Agency Problem: David Sokol’s Controversial Resignation From Warren Buffett’s Berkshire Hathaway

A good running example of the principal-agent or the agency problem in play has been the unravelling controversy over Warren Buffett’s supposed “would be” successor-David Sokol.

David Sokol recently resigned from Berkshire Hathaway following allegations of unethical practice.

According to Steve Shaefer of Forbes,

Berkshire Hathaway executive David Sokol, who served as chairman of MidAmerican Holding Company and Johns Manville as well as Chairman and CEO of NetJets, resigned from the company in a letter to Warren Buffett Monday.

Buffett announced his departure in a press release Wednesday, which also noted that Sokol owned shares in Lubrizol, a company Berkshire recently agreed to acquire for some $9 billion. The departure of Sokol comes as a shock to Berkshire watchers who figured the executive was one of the potential successors for Buffett.

In the announcement, Buffett stressed that he and Sokol do not feel there was anything illegal in his trades of Lubrizol shares.

Although both David Sokol and Warren Buffett via Berkshire Hathaway denied that this has been the cause of his resignation, media has been all over what has been perceived as ethical impropriety.

The Sokol affair simply highlights what we have been talking about as the conflict of interests by participating agents—based not only from asymmetric information but from asymmetric interests or incentives that drives people’s actions.

Principal Agent Problem Diagram from Wikipedia.org

Mr. Sokol, who acquired shares of Lubrizol before pitching it to his boss, Mr. Buffett, saw nothing wrong with this. In fact, in a CNBC interview Mr. Sokol cites Mr. Charles Munger, Mr. Buffett’s close friend and vice chairman of Berkshire Hathaway of doing the same.

“I don’t believe I did anything wrong. Charlie Munger owned 3% of BYD before he asked me to go look at it.” [dawnwires.com]

In the stock market, when agents or brokers pre-empt their clients by taking positions for his/her account, in the expectations that the clients orders could affect the price movements of specific stocks, is known as “frontrunning” (investopedia.com) an illegal practise that is punishable by law.

Although Mr. Sokol’s case hardly resembles frontrunning, because he bought the shares before he offered it to Mr. Buffett, this goes to show how such practices has punctured on the current laws.

Notes Mr. Jason Zweig at the Wall Street Journal, (bold emphasis mine)

Mr. Sokol's trading falls under what Stephen Bainbridge, an expert on securities at the UCLA School of Law, calls "an enormously gray area of the law." It also is a reminder that a basic principle of securities law—disclosure cures conflicts—is nonsense.

"Even assuming that [Mr. Sokol] did nothing illegal, [his action] is typical of the kinds of conflicts of interest permitted by our financial system that undermine the integrity of markets," says Max Bazerman, an ethicist at Harvard Business School and co-author of the new book "Blind Spots."

Most people have what Mr. Bazerman calls an ethical blind spot. Faced with a potential conflict of interest, you automatically conclude that it couldn't possibly offer any temptation to someone of superior character—like you or those closest to you.

While I agree that this seems like an issue of ‘ethical blind spots’, I don’t share the impression that “conflicts of interest permitted by our financial system that undermine the integrity of markets” or of the insinuation that ‘ethical’ laws are needed to keep the “integrity of markets”. That would be misstating the case.

And that’s because it is the nature of people to be guided by self-interest based on the individual’s distinctive value preferences or priorities. And people’s diversified self interests always conflict with each other, but still could represent benefits for all the concerned, though not equally.(This is the essence of trade)

What has actually undermined the financial system is the conflict of interest (agency problem) between the political agents along with their regulatory patrons and their economic clients. Regulatory arbitrages, regulatory capture, revolving door politics, bailouts to name a few, has been significant contributors to the political-economic inequality.

And as one can see from the above account, current disclosure laws can’t stop people from circumventing them.

Besides, if Mr. Sokol’s allegation of Mr. Munger is accurate, then Mr. Buffett has been obviously tolerant of such practice.

To see why, Mr. Buffett probably sees this as a way to reward his underlings, who by diligent scrutiny over the target companies, takes on risks directly to emphasize their vote of confidence. It’s not even sure that what the underlings buy will be bought by Mr. Buffett.

As Mr. Buffett stressed on Berkshire’s recent press release,

Dave’s purchases were made before he had discussed Lubrizol with me and with no knowledge of how I might react to his idea. In addition, of course, he did not know what Lubrizol’s reaction would be if I developed an interest. (bold emphasis mine)

Thus such actions represent risks borne solely by both Mr. Munger and Mr. Sokol.

Perhaps, for Mr. Buffett this could have signified as parallel to a finder’s fee, that’s if he ever agrees with their investment concept.

This also highlights on the differences of what is seen as an ethical issue. What may seem wrong to the others may seem right to Mr. Buffett (although I would assume that he would distance himself from this controversy)

I think the editorial of Financial Times captures this well, (bold highlights mine)

That Mr Sokol has left to build his own investment portfolio is more than unintentionally ironic. The whole affair highlights Berkshire’s informal style of operation. This is possible because of the high degree of confidence reposed in the company by investors. Mr Buffett and his team can scour the world for opportunities untrammelled by investment mandates and other bureaucratic restraints.

The licence exists, of course, because of Mr Buffett’s superior investment record. He has beaten the stock market indices by a broad margin since the mid-1960s. But it will be harder for Berkshire to continue outperforming given its now-vast size, as even Mr Buffett has admitted. This should give investors pause. The risk of executives abusing informal processes is greatest at times when operational performance is under pressure.

