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GMO QUARTERLY LETTER April 2013 The Race of Our Lives Jeremy Grantham (pages 2-12) A Funny Thing Happened on the Way to Equilibrium Ben Inker (pages 13-22) GMO QUARTERLY LETTER April 2013 The Race of Our Lives 1 Jeremy Grantham Summary Our global economy, reckless in its use of all resources and natural systems, shows many of the indicators of potential failure that brought down so many civilizations before ours. By sheer luck, though, ours has two features that might just save our bacon: declining fertility rates and progress in alternative energy. Our survival might well depend on doing everything we can to encourage their progress. Vested interests, though, defend the status quo effectively and the majority much prefers optimistic propaganda to uncomfortable truth and wishful thinking rather than tough action. It is likely to be a close race.

The Fall of Civilizations The collapse of civilizations is a gripping and resonant topic for many of us and one that has attracted many scholars over the years. They see many possible contributing factors to the collapse of previous civilizations, the evidence pieced together shard by shard from civilizations that often left few records. But some themes reoccur in the scholars’ work: geographic locations that had misfortune in the availability of useful animal and vegetable life, soil, water, and a source of energy; mismanagement in the overuse and depletion of resources, especially forests, soil, and water; the lack of a safety margin or storage against inevitable droughts and famines; overexpansion and costly unnecessary wars; sometimes a failure of moral spirit as the pioneering toughness and willingness to sacrifice gave way to softer and more cynical ways; increasing complexity of a growing empire that became by degree too expensive in human costs and in the use of limited resources to justify the effort, until the taxes and other demands on ordinary citizens became unbearable, so that an empire, pushed beyond sustainable limits, became vulnerable to even modest shocks that could in earlier days have been easily withstood. Probably the greatest agreement among scholars, though, is that the failing civilizations suffered from growing hubris and overconfidence: the belief that their capabilities after many earlier tests would always rise to the occasion and that growing signs of weakness could be ignored as pessimistic. After all, after 200 or even 500 years, many other dangers had been warned of yet always they had persevered. Until finally they did not.

The bad news is that as I read about these varied scenarios – and I have missed listing several – they all appear plausible and each seems to be relevant to several earlier collapses of empires and civilizations both large and small. Very recently, one of these scholars, William Ophuls, wrote a new book, Immoderate Greatness2 (a quote from Gibbons’s Decline and Fall of the Roman Empire), with the subtitle Why Civilizations Fail. It is a straightforward summary and synthesis of all of the ways to fail in 70 small pages, yet with extensive notes and references. It is written in remarkably accessible, simple language and divides the causes of failure into six categories. Unfortunately, 1 The last of a series of six special reports, all of which can be found on the GMO website with free registration: “Time to Wake Up: Days of Abundant Re-sources and Falling Prices Are Over Forever,” April 25, 2011; “Resource Limitations 2: Separating the Dangerous from the Merely Serious,” July 22, 2011; “Your Grandchildren Have No Value (and Other Deficiencies of Capitalism),” February 24, 2012; "Welcome to Dystopia!" July 31, 2012; "On the Road to Zero Growth" November 20, 2012; “Investing In a Low-Growth World,” February 6, 2013.

2 Published by CreateSpace Independent Publishing Platform (December 28, 2012). It costs just $5 on Kindle. Unfortunately, I receive no royalties.

GMO Quarterly Letter – The Race of Our Lives – April 2013 2 all six seem to apply to us today in varying degrees, and where one factor might be manageable – although often has not been – he makes the chances of our managing all six seem slight. It is persuasive and needs to be read. It takes about two hours.

William Ophuls’s conclusion is that we will not resist the impressive list of erosive factors and that, in fact, we are in the fairly late stages of our current civilization’s race for the cliff edge with nothing much to head us off. His study of history leads him to believe that civilizations are actually hard wired to self-destruct: programmed to be overconfident, to keep on pushing for growth until limits are overstepped and risks accumulated to the breaking point. His offer of good news is that after the New Dark Ages, when civilization again rears its head, presumably with a much smaller population, we will have acquired the good sense to be less overreaching, less hubristic, a lot humbler about growth and our use of resources, and more determined to live in balance with the natural energy we receive from the sun and the heat, food, and water with which we can sustainably be provided.

I have just two comments about our current problems. First, that there is one particular pressure this time that seems particularly serious: aversion to bad news. The investment business has taught me – increasingly as the years have passed – that people, especially investors (and, I believe, Americans), prefer good news and wishful thinking to bad news; and that there are always vested interests to offer facile, optimistic alternatives to the bad news. The good news is obviously an easier sell. Good news in investing in particular is better for business; good news on resource limitation is better for the suppliers of resources; and good news on climate change – that it basically does not exist and is even a hoax – is better for energy companies, among the biggest and most profitable of all companies. Historians have pointed out the bias against the need for change: there are always clear beneficiaries of the current state of affairs but the benefits of a changed world in contrast will look vague and uncertain to the likely beneficiaries. That is always the case. What is less common, although not unique in history, is what we have today: the near complete control of government by the powerful beneficiaries of the current system.

The second point is that although I find Ophuls’s argument well-reasoned and although I must acknowledge the strong possibility of a very negative outcome, I feel it is too pessimistic (which, sadly, is a rare occurrence for me on this topic). Yes, we are taking extreme risks with resource depletion and with the environment, especially concerning climate damage and ocean acidification. Yet I believe the case for the near certainty of our running off the cliff misses the existence of two extraordinarily lucky (and, one could argue, undeserved) gifts that were not available to any prior stressed civilization. They may arrive like the U.S. Cavalry, just in time to turn us away from the cliff edge. But at best, as Wellington is famously paraphrased as saying about the Battle of Waterloo, it will be a “damn closely run thing.”3 It will be the race of our lives.

