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The True Costs of Compliance

from Daniel Yergin at the WSJ, Markets Run Into Skepticism—and Regulators

There had been a shift in the balance of confidence—the respective weighting in people’s minds between the role of markets and government, between the invisible hand and the visible one. I once asked the great statesman Lee Kuan Yew, the founder of modern Singapore: What caused the shift? He answered with his customary simplicity, “Communism collapsed, and the mixed economy failed. What else is there?”

In other words, it became clear that over-reliance on governments tended to run economies into a wall—whether it was stagflation in the U.S., or paralysis in the mixed economies of Britain and Western Europe, or devastating hyperinflation and budget deficits in Latin America.

After the 2008 crisis, financial regulation needed to be fixed. But what about the results? The Dodd-Frank bill was 2,300 pages. Should it have been 2,500 pages, or would 1,800 have been enough? On top of that are an estimated 26,000 pages of complex rules to implement the bill.

If it is not instituted wisely, with restraint and foresight, regulation becomes a drag on the economy, a tax on job creation, a barrier to innovation. It also boosts “compliance,” America’s great new growth industry. Indeed, in these days of the gig economy, it is said that if you want lifetime employment, go into compliance.

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Capitalization vs Regulation

While the left claims the greedy 1% led us to financial ruin, years of reflection indicate that wrongheaded regulation and policy had much to do with magnifying the depth of the recession. Deregulation was not the problem, wrong regulation was the problem and Dodd Frank has not fixed it.

Regulations are not better if they are longer. Most likely the opposite is true. Simple regulations strongly enforced will serve us better.

Letting banks opt out of regulations by holding higher capital ratios is a great way to bring competition to the bloated salaries on Wall Street while protecting the taxpayer.

From the editors of The Wall Street Journal, Fixing American Finance

Don’t believe the shrieks that this is about “rolling back” financial reform to let the banks run wild. The financial system was heavily regulated before the 2008 panic; regulators failed to do their job (see Citigroup) and missed signals from the housing market, among other mistakes. The Dodd-Frank Act of 2010 doubled down on the same approach: Give even more power to regulators with the promise they’ll be smarter the next time.

History tells us that is a fantasy. Regulators will focus on solving the previous problem, while they miss where the excesses are really building. As Charles Kindleberger taught, the essence of a credit mania is that everyone follows everyone else and thinks it will never end. Regulators are no better than bankers. As late as March 2008, then New York Fed President Tim Geithner was telling his colleagues on the Open Market Committee that banks were in good shape.

Mr. Hensarling has a better idea, which is to let banks build much higher equity-capital cushions to protect against the next mania and panic. Now, as before the crisis, regulators pretend that giant banks have abundant resources to absorb losses by allowing them to report a bogus “Tier 1 risk-based capital ratio.”

With a complicated process subject to intense lobbying, regulators undercount exposures they deem to be safe—the way they designated mortgage-backed securities rock-solid before the last panic. This allows well-connected bankers to convince Washington that their favorite assets should have low “risk weights.” Regulators can politically allocate credit by favoring some types of lending over others.

The Texas Congressman wants a simpler system in which private investors with money at risk decide which assets are safe. Under the Hensarling plan, banks can opt out of today’s complicated rules if they have capital equal to 10% of their assets. Their tally of assets has to include off-balance-sheet exposures. No more hiding toxic paper in conduits or structured-investment vehicles as Mr. Geithner allowed Citi to do before the financial crisis. And no more pretending that a financial instrument has no risk because a regulator says so.

Capital at the largest banks today often runs below 7% of assets. The Wall Street giants would have to raise a lot more equity—and therefore pose less danger to the public—to get regulatory relief. They thus may not like the Hensarling plan, which is fine. Smaller competitors willing to operate without a taxpayer safety net deserve the advantage of lower regulatory costs.

The promise of the Hensarling plan is more safety for taxpayers and a banking system that supports a growing economy. One reason Dodd-Frank has never delivered the economic boost that PresidentObama promised in 2010 is that Washington’s distorting role in the flow of credit was dramatically increased.

In this era of hyper-regulation, David Malpass of Encima Global notes that banks have been making relatively few loans to small and mid-size companies while extending huge credit to large corporations and government. A slow-growth economy that doesn’t efficiently allocate credit isn’t safe for anyone.

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Thoughts on Brexit

hko in Israel

by Henry Oliner

Many Americans have become familiar with basic economic concepts because it affects them so regularly, but our understanding usually stops at our shore. The Brexit vote has us scratching our head to comprehend something we hardly knew was an issue a few days ago. Before 9/11 we knew who Muslims were but a few weeks later were reading and trying to comprehend the difference between Sunnis and Shiites. Taliban and Al Qaeda were soon correctable on our spell checks.

The economists and the financial community will absorb, comment and predict for the coming months but here are a few observations and thoughts.

The polling was very wrong.  This appears to becoming common. This is because the media that governs so much of the polling is far too monolithic and dismissive.  This is the price they pay for their lack of intellectual diversity. This may explain why even the betting services were so wrong.  When so much of the coverage is one sided it affects even the odds makers.

The British national mood appears to be very similar to the mood in America that begat the Trump and Bernie Sanders campaign.  They are increasingly at odds with the leaders.  The critical issue may be the dual related fears of immigration and national security, but this is also representative of a lack of respect between the governing elite and the great unwashed and will influence other issues.

