Philippine Economy: The Unseen Factors behind the “Doing Business” improvements

Domestic media and the mainstream cheers on reports of the vast improvements by the Philippines in the Doing Business rankings by the IFC-World Bank. 

The Philippines joins other outperformers led by Ukraine, Rwanda, the Russian Federation, Kosovo, Djibouti, Côte d’Ivoire, Burundi, the former Yugoslav Republic of Macedonia, and Guatemala 

This article from Rappler gives a good account where the gist of the so-called positive developments has been allegedly made.

Regulatory reforms that helped improve the Philippines' ranking were evident in the following 3 criteria:

One, the introduction of a fully operational online filing and payment system that made tax compliance easier for companies.

The government has aimed to reduce the number of steps to pay taxes to 14 from the previous 47. The survey showed it still takes 36 steps.

Two, the simplified occupancy clearances that eased construction permitting:

The government wanted to cut the steps to obtaining construction permits to just 12 from 29. The survey results showed it currently takes 25.

Three, the new regulations guaranteeing borrowers’ right to access their data in the country’s largest credit bureau.

These were some of the areas the government has created specialized teams for to address each of the 10 indicators on the difficulty or ease of doing business in the country that IFC is tracking.

The teams' priorities were on indicators that have to do with starting a business, getting credit, protecting investors and resolving insolvency.

Here I will offer a contrarian analysis (using the great Bastiat's Seen and Unseen analytical framework) of the so-called outperformance in Doing Business rankings based on the areas which posted the biggest advancement.

1. Paying Taxes. 

It is natural for the Philippine government to prioritize in the enhancements of tax collections.

That’s because the government has been spending far more than the revenues the government has generated. Data from NSCB and Bureau of Treasury

Yet the increase in the growth rate of government spending has been accelerating to the upside. On the other hand, revenues while also increasing has failed to keep up with the pace of spending growth. 

Moreover, while the rate of government spending appears “linear”, revenues has been subject to fluctuations in the economy

The current “boom” has hardly cut back on the budget deficits that had been accrued during the global 2008 crisis.

In 2010, deficits swelled in the aftermath of a sharp decline in tax revenue collections relative to what seems as steady or constant increase in the trend of government spending. The current deterioration of deficits erased the earlier efforts by the past administration to balance the budget.

In addition, according to the Department of Finance, through July year on year growth of revenues was at 17.3% relative to spending at 21.7%. So nominal deficits (-4.4%) at the current rate will likely even deteriorate more if such a trend persists.

Of course deficit spending unfilled by taxes has been and will be covered by debts. So underneath the surface of a supposed boom has been the swelling of the debt levels. 

The government has already been spending a lot more than they can earn, even at pre-Doing Business improvement levels. This means that in contrast to the optimistic perspective, more efficient tax collection will motivate politicians to spend even more.  And with bigger government spending, efficient tax collections will extrapolate to higher taxes. 

Moreover, money spent for public consumption will mean less money spent for productive activities. Government spending will only add temporarily to statistical growth. In reality, via crowding out of the private sector, government spending diminishes real economic growth. That's because government has no resources to fund any of their spending programs such that the government principally relies on the forcible extraction of savings, output or wealth from the productive agents by taxation. And because government spending cannot be measured by market metrics as they are a monopoly, such spending represent consumption.

So this hardly signifies a positive news over the long term.

2. Construction Permits

In the consensus perspective, ballooning budget deficit and public debt figures when compared to the statistical growth (debt/gdp, deficit/gdp) has been seen as 'stable' or barely viewed as a source of concern.

This is largely because the 'strong' denominator or statistical growth figure (gdp) have “muted” the numerators (debt and deficit).

Such underappreciation of risks has been due to the skewed computation of statistical growth. Yet debts and deficits has largely been driven by the very factors (government spending), aside from the bubbles in the formal economy (nominal private sector debt), constituting statistical growth.

This leads us to the next "big" advance in Doing Business.

The 2nd quarter 2013 Philippine statistical growth clock came at 7.8%. But when one scrutinizes on the National Statistical Coordination Board data, economic growth emanated from mostly construction and government spending (based on expenditures).

And the construction share of growth includes government spending, where the share of public construction has increasingly added to statistical growth data based on World Bank data

In short, measures to improve regulations in the construction and real estate industry seem as deliberately designed to accommodate a real estate-construction boom in order to boost the statistical economy.

Yet how has the boom in these sectors been funded? Well by credit expansion.

