Every year, Warren Buffett, the Sage from Omaha, delivers his Annual Letter to Berkshire Hathaway shareholders. What is so special about it? After all, tens of thousands of companies do the same. Each one produces an annual report with a letter to shareholders giving investors an account of how their corporation performed in the previous year and what lies in the pipe for the forthcoming year.
Of all those letters, the one that excites the most interest is the annual missive from the Sage of Omaha, Warren Buffett, whose iconoclastic approach to running a company has made Berkshire Hathaway Inc.'s class A shares the most expensive stock in America. For instance, the 2015 Letter is pure Buffett:
"I've mentioned in the past that my experience in business helps me as an investor and that my investment experience has made me a better businessman. Each pursuit teaches lessons that are applicable to the other. And some truths can only be fully learned through experience. In Fred Schwed's wonderful book, Where Are the Customers' Yachts?, a Peter Arno cartoon depicts a puzzled Adam looking at an eager Eve, while a caption says, "There are certain things that cannot be adequately explained to a virgin either by words or pictures." If you haven't read Schwed's book, buy a copy at our annual meeting. Its wisdom and humor are truly priceless."
Note that Buffett does not offer Schwed's book, shareholders have to buy their own copy, no small profit!
In another letter Buffett told Berkshire shareholders that Ajit Jain, who runs Berkshire reinsurance operations, wrote a rather unusual insurance policy. Indeed, in 2003 PepsiCo promoted a drawing that offered participants a (slim) chance to win a $1 billion prize. After multiple numbers-based games of chances and progressive eliminations, a single individual stood in the race facing the ultimate challenge. The six-digit number he was carrying had to be perfectly matched by the random drawings made by a 4 year old chimp named Kendall.
Despite the incredibly low odds, Pepsi management was worried that somebody might hit the jackpot. Hence, it decided to find somebody to lay off the risk. And, guess what, Berkshire issued a policy for the whole risk (as a matter of fact, the risk was less than $1 billion as the prize was to be paid over yearly installments, namely a present value of $250 million). The drawing was held on September 14th, 2003 and you can imagine that Jain and Buffett were holding their breadth while Kendall the chimp was carrying its duty. Fortunately for Berkshire, nobody won!
This story is not only interesting per se but also because it raises the question of whether you can trade away any type of risks. In the sixties, Kenneth Arrow and Gérard Debreu, two Economics Nobel laureates, came up with the so-called complete markets model where any event can be spanned by a security yielding a $1 payoff upon the occurrence of that event and none in case of no-occurrence. In Kendall the chimp case, Berkshire issued one billion of them paying $1 each if Kendall drawings were to match the finalist numbers. Real life is obviously far from this abstraction. But, as Buffet's example shows, market creativity tends to reduce the gap between the theoretical Arrow-Debreu world and reality.
This reminds me of the late Karl Borch story about the Loch Ness monster. Karl was a first-class economist and a true gentleman. He dedicated his entire life to the study of insurance and the economics of uncertainty. One of his pet example of an Arrow-Debreu market was that of Scottish whisky distillery Cutty Sark that had promised one million pounds for the capture of the Loch Ness monster. The distillery was fearing that, despite the low odds, somebody might succeed. Lloyd's of London did not shy away. Its underwriters issued a policy to cover the risk! The policy required the payment of a £ 2,500 premium. It covered the period 1st May 1971 to 30th April 1972. The monster was to be captured alive. It spelled the following extra conditions:
"As far this insurance is concerned, the Loch Ness Monster shall be: 1/ in excess of 20 feet in length, 2/ acceptable as the Loch Ness Museum to the curators of the National History Museum, London. In the event of loss hereunder, the Monster shall become the property of the underwriters hereon."
What is the lesson, if any, to be drawn from this? Apart, of course, from the fact that Lloyd's underwriters are shrewd: They become owners of the Monster! The lesson is that, contrarily to a widespread belief, we do not suffer from an excess of markets. As a matter of fact, a simple look at daily life strongly suggests that we suffer from not having enough markets to fine-tune our exposures to daily contingencies. Think of your home: Real estate prices are volatile and your home is usually a major fraction of your wealth. Still, you have to live with the hard fact that your home may one day become a lot less valuable than it used to be. And, for that exposure, unlike the Loch Ness Monster case, you do not have any insurance available. Markets are missing. Worse, the available markets fail us when we badly need them. The recent crisis is a sad illustration of this costly failure.
Missing markets are another example of the "all or nothing society." Either you have access to them or you don't. In today digital economy the situation is even worse. Millions of people who made so far a decent living out of their services are now dis-intermediated without any compensation. Jaron Lanier, in his remarkable Who Owns The Future? Book, notes for instance that when we use automatic translation services, such as Google Translate, we naively believe that we are using some sort of state of the art polyglot AI algorithm. Nothing can be further from truth. As a matter of fact, we access a cloud made of millions of translation snippets written by real human translators that are constantly harvested over the Web. What we submit for translation is compared to material that was previously translated. That's how we get the translation results. The thorny issue is that in the course of doing so the original human translators do not get a penny for their work as Google does not pay them anything. We get value from the translation service, Google gets good advertising money but the source of the original value is expropriated. All or nothing at play again. Lanier rightly argues it does not have to be so. Worse it is unsustainable. Quoting Ted Nelson's pioneering work on hypertext, Lanier advocates a micro-payment market whose aim would be to remunerate the authors of "borrowed" information. Since everything is stored in the cloud and can be traced back to the original authors, it should not be that difficult to organize a market that will reward these authors for the use of their work. Redneck pirates will certainly object to this proposal as it collides with their information wants to be free leitmotiv.
But this leitmotiv is awfully myopic. Free in a digital economy invariably leads to Leviathans through increasing returns to scale. Free means long term impoverishment. We end up being unfairly swapped: Free means that we have to accept an Faustian swap à la Google, Facebook, Instagram and so on. The swap is odious as it expropriates millions of people who keep joining the ocean of wannabes while the Google, Facebook... superstars capture all the gains. This is simply an unsustainable social contract. The future is broken if we are not able to engineer the missing markets necessary to recapture and fairly redistribute the value that has been expropriated on an unprecedented scale.
Let's put this way. We suffer from two deadly diseases: Too many (poorly designed) buoyant markets and too many missing (to be designed) markets!
Let us work on curing them both.