In short, this hasn’t been an issue to Berkshire’s investors because of the rewards these investors have been showered with over these years. It would all be a different story if Berkshire lost money or has underperformed.

The other point is that people should be self-vigilant over their investments in the knowledge that there will always be conflict of interest issues at hand.

To rely on government to resolve ethical issues will only bring about dependency, complacency, and equally, conflict of interest issues but not between private agents but among public and private agents, which should even complicate and worsen the case, as manifested during the last crisis. In other words, more problems will arise from regulations meant to address ethical issues.

The market mechanism for discipline enforced by such perceived misconduct is social stigma or ostracism or reputational risk.

Finally, the public trial faced by Berkshire Hathaway and Mr. Sokol simply highlights of the uniqueness of Mr. Buffett’s management style.

Once Mr. Buffett goes, perhaps Berkshire would most likely lose its magic. All these seem ominous with Moody’s projecting the “Sokol affair” as negative for Berkshire’s credit rating standings (Reuters).

Berkshire’s Corporate Structure and Investment Holdings From theofficialboard.com

Still yet, the complexity of Warren Buffett’s flagship Berkshire Hathaway’s organizational structure operating on her vast investment holdings also underscores the FT’s editorial observations of Berkshire at “now-vast size” or perhaps reaching its growth limit.

And that’s why I have argued here that Mr. Buffett has resorted to political entrepreneurship perhaps out of the desperation to maintain public’s high expectations from a Warren Buffett managed Berkshire.

Bottom line: the principal-agent problem is an inherent feature of the marketplace, which has been immensely underappreciated but must be understood by all.

Video: Don Boudreaux On Understanding Trade Deficits

Professor Donald Boudreaux explains why trade deficits shouldn't be feared (HT: Mark Perry)

Phisix and ASEAN Equities: The Tide Has Turned To Favor The Bulls!

A good trader has to have three things: a chronic inability to accept things at face value, to feel continuously unsettled, and to have humility. -Michael Steinhardt, American investor and philanthropist

The tide must have turned immensely to favor the bulls.

Figure 1: Bloomberg: Jumpstarting the ASEAN Equity Markets

ASEAN markets appear to have been jumpstarted.

We have been repeatedly pounding on the table saying that this turnaround was about to happen. The bulls have been knocking on the door, but few had the grit to pay heed.

And that the previous weakness was not a manifestation of an inflection point nor was it representative of a reversal back to the bear market days. Instead, such market infirmities accounted for as a normal countercyclical process called profit-taking. The basic market lesson is that trends do not move in a straight line.

Yet the profit taking theme seemed unacceptable for the consensus. First because it is boring stuff. And second, because it would seem unworthy of conversations. Part of social conformity requires contemporaneous expressions. And unstylish themes don’t fit such bill.

Social signalling is prioritized more than the relevance of the returns on investments.

Moreover, because people’s intuitive desire is for the graphic, the controversial and the sensational, mainstream experts fed on this false attribution by fixating on the current exogenous factors—the political crisis in Middle East and Africa and Japan’s triple whammy calamity—which they interpreted as having driven markets.

Never mind if evidences hardly supported such assertions, the important thing was to blabber on what seemed fashionable and conversational.

Hardly anyone appear to realize that applying mental shortcuts or heuristics (such as available bias) draped with technical gobbledygook, which would look good from the outside or from the surface, are hardly the pertinent factors when accounting for real investment returns.

In reality, risks and uncertainties stare at our faces at every moment of our lives. Yet, it is just a matter of managing the diversified degree of risk-uncertainty environment that makes the difference. The proverbial wheat is, thus, separated from the chaff.

And as predicted, markets have gradually been digesting on the uncertainty-risk environment from these events. The constant stream of variable, localized, fragmented and frequently contradictory information, which allows markets to discount[1] the uncertainty-risk factor[2], has apparently reduced the perception of the event risk.

The aesthetics of the marketplace is the scintillating evidence of the perpetual flow of the great F. A. Hayek’s description of knowledge[3] and its indispensible role in breathing life to the marketplace via the pricing mechanism and the coordination and discoordination process underpinning the dynamism of prices.

We are now in the process of being vindicated anew!

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[1] See Managing Risk and Uncertainty With Emotional Intelligence, March 20, 2011

[2] See “I Told You So!” Moment: Being Right In Gold and Disproving False Causations, March 6, 2011

[3] Hayek, Friedrich von The Use of Knowledge in Society, econolib.org, 1945

Some Thoughts On The PLDT’s Buyout Of Digitel

Investing without research is like playing stud poker and never looking at the cards. - Peter Lynch

The story of the week belongs no less than to the buyout of Taipan Gokongwei owned Digitel Telecommunications [DGTL] by the largest phone company and publicly listed firm Philippine Long Distance Telecommunication [TEL].

PLDT’s Buyout of DGTL Provides Bulls The Excuse To Bid Up Markets

Figure 2: Recovering Phisix Buttressed By PLDT Buyout Story

It would be inaccurate to say that the PLDT-DGTL story entirely drove the domestic market higher.

The fact that MAJOR ASEAN markets were significantly higher this week, only suggests that bullish sentiment underpinned the markets in the Philippines and among our ASEAN contemporaries.

In addition, the Phisix (red bar chart in Figure 2) has been recovering even prior to the recent spike in PLDT (black candle) share prices last week.