BSP data shows how bank lending to the real estate has exploded since 2010 until 2012

Despite some moderation in the current pace of bank lending, construction and real estate loans remains vastly above “statistical growth”. Of course there has also been the Philippine version of the shadow banking industry.

3. Getting Credit.

The third room for the Doing Business upgrade has been in the partial easing of credit regulations, particularly “guaranteeing borrowers’ right to access their data” 

As noted above, the booming areas, specifically real estate and construction and allied industries have mainly been funded by a credit boom

On the consumer side, given that 8 in every 10 households are estimated as unbanked according to the BSP’s annual report…

…and that only 4% of the households have credit cards…

…and where 6.8% of households borrowed money for housing

The above data suggests that “Guaranteeing borrowers’ right to access their data” will hardly be a factor in enticing the informal economy to access the formal banking sector. The average borrower will hardly be concerned about right to access data but rather over access to funds.

True, consumer credit has grown in 2010-2012

…and also through 2013, but they have largely remained below the pace of the supply side growth rate.

Again the so-called “guaranteeing borrowers’ right to access their data” will unlikely boost the overall credit market for the simple reason it does not address the disease: rigid regulations (e.g. AMLA) and taxes that inhibit access to the formal banking system.

Instead “getting credit” will likely buttress the asset speculators, whom have been driving an asset mania, the same entities who have access to the formal banking sector and to the capital markets, as well as, the financiers of these speculative boom.

In short, the credit financed boom has been concentrated to a small sector of the Philippine economy who will benefit from "doing business" upgrade. 

Yet in order to maintain current statistical growth levels largely dependent on debt, this means inflating bigger asset bubbles financed by even more ballooning of debt levels. The so-called Doing Business reforms has just facilitated this.

Bottom line: The biggest improvements in the Philippine IFC’s "Doing Business" has hardly been about promoting small and medium scale businesses and or the informal economy

Induced by zero bound rates, the selective easing of regulations essentially compounds on the accommodation by the government of the debt financed speculative binge on asset markets, as well as, debt financed government consumption. 

Instead, ease of paying taxes, construction permits and getting credit only reinforces the transfer of resources (via inflationism, deficit spending and asset inflation) from society to the political class and their favored allies and constituents

This has been hailed by the short term looking consensus as an ideal growth paradigm. 

But as the great Austrian economist Ludwig von Mises warned,

The popularity of inflation and credit expansion, the ultimate source of the repeated attempts to render people prosperous by credit expansion, and thus the cause of the cyclical fluctuations of business, manifests itself clearly in the customary terminology. The boom is called good business, prosperity, and upswing. Its unavoidable aftermath, the readjustment of conditions to the real data of the market, is called crisis, slump, bad business, depression. People rebel against the insight that the disturbing element is to be seen in the malinvestment and the overconsumption of the boom period and that such an artificially induced boom is doomed. They are looking for the philosophers' stone to make it last.

Yet the soundness of such paradigm may soon be tested by the global bond vigilantes

How Regulations Deter Investments: The China-Europe Story

Many Chinese firms including State Owned Enterprises (SoE) have been considering to invest in Europe as the latter eyes $560 billion of Chinese FDIs in 5 years.

Unfortunately regulatory barriers have been a huge turn off

From Reuters:

But getting your head around European laws and visa restrictions, as well as the fear that tough economic times could spark more political instability, make Europe hard to navigate for Chinese firms.

In fact the surveyed firms perceive Africa and the Middle East as having a more favourable business environment than the EU.

Chinese firms find EU law particularly troublesome because there is no unified inbound investment approval process and some member states have their own security reviews…

Six in 10 of the firms surveyed were SOEs and the most popular EU country for Chinese investment was Germany, with France a distant second.

Chinese firms asked for more support with the operational issues they face from policymakers in Europe and back home.

Regulatory obstacles can also signify as forms of disguised protectionism via technical barriers to trade as product or safety standards as well as people protectionism which limits flow of people.

The European crisis will hardly be resolved until real reforms to promote a business friendly environment or by the liberalization of the economy.

Also the above also reflects on the Africa’s ‘globalization’ boom story which has been attracting lots of Chinese investments. Chinese FDI reportedly zoomed to $14.7 billion in 2012 up by 60% from 2009 (ChinaUSfocus.com)

Italy’s Regulation Choked Labor Markets

Here is another example of the normative way of how politicians deal with problems: They treat the symptoms rather than the disease.

From the Wall Street Journal,

Prime Minister Mario Monti has issued a new "growth decree" to revive Italy's moribund economy. Among other initiatives, the 185-page plan proposes discount loans for corporate R&D, tax credits for businesses that hire employees with advanced degrees, and reduced headcount at select government ministries.

