extremism, widens
the gulf between people and parties (the statistical evidence in this regard is compelling), and makes
bipartisanship less likely.
Can the current political conditions be improved upon? Is the situation hopeless? While the economic
and social trends discussed above wont be easily altered, there are some mechanical fixes that could
make our political process work better.
First, the drawing of district lines for elections to the House of Representatives should be depoliticized. Under the current rules, district lines are redrawn every ten years, after the census, by the
party controlling each states legislature. That means theyre able to gerrymander the congressional
map, drawing the lines so that opposition voters are concentrated into a small number of districts and
allowing the party in power to win a disproportionately high number of House seats. Thus, for example,
in the 2012 election in Pennsylvania, Democrats received 51% of the votes for the House of
Representatives. But, thanks to the way the lines had been drawn by the Republican-dominated state
legislature, that 51% majority was crammed mostly into a small number of districts, such that the
Democrats won only five (or 28%) of Pennsylvanias eighteen House seats.
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As a result of gerrymandering, most House races are easy pickings for the party that drew the lines, and
many that remain are equally easy pickings for the opposition party. Thus the vast majority of seats in the
House are viewed as noncompetitive: theres only one party that can win.
The outcome of 94 percent of House races is a foregone conclusion. If this happened in
any country but the U.S., wed question whether it was a democracy. (Christian
Science Monitor, October 14, 2014)
For example, according to The New York Times, in the ten years prior to the enactment of the changes in
redistricting and primaries described below, congressional seats in California were so safe that in 255
elections, only one shifted from the control of one party to the other.
If the lines for House districts were drawn by independent, non-political committees, I think House
members would be less ideological and more likely to compromise, on average, and the process of
governing would be less combative and more productive. This process is underway already in my
former home state of California. Congressional districts were redrawn by an independent commission in
2011. Although its too early to judge the results, it appears that the new districts, which follow more
natural geographic and demographic boundaries combined with the new primary system described
below have created races that are more competitive and more inclined toward moderation.
Second, the structure of primaries should be reformed. As described above, district lines usually
ensure that a given party will win each House seat. That means in a noncompetitive district, being
nominated by the unbeatable party is tantamount to being elected. Thus the real contest today is in the
primaries, which are likely to be won by ideologically-zealous candidates. This is so because (a)
according to the website fivethirtyeight, in 2014 less than 15% of eligible voters participated in
congressional primaries, (b) the few who do vote in primaries are likely to be the most motivated, and
thus ideological, party members, and (c) gerrymandering has freed the candidate of the inevitable winning
party from having to appeal to members of the other party or to independents. This combination
encourages extremism.
The results might be different if the rules provided that (a) theres only one primary, in which everyone
can vote, and (b) the two top vote-getters in that primary regardless of party get to run in the general
election. Thus, for example, both of the general election candidates for a House seat in a heavily
Republican district could be Republicans, with no Democrat taking up space on the ballot in an election
he has no chance to win. In that case, the more moderate of the two Republicans might pick up support
from other moderate Republicans (when they turn out in greater numbers in the general election), as well
as from Democrats, and be elected to Congress.
This top-two primary system is already in place in California, Louisiana and Washington, with the
potential to elect moderates rather than extremists. According to fivethirtyeight, thats exactly what
happened in Washingtons 4th district in 2014. A Tea Party hero beat out a moderate Republican in the
primary, 32% to 26%, while the leading Democrat got only 12% of the vote. In a state with separate
Republican and Democratic primaries, the Tea Partier would have run against the Democrat in the general
election and been a sure winner. But in Washington, the top two Republicans faced off, and the more
moderate candidate won with support from moderate Republicans and some Democrats.
If more moderates won as was much more common a few decades ago it would be easier to
imagine the two parties working together, producing compromise rather than gridlock. Some
people think gridlock is more desirable than government action, but the way I see it, there are serious
problems that need solving, and as long as the two houses of Congress are in the hands of extremists from
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two different parties or are both led by extremists from a party thats different from the one occupying
the White House solutions are unlikely to be found.
