Regulation, Gravity and The “Isms”: The Education of a President

obamaEconomic regulation and its counter-effect on economic growth — a rising background issue until now — has just vaulted to the front pages with President Obama’s recent speaking tour, signaling a redirection of policies and mischief ahead.

The concern about regulation today, as always, is that it is leads to a hardening of the economic arteries that restricts entrepreneurship and negates the income and jobs that follow.

In limited circumstances, well-structured regulation can be worth the economic cost by yielding benefits most found in the areas of health, safety and the environment, as China can attest.

But most economic regulation is mindless and costly — not just in terms of opportunity cost, but also government administrative costs and the reporting and compliance costs that come with operating under a regulatory regime.  All of that reduces real economic activity and real income, so regulation is effectively an out-of-the-limelight, macroeconomic issue.

When the Fed complains endlessly about “headwinds” to economic growth, it implicitly recognizes regulation as a ghost factor that neutralizes its own monetary policy. This leads to the economy repeatedly falling short of the Fed’s expectations and yet more accommodative policy, as occurred this week.

When R.A. Posner studied the common causes of regulation in 1974 (another regulatory era), he observed that regulatory intervention is a tempting option for those in government who don’t believe that market prices and allocation mechanisms create desired social or economic outcomes.

Posner also indicated that income inequality is a further cause for governments to turn to regulation.

Hence, there is nothing like a Great Depression or Great Recession with depressed income and wider inequality to become a regulatory breeding ground that indeed deepens the macroeconomic quagmire.

Slowing economic growth comes about when regulatory barriers and costs makes production less viable, at least in the U.S.

As former Intel CEO Paul Otellini explains it, even the job- and income-generating computer chip industry is moving away, not just for production but also for R&D.

The decision to relocate or stop production altogether occurs when the rules of regulatory fiat restrict investor incentives to deploy capital and enterprise to activities in which prices and profits are rising, and divert them away from activities in which the reverse is true.

This is the heart of the system in which prices direct the commitment of resources, a policy that used to be known as laissez faire — a case for the passivity of central direction.

According to Wikipedia, “laissez faire stems from a meeting in about 1680 between the powerful French finance minister Jean-Baptiste Colbert and a group of French businessmen led by a certain M. Le Gendre. When the eager mercantilist minister asked how the French state could be of service to the merchants and help promote their commerce, Le Gendre replied simply “Laissez-nous faire” (“Leave us be”, lit. “Let us do”).”

But regulation becomes a costly visible hand of government that overrides the “Invisible Hand” in which Adam Smith also saw the market providing for wants as a superior guidance for outcomes.

As indicated above, the most fertile time to give rise to perceived needs for regulatory corrections to market outcomes would presumably be the shock of a Great Depression. Due to that and the exigencies of World War II, the command economy emerged out of Washington DC and bureaucrats, as they came to be known, overrode economic decision making.

And of course, it creates scarcity that markets do not rectify.

My views on the subject were formed early on. As a teenager I accompanied my father to Washington, where he testified at a hearing conducted by the now-defunct Interstate Commerce Commission having to do with the difficulties of obtaining trucking capacity, which was obstructed by a command-and-control agency for a myriad of perceived purposes — take your pick.  For me, it was an introduction to government and a lasting impression of regulation. (I was impressed with the stately Hearing Room!)

By the 1970s, following decades of regulatory dead-weight loss, the wisdom of Washington’s visible hand was questioned by yes, a Democrat, Jimmy Carter, who lead the way to deregulation industry by industry and agency by agency, followed up in the 1980s by Ronald Reagan and Maggie Thatcher in the U.K. The repulsion of mindless regulation then appeared to be a bipartisan conclusion.

By 2007, celebrating 25 years of economic deregulation, Robert Crandall of the Brookings Institution calculated that the 25-year deregulation movement dating from Carter’s time had liberated the regulatory controlled economy and reduced prices by 30 percent in the industries it directly affected.  Hence, deregulation represented a substantial gain in real income per person.

But alas, the celebration of the deregulatory gains in America was premature.

At the very time when Crandall was tallying the gains from deregulation, we were on cusp of a great financial/economic shock and a spreading war on terrorism that had the same one-two punch to send Washington back down the regulatory road as it did in the 1930s and 1940s.