Will any of this solve Italy's economic problems? Only in the sense that one could theoretically drain Lake Como with a ladle and straw. Allow us, then, to illustrate why Italy's economy stagnates.

Imagine you're an ambitious Italian entrepreneur, trying to make a go of a new business. You know you will have to pay at least two-thirds of your employees' social security costs. You also know you're going to run into problems once you hire your 16th employee, since that will trigger provisions making it either impossible or very expensive to dismiss a staffer.

But there's so much more. Once you hire employee 11, you must submit an annual self-assessment to the national authorities outlining every possible health and safety hazard to which your employees might be subject. These include stress that is work-related or caused by age, gender and racial differences. You must also note all precautionary and individual measures to prevent risks, procedures to carry them out, the names of employees in charge of safety, as well as the physician whose presence is required for the assessment.

Now say you decide to scale up. Beware again: Once you hire your 16th employee, national unions can set up shop. As your company grows, so does the number of required employee representatives, each of whom is entitled to eight hours of paid leave monthly to fulfill union or works-council duties. Management must consult these worker reps on everything from gender equality to the introduction of new technology.

Hire No. 16 also means that your next recruit must qualify as disabled. By the time your firm hires its 51st worker, 7% of the payroll must be handicapped in some way, or else your company owes fees in-kind. During hard times, your company may apply for exemptions from these quotas—though as with everything in Italy, it's a toss-up whether it's worth it after the necessary paperwork.

Once you hire your 101st employee, you must submit a report every two years on the gender dynamics within the company. This must include a tabulation of the men and women employed in each production unit, their functions and level within the company, details of compensation and benefits, and dates and reasons for recruitments, promotions and transfers, as well as the estimated revenue impact.

I earlier posted the labor markets of France and Germany compared to Spain.

Such astounding maze of regulations has been one of the major dynamics for today’s crisis. This has produced a huge bureaucracy that has been draining productive resources from entrepreneurs. This has also increased the costs of doing business. Reduced the incentives of entrepreneurs to expand. Shifted many activities to the informal or shadow economy.

Italy has one of the largest informal economies relative to the OECD nations

As well as encouraged corruption. Italy ranks as one of the most corrupt in Eurozone. Overall, such regulations has reduced Italy’s competitiveness.

So reduced competitiveness leads to diminshed output (income) – ballooning government (expense)= crisis (deficits)

And how does the Italian government intend to fix the problem?

Among other initiatives, the 185-page plan proposes discount loans for corporate R&D, tax credits for businesses that hire employees with advanced degrees, and reduced headcount at select government ministries

Gosh, 185 pages of more regulations and more bureaucracy.

Note: reduced headcount at “select” government ministries looks more symbolical and seems like a loophole.

Yet the mainstream advice of solving this problem by inflation will only worsen the situation, as this does not address the root: asphyxiation from big government.

Doing it over and over again and expecting different results only reinforces the worsening of this crisis.

Germany’s Competitive Advantage over Spain: Freer Labor Markets

When politics is involved, common sense is eschewed.

The vicious propaganda against “austerity” aims to paint the government as the only solution to the crisis, where the so-called “growth” can only be attained through additional government spending funded by more debt. Unfortunately, these politically confused people have forgotten that today’s crisis has been caused by the same factors which they have been prescribing: debt. In short, their answer to the problem of debt is to acquire more debt.

The same with clamors for crisis plagued nations to “exit” the Eurozone in order to devalue the currency. Inflating away standards of living, it is held, will miraculously solve the social problems caused by too much government interventionism that has led to inordinate debt loads.

Professor John Cochrane of the Chicago School nicely chaffs at statist overtures,

The supposed benefit of euro exit and swift devaluation is the belief that people will be fooled that the 10 Drachmas are not a "cut" like the 5 euros would be. Good luck with that.

Little has been given thought to what’s happening on the ground, particularly achieving genuine competitiveness by allowing entrepreneurs to prosper.

At the Mises Institute, Ms Carolina Carmenes and Professor Howden lucidly explains why Germany has been far more competitive than Spain, specifically in the labor markets .

Spain’s labor costs have been cheaper than Germany, yet the Germans get the jobs. Writes Ms. Carmenes and Prof Howden (bold emphasis added)

Spanish employment is now hovering around 23 percent, with over 50 percent of youths jobless. Only around 6 percent of Germans are without work, almost the lowest level in the country since reunification. This divide solidifies Spain's position among the worst-performing economies of the continent, and Germany's vaunted position as among the best.