Our Last Best Hopes: Declining Fertility and Improving Technology for Renewable Energy Declining Fertility The first of the two incredibly fortunate factors that might enable our current world to avoid at least partial collapse is declining fertility. Malthus correctly analyzed the main problem of our then history (in 1800): population had always kept up with food supply, leaving even successful societies only a few bad growing seasons away from starvation. He predicted that this would always be the case and he was wrong on two counts. The first is a short-term factor – only existing for 200 or 300 years and therefore irrelevant for the longer term of our species – and that is the increased ability to extract previously stored energy in the form of coal and oil. This hydrocarbon interlude will end either when that share of hydrocarbons that can be extracted economically is used up, or more likely when the tyranny of the second law of thermodynamics imposes its will: enough of the higher forms of convenient compact energy like coal and oil will have been converted into heat, waste, and especially carbon dioxide to ruin our climate in particular and our environment in general.

3 The actual quote was, “It has been a damned nice thing – the nearest run thing you ever saw in your life.” His is a nice use of the word “nice,” which back then also had the meaning of “uncertainty.”

GMO Quarterly Letter – The Race of Our Lives – April 2013 3 Malthus, however, completely missed declining fertility, a potentially very long-term and hence much more critical factor to the survival of our species. Neither he nor anyone else before 1960 even dreamed that we would voluntarily decide to have fewer children even as we became richer. In his day and until the early twentieth century, rich families routinely had eight or more children. Ironically, it has turned out that the same instincts that bring us the problems of excessive consumption and unnecessarily rapid resource depletion have also brought us the attitude that children are inconvenient and desperately expensive. Improved medical services that further allowed populations to explode now allow the confidence to have smaller families. Increased farm technology lowers the significance of the labor from many children. The most obvious drivers of lower birth rates, though, are the improved education of women and advances in birth control methods. The net effect of these factors is a change so profound that just a hundred years ago it was not even guessed at, and indeed population growth and fertility continued to rise until about 1960 – just the other day.

The following exhibits show the remarkable and promising data. The dashed horizontal line at 2.1 in Exhibits 1 through 4 is the fertility level required to have a stable population in the modern world under normal conditions. Exhibit 1 shows the remarkable drop in fertility in the richer East Asian countries, including China, with almost a fifth Exhibit 1 Falling Populations in Asia p 6.0 5.0 Fertility Rate, Children / Woman 4.0 3.0 Replacement Rate 2.0 China Japan Korea Singapore 1.0 Hong Kong 0.0 1961 1971 1981 1991 2001 2011 Source: World Bank As of 12/31/12 of the world’s population. Exhibit 2 shows the drop in the larger and wealthier countries to an average level just be-low replacement, with the very latest update for U.S. fertility in 2012 dropping below replacement. Exhibit 3 shows selected important and sometimes spectacularly unexpected examples. At the top of the unexpected list is Iran, which has dropped from a fertility rate of 7 – children per woman! – in 1960 to an almost unbelievable 1.6 today. Another remarkable example of a large Islamic country is Bangladesh, which has also fallen from 7 in 1960 to 2.2. This is extraordinary given their extreme poverty. The particularly important India, with its 1.2 billion people, has fallen from 6 to 2.6. This is quite remarkable in absolute terms, but given the previous two examples and given India’s pressure from overpopulation, it’s almost a disappointment. Exhibit 4 shows the more serious disappointments. Yes, the rates have dropped in these countries, but their populations are still growing rapidly and most of them have intermittent food problems already. They are almost all in Africa. Unless they and the world are lucky and they improve (perhaps with appropriate help from rich countries), we are likely to end up looking to the students of long-term civilizations as if we have had two separate systems: one in Africa, with failed states, poverty and malnutrition, and rapid population GMO Quarterly Letter – The Race of Our Lives – April 2013 4 Exhibit 2 Low Birthrates in the “Western World” Low Birthrates in the "Western World" 4.0 3.5 3.0 Fertility Rate, Children / Woman 2.5 Replacement Rate France 2.0 United States United Kingdom Canada 1.5 Italy Germany 1.0 0.5 0.0 1961 1971 1981 1991 2001 2011 Source: World Bank, Centers for Disease Control and Prevention As of 12/31/12 Exhibit 3 Important Declines in Emerging g g 8.0 7.0 6.0 Fertility Rate, Children / Woman 5.0 4.0 Egypt 3.0 Malaysia India Replacement Rate Morocco 2.0 Bangladesh Iran 1.0 0.0 1961 1971 1981 1991 2001 2011 Source: World Bank As of 12/31/12 growth, probably having been left increasingly to cope on their own; the second in the rest of the world, with substantial and still growing affluence and with fertility below the replacement rate, forming a single market for resources and global trade in general, and trading as if they comprised one gigantic old fashioned imperial economy.

GMO Quarterly Letter – The Race of Our Lives – April 2013 5 Exhibit 4 Holdouts / Failed States Holdouts / Failed States 9.0 8.0 7.0 Somalia Fertility Rate, Children / Woman Zambia 6.0 Uganda Congo 5.0 Rwanda Liberia 4.0 Iraq 3.0 Replacement Rate 2.0 1.0 0.0 1961 1971 1981 1991 2001 2011 Source: World Bank, Centers for Disease Control and Prevention As of 12/31/12 This remarkable decline in fertility is our last best hope, both from our civilization’s point of view as well as for the well-being of all of the life on our planet. Exhibit 5 summarizes the past data and projects the more optimistic end of the U.N. data for future global population. The world’s population is shown peaking around 2050 at just Exhibit 5 Important Declines in Emerging World Population and Projection, 1950-2100 Low Fertility Scenario 9,000,000,000 8,000,000,000 World 7,000,000,000 6,000,000,000 World ex-Africa 5,000,000,000 4,000,000,000 3,000,000,000 2,000,000,000 1,000,000,000 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 2090 2100 Source: UN Department of Economic and Social Affairs As of 12/6/12 Future projections are not a guarantee and speak only as of the date they are made, and GMO assumes no duty to and does not undertake to update such projections. Future projections are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual results may differ materially from those anticipated in the projections provided.

