Taming Leviathan

Michael Boskin

27 January 2013


STANFORDA successful society needs effective, affordable government to perform its necessary functions well, and that includes sufficient revenue to fund those functions. But a government that grows too large, centralized, bureaucratic, and expensive substantially impairs the private economy by eroding individual initiative and responsibility; crowding out private investment, consumption, and charity; and damaging incentives with high tax rates. It also risks crowding out necessary government functions such as defense. That is today’s Europe in a nutshell, with America not far behind.

The recent death of James M. Buchanan, the father of public-choice economics, is reason to reflect on his sage warnings. Buchanan was awarded the Nobel Prize in 1986 for bringing to the study of government and the behavior of government officials the same rigorous analysis that economists had long applied to private economic decision-making. Buchanan concluded that politicians’ pursuit of self-interest inevitably leads to poor outcomes.

Buchanan’s analysis stood in marked contrast not only to Adam Smith’s dictum that the pursuit of self-interest leads, as if “by an invisible hand,” to desirable social outcomes, but also to the prevailing approach to policy analysis, which views government as a benevolent planner, implementing textbooksolutions” to market failures.

According to this view, if markets do not fully internalize all of the costs of private actionenvironmental pollution is a classic example – some “optimaltax or subsidy supposedly can correct the problem. So, if a monopoly is restricting output and raising prices, regulate firms and industries.

When weak demand leads to recession, increase government spending and/or cut taxes by just the right amount, determined by a Keynesian multiplier, and – presto! – the economy rebounds quickly.

Buchanan considered such analysis romantic. He showed that public officials, like everyone else, are driven by self-interest and governed by the rules and constraints operating in their economic environment. Households have a budget constraint. Firms have technological, competitive, and bottom-line constraints. For politicians, the ability to exercise power – for their own interests or those of vested interests – is constrained by the need to get elected.

Buchanan predicted that, by hiding the full costs, the ability to finance public spending through deficits would lead to higher spending and lower taxes at the expense of future generations, whose members were not directly represented in current voting. He predicted ever-larger deficits and debt – and ever-larger government as a result.

On this issue, Buchanan was, unfortunately, prescient – and well before financial crisis and deep recession led to yet another jump in the size and scope of government, accompanied by large deficits and exploding debt in the United States, Europe, and Japan. Buchanan argued tirelessly for lower government spending, balanced budgets (even a balanced-budget amendment to the US Constitution), and streamlined regulation.

Buchanan, along with Milton Friedman and many others, correctly pointed out that government failures are as numerous as market failures. So, even in areas like infrastructure or education, it is necessary to compare the benefits and costs of the imperfect fiscal and regulatory policies likely to be implemented by fallible, self-interested officials with potentially imperfect market outcomes.

These government failures include rent-seeking, pork-barrel spending, social engineering, regulatory capture, and induced dependency. Market failures or claims of unmet need are not sufficient to prescribe government intervention in the private economy, because the cure may be worse than the disease.

There are, of course, important, successful government programs. In America, the post-World War II G.I. Bill financed higher education for demobilized soldiers, and was a highly beneficial public investment in human capital. Social Security has helped reduce poverty among the elderly. The military has kept the US safe and free.

But the gap between textbook solutions drawn up in universities and think tanks and the reality on the ground can be vast. More spending or regulation does not always lead to better outcomes.

Government spending is no less subject to diminishing returns than anything else. Programs become entrenched, develop powerful constituencies, and are hard to shrink. Few programs are targeted carefully enough to real needs – or to the really needy – as politicians buy votes by spreading coverage far beyond what is needed to achieve programs’ stated goals. Hence Buchanan’s disdain for romanticizing government action.

In country after country, one casualty of the ongoing debate over spending, taxes, deficits, and debt has been efforts to make government more effective and efficient. In most areas of government, from defense to entitlements, better outcomes can be achieved at much lower cost, which should please both the left and the right.