Yet such a situation might seem paradoxical. One could, for example, look at the wage rates of the respective workers and find that low-cost Spaniards are much more affordable. Profit-maximizing businesses should be expanding their facilities to take advantage of the opportunity the Spanish crisis has provided and eschew higher-cost German labor.

While fixating on nominal labor costs might provide a compelling case for a bright Spanish future, delving into the details provides some darker figures.

Once again the German-Spain comparison shows of the myth of cheap labor

Little thought has also been given to the impact of minimum wage and excessive labor regulations which stifles investment and therefore adds to the pressures of unemployment

Again Ms. Carmenes and Prof Howden (bold emphasis added)

One of the main differences between Germany's and Spain's labor markets is their minimum-wage rates. A Spanish minimum-wage worker can expect to earn about €633 per month. Germany on the other hand enforces no across-the-board minimum wage except in isolated professions — construction workers, roofers, and electricians, as examples.

German employees are free to negotiate their salaries with their employers, without any price-fixing intervention by the government in the form of wage control. (This is not to imply that the German labor market is completely unhampered — jobs are cartelized by industry each with its own wage controls. While this cartelization is not perfect, it does at least recognize that a one-size-fits-all minimum-wage policy is not optimal for the whole country.)

As an example of the German approach to wages, consider the case of a construction worker. In eastern Germany this worker would make a minimum wage of around €9 per hour. His counterpart in western Germany would earn considerably more — almost €11 an hour. This difference allows for productivity differences to be priced separately or local supply-and-demand conditions to influence wages. Working for five days at eight hours a day would yield this German worker anywhere from €360 to €440.

It is obvious that the German weekly wage is almost as high as the monthly Spanish one. What is less obvious is why Germans do not move their facilities to lower-cost Spain.

As the old saying goes, "the more expensive you are to fire, the more expensive you are to hire." If a Spanish company decides to lay off an employee, the severance payment for most labor contracts (a finiquito in Spanish) will amount to 32 days for each year the employee has worked with the company. Although this process is not simple in Germany either, there is no legal severance requirement that companies must pay to redundant workers. The sole requirement is for ample notice to be given, sometimes up to six months in advance. If a Spanish company hires a worker who does not work out as intended, a substantial cost will be incurred in the future to offload the employee. Employers know this, and when hiring workers they exercise caution accordingly, lest this unfortunate and unplanned-for future materialize.

These factors make the perceived or expected cost of labor at times higher in Spain than in Germany, despite the actual monetary cost being lower in euro terms. This effect has been especially pronounced since the adoption of the common currency over a decade ago. As we can see below, the average cost of German labor is largely unmoved since 2000, while Spanish labor has increased about 25 percent over the same period.

When hiring a worker, the nominal wage is only half the story. The employer also needs to know how productive that worker will be. Even after we factor for the extra costs on Spanish labor, a German worker could be more costly. A firm would still choose to hire that worker if his or her productivity was greater.

As we can see in the two figures below, over the last decade a large divergence has emerged between the two countries. While German productivity has more or less kept pace with its small increases in wage rates, the Spanish story is remarkably different. Productivity has lagged, meaning that on a real basis Spanish laborers are much more costly today than they were just 10 years ago.

Of course, boom bust policies have also contributed to such imbalances. The EU integration which had the ECB inflating the system essentially pushed Spanish wages levels up substantially, thereby overvaluing Spanish labor relative to productivity and relative to the Germans and to other European nations…

In his book The Tragedy of the Euro, Philipp Bagus mentions a similar phenomenon. Bagus points to the combination of (1) the rising labor costs that result from eurozone inflation and (2) divergent productivity rates between the countries as a source of imbalance. Indeed, inflation has been one driver of rising (and destabilizing) wages in the periphery of Europe, and especially in Spain. Others include, as we have noted here, minimum wages, regulatory burdens, and severance packages that increase the potential cost of labor.

In either case the effect is the same: wage rates do not necessarily reflect the labor itself, but rather the regulation surrounding it. In Spain, this translates to noncompetitive wages. It is important to remember, though, that this does not imply that the labor itself is necessarily uncompetitive — it is price dependent after all.

Every good has its price, even labor. When prices are hindered from fluctuating to clear markets, imbalances occur. In labor markets those imbalances are unemployed people. Policies such as a one-size-fits-all minimum wage and high mandated severance packages keep the price of Spanish labor above what it needs to be to clear the market.