GMO Quarterly Letter – The Race of Our Lives – April 2013 6 over 8 billion and then declining to near 6 billion by 2100. Ex-Africa, it reaches just under 6.5 billion in 2040 and declines to below 4 billion in 2100, back to where it was in about 1978. Africa is shown growing from about 250 million in 1950 to well over a billion today and, even under this relatively favorable outlook, continuing to expand to over 2.3 billion by 2100. The U.N.’s more pessimistic end of the range (not shown) has a continuing rise in population, but at a slowing rate, to 11 billion and beyond. At that level the stresses on global food and on global law and order, especially in Africa, will almost certainly be too great and Ophuls’s prediction will likely be correct. The lower population track, in contrast, holds out a strong hope of survival – that is, of maintaining a reasonably stable global civilization and continuing to improve the quality of the average life. The return, therefore, to helping encourage a lower population everywhere is incredibly high. Yet little is done at an international level and indeed the issue is treated like a hot potato even by usually well-meaning NGOs. But we can do it, and my guess is that we will indeed succeed on this front. In the meantime it would be encouraging if economists, The Economist (not to pick on them but I tend to hold them to higher standards than others), and economic discussions in general would look out a few more years and stop discussing lower population growth as if it were a dire economic threat rather than our last best hope. Of course, as growth rates drop rapidly and populations quickly age, there is an added burden to workers of carrying more non-workers for one generation as the changes flow through the system. Then things stabilize again. This cycle can be ameliorated enormously by having older people extend their contributions and by facilitating the full participation of women in all countries. The ruinous alternative is to have an ever-growing population run off the cliff collectively. The economics industry has indeed done a particularly inadequate job on long-term sustainability in a world of finite resources. It is a good time for them to wake up to the problems we face on this front. Fortunately, individual decisions on fertility might well get the job done anyway, without any help from a potentially less blink-ered and longer-term economic theory.

Renewable Energy This brings us to the second remarkable gift, which involves a branch of the “cornucopian” optimism that I usually deplore: that the infinite human brain combined with technology will solve all problems. Yes, this is the same brain that brought us World War II, several thousand years of soil erosion, and the collapse of endless empires. An obvious generic weakness in this cornucopian argument is that it ignores our massive dependence on cheap energy. Trains and coal, cars and gas, and electricity and air conditioners and refrigerators in turn drove forward economic activity and the feeling of well-being (try being in Sydney on January 18, at 114.4°F, the hottest day in that seaside city’s history, without air conditioning!), but each came with a cost – an increased wave of energy use, almost all of it from our irreplaceable stores of oil and coal. Yet now, finally, there is an example of a great technological leap that for the first time is accompanied by less energy use – the technologies of solar, wind power, and other alternatives as well as electric grid efficiencies and improved energy storage.

For once, all of the innovations, corporate start-ups, and risk taking – the best part of the capitalist system – work to decrease our use of depleting hydrocarbons and therefore to increase our chance of stabilizing our civilization before the cliff edge is reached. Exhibit 6 shows in orange the truly remarkable decline in the cost of electricity from photo-voltaic cells. The only thing to compare it to is the Moore’s Law decline in the price of semiconductors. That would indeed be a happy comparison, for perceived physical limits to semiconductor progress have been overcome time and time again. If the physical limits on photovoltaic efficiency, and hence its price, are similarly maneuvered in future decades, then the price of photovoltaic energy would guarantee us cheap and plentiful energy forever. Wind power may also be vital in less sunny zones, but there the cost reductions are, probably, mainly behind us. Exhibit 6 shows in green the early rapid declines in the costs of wind power mainly as improved technology allowed for increases in size and therefore efficiency. However, during the great leap in resource costs between 2002 and 2008, which I have been obsessing about for the last two years, the price of steel, cement, and aluminum from which wind towers are built (and all of which are incredibly energy-intensive), all rose from two to three times! Only the flat cost of human labor and improved turbines allowed for wind costs to rise by only 40% during this period. Our exhibit allows for only modest reductions in future wind costs, so that even by 2025 wind costs are estimated to be still higher than 2000, before the GMO Quarterly Letter – The Race of Our Lives – April 2013 7 great surge in material prices. The remaining component of Exhibit 6 is the cost of coal-fired electricity. For future estimates we have made a range. The lower end represents a modest 1% a year increase in coal prices and the upper Exhibit 6 Renewable Energy Competitive Soon Total Cost of Energy by Source, and Projections to 2030 2010 US$ / MWh $1,600 Solar Wind Coal Projections $800 2010 $ / MWh, Log Scale $400 $200 $100 $50 $25 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030 Source: National Renewable Energy Laboratory, Greentech Media, McNerney et al., Global Financial Data, Bloomberg, GMO Future projections are not a guarantee and speak only as of the date they are made, and GMO assumes no duty to and does not undertake to update such projections. Future projections are subject to numerous assumptions, risks, and uncertainties, which change over time. Actual results may differ materially from those anticipated in the projections provided.

end 4% a year, which is still a little less than the 5% annual average price rise for coal of the last 10 years. As can be seen, by 2025 to 2030 both solar and wind power are likely to be cheaper than coal. All of these comparisons, of course, are made without charging coal for “externalities” – those ills that the coal industry inflicts that we the people have to pay for: mountain tops ripped off and mountain streams polluted, acid rain, and particulate matter damaging health. Even more serious in the long run, the CO2 that is released by burning coal imposes the increasing costs of ris-ing global temperatures: unstable weather for crops and rising costs of more extreme weather-related events. Coal is likely to be a hopeless choice for electricity generation in 20 years, as its price rises and those for alternatives fall, but fully costed for externalities it is an uneconomic choice today. Any potential investors today in a new coal-fired utility should ask some tough questions about “stranded assets” – cost-ineffective assets that will not have had the time to make a positive return on their investment before they will have become uncompetitive or illegal, caught between the falling costs of alternative energy and the rising costs of controlling for “externalities” – pollution and climate damage – that were once passed on as public costs but that will become steadily the responsibility of the emitter.