Figure 3: Weekly Sectoral Performance

Besides, while the service sector vastly outperformed the general market led by PLDT rival Globe Telecoms [GLO] (up 22.3%) which ironically eclipsed PLDT’s superb (16.4%) gains over the week, even if Globe had been outside the buyout story, the Phisix which surged by an astounding 6.5% was also driven by advances from the broader market.

Yes, all sectors registered positive gains (figure 3). But only the service sector posted gains far above the Phisix while the financial sector was nearly at par with that of the Phisix. All the rest underperformed.

This means that the extraordinary surge in PLDT prices has materially influenced the gains of the Phisix, given that PLDT commands the largest share in terms of market cap weightings of the Phisix basket.

In other words, the PLDT-DGTL buyout story has nudged the overall market higher. Bulls, whom have been looking for a crucial excuse to bid up the markets (as shown by the gradual ascent prior to last week), appears to have found one in the PLDT-DGTL narrative.

Figure 4: Rotational Effects In Play

Yet this week’s exemplary actions have nearly closed the year-to-date deficits of the various sectors in the Philippine Stock Exchange including the Phisix.

As of Friday’s close, the Phisix is just down 1.7% from the start of the year.

But the more important story is one of the rotational effects.

The tale of the two sectoral outperformers (service and financials) for this week is a splendid manifestation of the Livermore-Machlup model[1] in action-where stock price movements are largely or mainly influenced by inflationist policies (Machlup) which can be empirically observed by relative price actions (rotations) but results to increases in general price levels overtime (Livermore).

Both these sectors have alot of catching up to do, considering that both have lagged the general market as shown above. In short, erstwhile laggards have turned into leaders.

This is further evidenced by the turnaround in the ALL shares index which has popped to the positive zone. This also means that the broader market has been substantially outperforming key Service and Financial issues until last week.

Yet if the tailwinds should persist to fuel the bull’s newfound momentum in the coming sessions or weeks, where the former laggards, many of which constitute as the core Phisix heavyweights, should spearhead an accelerated recovery, then we should see the Phisix clamber out of the rut and possibly post hefty positive returns by the end of April.

Stake In PLDT: Taipan Gokongwei’s Dream Come True

As we earlier said, the bulls found a pretext to fillip the markets, which was through the announcement of PLDT’s buyout of rival company Gokongwei owned Digitel [DGTL].

Here are some information on the buyout as per PSE disclosure[2]

Almost the entire transactions for the buyout (or 51.5% of DGTL) will be executed and financed via share swaps.

A tender offer will be made to the minority shareholders at a ratio of 2,500 pesos or 1 PLDT share for the equivalent number of DGTL shares held—valued at 1.60 per share.

The value of transactions for the Gokongwei owned shares are at php 69.2 billion. If an all cash outlay for the minority tender will be incorporated, the transaction value would rise to php 74.1 billion. If it will be an all share swap transaction minority plus the Gokongwei group will own 13.7% of PLDT. Definitely, the tender offer will translate to somewhere in between (cash tenders or PLDT swaps).

The completion of the buyout would mean that the Gokongwei flagship company JGS summit would hold 12.8% of PLDT.

Ascertaining the derivative value per share of the PLDT’s acquisition of DGTL seems ambiguous because it includes other matters that had not been appropriately detailed—such as the treatment of DGTL’s zero coupon convertible bonds which represents an approximate 18.6 billion of shares (or php 29.76 billion @1.6 per share-my estimates) and DGTL’s intercompany cash advances of 34.1 billion.

If we add both the intercompany cash advance with the estimated convertible bond equivalent, then the net value of the transaction would tally to php 63.86 billion. Thus, the variance between the broadcasted prices of the deal at php 69.2 billion and the above (cash advances plus bond convertible) or php 5.34 billion could have represented as goodwill money.

Digitel’s current outstanding shares is at 6,356,976,310 (PSE data) while the 51.5% stake involved in the PLDT buyout transaction is declared at 3,277,135,882 shares.

Simply dividing the net declared amount of php 69.2 billion with the outstanding or with the 51.5% stake or even including the 18.6 billion shares (from zero bond convertible) would result to prices far above the current share value. This is not to imply of an undervaluation, but of the black area arising from the incompleteness of the divulged or disclosed information.

The more important issue for me is that the Gokongwei group has been eyeing a significant stake in PLDT since October of 2002. The botched attempt in 2002 had been predicated on conflict of interest issues from the former’s ownership of Digitel[3].

Apparently this time around, the conflict of interest issue has been circumvented or resolved by using DGTL as the key vehicle for Gokongwei’s long wish to gain a foothold at PLDT.

I am partly puzzled by the seeming obsession of Taipan Gokongwei to secure a stake on PLDT despite some makeover in PLDT’s business model from the 2002 and today.

PLDT has branched out to the energy industry through a substantial claim on Meralco’s equity[4].

Meralco, as we have earlier written[5], epitomizes the Philippine brand of state capitalism. Meralco’s legalized monopoly translates to economic rents for the economic clients of the high echelon political patrons. Remember, Meralco’s pricing system is controlled by the Energy Regulatory Board (ERB) an agency which is directly under the Office of the President. In short, the President of the Philippines decides on how much these private sector owners of the energy monopoly franchise earns[6].

Though of course, Gokongwei’s passion for PLDT could also be due to the latter’s stranglehold of having the significant majority in the market share of the mobile business in the Philippine telecom industry.