Until something is done to ease these policies, Spanish labor will remain uncompetitively priced. Until Spanish labor costs can be repriced competitively, Spain's masses will need to endure stifling levels of unemployment.

The only solution to the current crisis is to allow economic freedom to prevail. Of course, this means less power for the politicians and their allies which is why they won't resort to this. Their remedies will naturally be worst than the disease.

How the Web Nurtures Underground Economies

Through Anonymous Web Proxy Servers.

From author Bill Rounds (howtovanish.com), [hat tip Charleston Voice]

Communist Cuba is a great example of how this is being done. It has a thriving market for goods and services, even though strict regulations prohibit entrepreneurship, because the citizens find ways to exercise their enterprising minds. A site similar to Craigslist, called revolico.com, allows Cubans to exchange everything from baseball equipment to their place in line and they love their hawaladar. For the good of the people, the site is blocked by the government. But the site thrives nonetheless. How do the Cubans get around the repressive and immoral policies of their overbearing government? They use anonymous web surfing practices.

Anonymous web surfing is generally done by using proxy servers. Proxy servers allow the proxy computer, outside of Cuba and not subject to Cuban government regulations, to do the web surfing for the Cubans. The ISP registers that they have visited the proxy server, not the sites visited by the proxy server on their behalf. And, because there are many thousands of servers available at any moment, some of which have never been used before as a proxy, it is far more difficult to restrict access to proxy servers than to individual websites. This way, the web surfing activity of individual Cubans is made anonymous to those who are watching them.

Cubans using anonymous proxy servers for anonymous browsing which don’t disclose their IP address to the websites that they visit, nor the fact that the proxy server is even surfing for someone else, make it that much harder for a repressive government, like Cuba, to discover which citizens are visiting a site and then prevent them from visiting the site.

Cuba is not the only example. China, Iran, and many other countries have seen their citizens utilize proxy servers to spread information and ideas. I am sure that governments are not done trying to prevent their citizens from accessing information, sharing information, or associating with others through the internet, but I am also sure that there will always be those who circumvent limitations placed on them through the use of anonymous web surfing techniques. Some people might want to seek residency in another country that is more free and allows for more privacy.

Rapid innovation and accelerating diffusion of technology usage has been eroding the political framework of the 20th century. Also these have been fostering economic activities that goes beyond the clutches of political authorities.

And this means that the greater the penetration levels of technology, the bigger the informal economy, as well as, greater pressures applied to existing vertical structured political institutions. Put differently, closed door political economies are incrementally being pried open by the globalization through technology.

The relationship between markets and regulations can be analogized to a “cat and mouse” game which Wikipedia.org defines as “a contrived action involving constant pursuit, near captures, and repeated escapes” where the interrelationship exists via a feedback mechanism: the markets always discovers means to skirt political shackles, and the political response to innovation would be to introduce new regulations.

Nonetheless the markets are always way ahead of and smarter than politicians, which is one fundamental reason to be optimistic despite the many challenges posed by the incumbent political agents and their lackeys.

Peter Schiff Schools US Congress: Government Spending Represents Shot of Monetary and Fiscal Heroin

Peter Schiff does a magnificent job lecturing Congress and their private sector ally in this testimony...

Part 1 On burdensome regulations

Part 2 On baneful impacts of government spending

Asian Capital Markets Likely a Beneficiary of Europe’s High Taxes and Regulatory Maze

“If you tax something, you get less of it”, that’s Professor Mark Perry’s Economics 101

The following should be a great example, from Bloomberg, (bold highlights mine)

Banks in Europe are exploring ways to cut costs by routing more of their trades and other business through overseas subsidiaries, a plan that may shift tax revenue away from London and loosen European regulators’ influence over the lenders.

Nomura Holdings Inc., HSBC Holdings Plc (HSBA) and UBS AG (UBSN) are among lenders preparing plans to book as much business as possible through legal entities in jurisdictions where tax rates are lower and rules on capital and liquidity are less onerous, the banks and lawyers and accountants working with them say.

“Every bank is trying to work out the best way to be structured under the new rules,” Chris Matten, a partner at PricewaterhouseCoopers LLP in Singapore, said in a telephone interview. “It’s not just a question of what activities banks are in. It’s about which entities they put that business through and in which jurisdictions.”

Banks could record as much as 30 percent of the value of their trades through Hong Kong, Singapore and other jurisdictions instead of hubs such as London and New York without running into trouble with regulators, Matten said. Such a move would hurt traditional hubs such as London because assets are treated for tax and regulatory purposes in the country where they are booked. It would also allow banks to sidestep the U.K. bank levy, introduced last year to raise 2.5 billion pounds ($4.1 billion) from lenders operating in Britain, as well as any financial transaction tax imposed by the European Union.