We have the time, technology, and money to completely replace nonrenewable energy in 30 to 50 years and, on aver-age, in that time period such replacement will be economic (less so in the earlier years but by a wide margin later). As we do it, we will increasingly have much lower marginal costs, for what is often forgotten in these comparisons is that the high cost component in our two main alternatives, solar and wind, are up-front capital costs. Once constructed, the marginal costs of merely operating the wind and solar farms is far, far lower than the marginal costs of digging and shipping coal, even without those other health and environmental costs borne by the general public. You should be aware that when we calculate the costs of alternative energy projects, a high corporate discount rate is used to reflect the idea that to a corporation a dollar spent today to build a wind power project needs to be offset by a dollar and 10 GMO Quarterly Letter – The Race of Our Lives – April 2013 8 or even 14 cents next year, or $8 or so in 18 years, to pay for the current loss of the use of money and to jump over the corporation’s hurdle rate for attractive investments. The required investment return (hurdle rates) for alternative energy investments is often higher than for traditional corporate investments partly because of unnecessary uncertainties still surrounding these projects: erratic government policies, rapidly changing technologies resulting in most projects having new features, and general unfamiliarity to providers of capital.

But what of the social benefits of these alternative energy projects? Personal average wealth and income has been rising by only 1% to 3% a year for the last 30 years, not 10% or 14%! Solving our long-term energy problems may not only be the most critical economic problem, it may also, as I argue here, be one of two most critical inputs into our future viability as a civilization. A discount rate that would reflect this significance should obviously, in a reasonable world, be far less than the 10% or 14% return needed by a corporation for such projects. I could make a case for a zero social return hurdle in this extreme case, but let us merely settle for a lower-than-average corporate hurdle rate – say, 5%. At a 5% real return (which, by the way, compares to an average delivered 7% real return on all corporate capital in the past), these wind and solar projects would have a much lower levelized cost of energy (the cost that reflects both operating and capital costs) than they would have at higher corporate rates – up to 40% lower. At those lower capital costs typical wind power projects would have a lower “levelized cost” than a typical coal-fired plant and be far ahead in 10 years. Solar farms would still need 10 years at the current rate of progress in cost reductions to catch up with wind power (although roof-top solar is getting to retail rates as we speak). The point to remember is that once the capital is found and the project is built, a wind or solar farm delivers far cheaper energy than a coal-fired utility plant, at around one-third of the marginal cost of coal (about 1¢ per kilowatt hour at a minimum of 3¢ for coal).

The impressions the average businessman carries in his head tend to be a moving average of the last five years’ in-formation. Life is too busy to keep up with everything and usually five years is recent enough. But when there is a sudden shift in a year or two, average opinion is left sometimes far behind and that is exactly what has happened to solar energy and to a lesser extent to wind power. The current issue of Prospect magazine in England carries a story of an energy expert who invested three years ago in heavily subsidized home solar panels in the U.K. because doing so more or less guaranteed a 7.5% return (tax-free because the benefit comes in the form of lower bills), which for a low-risk investment was and is far better than anything else these days. You might suspect, the author argued, that the recent two-thirds drop in subsidies would end that game, but he points out that the installation costs of panels (adjusted for increased efficiency) have also dropped from £6,000 to £2,000 for a typical home in just over two years so that homeowners still receive a handsome return. You can just imagine how much easier it is to get a handsome return, without subsidy, at these new lower prices in areas where the sun actually shines – say, California, which receives almost twice the sun of London. (I’m stinging from a totally grey month in London.) At the other end of the spectrum, Duke Power was reported in Bloomberg as stating that the cost of solar panels to them had dropped by 75% in two years. These are truly remarkable shifts and now even modest steady progress from here will get the job done. Meanwhile in wind, the very latest large-scale wind farm in Australia was announced as having levelized costs lower than recent coal plants. All in a world where the cost of coal has doubled and oil quadrupled since 2000. This is not the same game that it was just three years ago.

Energy Storage Energy storage is now the Holy Grail of environmental progress. The bad news is that progress in the past has been slow. The good news is that there are now scores, if not hundreds, of research teams working on this. Before wind and solar reach a large percentage of total electricity production, it is extremely likely in my opinion that some real cost progress will be made in storage (halving or so), especially at the retail level where a storage device, unlike a car battery, can be heavy, bulky, and relatively inefficient as long as it is cheap. Cheapness would deliver to the household electric market the potential for grid independence. However, let it be admitted that lack of expected progress in energy storage could materially slow down the rate at which alternative energy is adopted. It is therefore an area that particularly needs encouragement and good fortune.

GMO Quarterly Letter – The Race of Our Lives – April 2013 9 Smart Grid Over several decades, modernizing the grid to allow much wider and more efficient transfer would dramatically reduce storage needs. Reaching into homes and using temporary electric car battery and refrigerator adjustments, etc., (all by agreement and for a discount) would also reduce the problem. As back-up, natural gas electric generation is the ideal technology with perhaps some use of bio mass and urban waste. Coal for electricity generation is just not necessary today in the U.S., and the last coal plants anywhere may be built in the next 20 years.

Chinese Cavalry to the Rescue On this topic, I have high hopes of China setting a brilliant example. They are embarrassingly long capital, accused of wasting much of their 50% of GDP capital investments on subway stops in the middle of farm fields, empty cities, and redundant regional airports. We, in contrast, are embarrassingly short capital, with capital spending having fallen to 16% of GDP and federal debt owed to the public having accumulated to over 70% of GDP and currently increasing at 6% of GDP per year. China could smooth out their potentially dangerous transition from 50% capital spending to a more reasonable 35% over the next 20 years or so by managing a giant program of alternative energy, including the smartest-yet national grid and broad-based research into storage, and all sources of renewable energy, including fusion. (As with the U.S., natural gas from fracking would help in the transition.) Such a massive broad-based program would potentially give them global dominance in the most important industries of the future and would relieve them of their greatest single worry: energy security. It would also relieve them of what will surely become their greatest societal irritant: the incredible air pollution of their major cities, which must already be reducing life expectancy in those cities by several years, as well as substantially increasing health costs. Best of all for them, it would leave them as the low-cost energy player in global trade, and if that, added to their lower labor costs, rising educational standards, rapidly improving infrastructure, and capital deepening, does not put the fear of God into U.S. capitalists, then it should.