The third improvement would be a reduction in the role of money in politics. Money is everywhere
in American politics, and the trends are negative in this regard.
The 2012 presidential election cost a total of $2 billion, and 2016s may dwarf that.
The total amount spent on all federal elections in 2012 is estimated at $7 billion.
Virtually all the cash comes from private interests, rather than public funding as in some other
countries. In addition to individual donors, corporations and unions can have great influence.
Recent court decisions have made it possible for the amounts given to increase and harder for
union members to refuse to share in their unions giving. Political giving has been interpreted to
be a form of free speech, making it quite difficult to regulate.
The lobbying industry has over 11,000 members and bills over $3 billion per year.
Every interest group has its paid lobbyists, especially the ones (like tobacco 50 years ago) that
will only maintain profits if they can hold back reforms.
Elected representatives have to drum up contributions in order to fill their war chests. What politician can
fail to support his big donors? Thus some may come to serve more as advocates than prudent
policymakers.
Several years back I met a young man whom I decided to support in his first House race. When he called
me the day after his election, I assumed it was to celebrate and thank me. But instead he asked for a
contribution for his next race! With terms of just two years, Congressmen are never not running. This is
only one example of the ways in which fundraising is too important in American elections.
I have a fourth suggestion, but fortunately its one that is superfluous at the Federal level: avoid the use
of referendums to make decisions. Wisely, the Founding Fathers omitted referendums from the process
that governs the U.S. I like to think it was because they knew better than to leave big decisions up to a
direct vote of the populace and were worried about the tyranny of the majority, but it also seems they
expected the referendums to occur at the state level.
Its interesting in the current context to note Prime Minister Margaret Thatchers 1975 opposition to
referendums (in defending membership in the European Union against its unpopularity):
Without the protections and definition afforded by a written constitution, referendums,
she said, sacrificed parliamentary sovereignty to political expediency. In a system such
as Britain's, that threatened minorities by trading liberal democracy for majoritarianism.
Perhaps the late Lord Attlee was right, she observed, when he said that the referendum
was a device of dictators and demagogues. (Financial Times, September 11, 2007)
We just cannot allow a simple majority of those who vote to directly decide important issues like Brexit.
First, fewer people vote than we would hope, so decisions can turn on the wishes of a relatively small
group. And second, many voters may lack the knowledge and analytical skills necessary for good
decision-making. Consider the questions asked most often on Google in the UK in the hours after the
Brexit polls closed: What does it mean to leave the EU? and What is the EU? Presumably many of
the people asking these questions were the same ones who had just decided Britains future. It might
have been better if they had asked those questions before the vote.
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I wrote this memo to explain what happened in the UK this year and what I think is happening in the U.S.
I wanted to point out that politics rarely hews to economic reality; rather, it has a reality all its own.
The recent trends in income, wealth, trade and employment are causing a lot of dissatisfaction in the U.S.
and Europe, and I expect them to have a strong impact on politics for years to come. Widespread
economic dislocation can cause voters to choose the wrong leaders. The U.S. is not exempt, and we
must be highly vigilant in this regard.
August 17, 2016
P.S.: Some readers may feel its wrong for me to make any statements regarding the presidential
candidates, and to criticize what I see as Trumps take on economic issues. Others may simply disagree
with my views but they are my views, and I hope youll feel I have the right to express them. Ive tried
hard to stick to matters of economics and fact, rather than non-economic policy or programs, opinion or
personal preference. Im sorry if my statements cause unhappiness. Anyone who takes factual issue with
anything I say here is welcome to let me know.
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Memo to:
Oaktree Clients
From:
Howard Marks
Re:
Implications of the Election
Im starting this memo a week before Election Day. I promise to try to stay away from the merits of the
candidates and the question of who will win, and instead confine myself to the important messages that
we should take away from the election and the actions we should push for as a result. The outcome of
tomorrows election wont change these things as far as Im concerned.
Angry Voters
Of course, the big story of this election year has been the unprecedented, unconventional rise of Donald
Trump. Trump threw his hat into the ring with a complete lack of experience in elected office or other
public service, and without an established campaign organization. In fact, he had no established partys
ideology. He adopted some Republican elements but rejected others. And yet he has been able to attract