This is one major lesson politicians and their followers can’t seem to digest, absorb or learn.

Nevertheless, this is also one major factor that could drive funds and the banking business to Asia.

Their loss could be our gain, that’s if we heed of the fundamental truism shown above.

Loss of Economic Freedom means Business Exodus: The California Experience

This is what happens when Economic Freedom gets curtailed: economic opportunities shrivels as investors leave for better alternatives. In short, money goes where it is treated best.

The California experience from CNN:

Buffeted by high taxes, strict regulations and uncertain state budgets, a growing number of California companies are seeking friendlier business environments outside of the Golden State.

And governors around the country, smelling blood in the water, have stepped up their courtship of California companies. Officials in states like Florida, Texas, Arizona and Utah are telling California firms how business-friendly they are in comparison.

Companies are "disinvesting" in California at a rate five times greater than just two years ago, said Joseph Vranich, a business relocation expert based in Irvine. This includes leaving altogether, establishing divisions elsewhere or opting not to set up shop in California.

People respond to incentives. This is what regulators and policymakers everywhere, including the Philippines, don’t seem to understand.

Financial Reform Bill And Regime Uncertainty

``But the law is made, generally, by one man, or by one class of men. And as law cannot exist without the sanction and the support of a preponderant force, it must finally place this force in the hands of those who legislate. This inevitable phenomenon, combined with the fatal tendency that, we have said, exists in the heart of man, explains the almost universal perversion of law. It is easy to conceive that, instead of being a check upon injustice, it becomes its most invincible instrument.” Frédéric Bastiat, The Law

Yo-yo Markets And The Financial Reform Bill

Writing in the Wall Street Journal, hedge fund manager and author Andy Kessler seems right; the actions of the US markets, which directly affects other financial markets, will be in a state of a Yo-yo for as long as the US government continually intervenes to suppress market forces from revealing its true conditions.

Mr. Kessler writes[1],

``Call it the yo-yo market—from the top of the wall to the bottom of the pit and back—and you better get used to it. It's hard to tell which market moves are real and based on prospects for better profits, as opposed to moves that are driven by all the extraordinary government measures to prop up the world economy. Until a few things are resolved, you'd better learn the yo-yo sleeper trick—that is, keep spinning at the bottom without going up.”

Mr. Kessler appears to echo what we’ve been saying all along[2]---that politics has and will shape the outcome of the markets.

Mr. Kessler cites the pervasive impact of the Zero Interest Rate Policy (ZIRP), the assorted “crutches” or the guarantees, stimulus packages, and money printing, and importantly, the impact of the changes in the regulatory environment.

Since we had exhaustively discussed on the first two factors, in the light of the passage of the Financial Reform Bill[3], we’d tackle more on the aspects of the regulatory environment.

After having a rather promising start for the week, the US markets fell hard Friday after the ratification Financial Reform Bill. The losses virtually expunged on the early gains made whereby the net weekly result for the US S&P 500 had been a net loss of 1.21% (see figure 1).

Figure 1: US Global Investors[4]: Sectoral Performance

Nevertheless the degree of losses had been uneven, where some sectors of the S&P 500 have managed to escape the clutches of the selling pressures, such as the Consumer staples and the Technology sector.

True, correlation doesn’t automatically translate to causation. The Financial Reform bill may or may not have directly affected Friday’s performance.

However, given that the largest victim of the selloff had been in the financial sector, which is the target of the slew of new regulations, then I must argue that there could have been a substantial connection in the way the markets perceive how these purported reforms would affect the industry.

In other words, markets may have seen more downside risks to the industry, as a result of the law, and these perceptions have filtered into the other sectors.

Yet it’s simply amazing how some mainstream analysts fail to acknowledge of the vital role played by the regulatory environment in shaping the allocation of resources.

They seem to think that investment is merely consequence of waking up on a particular side of the bed which determines their “animal spirits”, or that, confidence is simplistically established as a function of random temperaments or moods—and largely detached from the coordination of consumers and producers in the marketplace.

Thus, many make specious arguments that new regulations won’t affect the business operations.

Importantly, the same experts fail to take into account that entrepreneurs invest with the aim to profit from providing or servicing the needs or desires of the consumers. Thus, a material change in the regulatory environment may affect the fundamental profit and loss equation. And the ensuing changes could also alter the feasibility of the operations of any enterprises, to the point which could lead to either closures, or impair the business operations. The net effect should be more losses and rising unemployment.