It would be a blessing in disguise for the developed world and the U.S. in particular if China announced a 25-year program of alternative energy (enough of these paltry five-year plans!) that embodied a Manhattan project level of commitment. Within just a handful of years of watching them execute this program, we would calculate the competitive consequences and would be forced defensively to emulate them. We would surely discover that we are in fact still wealthy and can afford worthy projects with long-term payoffs and that our perceived poverty is more about leadership and perceptions than it is about reality. The U.S. is, after all, richer than it has ever been and is still the richest large country in the world. I have made a part of this point before. I am repeating it because: a) it’s very important; and b) the Chinese government has inexplicably failed to snatch up my idea. It would be a lay-up for them if they did. (Dear Chinese translator, a “lay-up” means “an easily achievable goal.”) In a world lacking U.S. leadership in energy sustainability, a truly major Chinese effort might be the difference between collective global success and failure. In this case it would be the Chinese cavalry heading us off at the cliff edge, but I’ll take any cavalry we can get.

(Postscript: recently, several leading Chinese cities recorded disastrous levels of pollution. On a scale where 30 is the barely safe limit, they hit over 300 several times. The Chinese government responded almost immediately, which was not a bad idea, because yearly reoccurrences of dangerous pollution will pretty soon guarantee that some smart but critical people will move out of these worst cities. Wouldn’t you? They upped their current target [already very aggressive by U.S. standards] for installed solar generation capability in just three years by 65%! Astonishing by any standard and currently politically impossible outside China. This new target means that they will have the equivalent in solar power of seven4 or so giant coal-fired plants, a very large absolute number anywhere except in China, where it is still dwarfed by coal plants. But, it is a down payment.)

4 It is equivalent to seven or so coal plants in total electricity production, but in value terms it is more like 10 or more because the sun shines precisely at the time when high-value peak demand occurs.

GMO Quarterly Letter – The Race of Our Lives – April 2013 10 Epilogue The two favorable factors described, with luck and some improved effort and leadership, may buy us enough time to completely retune our agricultural system, for it will take many decades to change attitudes and build the infrastructure, training, and research to move to complete agricultural sustainability. That in turn would allow us time in a stable environment to address the problem that will no doubt take the longest time of all: addressing our failing supplies of metals. Yes, we are blessed with large supplies of aluminum and iron ore, although, like agriculture and civilization itself, their usefulness to us is completely dependent on the availability of cheap energy. More to the present point, affordable supplies of most other metals, some very useful, will run low this century and must be replaced by organic alternatives, which process will need all the time and research that success with the other factors might be able to deliver.

Suspended over this close horserace between destructive and regenerative forces are the wild cards of rising temperatures, slowly rising sea levels, ocean acidification, and, above all, destabilized weather for farming. Even if the cavalry arrives in time to prevent the main disaster – a rolling collapse of much of civilization – much damage is being done and will definitely continue to be done to the environment and biodiversity as global temperatures continue to rise. But with improved behavior, we may well buy enough time to save our own species and most of what we really value. In my opinion, all of the other factors in this mix are reasonably susceptible to data and analysis. The scary part of the climate issue is that by its nature there can be no precision on extent or timing and, consequently (as I have mentioned before), scientists, in their desire to avoid being seen to exaggerate, end up systematically underestimating the case.

The January 23 New York Times science section, for example, had an article on rising sea levels that said that the authors – scientists all – “share an emerging consensus that the increase in ocean level in this century will probably be on the order of three feet, perhaps as much as six feet,” requiring many millions to evacuate. “But many scientists,” they add “are plagued by a nagging fear… that their calculations will turn out to have been too conservative, and social stability will eventually be threatened.” “At every point as our knowledge increases,” Dr. Raymo,5 the leader of the project, is quoted as saying, “we’ve always discovered that the climate system is more sensitive than we thought it could be, not less.” [Emphasis added.] To be perhaps a little cruel, a statistician might suggest that after serial underestimations, expectations might be adjusted.

The bottom line is that if we put our minds to it we can overcome normal inertia and abnormally powerful vested interests that oppose necessary change. Our population is likely to start declining in a few decades, slowly but surely, and the fertility rate of 1.8% or less would allow global population to fall back more or less gracefully by 2200 to a probably sustainable level of 4 billion, particularly if we sensibly encourage its decline. Important progress in alternatives is certain. Other scientific progress, especially in computing power will also help. Whether we can move fast enough on these fronts and at the same time reduce the output of greenhouse gases to avoid going off the cliff is simply not knowable for certain, but every minute saved and improvement made, betters our odds. Let the race begin.

Dr. Maureen Raymo works at the Lamont-Doherty Earth Observatory at Columbia University.

GMO Quarterly Letter – The Race of Our Lives – April 2013 11 Correction: Natural Gas Forecast I am bullish about the longer-term price of natural gas and in my personal account I am long the futures several years out. At five years out, the implied price is $4.50 mcf. However, in the Q&A section of a talk I gave recently I was quoted as saying that in five years the price “would have tripled.” This implies a price, then, of $12. This is either a misquote or a misspeak. What I intended to say and have said before was that from the low last year the price would be likely to triple in 5 years: that is to about $6 or $7 mcf, far above the assumed $4.50 then, but far below the number in the quote.

Disclaimer: The views expressed are the views of Jeremy Grantham through the period ending April 26, 2013, and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.

Copyright © 2013 by GMO LLC. All rights reserved.

GMO Quarterly Letter – The Race of Our Lives – April 2013 12 GMO QUARTERLY LETTER April 2013 A Funny Thing Happened on the Way to Equilibrium Ben Inker T he bedrock of GMO’s investment philosophy is reversion to the mean. We believe that capitalism should cause the return on capital to be in line with the cost of capital, and that assets that embody similar risks should offer similar long-term returns. These beliefs, in turn, guide our assumptions that equities should trade at replacement cost, that the long-term return to equities should be approximately the same as their normalized earnings yield, and that assets without long return histories should have similar valuations and equilibrium returns as related assets with longer histories.

These beliefs have allowed us to sleep reasonably easy even at times, such as the late 1990s or 2006-7, when valuations and returns were doing things we thought were irrational. And they have also allowed us to take the leap into assets such as emerging equity and debt, REITs, and TIPS even when we did not have a lot of historical data to confirm the apparent cheapness of those asset classes.