For example, America’s federal government has 47 separate job-training programs in nine different agencies, costing almost $20 billion a year, most of which the Government Accountability Office reckons are ineffective or poorly run. President Barack Obama added the 47th – for green-energy job training – in 2009. The success rate was so poor (a tiny percentage of participants got targeted jobs) that the Labor Department’s Inspector General recommended shutting it down – and this at a time of massive unemployment, with firms listing millions of job openings but unable to find workers with the required skills.

We have seen what ultimately results when unsustainable spending leads to exploding debt: economic chaos and human tragedy. Somewhere betweenromanticizedgovernment solutions to problems and Buchanan’s self-interested government officials, we must find leaders willing to eliminate poorly performing programs; modernize, streamline, and consolidate others; improve services; and limit pressure for ever-higher growth-destroying taxes.

Michael Boskin is Professor of Economics at Stanford University and Senior Fellow at the Hoover Institution. He was Chairman of George H.W. Bush’s Council of Economic Advisers from 1989 to 1993, and headed the so-called Boskin Commission, a congressional advisory body that highlighted errors in official US inflation estimates.

January 27, 2013 7:21 pm
Budget battles and careless cuts
Whatever happens at the next fiscal cliff will further dent America’s growth prospects
Comment Page, pfeatures

Last week Barack Obama put his hand on the bible, swore an oath of office and gave Republicans the middle finger. Two days later they caved in on their threat to hold the debt ceiling hostage (or at least until May). So much for the drawbacks of the president sounding too liberal.

But the “let Obama be Obamacrowd might be counting their fiscal chickens too soon. The Republicans did not walk away from the game of US budgetary poker. Their new and less self-destructive tactic is to drag it out.

From Mr Obama’s point of view, it is better to contemplate a war of fiscal attrition than the threat of a sovereign debt default. But the economic costs from whatever deal – or series of mini-deals – that emerge in the coming months are unlikely to be trivial.

The first and most immediate is to 2013 growth prospects. As both Lawrence Summers, Mr Obama’s former senior economic adviser, and my colleague Martin Wolf pointed out last week, there is nothing about the anaemic US recovery that merits austerity at this point. America’s fiscal crisis is political. Anyone doubting that should check with the bond markets, which in real terms continue to pay the US Treasury for the privilege of lending to it.

Last month’s deal to avert the original fiscal cliff imposed a budgetary contraction of roughly 1.5 percentage points of US gross domestic product. Most of that hit came from the decision to allow the holiday on payroll taxes to expire – an ill-timed move from a cyclical point of view.

Whatever happens at the next fiscal cliff on March 1 – whether it triggers a full spending sequester of $110bn or a deal to cut spending and raise revenues by a similar amount – will subtract further from 2013 growth prospects. At a point where the US could be experiencing catch-up growth to make up for the output lost since 2007, Washington is importing European austerity.

Second, as we saw with the expiry of the payroll tax holiday, the quality of Washington’s austerity tends to be poor. There are relatively harmless cuts, which will not affect future growth prospects. And there are unintelligent cuts that do. On this Democrats are as much to blame as Republicans.

In 2011 Mr Obama agreed to domestic spending cuts worth $1,500bn over 10 years. Many Democrats have made it clear they would rather trigger next month’s sequester, which would impose another $600bn worth of domestic cuts, than agree to any cuts in US entitlement programmesnotably Medicare and social security.

To be fair, there is nothing that merits steep cuts to either programme at this point. America’s entitlements crisis will only really start to bite in the mid-2020s.

But the impact in the meantime of further cuts to the portion of the US budget known as domestic non-defence discretionary spending will be damaging. It is the smallest part, accounting for 19 per cent of federal outlays. Yet it is the most important for future US competitiveness: it includes infrastructure, research and development, education and worker training.

Alas, it is the only area on which Republicans and Democrats have so far been able to agree. Most Republicans would rather protect defence, which accounts for almost a fifth of spending. And most Democrats would rather preserve entitlements, which now gobble up more than half (debt interest payments make up the remainder).

Domestic spending is already heading to a postwar low of 2.7 per cent of GDP (from an average of 3.9 per cent), according to the Centre on Budget and Policy Priorities, a liberal think-tank. It looks destined to fall further.