Figure 5: nadventures.com[7] mobile market share

My naughty (outside the box) mind whispers to me that this buyout, which has its roots since 2002, could also have been incented from either flows of political money trying to find a legitimate front or that such acquisition could have operated from more from political incentives than from an economic one.

Nevertheless, my suspicions are just that...suspicions until evidence can back these up.

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[1] See Are Stock Market Prices Driven By Earnings or Inflation? January 25, 2009

[2] Digitel Telecommunications, JG Summit To Acquire Stake In PLDT In All-Share Transaction, Philippine Stock Exchange, March 29, 2011

[3] CNN.com Gokongwei still eyeing PLDT stake, October 3, 2002

[4] Philstar.com PLDT buys 20% Lopez stake in Meralco, March 14, 2009

[5] See Bubble Thoughts Over Meralco’s Bubble August 2, 2009

[6] See Has Meralco’s Takeover Been A Good Sign?, March 22, 2009

[7] Zita, Ken Philippine Telecom Brief (Network Dynamics Associates) nadventures.com

Philippine Telecom Industry: Buyouts And Mergers Don’t Kill Competition, Laws Do

“The consumers suffer when the laws of the country prevent the most efficient entrepreneurs from expanding the sphere of their activities. What made some enterprises develop into big business was precisely their success in filling best the demand of the masses.”-Ludwig von Mises

One thing we can be sure of is that the PLDT buyout of Digitel will reduce the mobile network providers to two major players (Figure 5).

This comes to fore the next important issue: Some politicians have been pondering on expanding political power to avoid “killing a strong competitor”[1] by impliedly calling for the institution of anti-trust laws.

This represents sheer hooey.

Figure 6: ITU/DOTC: Regulatory Framework On Philippine Telecoms

The path towards the monopolistic character of our telecom industry is a product of our existing laws[2]. (see figure 6)

One, there is a constitutional limitation on foreign ownership in public utilities to 40%.

Two, licenses per se are not issued to telecom service operators in the Philippines unlike many countries. Instead, operators are required of a legislative franchise (issued by Congress).

Three, another requirement is the certificate of Public Convenience and Necessity issued by the National Telecommunication Commission (NTC), and

Lastly, approval to provide telecom service via grant authority for operation also from the NTC, which usually covers a provisional period of 5 years.

The above is a manifestation of the huge structural obstacle imposed against companies wishing to enter and compete with present participants in the telecom industry.

Such regulatory labyrinth represents as the anti-competitive anti-business nature of the Philippine business climate that enables such monopolistic character to take place because it substantially raises the barriers to entry, increases the hurdle rate for investors just to comply with these web of statutes and whose success to secure license-to-operate would depend on the whims of venal politicians.

Imagine, any business entity wishing to enter and compete with the entrenched bigwigs would need huge sums of lobby money to get a franchise, and to outbid the existing companies protected by these laws, who would likewise spend enormous amounts of lobby money to oppose their entry!

And that’s not all. There are other administrative regulatory compliance costs such as the NTC requirements et. al. with which prospective new players need to deal with.

So in effect, alot of productive capital will go down the drain just to acquire licenses, pay regulatory fees, and also to oppose entry of competition! And alot of those wasted money would only go to the pockets of these grandstanding politicians and the bureaucrats. And this doesn’t even count on the productive time lost to secure licenses and to comply with such regulations.

The point is: Buyouts and mergers don’t kill competition, (anti-competition) laws do.

These politicians are barking at the wrong tree!

Yet by adding more layers of legal impediments to an environment already stultified by barriers of anti-competitive laws will only punish consumers and reward politically connected persons (Could this also be the reason why Gokongwei is very much interested with PLDT?)

What these politicians should instead do to enhance competition is to dismantle the constitutional restrictions on foreign ownership of the domestic telecom industry, liberalize investments by revoking the need for Congressional franchise, and to streamline administrative regulations. I might add that income and capital gains taxes should likewise be substantially reduced, if not abolished.

Surely, in a blink of an eye competition will flourish.

Also, for politicians to claim that they can politically impose competition is nothing but sheer absurdity.

Using monopolistic coercion to induce competition only translates to institutionalizing crony capitalism and corruption.

Investors operate on the discipline and incentives of profit and loss. An unviable project will not be undertaken by free market agents. Coercing institutions to “compete” would only translate to endowments of political privileges to ensure the viability of favoured political economic agents.

Thus, crony capitalists have little intention to please the consumers but would work steadfastly to satisfy the desires of their political masters whom they owe their economic rent privileges.

Nevertheless competition is not about the number of companies.

Competition, according to Murray Rothbard[3], is a process, whereby individuals and firms supply goods on the market without using force. To preserve "competition" does not mean to dictate arbitrarily that a certain number of firms of a certain size have to exist in an industry or area; it means to see to it that men are free to compete (or not) unrestrained by the use of force.

In short, even if there are only two players in the industry, for as long as they are free to compete without political restraints then marketplace competition will prevail. All politicians have to do is to lay their hands-off these firms.

But with the huge profits the industry has been raking (even if they have recently been declining[4]), the temptation for politicians to dip into them seems so irresistible. That’s one of the reasons why politicos have been looking at various ways to intervene and call for more regulation of the industry; remember proposals by politicos to impose free texting[5]? Or how about recent clamor to have prepaid cards registered[6] in the name of security?