But our sleep is not always altogether easy. There are times when the markets do not seem to be following the script properly, and we are left wondering whether we are dealing with a temporary anomaly or a more permanent problem. Today we are faced with one of these problems: the persistently high profit margins of U.S. corporations. High profit margins should not persist in a mean-reverting world, and yet profitability in the U.S. has been higher than long-term averages for most of the last 20 years, oddly pretty close to the same length of time that the U.S. market has been trading above replacement cost.

At first thought, it may not seem that odd that high profitability is associated with an expensive stock market – after all, shouldn’t investors be willing to pay more for assets that achieve a high return? But high valuations imply a low cost of equity capital, which should encourage corporations to issue more equity, and a high return on capital should encourage corporations to do more investing. These pressures should gradually push the cost of capital up and the return on capital down. But in the period since the mid-1990s, stock issuance has been down and corporate investment has fallen as well, in apparent contravention of the basic rules of capitalism. A high return on capital that occurred simultaneously with a high cost of capital – that is a market selling below replacement cost – would make sense because there is no discrepancy to arbitrage. The current situation is not supposed to happen, which makes it tricky for us to understand exactly when it will end.

As investors, we believe that our first job for our clients is to try to avoid losing them money. Therefore, we have chosen the path of conservatism in our forecasts, assuming that profitability will revert. It is always possible we are wrong and we are doing a disservice to the U.S. stock market (and most other stock markets around the world, which also show elevated profit margins), but it does not seem prudent to assume a non-equilibrium situation will persist indefinitely, even if it has gone on for a surprising length of time. Herb Stein’s Law states “If something cannot go on GMO A Funny Thing Happened on the Way to Equilibrium – April 2013 13 forever, it will stop.” History has been kind to Stein’s Law, but there should probably also be a related admonition: “If something that cannot go on forever has been going on for an inexplicable length of time, try to understand why it has been going on so long and whether your model might be the problem.” I admit it is nowhere near as pithy as Stein’s Law, but the rest of this paper will be an attempt to follow that admonition where it leads us. For those who don’t want to read through the gory details, the result is that there are ways for profits to stay high indefinitely, but it is far from obvious that society will be willing to put up with them.

The Current Situation I do not want to give the false impression that today’s profitability is fundamentally inexplicable. Today’s profitability makes perfect sense in light of the current conditions in the economy. As my colleague James Montier pointed out in his paper “What Goes Up Must Come Down,” we can use the Kalecki equation to understand the level of profitability from a macroeconomic perspective. Unlike our beliefs about equilibrium in a capitalist system, the Kalecki equation holds at all times, being an economic identity. The equation, for anyone who has not committed James’s piece to memory, states: Profits = Investment + Dividends -Household Savings -Government Savings -Foreign Savings Historically, the major driver of the ebb and flow of profits has been the ebb and flow of investment, as we can see in Exhibit 1.

Exhibit 1 Profits and Investment 1929-1986 20% 10% Correlation = 0.75 15% 8% Investment as Percent of GDP Profits as Percent of GDP 10% 6% 5% 4% 0% 2% -5% 0% -10% -2% Mar- 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 Source: Bureau of Economic Analysis, Federal Reserve GMO A Funny Thing Happened on the Way to Equilibrium – April 2013 14 Up until 1987, this was a very tight relationship, with a correlation of 0.75 between investment and profits. However, in recent years, the situation has changed, as we can see in Exhibit 2.

Exhibit 2 Profits and Investment 1929-2012 20% 12% 10% 15% 8% Investment as Percent of GDP Profits as Percent of GDP 10% 6% 5% 4% 2% 0% 0% -5% Correlations: 1987-1999 1987- 2000-0.75 1999 2012 -2% 0.43 -0.48 -10% -4% Mar- 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97 01 05 09 Source: Bureau of Economic Analysis, Federal Reserve From 1987-99, we saw a marked deterioration in the correlation between the two series, and since 2000 the relationship has been positively perverse, with a correlation of -0.48. As the Kalecki equation states that, all else equal, lower investment should lead to lower profitability, it must be the case that all else has not been equal. And sure enough, very few things have been equal since 2000.

In the 1990s, the investment associated with the internet bubble did indeed lead to high profitability – and perhaps we can forgive the relationship for not being even stronger than it was because the major factor driving down profits in the last few years of the 20th century was the lost profits associated with the extraordinary wealth transfer to some lucky workers in the form of stock options on technology companies. From a national income account perspective, the money that employees received from the exercise of their options is counted as a cost to corporations. It’s easy to have sympathy for this accounting, as the losers in the exchange were shareholders who wound up giving away untold billions to the option holders. But thanks to the power of the technology companies’ lobbying efforts, stock options are not properly expensed under GAAP accounting even today, except in a footnote.

Since 2000, investment has fallen off to levels lower than we have ever seen apart from the Great Depression, and yet profitability has risen to an all-time peak. This has been possible because other pieces from the Kalecki equation have kicked in in a way we haven’t seen before. Exhibit 3 shows the sum of household and government savings as a percent of GDP.

GMO A Funny Thing Happened on the Way to Equilibrium – April 2013 15 Exhibit 3 Household plus Government Savings 15% 10% Savings as Percent of GDP 5% 0% -5% Correlations: 1987-1999 1987-1999 2000--10% 0.75 0.43 2012 -0.48 -15% Mar- 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97 01 05 09 Source: Federal Reserve As of 12/31/12 Apart from the Great Depression and the latter part of World War II, the combination of the household and government sectors has saved around 3-7% of GDP. From 2001 to 2007, the sum hovered around zero, and since the financial crisis, we have been bouncing around somewhere near -5%. This means that relative to the last 60 years of U.S. history, household and government savings are responsible for profits being about 10% of GDP higher than they would otherwise be. As profits are approximately 10% of GDP, one could say that this burst of profligacy has been responsible for more or less all of corporate profitability since the financial crisis.

We could chalk this up as a fine example of Stein’s Law – profit margins are high because savings rates are unsustainably low, savings rates must eventually come up, and therefore profits will eventually come down – except for two problems. The first is that profit margins have generally been high since the mid-1990s, long before savings went negative. And the second is that there is no guarantee that all else will be equal. Perhaps other pieces of the Kalecki equation will help keep profits high.