a large group of voters, probably about 50 million strong.
He did this by assembling backing from an unusually diverse mix of elements. These included dedicated
Republicans who werent about to vote for a candidate of another party; the many Clinton haters whove
had 24 years to gel since Bills first inauguration; people who were attracted to Trumps celebrity,
reputation for business success, outspokenness and colorful manner; and supporters of the right. But this
tells only part of the story.
The aspect I consider most important for the future relates to the Trump supporters and some of
the most active and vocal ones who are motivated by an anger regarding the system that is
neither purely emotional nor illegitimate.
Many are older, white, non-college-educated men who might be described as demographically
dislocated. When these men were born, white males ran America; their communities werent mixed and
becoming more so; and the cultural shifts occasioned by the civil and womens rights movements,
technological change and mass immigration were unimagined. Certainly the shift to the America of
today with all these things quite different might be jarring and unpleasant to the people I
describe.
At the same time, many Americans and often the same ones are experiencing the effects of job
loss and diminished economic prospects. Fifty or even thirty years ago, men without college degrees
could easily obtain good-paying jobs and the pride associated with being able to maintain their families at
a good standard of living. One earner per household was enough, and one job per earner. Strong labor
unions ensured adequate pay and benefits and protected workers from too-rapid changes in work rules
and processes.
Now the number of unskilled jobs has been reduced by automation, foreign manufacturing and increased
globalization of trade. Unions are much less powerful in the private sector (name a powerful union leader
of today who comes to mind). Men of the sort described above older, white and non-collegeeducated are likely to have lost jobs, know someone who has, or seen the impact on their
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Importantly, until 2000, most Americans felt their children would live better than they did. Now this is
no longer true:
When asked if life for our childrens generation will be better than it has been for us, fully
76 percent said they do not have such confidence. Only 21 percent did. That was the worst
ever recorded in the poll; in 2001, 49 percent were confident and 43 percent were not. . . .
virtually all polling shows a steep decline in optimism since the late 1990s and early 2000s.
(The Washington Post, August 12, 2014)
Heres a quote from Thomas Friedman in The International New York Times of June 30 that I used to sum
up in Political Reality (August 2016). As I wrote there, I think it does a great job of capturing the
situation:
Its the story of our time: The pace of change in technology, globalization and climate
have started to outrun the ability of our political systems to build the social,
educational, community, workplace and political innovations needed for some
citizens to keep up.
We have globalized trade and manufacturing, and we have introduced robots and
artificial intelligent systems, far faster than we have designed the social safety nets, trade
surge protectors and educational advancement options that would allow people caught in
this transition to have the time, space and tools to thrive. Its left a lot of people dizzy
and dislocated.
What we have is a country in fact, a world that is changing rapidly and in ways that are
unpleasant and disorienting for large segments of the population. The present is different from the
past, and the future looks worse than it used to. Slower economic growth is producing less opportunity
overall, and a number of forces are supplementing slow growth in diminishing the outlook. Rising
income inequality is directing an increasing share of the gains to top earners. Older people lacking higher
education are particularly ill-equipped to deal with the changes.
I think this is an apt description of conditions in the U.S., but it seems equally applicable to much of the
developed world. In an opinion piece on October 26, starting from the German point of view, Joachen
Bittner of the International New York Times described a broad group he called Wutbrgers, or angry
citizens. I think theyre rising everywhere:
It is a relatively new expression, with a derogatory connotation. A Wutbrger rages
against a new train station and tilts against wind turbines. Wutbrgers came out in
protest after the Berlin government decided to bail out Greece and to accept roughly one
million refugees and migrants into Germany.
Wutbrgers lie at both ends of the political spectrum; they flock to the right-wing
Alternative fr Deutschland and the socialist Linke (Left) Party. The left wing has long
had a place in German politics, and the Linke has deep roots in the former East
Germanys ruling party. And weve had a fringe right wing since the postwar period
began. But the populist anger of the A.F.D. is something new: Anti-establishment, antiEuropean Union and anti-globalization. . . .
The same thing is happening elsewhere in Europe: Many British Wutbrgers voted for
Brexit. French Wutbrgers will vote for Marine Le Pens National Front. Perhaps the
most powerful Wutbrger of them all is Donald J. Trump.
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Which raises the question: How was anger hijacked?