In today’s environment, the regulatory and tax tone is simply anti-business, not just preventing new firms from getting off the ground, but also causing large companies to redirect activities to those countries where business is most welcomed.

To add to the compulsion for regulation in this Great Recession, the U.S. government is in a financial bind.  Without the ability to legislatively change broad-based tax rates or benefits, it does so in a de facto way by putting its citizens through a greater burden of proof for tax deductions and eligibility to receive benefits as an indirect means of deficit control.

Art Laffer, a classmate who went on to be a champion of supply side economics, has studied the regulatory and compliance costs imposed from U.S. taxation. He deems these amounts to be 30% of total income taxes collected, increasing with tax complexity. That’s the situation we’re in now that the fiscal bind is ramping up.

Which brings us to Obamacare.  Not only is there regulatory complexity and reporting to produce and receive benefits, but moreover the loss in aggregate efficiency in U.S. production could grow even larger. For example, John Mauldin reports that many businesses are reorganizing their work forces to deflect the Obamacare tax by working with subcontractors that employ no more than 50 workers each who work fewer than 30 hours per week.

But how do you document lost production from the loss of the cohesiveness of a work force? It would be like fielding an NBA basketball team with a group of underpaid rented part-timers on the way to their next hiatus. (Incidentally, to appreciate the role of player connectivity and continuity in professional basketball, take a look at Phil Jackson’s new book, “Eleven Rings”).

Also in this post Great Recession re-regulatory environment, let me not fail to mention the costs of financial regulation.  There are crippling reporting and compliance costs involved, so multiple government agencies can judge the appropriateness of a loan for both borrower and lender in banking.  As a result we are not using our financial resources provided by the Fed.

As the graph indicates, we are in an unprecedented situation in which trillions of dollars of excess commercial bank cash reserves are sitting on deposit at the Fed rather than being loaned out.  While indeed there are other causes as well for the unloaned cash accumulation in commercial banks, financial regulation is under-rewarded for praise.

To attempt to document the growth of regulation, some have taken to counting the numbers of new regulations that have been codified which is more than alarming, but only implies economic loss without measuring it. Others count the number of regulatory and compliance lawyers and accountants.

But the Weidenbaum Center at Washington University in St. Louis and the Regulatory Studies Center at George Washington University in Washington, D.C., have put the regulatory compliance and administration cost in dollar terms. They jointly estimate it to be 11.6% of GDP as of 2011, and no doubt rising with complexity.

But how to put a cost on the whole ball of wax of regulation so as to clearly see the implications for lost growth?  After all, it’s not possible to generate statistics on what didn’t happen.  That is, it is effectively impossible to measure the opportunity cost of investments not undertaken, nor plants not built, nor inventions and potential jobs that fell by the wayside, except indirectly by the lost output capability of the U.S. economy.

On that there is one rough measure of the decline in the pre-Great Recession projections of the U.S. Potential GDP. The estimate of the frontier of possible output has shrunk and the supply side of GDP is projected to be growing at a slower rate than previously projected.  This is a very rough measure of the shrinkage of the supply capability of the economy.

Other evidence of malaise reported by Lacy Hunt includes the fact that real median household income today is back to its 1995 level. Something is clearly amiss, and it’s not from a lack of mega-demand-side fiscal and monetary policy.

In a rare reflective moment regarding jobs not created and middle-income not produced, President Obama this past week conducted a series of hinterland college speeches in which he indicated that jobs and middle-class opportunity were missing from the American landscape and that we are suffering “unfairness” in income distribution. The opportunities are not there any longer for the middle class, he proclaimed.

Well how do you achieve fairness in income distribution except to redistribute from the top down?  Rather than uttering income redistribution and being declared a socialist, he prefers “fairness” making himself a modern day populist in today’s discussion of the “isms.”

To be sure, there is a link between a lack of business development and middle-income jobs, but it runs from a lack of incentives or ability to navigate past regulations and taxes, obtaining financial resources and being unleashed to produce so that middle class jobs are forthcoming.

But in Obama’s world, the linkages run from middle class income to generate spending for companies to prosper. He explains this phenomenon as “leading with the middle class, an economy that grows from the middle out, not the top down.”

If this were physics, he would have gravity running upside down.