Dis-equilibrium in the System Returning to the equilibrium arguments I started the paper with, the odd thing about this period from the perspective of a profit maximizing capitalist is that we’ve had an extended period of time with a high return on capital and a low cost of capital without having the expected response of increased equity issuance and increased corporate investment. Exhibit 4 shows the price to replacement cost of the U.S. stock market over time.

GMO A Funny Thing Happened on the Way to Equilibrium – April 2013 16 Exhibit 4 Tobin's Q 1.2 1.0 0.8 Log of Tobin's Q vs. Its Average 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 Mar- 52 54 56 58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 Source: Federal Reserve, Smithers & Co. As of 12/31/12 Apart from about 5 months from late 2008 to early 2009, we have traded above the long-term average continually for 20 years. This should have been an inducement to issue stock, but this has definitely not shown up on an aggregate basis, as we can see in Exhibit 5.

Exhibit 5 U.S. Stock Issuance as Percent of Market Cap 2% 1% NetofLBOs 0% -1% -2% -3% -4% LBOBooms -5% -6% Dec- 52 56 60 64 68 72 76 80 84 88 92 96 00 04 08 12 Source: Federal Reserve, Factset As of 12/31/12 GMO A Funny Thing Happened on the Way to Equilibrium – April 2013 17 One factor that has confused the situation since the mid-1980s is the existence of LBOs, which count as stock buybacks. In principle, this should even out in the end because the goal of private equity firms is to eventually sell the companies they buy back into the public markets, either through an IPO or selling to another public company. As it happens, the size of the portfolios of private equity firms has ballooned over time, so we have net had more companies taken out of the public markets than put back. We don’t have good data on LBOs before 1995, but we’ve also shown the series net of LBO activity since then, and the basic pattern persists. The period since the mid-1990s, which seems like it should have shown a long wave of issuance, has instead shown the longest period of net buybacks we have ever seen.

We have talked about the investment fall-off in the U.S., but it’s worth showing again, without the profit series superimposed, in Exhibit 6.

Exhibit 6 U.S. Investment 20% 15% Investment as Percent of GDP 10% 5% Trend?

0% -5% -10% Mar- 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97 01 05 09 Source: Federal Reserve As of 9/30/12 The fall-off in investment has really been just since the financial crisis. Before that, overall investment looked about normal. Admittedly, it did not really push above the levels of the 50s, 60s, or 70s. On the other hand, it does look as if the series has had a declining trend since the 1960s, which would have put “normal” for the 1990s and 2000s at around 5-6% of GDP, down from 8-10% in the immediate post-WWII period. Relative to that possible trend, we did see a couple of bursts of investment that coincided with the internet and housing booms, but the current period is truly an anomaly. Corporations are making plenty of money – profits are just off their all-time high relative to GDP – but investing less than at any point since the Great Depression.

It is as if corporations view their current profitability as a windfall rather than a permanent condition. Viewing the profits as a windfall certainly isn’t irrational, but it is surprising for corporations that have been living in a world of high profitability for close to two decades to be so cautious. Andrew Smithers of Smithers & Co. has argued that U.S. corporations’ unwillingness to invest is a symptom of the “bonus culture” in which CEOs who realize their tenure may not be all that long focus their attention on activities that can bring stock prices up in the short term so they can get rich quickly, and ignore the long run as it is unlikely to come about on their watch. He may well be right, but the fall-off in investment has occurred more recently than the rise of bonuses, stock options, and revolving-door CEOs, so even if “bonus culture” is the answer today, that doesn’t mean investment rates will remain low indefinitely.

GMO A Funny Thing Happened on the Way to Equilibrium – April 2013 18 And if investment were to rise from here, we know from the Kalecki equation that in the near term it would be a plus for profits, even though I argued early on that investment should, in the longer run, compete down high profitability. From a macro-economic perspective, it is easy to see why high investment generally equals high profits. Investment can be redefined as “that which is depreciated over time.” It is this, after all, that separates investment from consumption. The trouble with consumption is that one entity’s revenues are another entity’s costs – if an automaker buys steel, it is revenue for the steelmaker and a cost for the automaker. But if the automaker buys a stamping machine to turn that steel into a car door, it is revenue for the producer of the machine, but not officially a cost for the automaker. It is “investment” and so does not get subtracted from the income of the automaker. This is true even if the automaker never actually uses the machine, or uses it to make car doors that no one ever buys. In those circumstances, the automaker will eventually have to write off the investment, reducing future profits, but the original investment increases profits in the period it is bought regardless of the usefulness of that investment in the end. So in the short run, were we to get a burst of investment today, it would cause profits to go up, holding all else equal. In the longer run, it would increase industrial capacity and put pressure on margins.

But what if we never get that increase in investment? What if investment stays low and that pressure on profits does not materialize? Could profits stay high forever? They could, but there would be implications that might not be sustainable. If profits are to stay high while the government deficit shrinks, we would need other pieces of the equation to pick up the slack. We would need to see some combination of a shrinking current account deficit, falling household savings, and rising dividends. The U.S. current account deficit could improve from here, particularly insofar as rising oil and gas output allows us to cut back petroleum imports. But given the generally weak economic environment outside the U.S. and a U.S. dollar that has been strengthening versus trading partners, it seems unlikely that this will be a large effect. We could see a falling household savings rate. The current rate looks to be on the low side, as we can see in Exhibit 7, and that does make a falling rate seem implausible at first.