In short, business confidence is a function, not of some mood swings, but of property rights. Likewise confidence relative to investment should be predicated not just with the return ON capital, but with the return OF capital.

Regime Uncertainty From Arbitrary Laws

Economist Robert Higgs calls this reduced confidence factor as “regime uncertainty” where he argues[5] (bold emphasis mine)

``To narrow the concept of business confidence, I adopt the interpretation that businesspeople may be more or less “uncertain about the regime,” by which I mean, distressed that investors’ private property rights in their capital and the income it yields will be attenuated further by government action. Such attenuations can arise from many sources, ranging from simple tax-rate increases to the imposition of new kinds of taxes to outright confiscation of private property. Many intermediate threats can arise from various sorts of regulation, for instance, of securities markets, labor markets, and product markets. In any event, the security of private property rights rests not so much on the letter of the law as on the character of the government that enforces, or threatens, presumptive rights.”

Thus, to allege that new regulations will hardly be a factor in the investment environment would redound to utter detachment with reality.

Well, what can we expect from so-called ivory tower “experts” who seem to think that they own the monopoly of knowledge, via mathematical models and aggregates, when their sources of income depends on wages than from wagering on the dynamic trends of the marketplace? (Pardon me for the ad hominem, but perspectives are mostly shaped by interests)

Take the Great Depression (GD) of 1930s, which many prominent bears have anchored their projections as the probable direction of today’s market.

From the monetarist viewpoint, the GD had been all about monetary contraction, whereas from the Keynesian perspective this had been about falling aggregate demand. Both of which has been diagnosed by the incumbent Federal Reserve chief Ben Bernanke[6] as the major causes from which current policies have been designed to address. Yes—the solution? The printing press!

While both did have a role to play, the oversimplistic account of the GD fails to incorporate the havoc generated by the legion of intrusive laws enacted by the US government’s New Deal program, aimed at keeping prices at status quo ante or from adjusting to the realities of the unsustainable misdirection of capital from the inflation boom induced depression. These policies, which threatened property rights, had greatly exacerbated and prolonged the grim conditions then.

These laws included[7]:

1933 Agricultural Adjustment Act, National Industrial Recovery Act, Emergency Banking Relief Act, Banking Act of 1933 Act, Federal Securities Act, Tennessee Valley Authority Act, Gold Repeal Joint Resolution, Farm Credit Act, Emergency Railroad Transport Act, Emergency Farm Mortgage Act National Housing Act, Home Owners Loan Corporation Act

1934 Securities Exchange Act, Gold Reserve Act, Communications Act, Railway Labor Act

1935 Investment Company Act, Revenue Act of 1940, Bituminous Coal Stabilization Act, Connally (“hot oil”) Act, Revenue Act of 1935, National Labor Relations Act, Social Security Act, Public Utilities Holding Company Act, Banking Act of 1935, Emergency Relief Appropriations Act, Farm Mortgage Moratorium Act

1936 Soil Conservation & Domestic Allotment Act, Federal Anti-Price Discrimination, Revenue Act of 1936

1937 Bituminous Coal Act, Revenue Act of 1937, Act Enabling (Miller-Tydings) Act

1938 Agricultural Adjustment Act, Fair Labor Standards Act, Civil Aeronautics Act, Food, Drug & Cosmetic Act

1939 Administrative Reorganization Act

1940, Second Revenue Act of 1940

Figure 2: Wikipedia.org[8]: US Income Tax (left window), Higgs: Government Purchases (Current$) and Gross Private Investment (Current$) Relative to Gross Domestic Product (Current$), 1929–1950

For instance, one should also take into account how the surge in taxation (left window) to fund the explosion in government expenditures during the Great Depression (right window) contributed to stymie investments or production (see figure 2)

As Henry Hazlitt aptly described how taxes affect investment or production[9]

``When the total tax burden grows beyond a bearable size, the problem of devising taxes that will not discourage and disrupt production becomes insoluble.”

In other words, when the expectations for profits are reduced, borne out of the expectations of higher taxes or from other regulatory interdictions which places property rights at risks, then investments will obviously follow—and decline.

Therefore the regulatory and tax regime functions as crucial factors to the conditions of confidence in the marketplace.

Paradoxically, one function of the law is the avoidance of this “regime uncertainty”. But when the state is unclear about the direction of policies and regulation, the “means” can contradict the “end”. So, instead of stability, such laws could engender or promote “regime uncertainty”. Yet, these are commonplace feature of many arbitrary laws.