In its pure form, anger is a wonderful force of change. Just imagine a world without
anger. In Germany, without the anger of the labor movement, we would still have a
class-based voting system that privileged the wealthy, and workers would still toil 16
hours a day without pension rights. Britain and France would still be ruled by absolute
monarchs. The Iron Curtain would still divide Europe, the United States would still be a
British colony and its slaves could only dream of casting a vote this Nov. 8.
Karl Marx was a Wutbrger. So were Montesquieu [who articulated the concept of
separation of powers within a government], William Wilberforce [the leader of the
abolitionist movement in Britain], the Rev. Dr. Martin Luther King Jr. and the tens of
thousands of Eastern German protesters who brought down the Berlin Wall in 1989. . . .
Now: Compare these spirits to the current parties claiming to stand for necessary change.
. . . Sadly, the leaders of todays Wutbrger movements never grasped the difference
between anger driven by righteousness and anger driven by hate.
Anger works like gasoline. If you use it intelligently and in a controlled manner, you can
move the world. Thats called progress. Or you just spill it about and ignite it, creating
spectacular explosions. Thats called arson.
Unfortunately, this lack of maturity and prudence today exists among not just the new
populist class, but parts of the political establishment. The governing class needs to
understand that just because people are embittered and paranoid doesnt mean they dont
have a case. A growing number of voters are going into meltdown because they
believe that politicians and journalists dont see what they see. . . .
The grievances of white, often less-educated voters on both sides of the Atlantic are
often dismissed as xenophobic, simplistic hillbillyism. But doing so comes at a cost.
Europes traditional source of social change, its social democrats, appear to just not get it.
When Hillary Clinton calls half of Mr. Trumps voters a basket of deplorables, she
sounds as aloof as Marie Antoinette, telling French subjects who had no bread to eat
cake.
. . . Amid their mutual finger-pointing, neither populist nor established parties
acknowledge that both are squandering peoples anger, either by turning this anger
into counter-productive hatred or by denouncing and dismissing it. Mrs. Clinton
[making the presumption that she would win, as seemed clear on October 26] has the
chance to change, by leading a political establishment that examines and processes anger
instead of merely producing and dismissing it. If she does, lets hope Europe once again
looks to America as a model for democracy. (Emphasis added)
The point of all of this is that Trump is importantly supported by dislocated, disoriented voters who
are angry about a number of unquestionably significant trends that are impacting them and their
communities. Regardless of the outcome of the election, they and their sentiments will remain a
powerful force.
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Heres how I concluded the relevant section of Political Reality. Ill let it do the same here:
What, then if anything should be done to arrest the trends described above? If
we dont do something, its likely that the income and wealth gap will continue to grow;
the downside of globalization will continue to be felt; and our political process will
continue to be riven by widespread dissatisfaction.
Eduardo Porter, an economics columnist, summed up succinctly in The New York Times
of May 25:
We shouldnt try to stop globalization, even if we could. But if we dont do a
better job managing a changing world economy, it seems clear that it will end
badly . . .
The trends discussed above and resentment over experiencing them, fear of doing
so, and anger upon seeing them at work in ones community have been big
contributors to Trumps popularity over the last year, and also to Sanderss appeal
to large numbers of Democratic primary voters. Similar sentiment played a big
part in the Brexit vote to Leave and is on the rise in Europe. The issues wont end
with this years presidential election. Rather, I believe they are likely to prove longlasting and difficult to resolve. They and the non-economic forces at play in this election
are likely to have significant influence on U.S. politics for years to come.
A Call to Action
As Bittner wrote, voter anger can be a potentially-powerful force for change. It is my hope that the
presence of this anger will make it clear to our elected leaders that change is needed, rather than that they
should dig in their heels further to fight the opposing party.
As I recall, it was in the 1980s that a massive ideological gulf opened between the Democrats and
Republicans, with the liberal views Carter had espoused while in office (1976-80) contrasting sharply
with the strict conservative philosophy Reagan brought to his presidency (1980-88). After the quieter
presidency of Bush the Elder, Bill Clinton held office in 1992-2000, and the attitude of the right
approached revulsion, whether based on his liberal agenda or his personal conduct. Very negative
feelings also befell George W. Bush in 2000-08 (who was named president after an election decided by
the Supreme Court, and who took us into war in the Middle East) and Barack Obama in the last eight
years (with what the right considered his overreaching plan for health care).
Over the last 36 years, then, politicians have become more combative and less willing to compromise
and certainly unwilling to take their lead from the occupant of the White House if hes from the other
party. It often seems the members of both parties have devoted themselves primarily to denying the other
any accomplishment. And in our system of government where the two houses of Congress and the
presidency can be under the control of different parties, and where in the Senate it can take 60 votes out
of 100 (not 51) to advance legislation its easy to prevent progress. The result has been gridlock and a
total lack of forward movement.
Some people and especially conservatives who think the size and role of government should be limited,
and libertarians who generally oppose coercive institutions think gridlock is a good thing. They think
the less government does, the better. This was a particularly popular sentiment around the time of the
Reagan presidency, when conservative ideology was in its heyday.
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But we cannot cope in this complex, rapidly changing world without some solutions. Inaction cant
always be depended on, especially given that were not starting from the ground zero of virgin territory.
Government has taken action in the past for example, setting the rules for Social Security and it
legitimately may have to rewrite those rules when circumstances change: when there are fewer people
working per retiree, or when people live longer. You cant say I prefer gridlock and assume the system
will remain solvent.
We need good decisions made and action taken on not just Social Security and other entitlements,
but also the health care system, trade agreements, infrastructure spending and other fiscal
stimulus, our defense posture and yes appointments to the Supreme Court. This year,
Republicans refused to deal with President Obamas nominee to fill a Court vacancy. That vacancy will
remain for the new president to fill, and two to three more are likely to open up in the next four years.
Will they be dealt with constructively by whichever party doesnt occupy the White House? Or will
there be continued obstructionism and a lack of decision making.
The writer of the 2014 Washington Post piece cited above, regarding diminished optimism, attributes
some of this to the slowness of the economic recovery since the financial crisis of 2008, and some to
increasing inequality, meaning fewer and fewer people are participating in the gains. And then she goes
on to cite another possible reason:
The lost optimism, [Fred Yang, a Democratic pollster] said, says a lot about how shaken
we are by the inability of our political system to address seemingly easy issues, and it
leaves us worried about the future.
Yang doesnt see that improving much, even as the economy does. The unsettledness of
the public is what is normal now, he said. To me, this is less about economic reality
than about our political system our lack of confidence that our political leaders,
regardless of party, are equipped to deal with the future.
Thus I believe that citizens are angry not just because of recent trends, but also because the government
hasnt done enough to stem them or lessen their impact. Even a conservative who favors a limited role
for government may want some action taken if he has lost his job due to globalization or automation.
Trump promised to help, and it has won him a lot of votes.
It is my hope that constructive action will be taken. Heres what Blackstone founder and former
Secretary of Commerce Pete Peterson wrote in his book Running on Empty:
. . . while our problems are not yet intractable, both political parties are increasingly
incorrigible. They are not facing our problems, they are running from them. They are
locked into a politics of denial, distraction, and self-indulgence that can only be
overcome if readers like you take back this country from the ideologues and spin doctors
of both the left and the right. . . .
With faith-driven catechisms that are largely impervious to analysis or evidence, and that
seem removed from any kind of serious political morality, both political parties have
formed an unholy alliance an undeclared war on the future. An undeclared war, that is,
on our children. From neither party do we hear anything about sacrificing today for
a better tomorrow. In some ways, our most formidable challenge may be our
leaders baffling indifference to our fiscal metastasis. As former Treasury Secretary
Larry Summers puts it, The only thing we have to fear is the lack of fear itself.
(Emphasis added)
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The Importance of Bipartisanship