We have always had elites and commoners, but there was a sense that in spite of their credentials and power that they shared common goals and values.  The attraction to Trump in spite of his elitist wealth is that he at least espouses concerns that the middle class also share.

The elites serve an important purpose; not just to exercise the technical skills to execute policy for the administrative state, but to adhere to principles that protect the long term interests of the people and their culture. The danger of the populist trend is the severing of commitments to principles to serve pragmatic ends. Problems created by the intelligent cannot by default  be solved by the ignorant. A Populist movement that can restore or progress  important values and principles can accomplish great ends, but  such movements are hard to control.  Witness the difference between the American and the French Revolution.

For the libertarian intellectuals Brexit was a rejection of centralization and bureaucratization from Brussels, but we like to see a cause that reflects our preferred view and narrative. I see another sign of the exhaustion of Progressivism.

Our own United States is an American form of the European Union with distinctive and important differences. It is governed by a clear constitution which every state adopts and respects, and it covers a common culture and language even if you often have to press ‘1’ for English.

Critics of the vote may express alarm at the seeming increase in nationalistic fervor, but Charles Cooke at National Review expressed an important distinction between patriotism and nationalism (The Brexit Vote Was Just the Beginning):

George Orwell contended that the difference between patriotism and nationalism was that patriotism involved “devotion to a particular place and a particular way of life, which one believes to be the best in the world but has no wish to force on other people,” while nationalism “is inseparable from the desire for power.” By this definition at least, Britain’s decision to extricate itself from the EU was patriotic, not nationalistic. Indeed, if there is any group within the debate that seeks to impose “a particular way of life . . . on other people,” it is the one that wants ever-closer integration into Europe, and, eventually, a federal super-state.


While we debate where this will ultimately lead this vote signals an important shift.  The Brexit vote has released a possibility that was inconceivable until last week.  Now we consider who will be next and whether the European Union can survive.

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Every Business Is a Social Science Experiment

Kevin_Williamson (1)

from Kevin Williams at National Review,Why does this gas station pay so well?

When I mentioned my surprise at what it pays to work at a gas station in Bastrop, I got two reactions, both predictable. One was from a purported conservative who sniffed that this pay scale was absurd for such low-skilled work, and that that was why a gallon of gas at Buc-ee’s cost a dime more than it did across the street. (For the record, this was not true of the Buc-ee’s in Bastrop.) And so I found myself having to accommodate the shock of a so-called conservative who has trouble mentally processing the fact that in a free market, consumers can choose between lots of price points offering different levels of service and amenities. (Given how purchasing decisions are actually made, I think they’re on to a pretty solid strategy here: A single man traveling alone may go to the funky service station across the street to save 80 cents — Hello, Dad! — but a man traveling with a wife and children is going to stop at the place that is famous for having the cleanest bathrooms in the business, even if it costs him an extra buck-and-a-half for a tank of high-test. Or he’s never going to hear the end of it.) There’s a reason that we have first class, business class, steerage, and Spirit Airlines: Some people are willing to pay more for better, and some people hate themselves and don’t care if their flight from Vegas to Houston runs a few hours late or never actually even takes off.

The left-wing response to Buc-eenomics is just as predictable and just as dumb: If Buc-ee’s can afford to pay gas-station attendants $17 an hour, then why can’t we mandate a $15-an-hour federal minimum wage? Put another way: If it’s a good idea for one specific business in one specific market at one specific time, why not everywhere? You get the same thing with Walmart vs. Costco: They’re superficially similar businesses, so how come the mean meanies in Arkansas can’t pay like the nice, nice men from Washington State do? The answer, of course, is that every situation is different, and every business is a social-science experiment, trying out different approaches to solving social problems, which is what entrepreneurs and successful firms actually do. If it weren’t for the self-interest of big, nasty corporations, it wouldn’t be a question of clean bathrooms vs. less clean ones: You’d be out there on the side of the road watering Mrs. Johnson’s beloved bluebonnets.

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Employment and Capital

A business makes a capital investment for two reasons: one is to expand production to meet rising consumer demand, and another is to increase efficiency or reduce cost.  The first reason is common during a growing economy and such investment can lead to increased employment.

Reducing costs is often ‘code’ for reducing labor. The cost of the equipment is weighed against the cost of labor. The higher the cost of labor and the lower the cost of equipment the greater is the incentive to replace labor with capital.

The cost of labor includes not just the wages and benefits but other friction costs ranging from compliance regulations, legal liability, unions, and administrative costs.

If a $50,000 a year employee can be replaced with a $500,000 capital investment, then this investment delivers a 10% return.  In an investment climate ruled by very low interest rates a 10% return can be alluring.  At the same time that low interest rates reduce the cap rate it also reduces the cost of the capital acquisition.

Such stimulation of capital investment is the stated intention of a low interest rate policy, but the combination of the low interest rates with high labor friction costs and a slow growth economy means that it will have less of an impact on employment and wages.

Anecdotally I still hear that employers are both reluctant to expand and that they have a very difficult time finding motivated quality workers, especially in the trades. Some fear another recession around the corner and others seek to avoid the higher friction costs associated with new hires, sometime referring to the ACA penalties.

Higher employment regulatory friction costs, and slow economic growth are offsetting the potential benefit to employment and wages from lower interest rates.