But it is welcome that after nearly 4 and a half years as President he is grappling with how to effectively produce jobs in America. Let’s hope he is a fast learner.

What I find interesting is that for the few one-off exceptions to promote an enterprise in order to keep jobs, the President provides subsidies, special tax breaks and a reduction in the paperwork that needed to be filled out (which to him seems but a minor irritant).  Now the question is, can this selective perception be generalize to all endeavors?

It’s important since we have amply demonstrated that demand side policies have been applied beyond their useful limits, and supply side policy is all that is left. But what it requires is for the control freaks in Washington to let go. They must leave laissez-faire alone.

Since most lawyers who run for office are on a mission to do something to make a difference, laissez faire is not their inclination, and Obama has indicated that he will use executive orders that push the limits of Presidential power.  For that reason, I’m not optimistic, as regulation is an adverse macroeconomic policy and income redistribution (under the guise of income “fairness”) eliminates income differences at lower levels of income for all.

It will probably take another farmer President like Jimmy Carter who toiled under the USDA to appreciate the virtues of laissez faire and allow it to thrive again.

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The Knockout Punch: Has America Turned to Socialism?

In the days following the election there was a numbing silence. It was as if the body politic was dazed by a heavyweight champion’s blow to the head. It staggered and sought clarity to understand what’s to become of our future.  Even the 24/7 financial market / economic blogosphere went silent in contemplation.

What began to emerge from the cobwebs was a trickle of semi-coherent commentary of what was learned in the 1930s. Was it again a New Deal tilt toward socialism? References to past classicists such as Von Mises, Hayek, and H.L. Mencken were everywhere. Ayn Rand’s Atlas Shrugged sold more than 1.5 million copies since the first Obama election — a startling comeback for a 55-year-old work of fiction — and sales are again soaring. It has also spawned a series of film adaptations.

A realization set in that Obama’s victory in 2008 was not a one-off reaction to the George W. Bush presidency. Rather, it validated the notion that the U.S. was now a left-leaning democracy in the European style.

If there were any doubts, as the first order of business by Friday of election week, the president asserted that the election was a referendum revealing that Americans want taxes to increase for the wealthiest citizens but not anyone below the $250,000 income level. In his words, “Nobody — not Republicans, not Democrats — wants taxes to go up for folks making under $250,000,” he proclaimed. The definition of the bad guys has hardened.

While a very good case can be made for all taxpayers to pay more, apparently the imperative to redistribute income was more important than the goal of growing jobs and the economy or containing the fiscal deficits.

The question is whether the goal to redistribute and regulate is a shift in fundamental American values or merely a reflection of the president’s own agenda.

While a morphing of the American willingness to redistribute is a socialistic ideal, it is also possible that the redistribution reaction to events that began to unfold in the early 1980s and could even be nearing its end.

At that time, the globe was bifurcated into the developed world (the U.S., Europe and Japan) and a large number of countries that fell into the category of Less Developed Countries (LDCs). There were extreme differences in wages and income per capita.

With wages differing between the developed nations and the LDCs — in some cases with a ratio of 100 to 1 — producers naturally would gravitate to the ultra-low-wage countries. But there was a catch: Tariffs deterring “cheap” goods from entering the high wage countries needed to be dismantled.

At first, exports to the developed world proceeded in a trickle as producers sought cracks in the tariff structure, but such vast cost differences would lead to creative means of dismantling trade barriers.

The major break in protectionism of goods to high-wage countries came in the form of multi-country treaties to systemically eliminate trade barriers among countries.

NAFTA broke the ice and the post-WWII efforts to lower tariff barriers — the General Agreement on Tariffs and Trade — was replaced by the more effective World Trade Organization (WTO) with membership leading to a phasing out of trade barriers. Even Russia, the latest of more than 150 WTO participating nations, pledged to open trade and the momentum continues with a proposed U.S.-EU free trade agreement making headway.

As trade opened and production and jobs gravitated to the low-cost producers, new terminology was invented. Off-shoring and globalization meant that LDCs were “emerging” and then “developing.” All in all, Ross Perrot was right in his great debate with Al Gore. There would be a “Giant Sucking Sound” of jobs (and income) gravitating to the low-wage countries.