For politicians, profits signify signs of evil or misconduct. Only they deserve to profit by pocketing on more revenues (legit or otherwise) by forcibly extracting or extorting from productive agents. And it is one reason why publicly listed companies would be incentivize to dampen income or profit reporting by padding on expenses (or spend on lobbies)—to keep away from the prying eyes of the envious the political class. Achieving inefficiencies translate to lost productivity which means reduced capital accumulation or wealth and more unemployment and poverty.

Like in most cases, politicians and their apologists always put up a strawman, embellished by noble intentions, to justify their interventionist desires. Yet like in most instances unintended consequences defeats such noble intentions.

We should be vigilant against these forces who always work to curb our freedom.

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[1] Inquirer.net Solons fear monopoly to rise from PLDT purchase of Digitel, March 31, 2011

[2] International Telecommunication Union (ITU) Pinoy Internet: Philippine Case Study, March 2002

[3] Rothbard, Murray N. Abolish Antitrust Laws, Mises.org

[4] Inquirer.net PH telecom companies facing tough challenges, February 26, 2011

[5] See Why Forcible “Free Texting” Will Only Lead To Increased Poverty, June 1, 2008

[6] Abs-cbnnews.com NTC powerless vs SMS rumourmongers, March 15, 2011

A Nation Of Takers Is A Path Towards Poverty

Wall Street Journal’s Stephen Moore in an Op-Ed suggests that the US is becoming more of a nation of takers than a nation of makers or producers.

Mr. Moore writes (bold emphasis mine)

If you want to understand better why so many states—from New York to Wisconsin to California—are teetering on the brink of bankruptcy, consider this depressing statistic: Today in America there are nearly twice as many people working for the government (22.5 million) than in all of manufacturing (11.5 million). This is an almost exact reversal of the situation in 1960, when there were 15 million workers in manufacturing and 8.7 million collecting a paycheck from the government.

It gets worse. More Americans work for the government than work in construction, farming, fishing, forestry, manufacturing, mining and utilities combined. We have moved decisively from a nation of makers to a nation of takers. Nearly half of the $2.2 trillion cost of state and local governments is the $1 trillion-a-year tab for pay and benefits of state and local employees. Is it any wonder that so many states and cities cannot pay their bills?

Every state in America today except for two—Indiana and Wisconsin—has more government workers on the payroll than people manufacturing industrial goods. Consider California, which has the highest budget deficit in the history of the states. The not-so Golden State now has an incredible 2.4 million government employees—twice as many as people at work in manufacturing. New Jersey has just under two-and-a-half as many government employees as manufacturers. Florida's ratio is more than 3 to 1. So is New York's.

Policy induced bubble cycles, bailouts, subsidies, welfarism, government fostered cartels (banking, military complex, green energy) and the palpable redistribution of power from the markets to the political sphere signifies as a mission creep towards a more socialized society in the US.

For the many statists who sees every imbalances as the fault of China, this clearly is an internally induced economic distortion. In short, the Chinese have little to do with the mistakes of American policymaking.

Chart from Heritage Foundation

And over the years, US politicians have used each crisis as an opportunity to expand government intervention in the name of security. Remember this quote popularized by Rahm Emanuel, "You never let a serious crisis go to waste. And what I mean by that it's an opportunity to do things you think could not do before."

The obvious outcome from the continued pursuit of such policies is likely a transition towards the Philippinization or emerging marketization or simply a material reduction of America’s living standards.

That’s because the welfare state represents an unsustainable model of governance—picking on someone’s pocket is a zero sum game that rewards non-productive agents at the expense of productive agents. Thus the welfare state breeds and nurtures political parasitism.

Ludwig Erhard, Vice-Chancellor and Minister for Economic Affairs of the German, who presided over the post war West German recovery known as the ‘German Miracle’ (Wirtschaftswunder) has this to say of the welfare state (Mises.org) [bold emphasis mine]

In recent times I have frequently been alarmed by the powerful call for collective security in the social sphere. Where shall we get to and how are we to maintain progress if we increasingly adopt a way of life in which no one wants any longer to assume responsibility for himself and everyone seeks security in collectivism? I have drastically described this flight from responsibility when I said that if this mania increases we shall slide into a social order under which everyone has one hand in the pocket of another. The principle would then be this: I provide for someone else and someone else provides for me.

The blindness and the intellectual inertia that are pushing us toward a welfare state can only bring disaster. This, more than any other tendency, will serve slowly but surely to kill the real human virtues — joy in assuming responsibility, love for one's fellow being, an urge to prove oneself, and a readiness to provide for oneself — and in the end there will probably ensue not a classless but a soulless mechanical society.

This process is particularly incomprehensible because, with the spread of prosperity and the growth of economic security, our economic basis becomes increasingly solid; the need to safeguard the achievements from all future dangers overshadows all other considerations. Here there exists a truly tragic mistake, for one meets with an apparent refusal to recognize that economic progress and prosperity based on effort cannot be combined with a system of collective security.

This call for security, which naturally must permit more state intervention, shows up the contradictions contained in this dishonest policy. If the words of these demands are reduced to a simple formula then what is being demanded is no more and no less than a lowering of taxation simultaneously with a greater demand on the public purse.

Politicians can fool MOST people for MOST of the time, but politicians CANNOT fool ALL the people ALL of the time. That’s because the laws of economics ensures that such deception or dishonest policies will be exposed for what they truly are.

Imbalances from unsustainable policies eventually implodes--the MENA political crisis should serve as a concrete example.