Third, there is the opportunity cost from the protracted budgetary battles. Last week Mr Obama gave an inaugural address about what he would like to accomplish in his second term. It was almost entirely domesticnot a single foreign country was mentioned.

Perhaps its most impassioned section was about tackling global warming, which Mr Obama made clear would be his biggest ambition, more so even than immigration reform and gun control. The longer the budgetary wars continue, the less room Mr Obama will have to pursue these goals.

The fiscal calendar already takes us up to May, when the debt ceiling expires. But it seems unlikely the wrangling will end there. Last week John Boehner, the speaker of the House of Representatives, accused Mr Obama of “trying to annihilate” the Republican party. In truth, Republicans have been doing most of the work themselves. But Mr Boehner’s assessment is shared among Republican lawmakers who see Mr Obama as the most partisan president in their lifetime. It does not matter whether their verdict is true. All that matters is that Republicans believe it to be.

Mr Boehner went on to say that he was “up for the fight” with Mr Obama. His chosen battleground is fiscal. And he has plenty of weapons available, from the March 1 sequester, to the March 27 potential government shutdown, all the way to the May debt ceiling, which he will want to keep on as short a leash as possible three or six-month extensions rather than the two years Mr Obama has requested.

Last week Mr Boehner beat a tactical retreat on the debt ceiling. It was a smart political move. If he can control his party he will try to eke this one out for as long as possible. None of which would be good for US growth.

Copyright The Financial Times Limited 2013

January 27, 2013
Precious Metals & Miners Making Waves and New Trends
Chris Vermeulen

The precious metals sector has been dormant since both gold and silver topped in 2011. But the long term bull market remains intact. As long as we do not have the price of gold close below the lower yellow box on the monthly chart then technical speaking precious metals should continue much higher.

Large consolidation periods (yellow boxes) provide investors with great insight for investments looking forward 6-18 months upon a breakout in either direction (up or down). The issue with investing during these times is the passage of time. One can hold a position for months and sometimes years having their investments fluctuate adding extra stress to their life when they really do not need to.

Once a breakout takes place a powerful rally or decline will start putting an investors' money to work within days of committing to that particular investment compared to money invested waiting months for the breakout and new capital gains to occur.

Gold Price Chart - Monthly

Gold Monthly Price Chart

Gold Price Chart - Daily

The chart of gold continues to form a large bull flag pattern with a potential 3 or 5 wave correction. If price reverses this week and breaks above the upper resistance trend line then it will be a 3 (ABC) wave correction which is very bullish. But there is potential for a full 5 wave correction which is still bullish, but it just means we have another month or two before metals bottom.
Gold Futures Trading Daily Chart

Gold Miner Stocks - GDX ETF Chart - Daily

Gold miners do not have the sexiest looking chart. It was formed a strong looking bull flag but has continued to correct and is not nearing a key support level. This level could act as a triple bottom (bullish) or if price breaks below then it would be breaking the neckline of a massive head and shoulders pattern which points to 50% decline. I remain bullish with the longer term gold trend until proven wrong.

Silver Price Chart - Daily

Silver remains in a long term bull market much like the monthly chart of gold shown earlier in this report. Silver continues to work its way through a large bull flag pattern with a positive outlook at this time.

Silver Price Chart Daily

Silver Miner Stocks - SIL ETF - Daily Chart

Reviewing the precious metals sector it seems that silver miners have the sexiest looking chart. All price patterns are showing strength and are in proportion to one other. If this chart plays out to what technical analysis is pointing to then we could see the precious metals sector put in a bottom and rally within the next week or two. And if this is the case then silver miner stocks should provide the most opportunity going forward.

Precious Metals Trading Conclusion:

In short, what you need to focus on is the yellow consolidation box on the monthly gold chart. A breaking in either direction will trigger a massive move that should last 6-18 months. Until then long term investors can simply sit back and watch the sector while they put their money to work in other active sectors.

From a short term traders point of view, that of mine. I am looking for a signs of a bottom on the daily chart to get my money working earlier to play the bounce/rally that takes place and actively managing the position until a breakout occurs. The charts overall are not that clear as to when a breakout will take place. Metals could start to rally next week or in a few months and all we can do is wait for a reversal to the upside before we get active.