Of course, as the process of globalization unfolded, wages in the formerly ultra-low-wage countries have subsequently risen while those in the U.S. have declined, leading to a convergence of labor costs across countries. We are not at absolute convergence, but enough movement has occurred so that the U.S. is not as relatively expensive a place to produce any longer. While the exportation of jobs is not over, we are beginning to see the end of the tide going out and a trickle of the tide coming in (see: Made in America Again).

This is a process economists call Factor Price Equalization. That is, wages (the price of labor in all countries free to trade) eventually meet in some middle ground given the incentives to shift production to the cheapest source.

How does all of this relate to the election and socialism? The distribution of income in the U.S. got fatter in the two tails: those made poorer by being forced to get in line with the ultra-low-wages competition, and those with capital or skills that could not easily be duplicated abroad, which were made richer. The two tails in the income distribution end up fighting it out through their respective presidential candidates.

But globalism has also significantly eroded the middle class and shaped the election result.

According to an August 2012 Pew Research Center report, “half of American households are middle-income, down from 61 percent in the 1970s. In addition, median middle-class (real) income decreased by 5 percent in the last decade, while (middle class) total wealth dropped 28 percent. According to the Economic Policy Institute, households in the wealthiest 1 percent of the U.S. population now have 288 times the amount of wealth of the average middle-class American family” — making that a less-than-ideal group from which to select a presidential candidate.

The trends of globalization, wage convergence and the declining numbers and income of the middle class have been in process for almost the last 40 years, which is largely attributable to declining wage income. Moreover, wage income as a percent of total income has declined by about 10 percentage points. This was an enormous reduction in the labor’s share of the income pie and accounts for the middle class decline.

However, to compensate for this loss of income over the same period, transfer payments by governments as a share of the income pie has increased by 10 percentage points, as shown in the accompanying graph.

Since there is no free lunch, the transfers known today as entitlements needed to be financed somehow. The two logical options for addressing this issue were to tax and redistribute corporate profits or to redistribute from the president’s targeted group. Given the political stand-off in our body politic, the expeditious means to sooth the labor income shortfall was to borrow on the credit of the U.S. and subsidize via transfers or entitlements. As a result, the Census Bureau reported that 49 percent of American families receive at least one government benefit.

So here we are in 2012, and the ability to continue compensating for the loss of wage income by borrowing and transferring has hit up against funding limits due to baby boomer entitlements coming due. The cookie is crumbling, but the election indicates the middle class still wants its cookie — and the ability to borrow someone else’s cookie and pass it around has reached an un-financeable end. We have three choices: take a cookie from “rich folks” and pass it around, grow the number of cookies, or realize there will be fewer cookies. The redistribution argument won at the ballot box.

Personally, I dont see Obamas reelection as an enthusiastic validation of a socialistic ideal but rather a vote to sustain labors income share but functionally it makes no difference.

As Forbes contributor Bill Frezza summarized it: “America has now hurtled past the dependency tipping point … and an electoral majority happily voted for itself unlimited benefits that will supposedly be paid for by a productive minority — until that productive minority starts eyeing the exits.”

Since blatant redistribution squashes incentives to produce and grow, the incentive to redistribute also grows. Once headed down that slippery slope, it takes dire circumstance, not a threat of dire circumstances, to cause a rethinking and a redirection back to free market capitalism.

China went all the way down the slippery slope.  With economic misery as a result, in the late 1970s Deng Xiaoping asked the question of how to provide more food as its state-owned farms didnt adequately feed the population (despite 82 percent of the population working in agriculture). The reform was to allow state farms to sell and retain the proceeds of its agriculture production in excess of its socialistic quota. Look what incentives did for China. She has never looked back and likely is now more capitalistic than the U.S.

In the election, Obama prevailed despite receiving 10 million fewer votes than he received in 2008. This was no apparent landslide for socialism. But the outcome was also a result of a Republican dialog that failed to demonstrate how making cookies includes a reward for the wage-earning middle class.

Both the message and the messenger were off key, and as a result we could be headed down that same slippery slope that might not be reversed until there are not enough cookies to go around. It could be generations before “reform,” such as in China, prompts us to reconsider entrepreneurs and the fruits of entrepreneurship.  At that time, they would once again be considered heroes rather than villains but that could be far down the road.

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