I think were on the way to a geometry proof (remember high school?).
The voters are angry about the level of government inaction.

Positive steps must be taken if were to solve todays pressing problems.
So whats the next step, the next essential ingredient? To me, its bipartisan compromise.
When I was a kid, the leaders of the two parties in Congress worked with the president to solve
problems and achieve legislative compromise. Heres what I wrote on this subject in A Fresh
Start (Hopefully), after the last election in 2012:
The opposite of gridlock is compromise. Thats what we need today. Compromise,
however, doesnt mean one party saying We get all we want and you get none of
what you want. Deals like that can only be inked if one party holds all the cards: either
the White House plus majorities in both the Senate (and preferably the 60 votes required
to stop a filibuster) and the House of Representatives or, at minimum, majorities in both
houses of Congress and enough votes to override a presidential veto. Both parties are far
from that today, and that may remain the case for a long time.
No, compromise means, We get some of what we want and you get some of what
you want. In practice, it means elected officials have to vote for things they
promised to fight and give up on things they swore to deliver. Unless you do that, the
other guy doesnt get any of what he wants meaning he has no reason to go along. This
is a reality that our political leaders have failed to confront and accept.
While compromise comes at a cost, gridlock can cost more. Last year, some long-term
U.S. debt was downgraded after a particularly unseemly battle over the federal debt
ceiling. This occurred not so much because of our fiscal situation, but because our
dysfunctional government showed itself to be unable to rise to the occasion and solve
problems. . . .
On November 7, The New York Times carried an excellent article by Thomas L. Friedman
entitled Hope and Change, Part II. In it, Friedman did a great job of outlining some of
the things Washington will have to do in order for the outlook to improve.
The next generation is going to need immigration of high-I.Q. risk-takers from
India, China and Latin America if the United States is going to remain at the
cutting edge of the Information Technology revolution and be able to afford the
government we want. . . .
. . . my prediction is that the biggest domestic issue in the next four years will
be how we respond to changes in technology, globalization and markets that
have, in a very short space of time, made the decent-wage, middle-skilled job
the backbone of the middle class increasingly obsolete. The only decentwage jobs will be high-skilled ones.
The answer to that challenge will require a new level of political imagination
a combination of educational reforms and unprecedented collaboration between
business, schools, universities and government to change how workers are
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trained and empowered to keep learning. It will require tax reforms and
immigration reforms. America today desperately needs a center-right
Republican party offering merit-based, market-based approaches to all these
issues and a willingness to meet the other side halfway. The country is
starved for practical, bipartisan cooperation, and it will reward politicians who
deliver it and punish those who dont. . . .
Im frustrated when I see Americans of both parties failing to punish or even
encouraging behavior on the part of their elected officials that is fractious,
partisan, ideological and non-compromising. Gridlock and inaction wont solve our
problems. Cooperation, adaptability and Friedmans imagination must be the
watchwords for the years ahead.
We need constructive action to solve the many problems we face, and theres only one
way for it to materialize: bipartisanship.
Flaws in Our Democracy