At the end of the day, redistributive policies camouflaged by noble intentions delivers the opposite outcome. A nation of takers will eventually drudgingly scuttle under the weight of debt, fiscal deficits and or inflationism.

Saudi Arabia’s Unsustainable Welfare State

The Wall Street blog reports, (bold highlights mine)

Another reason to brace for higher oil prices in coming years: big oil exporters are increasingly dependent on the income.

Saudi Arabia, due to higher government spending this year, will need its oil to sell for $88 a barrel in 2011 for its government to break even–up from $68 last year, according to a new estimate from the Institute of International Finance, a global bankers’ trade group.

The kingdom, in response to the unrest spreading throughout the Middle East and North Africa, is boosting government spending to provide new social benefits for its people. The support for housing units, unemployment benefits and wage hikes for public workers (among a long list of measures) will contribute to a 31% increase in government spending in 2011 from a year earlier.

Aside from the prospects of reducing oil supply to allegedly generate more income (i.e. by manipulating markets), this exemplifies how the welfare state, which works for the benefit of a few, will NOT last.

Like substance abuse, bribing the citizenry would only grow overtime (from demographics and from the feedback loop of the deepening of the dependency culture--which translates to more demand for welfarism).

Importantly, this also shows how the welfare state contributes to inflation and to high oil prices, aside from showing more proof that the global oil markets are vastly manipulated and distorted from the ratchet effect (irreversible expansion) of government interventions.

Lastly like a house of cards, once oil prices collapse, Saudi’s political leadership will most likely suffer from a political backlash which may end their grip on power.

At the end of the day, Saudi’s welfare state could only buy the political leaders some time before the day of reckoning arrives. What is unsustainable won’t last.

Correlation Isn't Causation: Food Prices and Global Riots

The IMF says that the string of antigovernment protests worldwide are all about rising food prices.

The Wall Street Journal blog writes, (bold emphasis original)

100%: The increase in antigovernment protests associated with a 10% rise in global food prices

Despotic leaders, entrenched inequality and new forms of communication have all played their roles in the political turmoil now shaking the Middle East. But new research by economists at the International Monetary Fund points to another potential contributor: global food prices.

Looking at food prices and instances of political unrest from 1970 through 2007, the economists — Rabah Arezki and Markus Brueckner — find a significant relationship between the two in low-income countries, a group that includes Tunisia, Egypt, Sudan and Yemen. To be exact, a 10% increase in international food prices corresponds to an added 0.5 antigovernment protests over the following year in the low-income world — a twofold increase from the annual average.

Rising food prices represent a symptom and NOT the cause of these riots.

People aren’t too dumb to protest on food prices alone, they attribute events to politics (e.g. inequality and etc...) to markets (e.g. speculation, hoarding, et.al.) to economy (e.g. emerging market growth) or to other exogenous causes (climate change etc...).

While all of the above have some grain of truths in them, they aren’t reflective of the entire picture or the bigger force driving these.

In other words, rising food prices serves as the trigger to the unrest from long built in domestic imbalances.

But here is the bigger picture...

US Adjusted Monetary Base has been exploding!

Chart from St Louis Federal Reserve

US Federal Reserve balance sheet has also been ballooning!

Federal Reserve of Cleveland

Bank holdings of US government securities have also been exploding. US Banks have been speculating more than lending. (chart from St. Louis Federal Reserve)

Stock Market leverage has also been ramping up (chart from Pragmatic Capitalism)

Unless money printing has no impact at all, then all these won’t matter. But obviously, money isn’t neutral, and all these money printing have been absorbed somewhere in the financial markets or the real economy.

Surprisingly, the Bank of Japan (BoJ) recognizes this government induced phenomenon. They write,

Globally accommodative monetary conditions have become unprecedented. The relative size of global money stock (M1) measured against the real GDP has surpassed its historical trend (Chart 14). This sustained global excess liquidity not only increases physical demand for commodities thereby affecting fundamentals, but also amplifies speculative factors, both of which are contributing to the sharp rise in global commodity prices.

Incidentally they have been big practitioners of inflationism too. This seems to be a case "where right hand doesn't know what the left hand is doing".

And this only proves how the mainstream economic perspective has been utterly wrong.

In other words, monetary policies by the US, as the de facto foreign currency reserve of the world, have been filtering throughout the global financial system and to the global real economy.

And surging food prices has been aggravated by the shared central bank practice of inflationism and artificially suppressed interest rates by OTHER nations, most especially by the OECD economies.

And in terms of supply side, another key factor behind surging food prices has been due to the restricted international trade of agriculture. Agriculture has been the least globalized among other sectors.

In short, protectionism from the political toxin called “self-sufficiency” has been responsible for the aggregate imbalances of food economics globally.

Chart from Guinness Atkinson

Of course, it is equally nonsense to attribute rising inflation to China as attributed by some observers.

China isn’t the world’s foreign currency reserve. While China is an important driver in the global consumption equation, (in as much as the supply side) China hasn’t been inflating as much as the developed economies. In short, China has only served as an aggravating factor to the main dynamics behind the world’s food price triggered riots. I might add that China has also been plagued by her domestic bubble policies.

Only the politically (and or mathematical formalism) blinded people can’t see anything wrong done by the state. Their knee jerk response is to lay the blame on the doorsteps of either the marketplace or to other nations, for what actually is truly a failure in domestic policies.

To quote Forrest Gump: Stupid is as stupid does.

