"Jeremy Grantham's quarterly letter which was referred to the other day also contained an appendix which was a reprise of his 5 minute presentation in a debate held by "The Economist". The debate was "Financial Innovation Boosts Economic Growth" Yes or No. Attending the debate, by the way, was Larry Summers, Tim Geithner, and Bernanke. I appreciate information that I was not aware of before and this is as informative as it gets. Here is Grantham's section [Ed: in italics]:

My Part in the Debate

I will try to make the case that our economy has a painfully overdeveloped financial sector.

Let's start with the Investment Industry component. It is so obvious in this business that it's a zero sum game. We collectively add nothing but costs. We produce no widgets; we merely shuffle the existing value of all stocks and all bonds in a cosmic poker game. At the end of each year, the investment community is behind the markets in total by about 1% costs and individuals by 2%.

And the costs have steadily grown. As our industry's assets grew tenfold from 1989 to 2007, despite huge economics of scale, the fees per dollar also grew. There was no fee competition, contrary to theory. Why?

a. Agency problems - we manage the other guy's money, and

b. Asymmetric information - the agent has much more information than the client.

Clients can't easily distinguish talent from luck or risk taking. It's an unfair contest, nothing like the fair fight assumed by standard Economics. As we add new products, options, futures, CDOs, hedge funds, and private equity, aggregate fees per dollar rise. As the layers of fees and layers of agents increase, so too products become more complicated and opaque, causing clients to need us more.

As total fees in the past grew by 0.5%, we agents basically reached into the clients' balance sheets, snatched the 0.5%, and turned it into income and GDP. Magic! But in doing so, we lowered the savings and investment rate by 0.5%. So, we got a short-term GDP kick at the expense of lower long-term growth.

This is true with the whole financial system. Let us say that by 1965 - the middle of one of the best decades in U.S. history - we had perfectly adequate financial services. Of course, adequate tools are vital. That is not the issue here. We're debating the razzmatazz of the last 10 to 15 years. Finance was 3% of GDP in 1965; now it is 7.5%. This is an extra 4.5% load that the real economy carries. The financial system is overfeeding on and slowing down the
real economy. It is like running with a large, heavy, and growing bloodsucker on your back. It slows you down.

For 100 years the GDP Battleship grew at 3.5%. (Even the Great Depression did not change that trend.) But after 1965 the GDP growth rate ex-finance fell to 3.2% a year. After 1982 it fell to 3.1%, and after 2000 to 2.5%, with all of these measurements to the end of 2007 before the current crisis.

From society's point of view, this additional 4.5% burden works like looting or an earthquake. Both increase short-term GDP through replacement effect, but chew up capital. All of the extra financial workers might as well be retirees or children, in that they are supported by the rest of the workforce, but they are much, much more expensive.

Economists have not studied the optimal size for finance. Indeed, a leading finance journal recently rejected a paper on this topic, saying "Finance cannot comment on social utility." That is perhaps why it has so little!

The underlying problem in the recent crisis was a touching faith in capitalism. This faith was based on 50 years of a dominant economic theory that was shockingly not based on facts but rather on unproven assumptions: rational expectations and the Efficient Market Hypothesis (EMH). Believe them and you don't have to regulate new instruments or, indeed, anything. Capitalism will look after itself. So Greenspan, Rubin, Summers, and Levitt of the SEC could beat back Brooksley Born when she dared to suggest regulating the new instruments.

But as Keynes knew by 1934, markets are behavioural jungles wracked by changing animal spirits that can mock the best laid plans. It is a world of agency problems and the "beauty contest." The EMH has proven to be the most wildly mis-specified theory in the history of finance, and the most expensive. Without it, we would have recognized market dysfunctionality and instituted more controls to help limit the wild expansion of the financial business. We might easily have steered clear of the three-sigma (100-year) bubbles in tech and U.S. housing that led to our present crisis. We might not even be debating this topic.

With perfect timing, my friend and former partner, Paul Woolley, started a center for the study of "Capital Market Dysfunctionality" at the London School of Economics. They have recently concluded in academese, with lots of math, that the growth of the financial world has become a rogue element, and that the overmatched clients have allowed the agents to move toward accruing all the rents or benefits of new financial instruments.