Theres a good chance that this years election result will demonstrate the presence of elements capable of
rendering our elections less than perfectly democratic. The main culprit is the Electoral College. Heres
more from A Fresh Start in 2012:
How did the too close to call headlines of the days just before the election turn into a
resounding victory, which the Democrats will argue has given them a mandate to lead?
How did Obamas small edge in the popular vote turn into a 62%-38% margin in terms of
the electoral votes that determine the winner? The answer lies in the peculiarities of our
electoral college.
I was traveling in Asia and the Middle East at election time, and I found myself having to
explain a system in which:
In all but a few states, 100% of the electoral votes go to whoever wins the popular
vote there, regardless of the margin.
Most of the 50 states this year it was roughly 43 are considered uncompetitive,
meaning one party or the other enjoys a substantial, dependable majority. For that
reason, a vote for a Republican is totally meaningless in a Democratic state like
California, as is a vote for a Democrat in Republican Utah.
On the other hand, the electoral system gives voters in a few states disproportionate
influence. Since the uncompetitive states electoral votes are not in play, elections
are determined by only the few so-called swing or battleground states. In fact,
this year many people thought the election might be determined largely by who won
in just one state: Ohio.
Perhaps most glaringly, a candidate can be elected president with a majority of
electoral votes despite having received fewer popular votes than another.
Our system was designed in the eighteenth century to centralize the job of choosing a
president in the hands of a few wise leaders and avoid the uncertainties associated with a
widespread and uninformed populace with which it was hard to communicate.
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But in the twenty-first century, with the impediments to a meaningful popular election
much reduced, its time to reassess the benefits of the electoral college its hard to say
what they are versus the costs in terms of potentially weird outcomes. In the days just
before the election, it seemed that for the second time in twelve years we could have
a president whod lost the popular vote. That tells me its time to reassess our
system of voting.
The existence of the Electoral College can lead to other possible complications. In Political Reality in
August, I raised the question of what happens if no candidate receives a majority of the 538 electoral
votes:
Ill give you the answer: in the absence of an electoral majority, the president is chosen
through a vote of the House of Representatives, with each state having one vote. Thus,
theoretically, the 26 least-populous states containing just 17% of Americas people
and, by definition, almost none of its big cities could choose the president. For me,
regardless of the political makeup of the House, the loss of proportional election is of
great concern . . .
Lastly under this heading, I want to touch on the role of money. In our elections (a) the vast bulk of
campaign funding is provided privately, not publicly, and (b) the Supreme Court has ruled, in effect, that
the amounts donated largely cannot be limited. The result, in my view, approaches the undoing of one
man, one vote. While each persons actual vote is the same, his or her influence on the outcome is not.
Here are just a few data points, according to Business Insider (October 31):
Nearly $6.6 billion is the amount candidates, parties, and outside groups are raising and spending
in trying to move things their way in the 2016 election cycle, the Center for Responsive Politics
estimates on its website, OpenSecrets.org. Its a new record. Its up by $86.5 million, adjusted
for inflation, from the 2012 presidential cycle, which had also been a record.
The biggest increases in money flows, compared to 2012, came from outside money groups that
purportedly work independently from candidates, the report said. Theyve greased this election
with $1.3 billion so far (through October 24), $190 million more than at this point in 2012,
accounting for 26.8% of total spending.
And its getting more concentrated: The top 100 families contributed $654 million to
candidates, political parties, and outside groups so far, or 11.9% of the total raised, up from 5.6%
in the 2012 election cycle.
The top ten families have given a total of $281 million so far this year.
It wasnt many years ago that contributions were limited to a couple of thousand dollars per candidate per
race. Now $100,000 isnt an uncommon ask, and there are legitimate (but possibly cynical) ways to
donate millions. Given the amounts involved and the private sourcing, I find it hard to believe that
elected officials are able to entirely ignore donors interests and preferences when they do their jobs. Im
not talking about corruption, just a not-quite-level playing field. This area is ripe for change. But given
that the Supreme Court ruled that political donations are speech and thus cant be regulated, change
would require a constitutional amendment or a different decision from the Supreme Court.
The Outlook for the Parties