The Political Folly of Energy Independence

Cato’s Economist Steve Hanke on the popular political drivel called “energy independence” (bold emphasis mine)

Every president since Richard Nixon has asserted that we are sitting ducks for those who brandish the oil weapon. To keep the evildoers at bay, the government must adopt policies that ensure our energy independence. Like his predecessors, President Obama is worshiping at this altar. And why not? How many elections have been lost by blaming foreigners for an impending crisis?

Despite their cynicism about politicians, most people actually believe that mineral resources, including oil, are doomed to disappear. It’s obvious: Start with a given stock of provisions in the cupboard, subtract consumption and eventually the cupboard will be bare.

But what is obvious is often wrong. We never run out of minerals. At some point it just costs too much to produce them profitably. In the 19th century, the big energy scare was in Europe. Most thought Europe was running out of coal. That doomsday scenario never materialized. Thanks to a plethora of substitutes, the prices that European coal could fetch today are far below its development and extraction costs. Consequently, Europe sits on top of billions of tons of worthless coal.

Once economics enters the picture, the notion of fixed reserves becomes meaningless. Reserves are not fixed. Proven oil reserves, for example, represent a warehouse inventory of the expected cumulative profitable output, not a fixed stock of oil thought to be in the ground.

When thinking about oil reserves, we must also acknowledge another economic reality: Oil is sold in a world market in which every barrel, regardless of its source, competes with every other barrel. Think globally, not locally. When we do, the dwindling reserves dogma becomes nonsense. In 1971, the world’s proven oil reserves were 612 billion barrels. Since then the world has produced approximately 990 billion barrels. We should have run out of reserves fourteen years ago, but we didn’t. In fact, today’s proven reserves are 1,354 billion barrels, or 742 billion barrels more than in 1971.

How could this be? Thanks to improved exploration and development techniques, costs have declined, investments have been made and reserves have been created. The sky is not falling.

Oil is just another economic good whose value is determined by the utility it provides. Thus like all economic goods, oil and energy products are subject to price sensitivity borne out of the forces of demand and supply and technological changes.

In other words, in contrast to naive views of neo-Malthusians, the economic value of oil is never fixed.

Proof of this has been man’s shifting use of energy from firewood to coal to whale oil to kerosene and now to the manifold derivative products of crude oil—gasoline, diesel, jet fuel and etc... That’s why while Peak oil is an engineering reality, Peak oil, as an economic concept, is a myth. Engineering does NOT capture human action.

Despite the recent rise in commodity prices, the real cost prices have been declining over the past 161 years!

Yet the recent price surges have partly been about consumptive demand (mostly imputed to emerging markets) but substantially also due to reservation demand (mostly identified as speculation).

The above graph reveals of the consumptive versus reservation demand from Bank of Japan.

The point is current imbalances of energy has been mainly caused by government interventions from artificial demand (quantitative easing programs, suppressed interest rates) to distortions on the supply side (geographical restrictions, price controls, subsidies, taxes and tariffs and etc).

Thus rising prices isn’t about energy dependency, peak oil and other interventionists babble, but about government failure.

The truth is that there is a cornucopia of commodities in the world as shown by the table from Brookenews. All it takes is for the market to discover and enable them to be commercially useful through price signals.

Yet neo-Malthusians interventionists believe in the fallacy where two wrongs equals a right. They address government intervention failure with even more government intervention, seeing that government is the be-all and end-all of human affairs.

Such political religion can be seen in the widespread celebration of the crass symbolism of the earth hour movement, whose anachronistic proposition is to regress human living standards back to medieval ages. It is more than a practise of atavism, it is an implied belief in misanthrope.

Of course people who fall for the energy independence idiocy simply disdain free trade. Such political blindspots are mainly rooted in the aversion to imports which is read as a mortal sin.

Yet what they preach is hardly what they practise. They don’t ever realize that by restricting the division of labor and comparative advantage, man regresses.

Say you hate fossil fuel? Then just walk or bike. Oh, since bike is also made out of fossil fuel, so just get a horse. But like the asinine shift to candlelight in order to project social conformity to earth hour, primitive means of transportation equates to more environmental hazards.

An example expressed by Gerard Jackson of Brookesnews,

The problem of coal smoke continued into the twentieth century when it was finally solved by the benefits of growth, which had already solved a multitude of other problems such as the tens of thousands of metric tonnes of horse manure that had to be taken from city streets each day (a horse produces about 20 kilos of dung per day), not to mention the 300 grams of liquid a horse releases per mile plus the thousands of dead horses that had to be disposed off each year.

The lengthening time of transport reduces man's productivity and increases the cost of doing things.

Also increasing the use of non-commercial energy via subsidies represent as redistribution of wealth from the consumers (through higher prices or through higher taxes), as well as the transfer of wealth from traditional market appointed suppliers, to the politically endowed industries.

Moreover higher prices and taxes reduces people's purchasing power.

So how does one "prosper" with such backwardness?

As you can see noble ‘romanticized’ intentions by socialists are frequently defeated by reality.

The energy dilemma should be resolved by espousing more trade freedom. Let the markets decide on which energy is more efficient, which energy meets the public’s demand for utility and which energy is the safest (one of the reason perhaps why nuclear energy flourished).

chart from Professor Mark Perry

Intervening politicians only distorts the marketplace and shifts the balance of trade towards political favourites, such as Japan’s nuclear ‘crony’ industry.