Knowing the big picture trends and patterns at play along with major support and resistance levels (breakout levels) is crucial for success and peace of mind.

January 27, 2013 9:59 pm
China’s brokerages turn shadow banks

Chinese securities brokerages have emerged as a crucial new link in the country’s shadow banking industry, a development that underscores how financial risks are spreading more widely in China.

People familiar with brokerages say they got started in shadow financing around the middle of last year, taking control of funds that banks wanted to remove from their balance sheets.

New industry data confirm this development and reveal a dramatic increase in such activity in the fourth quarter. For 2012 as a whole, shadow financing via brokerages appears to have increased almost 600 per cent.

Western rating agencies have warned that a rapid rise in off-balance-sheet banking activity is a threat to China’s financial stability. But Chinese regulators have countered by saying the risks are manageable. With the country’s financial system long dominated by state-run banks, they also view shadow lending as a byproduct of their attempts to unleash more market forces in the allocation of capital in China.

“In August we were told to start allocating more funds to securities companies because that channel was fully open,” said a manager with a midsized bank who has been directly involved in shifting assets off his bank’s balance sheet.

The Chinese securities association said last week that brokerages now manage almost Rmb2tn ($320bn) of so-called entrusted fundsfunds that banks have transferred to brokerages so they are off their balance sheetsseven times more than at the start of 2012.
Brokerages received Rmb1tn of entrusted funds in the fourth quarter alone, according to the industry figures.

Every year or so, China’s shadow banking morphs into a slightly different form as new players get involved and new products are launched. Regulators largely permit the experimentation to take place but clamp down when the risks are deemed excessive.

The emergence of brokerages as key conduits of shadow banking in China is a sign of how quickly the country’s financial institutions are evolving in response to regulatory changes.

Conventional bank loans account for a decreasing portion of Chinese financing, from 95 per cent in 2002 to just 58 per cent last year, according to the central bank. Total financing increased almost eightfold during that time.

For the past two years China’s shadow financing had centred on co-operation between banks and trust companies, which are loosely regulated fund management vehicles.

Banks had funnelled cash to trusts, and the trusts in turn made high-yield loans to companies such as property developers that were barred from borrowing from banks because they were perceived as too risky.

Late last year the Chinese banking regulator grew concerned at the surge in trust lending and forced greater disclosure of such financing arrangements.

“The Chinese Banking Regulatory Commission was becoming more restrictive on bank-trust co-operation and that opened the door to bank-brokerage co-operation,” said Howhow Zhang, head of research at Z-Ben Advisors, a Shanghai-based fund consultancy.

Banks have been competing more aggressively for customers by issuingwealth management products”, which effectively function like deposits but offer slightly higher rates. To generate the higher returns, banks must transfer the cash to non-bank entities which are less encumbered by lending restrictions. That is where the brokerages come in.

The brokerages play a passive role in managing the entrusted funds, according to people with knowledge of the matter. Banks give the brokerages strict investment instructions and pay them a tiny fee, as low as one basis point, in return.

People with knowledge of brokerages say they have used the entrusted funds for two main kinds of investments. First, they have bought undiscounted bills from banks, a move that gives the banks more on-balance-sheet room for lending. Second, they have invested in trust products, serving as an intermediary between banks and trusts.

There are clear risks in this enterprise. The undiscounted bills are backed by accounts receivable from companies, so the brokerages are potentially being used as a backdoor channel to fund companies that cannot collect their own debts. Moreover, the question of who bears the ultimate responsibility for defaults is only complicated by lengthening the chain of financing between banks and trusts to include brokerages.

The rise of brokerages as shadow banks has been remarkably fast, which is also a worry.
Nevertheless, looked at in absolute terms, the entrusted funds at brokerages are still just 1.6 per cent of overall bank assets.

“If you want a more comprehensive capital market in which the market share of banks drops, you have to allow things to happen outside the banking sector,” said an analyst who covers brokerages, speaking on the condition of anonymity. “It’s something that people should pay attention to. But it’s not alarming yet.”

Copyright The Financial Times Limited 2013.