Take the recently enacted Financial Reform Bill, it has been reported to contain 2,319 pages (see figure 2)

Figure 2: Mark Perry[10]: Major Financial Legislation: Number of Pages

The sheer mountain of pages by itself would make the reformist law seem like a regulatory quagmire and appears appallingly political relative to the enforcement issues.

Heritage’s Conn Carroll explains[11],

``With the single stroke of a pen, President Barack Obama signed the Dodd-Frank financial regulation bill that set in motion 243 new formal rule-makings by 11 different federal agencies. Each of the 243 rule-makings will employ hundreds of banking lobbyists as they try to shape what the final actual laws will look like. And when the rules are finally written, thousands of lawyers will bill millions of hours as the richest incumbent financial firms that caused the last crisis figure out how to game the new system.”

The implication is that where financial firms compete, not to please customers, but to gain the favour of regulators, this essentially represents as the hallmarks of corporatism or crony capitalism.

Thus, the financial reform bill is likely to foster political privileges which entrenches the “too big too fail” institutions, who will profit from economic rent.

The litany of adverse effects from such ambiguous bill will be one of expanded corruption, lack of credit access for consumers, reduced consumers protection (in contrast to the purported letter of the law), regulatory capture, regulatory arbitrages, higher risks to taxpayers on greater risk appetite for the politically privileged firms (moral hazard issue), increased red tape via an expanded bureaucracy, higher compliance costs, more government spending and reduced competition which overall translates to broad based economic inefficiencies.

Yet the reformist law is also said not only to be opaque, but gives undue confiscatory power based on the whims of regulators.

Mr. Kessler writes[12], ``What is even more troubling is the prospect of government seizures built into the Dodd-Frank financial bill. This is much like the seizure of property from auto industry bond holders (denounced as speculators) in the bankruptcy of GM and Chrysler.

``Dodd-Frank also provides government leeway to seize firms it considers a systemic risk, without really defining what that systemic risk is. Why anyone would provide debt to large financial institutions (or auto makers) is beyond me, certainly not without demanding a huge premium for the seizure risk. The cost of capital for the U.S. economy is sure to rise, slowing growth.”

This means that Financial Reform bill also entails that the political favoured institutions are likely to become veiled instruments for political agenda of those in power.

And laws of this nature is what Frédéric Bastiat long admonished[13],

``But, generally, the law is made by one man or one class of men. And since law cannot operate without the sanction and support of a dominating force, this force must be entrusted to those who make the laws.

``This fact, combined with the fatal tendency that exists in the heart of man to satisfy his wants with the least possible effort, explains the almost universal perversion of the law. Thus it is easy to understand how law, instead of checking injustice, becomes the invincible weapon of injustice. It is easy. to understand why the law is used by the legislator to destroy in varying degrees among the rest of the people, their personal independence by slavery, their liberty by oppression, and their property by plunder. This is done for the benefit of the person who makes the law, and in proportion to the power that he holds.”

In short, arbitrary laws, as the Financial Reform bill, can function as instruments of injustice.

Thus, it is NOT impractical or improbable to argue that in the wake of the enactment of the Financial Reform Bill, the ambiguity and arbitrariness of the law and the increased politicization of the financial industry would likely result to greater perception of risks which may be reflected on the “Yo-yo” actions or a more volatile US markets.

At the end of the day, regulatory obstacles will likely compel capital to look for a capital friendly environment from which to flourish.

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[1] Kessler, Andy, The Yo-Yo Market and You, Wall Street Journal, July 16, 2010

[2] See How Political Tea Leaves Will Shape The Investment Landscape

[3] Bloomberg, U.S. Congress Passes Wall Street Regulation Bill, July 15, 2010

[4] US Global Investors, Investor Alert, July 16, 2010

[5] Higgs, Robert Regime Uncertainty, Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War

[6] Bernanke, Ben Deflation: Making Sure "It" Doesn't Happen Here, Speech Before the National Economists Club, Washington, D.C. November 21, 2002

[7] Higgs, Ibid

[8] Wikipedia.org, Income tax in the United States

[9] Hazlitt, Henry Taxes Discourage Production, Chapter 5 Economics In One Lesson

[10] Perry, Mark ‘I Didn’t Have Time to Write a Short Bill, So I Wrote a Long One Instead,’ Part II The Enterprise Blog July 16

[11] Carroll, Conn Morning Bell: The Lawyers and Lobbyists Full Employment Act, Heritage Blog, July 16, 2010

[12] Kessler, Andy Ibid.

[13] Bastiat, Frédéric The Law