Exhibit 7 Household Savings 20% 15% Savings as Percent of GDP 10% 5% 0% -5% Mar- 29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97 01 05 09 Source: Federal Reserve As of 12/31/12 But perhaps this series is a bit misleading. We saw from Exhibit 5 that net stock buybacks have been running at high levels for a long time now. A stock buyback is really the same thing as a one-off dividend payment from the standpoint of shareholders, and the household sector in one way or another holds a large fraction of the stock market. Perhaps GMO A Funny Thing Happened on the Way to Equilibrium – April 2013 19 we need to adjust savings rates upward since the mid-1990s for buybacks. This wouldn’t be enough to bring savings rates up to long-term averages – some of the buybacks accrue to the benefit of foreign shareholders and this income is not properly captured as a negative in the current account balance – but it does mean that savings rates might not need to rise much as the long-term trend suggests. And if corporations are not investing, they can pay out more profits as dividends, which is also a plus via the Kalecki equation. High profits with high dividends – either “true” dividends or “effective” dividends through stock buybacks – is a sustainable situation according to the Kalecki equation. But while households do hold much of the stock market, those holdings are not spread equally. In fact, as unequal as the income distribution is in the U.S., the wealth distribution is far more unequal still. Furthermore, the predominant stores of wealth for the middle class are home equity and savings in the bank, so dividends accrue overwhelmingly to the rich. The rich have been doing very well in the past 30 years, even in terms of their share of labor income. Giving them a permanently large slug of income from capital as well will probably eventually cause a backlash even among the impressively stolid U.S. electorate. The belief in social mobility in the U.S. has been a strongly enduring one, but as copious research has shown in the past few years, it is increasingly a myth.1 An increasingly permanent upper class, which not only does far better in terms of labor income than the rest but further accumulates a further chunk of GDP in the form of persistently high dividends and stock buybacks, is likely to accumulate enemies. Even if the rich avoid this problem, it is essential that they actually spend their income in order for profits to stay high. The very wealthy tend to save a large chunk of their income, so if the distribution of income is skewed ever more in their favor, the need will arise for the less well-off to spend more than 100% of their income to stop the savings rate from rising. And rising savings, all else equal, hurts profits. Negative savings rates for the bulk of households actually seem to have been the case in the 1990s as people spent on the assumption that the stock market would always go up, and they occurred again in the 2000s as people spent on the assumption that home prices would always go up. More recently, the un- and under-employed have been spending more than their income because their incomes have fallen yet they still need to live. But with the possible exception of those lending to governments, there eventually comes a time when lenders stop lending to those who want to spend more than their income. If the rest of households stop dis-saving, it will require the rich to really up their spending to keep the system going. There may not actually be enough goods and services for the rich to buy to make this work, but even if it were possible, it would almost certainly increase the resentment of the have-nots until they took it out on them through the ballot box, if nothing else.

Conclusion The image of a dystopian future in which the rich gate themselves off from the rest of society for protection while buying off politicians to ensure their continued privilege2 doesn’t help us at all in understanding when the current situation will end. And the reality is that we really don’t know when it will. All else equal, falling budget deficits will hurt profitability, but if we do finally get the much-delayed recovery in investment or continued strong buyback activity, it is possible falling deficits could be absorbed without margins falling back toward historical averages. Rising investment would, in all likelihood, sow the seed of falling profits in time through increased competition, as would buybacks and dividends through rising savings or a societal response. But as for when, it is impossible to know. For us at GMO, the timing matters, but it is only of secondary importance. Given the very long duration of equities, even another decade of above-normal profits would serve only to increase the fair value of the stock market by perhaps 10 percentage points. It is only if profits are truly permanently higher that the impact is a really big deal. Can we swear that such a permanent increase is truly impossible? No. But it seems to us entirely imprudent to assume that such a permanent increase is in the cards, when the implications of being wrong would be quite damaging to our clients’ portfolios.

1 Among other studies, see “U.S. Economic Mobility: The Dream and the Data,” by Leila Bengali and Mary Day, Federal Reserve Bank of San Francisco, March 2013.

2 Admittedly, how dystopian this looks probably depends a lot on which side of the gate you are on.

GMO A Funny Thing Happened on the Way to Equilibrium – April 2013 20 Appendix: Global Return on Equity Capital There have been a number of commentators who have complained that a focus on U.S. profits as a percent of GDP is misleading, because in a global economy it is world GDP that should be in the denominator, not U.S. GDP. We think this is unlikely to explain currently high U.S. profitability because profit margins seem to be elevated in most places around the world. Surprisingly few countries provide their corporate profitability data as conveniently as the U.S. does, but for publically listed companies across the developed world, we can look instead at their real return on equity capital. This is a bit trickier than it sounds, but Martin Tarlie of our Global Equity team has led a group focused on putting together our best estimate for a true return on equity capital. The result of their efforts to date is presented in Exhibit A1.

Exhibit A1 Real Return on Equity Capital 12% 10% Europe 8% Return on Estimated Equity U.S.

U.K.

6% 4% Japan 2% 0% -2% Mar- 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 Source: GMO As of 3/31/13 Continental Europe and the U.K. have a surprisingly similar pattern of return on capital to the U.S. While Japan has clearly lagged behind, relative to its rather miserable historical standards, it, too, has had pretty good profitability over the last eight or nine years. This kind of analysis actually takes a good deal of historical data to come up with a good estimate of equity capital. We don’t have a long enough history on the emerging equity markets to do the same analysis, but we can look at return on stated book value as an imperfect proxy, as seen in Exhibit A2. On this basis, emerging profitability is less far above normal, but we see the same basic pattern of high profitability over the past eight or nine years with a dip for the financial crisis.

If U.S. corporations are not as anomalously profitable as they seem because we should be measuring U.S. profits against U.S. and not global GDP, then we should see them benefitting at the expense of foreign competitors. Profitability that is high around the world cannot be due to one group of companies disproportionately benefitting from global trade. Global profits are almost certainly near all-time highs as a percent of global GDP, which means any rationalization cannot rely on a local explanation or a problem properly calculating the profitability of a particular group of stocks.

GMO A Funny Thing Happened on the Way to Equilibrium – April 2013 21 Exhibit A2 Emerging ROE 18% Including Financials 16% 14% Excluding Financials 12% 10% 8% 6% Dec-88 89 90 91 92 93 93 94 95 96 97 98 98 99 00 01 02 03 03 04 05 06 07 08 08 09 10 11 12 13 Source: IFC, MSCI As of 3/31/13 Mr. Inker is the co-head of asset allocation.

Disclaimer: The views expressed herein are those of Ben Inker as of April 26, 2013 and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such.

Copyright © 2013 by GMO LLC. All rights reserved.

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