"My Comments

"My understanding is that financial markets are intended to allocate capital to business, rewarding the firms that produce a superior return on capital. Grantham's facts which I assume are well researched, indicate to me that developed financial markets began to lose their way and their purpose around 1982. The humongous fees charged by financial institutions literally pilfered capital that should have been earmarked for the real (ex-financial) economy. This is also the period when Hedge Funds make their first appearance. Because of this, ex-financial GDP began to slow dramatically. Talk about a disconnect between markets and the real economy. Looking at a 50-year monthly chart of the S&P (actually a bit less as the S&P began around 1965) we see almost a flat line until 1982 during the ranging period of 66-82. Then we see a trendline from 82 to 95 that seems unsustainable, followed by an almost vertical movement until 2000. Yet, during this time the "real" economy (ex-financial is slowing dramatically)

"This brings me to two conclusions that I strongly believe:

1) We had better get this right as far as the true purpose and scope of Banks and Investment Banks. We called on Paul Volcker once before to be the scrooge and all he did was put an end to runaway inflation and set the stage for a fantastic bull market. Possibly, we need him again to put our economy back on track, not as a financial economy but a real economy.

2) I have never swayed from believing that we are in a secular bear market and that 2003-2007 and March 09 to recently were bear market, mean reverting corrections.

3) The stock market seems to have lost its ability to be a leading indicator of the economy. A recovery was called for in March 09, but as it continued it seemed to disconnect from economic news.

"When I first began reading Fullermoney, 2004-5, David often referred to our being in a secular bear market. However, I have not seen that in some time and am curious as to what his view is today. Personally, I believe that we are in a secular bear or ranging market and secular bull for commodities or hard assets and would expect us to remain in such for another 5-10 years.

"However, I will not fight concrete chart evidence to the contrary."

David Fuller's view Thank you very much for this email. While I would normally condense long passages of text on the home page by using a PDF link, the section from Jeremy Grantham quoted is a must-read item for all students of the markets. I have long had the highest regard for Jeremy Grantham, not just because of his successful investment management business or his superb analysis in GMO Quarterly, but because he tells the truth. Others may wish to, but are usually silenced by employers and compliance officers, or they dare not take the career risk. Long ago, Grantham reached the age and station where he is free press and integrity matters more than financial remuneration.

Regarding secular bear markets, these occur after valuations have been stretched - with the help of excess liquidity, hedonic accounting and manias - to a point where they are unsustainable. A lengthy process of mean reversion towards average valuations inevitably follows, although with secular trends valuations do not just return to the mean, they almost invariably overshoot on the downside as we last saw in 2Q 1982.

You are correct in mentioning my view that the US stock market was most likely in a secular bear market, defined less by the price trend which was often confined to a broad range, than by a lengthy process of declining PERs and rising Yields, occurring not in linear fashion but rolling waves due to cyclical bull and bear markets within the secular trend. This last occurred from 1967 until 2Q 1982, as I have mentioned before. Following the Crash of 1987, Alan Greenspan created an environment of mostly easy money, leading to valuation expansion in the form of higher PERs and lower Yields.

Arguably, this environment still persists as Ben Bernanke and Congress fight deflation. However many of us think that US equity valuations are unsustainably high. They can come down by a process of higher earnings and stock market underperformance relative to its historic mean. I last referred to this, briefly, in my response to Jeff Fisher's analysis posted last Thursday. Lastly, Eoin and I agreed some time ago to talk less about a secular bear market for the USA, not because we had changed our minds regarding probable valuation contraction in rolling waves over time, but because it caused confusion among some readers, not least when one referred to a cyclical bull within a secular bear trend.

Since all forecasts are guesswork, educated or otherwise, I believe you are right in resolving "not [to] fight concrete chart evidence to the contrary." Interestingly, Jeremy Grantham said little in his latest Quarterly concerning the stock market's next move, as I recall, except that he would probably buy if it went down and sell if it went up. That is often a sensible strategy.