One thing thats uncertain as we move forward from here is what the future holds for the two main
parties.
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Many voters crossed long-standing party lines during this campaign:
Working class Americans, traditionally Democrats, were attracted to Trump by his antiestablishment, non-politically-correct, Make America Great Again approach.
Big business, traditionally Republican, failed to support Trump, perhaps because of his anti-trade
positions even though he might well be a more pro-business president than Clinton.
College-educated white Republicans and especially women among them backed Clinton,
presumably because of Trumps controversial behavior and Clintons role as the first woman
candidate.
Will these new party allegiances hold? Or, if they arose largely because voters felt either attracted to or
repelled by one of the 2016 candidates, will some or all of these developments reverse when the
candidates are different?
The leaders of both parties were challenged this year by angry members. Will those members stay with
their parties, or will they be less rooted in the future and up for grabs? The make-up and the
cohesiveness of both parties is in flux, and thus the next election may be another that deviates
from the usual path.
The Democrats have their issues. Its one of Trumps assertions that the Democratic party has been
taking its working class members for granted, talking up the connection at election time but failing to
come through with solutions, especially for displaced workers. (Democrats will counter that its because
Republicans have been successful in implementing gridlock so as to stymy programs like retraining.) The
fight between moderates and liberals for control of the Democratic party made clear in the divided
primary results between Clinton and Sanders is far from over. Sanders supporters may decide that the
party leadership isnt liberal enough.
But I think its the Republican party that faces greater challenges. Over the last few decades, the party
has been thrown together from largely unrelated and disjointed elements. As I described in Political
Reality, the traditional Republicans of 60 years ago fiscally responsible, pro-business, socially
moderate and strong on defense have been joined more recently by conservatives, the Tea Party,
Evangelical Christians, anti-gun-control voters, anti-abortion groups, and now the economically
dislocated. The glue is weak; rather than by ideology, they have been unified primarily by the fight
against Democrats.
Will all these groups stay within the party? Perhaps some of the last will vote with their feet with
regard to House Speaker and party leader Paul Ryan, who first refused to endorse Trump, then did
endorse him, then described Trumps raunchy 2005 video as troubling and said he wouldnt campaign
for him or support him, and then voted for him and expressed support but did so pointedly? without
mentioning his name. After Ryan responded to the video by disinviting Trump from a joint campaign
event in his home state of Wisconsin, he was booed by some in the crowd. Will Trump supporters remain
Republicans if Ryan continues to lead the party? Will Trump supporters elected to the House support
Ryan in his leadership of their caucus?
Ryans experience wasnt unique: numerous Republican politicians had problems with Trumps policies
or actions but needed his supporters, who constitute a large part of Republican voters. The conflict
between principle and pragmatism is very real, and the painfulness of their dilemma has been clear. It has
produced flip-flopping and confusing stances (raising the question of whether its possible to support a
candidate but not endorse him).
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If Trumps supporters desert the Republican party (or the political process) due to disenchantment with
the behavior of its leaders, the party may have a hard time pulling together a meaningful following in
future elections.
Trump has essentially run as an outsider who staged a hostile takeover of the Republican
party. If he loses, as is expected, he will still have won the votes of some 50 million
voters or more, and they will represent a continuing, potent force, roiling with
resentments, said [David Gergen, an adviser to four presidents three of them
Republicans]. Before Donald Trump brought his wrecking ball to the party, one might
have thought it highly likely that Republicans could unite after yet another losing
election. But one of Trumps many ugly legacies is that the chances of the party losing
its coherence or even breaking up now seems better than 50:50. (Financial Times,
October 29/30 clearly not a Democratic, or even an American, publication)
The Republicans plan after the defeat of Mitt Romney in 2012 centered around increasing its appeal to
women and Hispanics and other minorities. In this campaign, however, that effort probably went into
reverse.
I think the Republican party faces real issues. And my point here is that our country needs two strong
parties, not an elected dictatorship. With two strong parties there can be an active debate of ideas,
and neither is able to operate unopposed in a Washington devoid of meaningful resistance. The
complete opposite of gridlock free rein isnt desirable either.
On November 2, John Cassidy wrote in The New Yorker of:

