free lunches and the rule of law

"Nothing is free in this world."  That is one of the quotes I heard growing up on almost a daily basis.  Usually it was from my father, once again reminding me of something that I needed to do.  However, there may be no more of an apt quote to describe wealth creation in our society.  Contracts and business relationships are based on a symbiotic relationship between two parties: each offers something the other desires, and the parties offer to provide something the counter-party desires in return.  At the end of the day, each side is better off as they receive a benefit that they could not provide to themselves, and in order for the transaction to occur that benefit must at least be equal to the value of the payment in the mind of each party.  Hence, these transactions are often wealth generating, as each party is in a position they think that they are better off, and therefore more wealthy, than they were prior to the transaction.

In my opinion the Obama Administration does not recognize the market as a wealth creation mechanism or at the very least underestimates its importance.  Private transactions are the engines of economic growth, and if Obama were truly interested in turning around the job market and reinvigorating the economy he would put into place polices that further increase the incentives to do business such as lowering marginal tax rates, reorganizing and simplifying federal agencies in order to decrease complexity in industry and lower the barriers to entry, and begin addressing long term budgetary issues no so that markets will be reaffirmed in their belief of the long term solvency of the federal government (keeping low the cost of credit).

However, all of these policies have tradeoffs, be it decreased federal revenue, loss of some services or decreased payouts to those receiving entitlement payments (although it is worth to note that most of these savings would be at the expense of future benefits, not those currently on social security and medicare).  Many countries are already taking such measures, and they aren't your traditional list of unfettered capitalists: the United Kingdom, Germany and even partially France.  However, back in the good old U.S. Obama has made federal government spending in the form of jobless benefits, stimulus, and other spending programs the key to his economic development strategy.  According to Obama and the neo-Kenyesians who push this strategy, the U.S. economy's main problem is lack of demand, and that by pouring money into the system in the form of government contacts and welfare, demand will be boosted and the economy will grow.  This is partly the policy justification for the stimulus back in 2009, the continued extensions of jobless benefits and the current push to provide bailouts to that state governments so that they are not forced to make tough political decisions such as whether to fire teachers or raise taxes.  Obama continually dismisses the negative effect this spending has on the budget (which is completely financed through borrowing as the deficit is in the trillions of dollars) claiming that the extra debt is hardly a drop in the bucket compared to our total liabilities.  Therefore Obama is basically selling the position that the spending is all gain and no pain: we will experience growth now and the cost will be little more than interest payments down the road.

This brings me back to the adage, "Nothing in this world is free." Obama's policies seem to run afoul of this rule, and luckily more and more people are beginning to notice it.  Despite the administrations claim that the stimulus has created around 2.5 million jobs, which it has no way of supporting or justifying, there is little sign that it has had an overall positive effect on he economy.  The administration prefers these types of policy choices, whereby they can tout benefits immediately and push any potential liability down the road.  Well by this logic, why do we ever stop stimulating the economy? If wealth can be created simply by government spending, we should have government spend as much money as possible.  It's the elusive free lunch! The truth is that this type of spending dose little to encourage long term investment - the engine of wealth creation - and its adverse effects are simply kicked down the road.  This is endemic in many of Obama's policy choices: the healthcare bill, extension of jobless benefits, and all the other debt financed spending.  You know the day of reckoning for this debt is coming when even Western Europe is getting serious about fiscal restraint. Mr. Obama, there is a reason your European colleagues have rejected you calls for a new round of stimulus: even they no longer buy the hype that you can spend your way to growth.

On a slightly unrelated note, I also wanted to briefly discuss an issue that has become more and more troubling.  Since coming into office President Obama has done more to circumvent the rule of law there perhaps any president since FDR.  First, there was the Chrysler and GM bailouts, where Mr. Obama first "put his boot on the heel"of secured creditors in order to appease his union constituency (I documented it at the time here, here, here, here and here).  The bankruptcy system in this country is the envy of the world, and although it may sound counter-intuitive that is a very good thing.  Banks freely lend to businesses and homeowners because they have a mechanism to have that loan repaid even if the borrower defaults.  Usually this insurance takes the form of a security interest in property, whereby the bank will legally be allowed to take title upon default.  However, the system will only work if security priority rules are objective, straightforward and made prospectively.  Without this type of certainty, the lenders will not have faith in the system, and lending will dry up.  Just ask any entrepreneurs in Africa or Eastern Europe about their access to credit in countries that don't have such rules.  The economic growth of these countries suffers enormously as a result.

The GM and Chrysler bailouts were one example were the rule of law in credit allocation was eroded, and the BP shakedown for a cool $20 billion is another.  First, and let me make clear, it is completely BP's liability to compensate those who were adversely affected by this oil spill.  No one challenges this point.  In order for capitalism to properly function, an negligent or intentionally injured third party must be compensated when another party's actions have caused it economic damage.  This forces companies engaged in risky enterprises to take risk into consideration and price it into any business plan.  Just making BP pay these damages will incentivize other oil companies to either beef up their safety and security measures, purchase more insurance or a combination of both.  This is a good thing and example of the market's ability to absorb new information and price assets accordingly.  However, I absolutely do not agree with the President's choice to force BP to set aside $20 billion for claims to be distributed by a third party.  Although this may have been a smart business decision by BP (showing the public it s serious about its obligations, providing a low overhead way of distributing damages and otherwise forgoing at least part of what will be millions in legal fees by settling with some people quickly), BP's original announcement came after a meeting between its Chairman, Mr. Obama and Attorney General Holder.  I'm sure the threat of criminal investigations didn't come up in that meeting.  No I bet there was no quid pro quo at all.  Why would the Justice Department want to investigate the BP Chairman of the Board at all? How could a swedish director have any type of criminal liability for an explosion that happen in the Middle of the Gulf of Mexico?  The reality is there is no possible way to impose criminal liability on a director for this type of accident, although the threat of such an investigation is one hell of a bargaining tool...


What's more is the fact that Mr. Obama is once again rewriting the rules for creditors in an attempt to put politics ahead of the rule of law.  BP could not possibly come up with $20 billion cash without severely affecting its liquidity and cash flow.  Therefore it is making payment in roughly $1.5 billion quarterly installments.  However, until the total is paid, BP was forced to allow the federal government to put a lien on approximately $20 billion of BP's assets.  This may sound fair, but in reality this is giving the Feds first crack at BP's assets should a bankruptcy occur.  This secured interest is now on par with other secured creditors and I have no doubt that in the event of a bankruptcy the feds would be fully repaid at the expense of older creditors.  Although it may sound innocuous and just for the claims of those who have been damaged by the spill to be given a higher priority than creditors, this is simply not how our system works.  Congress designed the secured credit system as a way to ensure the adequate allocation of credit and it has worked exquisitely over time.  Capital from all over the world flows to the U.S. because of the protections it is provided and the impartiality of the courts that uphold the rules.  By turning the law on its head and giving the damages of tort victims higher priority than creditors, some faith and belief in the system is lost, and the rule of law eroded away.  Although innocuous in the short term, over time this trend will have devastating effects on our financial system.  Creditors will begin to price this uncertainty into the price of credit, making it more expensive.  Politically risky activities will begin to find it harder and harder to find credit at all.  This culture of ignoring the dictates of the rule of law, coupled with our increasing debt will, if let unchecked, eventually destroy credit allocation as we know it in this country.  Don't think the U.S. will be a financial powerhouse for ever, as money is the most fungible of all assets, and the flow in to the U.S. is surely vulnerable if the risk of loss is too high.  To protect against this, we must maintain the rule of law and not succumb to the political allocation of capital and economic rights that is more akin to Iran or Venezuela.