The fact is the political economic concept known as autarky, which is the root of the political call for energy independence, translates to the promotion of poverty. This also represents a form of neo-Luddism.

Should The Philippines Wage War With China Over The Executions Of The Drug Mules?

“It is just that the Philippines is less powerful than China in warfare” remarked a neighbor in the allusion that the Philippines is powerless to impose her will over its larger and far powerful Asian contemporary following yesterday’s execution of the 3 drug mules.

Stunned by this comment I retorted, “Do you honestly believe that the Philippines should go to war with China for them?”

Such unwarranted emotional interpretation of events appears to be the offshoot of the quality of reasoning peddled by mainstream media which the vulnerable public could have misinterpreted.

From the Inquirer.net

Three Filipinos convicted of drug smuggling were executed in China Wednesday, triggering condemnation in the Catholic Philippines and despair for family members who shared their final moments...

The executions came after repeated pleas by the Philippine government for their sentences to be commuted were turned down, and ended vigils in the country where supporters of the trio had prayed for a miracle.

There are many issues encompassing this case which makes it complex.

One it is the issue of drug trafficking.

Two it is the issue of death penalty.

The populist sentiment seems mostly aligned with the position taken by the influential Catholic church which hasn’t been about the legitimacy of DOMESTIC death penalty laws but death penalty as a moral principle.

From the same article,

Amnesty International as well as the influential Roman Catholic church swiftly condemned the executions.

"We strongly condemn the executions of the three Filipinos," Agence France-Presse quoted Amnesty's Philippine representative Aurora Parong.

"The Philippines should have taken a stronger action, and it is now its moral duty to lead a campaign against death penalty in Asia."

Amnesty International says China is the world's biggest executioner, with thousands of convicts killed every year. The Philippines has abolished the death penalty.

I wholeheartedly agree that death penalty should be abolished. But this is largely a non-sequitur. As you can see from the above article, the Philippines had been suggested to take “stronger action”? But how?

The populist perspective fundamentally ignores the fact that this issue is PRIMARILY about China’s DOMESTIC policies and NOT of ours.

It is the issue of FOREIGN POLITICAL relations.

If the US hasn’t been able to successfully compel China to alter her exchange rate policies (to resolve so called global imbalances) or on other contentious geopolitical issues as the UN environment saving program called the Kyoto Protocol, how the heck can we expect that the Philippines implement “stronger action” on China to save the felons-turned-victims?

As an aside, I don’t have the full knowledge of the circumstances behind this case for me to pass any judgments. I can only deduce from what I read or hear. So I am neutral on this.

So aside from geopolitical relations, the other very important issue is the FALSE impression that the Philippine political leadership can do something at all. This is an example of the religion of politics-the errant belief that government CAN and HAS to do SOMETHING.

Where the local political leadership can hardly control or manage domestic political issues, like the Congressional impeachment of the Ombudsman Merceditas Gutierrez or for many other matters, how can we expect the Philippine government to WANGLE her interests over China? Wage war as my neighbor implied?

The fact is that territorial borders IMPOSE a limit on the sphere of political power influence of the Philippine government.

This also means that the political priorities of the Chinese government will determine the fate of the Filipino drug mules and NOT the Philippine government (as had been the case).

The most we can do is to perhaps appeal—which is what the government did! But this serves no more than as photo OP and as advertisement mileage for politicians.

But in the realization that the Chinese government has been the largest practitioner of the death penalty, mostly applied to their own citizens, Filipinos shouldn’t expect much even from the government’s appeal.

As the Economist reported (bold emphasis added)

CHINA executes more of its own citizens than any other country, and more than all others in the world combined. “Thousands” of Chinese were executed in 2009 according to Amnesty International's annual study, which states that an exact number is impossible to determine because information on the death penalty is regarded as a state secret. But this gruesome record may yet change. The National People's Congress is reported to be reducing the number of offences that are punishable by execution. Among the crimes that currently carry the death penalty are bribing an official and stealing historical relics

Fatalities from China’s death penalty have even been far larger than the composite deaths of the whole world!!!

I’d like to add that there are reportedly some 125 cases of Filipinos scheduled to be executed elsewhere in the world where 85 are allegedly drug related cases, so why pick on China?

I am not a defender of the incumbent administration. But the essential point over this controversy is that the mainstream and the gullible public don’t seem to realize that this is a foreign policy issue, subject to the whims of China’s political leadership regarding the implementation of local rules on our supposedly erring immigrants or OFWs. This is also the issue of China's political and legal system.

This isn’t an issue of nationalist schism.

Importantly, this unfortunate event exposes on the grand delusion that the government CAN do something WHEN they can’t.

Filipinos abroad should realize that they are subject to political risk environment of their host countries that are vastly different than here, and must learn to safeguard their interest than rely on the government.

All the drivel from politicians about more spending to augment legal services for OFWs represent as mere ‘feel-good-vote-buying’ postures. Remember we don’t share the same legal process, institutions or framework with China, thus any assumption for more legal spending would likely only translate to waste.

Finally, when I asked the above question to the media indoctrinated youth, he simply turned around and walked away.

UPDATE: (I forgot to include this)

What happens if the Philippine government does successfully negotiate the mitigation of the sentences of the accused? Would this not serve as moral hazard that could encourage more drug related trades?

It is bad enough for us to expect our government to patently interfere with many aspects of our lives. But it is even worst to believe that our government has to intervene into the lives of people who lives beyond our borders.