. . . an America bitterly divided along class, racial, and cultural lines. To quote Benjamin
Disraeli, the nineteenth-century British statesman, we now have two nations between
whom there is no intercourse and no sympathy; who are as ignorant of each others
habits, thoughts, and feelings, as if they were dwellers in different zones, or inhabitants of
different planets.
Disraeli was writing about the rapidly industrializing England of the eighteen-forties, and
the two nations he referred to were the rich and the poor. In the United States, because of
its history of slavery, the Civil War, and mass immigration, the divisions have never been
that simple: vertical cleavages along racial, ethnic, and regional lines have often trumped
the horizontal class divide. But the gulf between Clintons America and Trumps
America, even though it cant be traced entirely along economic lines, is now a yawning
chasm.
Its very much worth noting that the electoral map showing whos expected to win which states has the
West Coast, the Northeast and the Upper Midwest quite solid for Clinton and a broad swath down the
middle of the country for Trump. The regions differences from each other are very significant, with the
people in Trump country more likely to live rural lives, to have been born in the U.S. (and often in the
same town in which they now live), and to have worked in manufacturing. These differences contribute
to the divide described above.
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The political arena this year seems like a battlefield, divided much more than usual by antagonism,
incivility, anger and downright hatred. Elites, establishments, experts, incumbents, insiders,
internationalists and political correctness all came under attack, with no one to defend them. Slow
economic growth accentuated by continuing automation and international trade is likely to continue to
leave dissatisfaction within the working class. And after having seen behavioral norms wiped away in the
first x-rated campaign and doubts raised about the impartiality of the FBI and even the fairness of our
elections large numbers of people may be left alienated. When the election is over, these things are
likely to remain the case.
But as I look forward, I see the need for constructive, bipartisan governmental action. Is that
wishful thinking? Winning future elections could become a function of producing solutions, and that in
turn could lead to cooperation and compromise between the two parties. Ill use a rarely seen word to
describe my dream: comity. Its definition makes it perfect for this use: courtesy and considerate
behavior toward others.
The environment described above doesnt feel like one that encourages comity or one in which the parties
can function internally and work together. Therefore we might have to hope that politicians will conclude
not only that the future of the country requires bipartisanship, but that their own success does as well.
Unlikely? Perhaps. But after a post-election memo in 2012 that proved far too optimistic, I say,
why quit now?
November 7, 2016
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2012-14: An Uncertain World

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the litany of meaningful macro risks described above,

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The Negatives Build

Growth remained flat or slowed in the U.S., Europe and Japan.

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The Tipping Point

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The Sources of Error

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January 14, 2016

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What Does the Market Know?

The Nature of Consensus Opinion

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A massive downward spiral ensued. Among the contributing factors were:

precipitous declines in the prices of bank stocks,

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A Case in Point Senior Loans in the Financial Crisis

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What Does a Falling Market Say About Value?

Belief that the price is high relative to the fundamentals.

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What Does a Falling Market Say About Psychology?

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What Do the Media Know?

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January 19, 2016

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May 26, 2016

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