The
original version of this article was written and published on 1/16/12.
A
Story of Regulation
Late
last year the city of San Francisco passed an ordinance that prohibits fast
food restaurants, more specifically McDonald’s, from including toys in
children’s meals that do not meet specific nutritional standards. While it
should be common knowledge that a McDonald’s burger with fries doesn’t rank up
there with a bowl of broccoli in terms of healthy meal choices, the new
regulation was put in place to deter fast food restaurants from luring the
innocent into their establishments in order to “seduce children to eat junk
food”, according to Harold Goldstein, executive director of the California
Center for Public Health Advocacy.
Officials
promoted this achievement quite publically as a victory in the battle of
childhood obesity. Never mind the fact that most fast food eateries have
already taken steps to attempt to increase nutritional content by, among other
things, replacing fries with fruit. By taking the toys out of the kids’ meals,
the thought was to make those meals less appealing to children.
McDonalds
found parents didn’t want government regulation to dictate their purchasing
decisions and demand for the meals did not dissipate. McDonald’s solution:
continue to sell the kids meal, and in compliance with the new laws that
prohibits toys to be included with the food, decided to make the toys available
with the meal for an additional $0.10. The proceeds then go support the Ronald
McDonald house of San Francisco, part of the national non-profit group.
So in
the end, it seems the only thing the new regulation achieved was raising the
cost of the kids’ meal.
The
point of this story is too many impetuous regulations administered by
government agencies will stifle economic growth and will stymie any meaningful
rally in the US equity market.
Politics
as a Guide
This
year is a Presidential election cycle in which our incumbent President, Barack
Obama will defend his office against Republican challenger Mitt Romney. The
Presidential election cycle is important to our 2013 investment thesis. Once
Mitt Romney is elected, we suspect there to be a new found optimism in regards
to a renewed direction and attitude of the American economy. In our opinion,
one key element behind our economic malaise has been uncertainty on the part of
business owners and investors.
There
has been a deluge of commentary on the subject this past year as it relates to
a more robust economic recovery.
Increased government oversight and regulation in the financial markets,
much of it a result of the passage of the Frank-Dodd bill was a major hot
button issue last year. On June 14, 2011 Clifford S. Asness, managing and
founding principal of AQR Capital Management went on to write in the Wall
Street Journal, “I
will also tell you Dodd-Frank, with its enshrining of too big to fail and its
large regulatory costs, is an albatross. I will add that ObamaCare's gigantic
new entitlement has hurt.
I
will throw in that massive additional regulatory costs being foisted upon
business is an extra drain on the economy. I would definitely say that the
disregard for law during the auto-company "bankruptcies" has
long-lasting negative effects. I'd even throw in that the president's
demonization of business has been harmful. Finally, I'd say the expected tax
increases, even if only on the "super rich"—defined as anyone still
gainfully employed—weigh upon us.”
Susan
Collins, Republican senator from Maine adds, “No wonder America's employers
dread what is coming next out of Washington. Our country cannot afford
regulations run amok at a time when no net new jobs are created and
unemployment remains above 9%...Business owners are reluctant to create jobs
today when they're going to need to pay more tomorrow to comply with onerous
new regulations. That's what employers mean when they say that uncertainty
generated by Washington is a big wet blanket on our economy…In sports,
time-outs are called to give athletes a chance to catch their breaths and make
better decisions about the next play. American workers and businesses are the
athletes in a global competition that we must win. They need a time-out from
excessive regulation so that America can get back to work.”
Our
Regulatory Dilemma
Rules
are important. Laws that are put in place for the betterment of society should
be followed. This has been an underlying proclamation behind the formation of
our free market principles and the foundation that this country was built on.
The real question comes in determining what regulations are beneficial and when
do they become intrusive.
Adam
Smith in his 1776 masterpiece, The Wealth of Nations, lays out the three
primary goals of government. “The first duty of the sovereign,
that of protecting the society from violence and invasion of other independent
societies, can be performed only by means of a military force. But the expence
both of preparing this military in time of peace, and of employing it in time
of war, is very different in the different states of society, in the different
periods of improvement.” Ultimately
the federal government is responsible for national security. The first role is
fairly straightforward.
He
goes on to write, “The
second duty of the sovereign, that of protecting, as far as possible, every
member of the society from the injustice or opposition of every other member of
it, or the duty of establishing an exact administration of justice requires two
very different degrees of expence in the different periods of society.”
The
third rule is where the views of modern politics and the original intent of
government diverge. “The
third and last duty of the sovereign or commonwealth is that of erecting and
maintaining those public institutions and those public works, which, though
they may be in the highest degree advantageous to a great society, are,
however, of such a nature, that the profit could never repay the expence to any
individual or small number of individuals, and which it therefore cannot be
expected that any individual or small number of individuals should erect or
maintain. The performance of this duty requires too very different degrees of
expence in the different periods of society. After the public institutions and
public works necessary for the defence of the society, and for the
administration of justice, both of which have already been mentioned, the other
works and institutions of this kind are chiefly those for facilitating the
commerce of the society, and those for promoting the instruction of the
people.”
In
Free to Choose, A Personal Statement, Milton and Rose Friedman best summarize
the third duty over the sovereign by stating, “Adam Smith’s third duty raises
the most troublesome issues. He himself regarded it as having a narrow
application.
It has since been used to justify an extremely
wide range of government activities. In our view it describes a valid duty of
government directed to preserving and strengthening a free society; but it can
also be interpreted to justify unlimited extensions of government power.”
Too
Much of a Good Thing?
The
question begs to be asked, what is considered too much regulation, what causes
politicians in Washington to aggressively pass massive regulatory bills and
when does too much regulation obstruct economic growth. We would like to
address these questions using broad brush strokes and how it will affect our
2013 investment thesis.
Too
much Regulation
“Sen.
John Barrasso, R-Wyo., earlier this month echoed the concerns of the U.S.
Chamber of Commerce and other business groups in detailing how much in new
regulation in July alone the administration imposed. The toll came to $9.5
billion in new regulatory costs with 229 proposed rules, plus the finalizing of
379 other regs, some from the Environmental Protection Agency, others from
financial changes.”
Get
Out Of The Way Of The Jobs – IBD opinion, 8/22/11.
“In
June, the oil industry issued a real job-creating plan that Obama refuses to
consider, and documented the cost in jobs of Obama's Gulf of Mexico drilling
moratorium.
"We
estimate that tens of thousands of jobs have been lost in response to the
decline in capital expenditures and operational spending" from 2008 to
2010, concluded the analysis by the Texas-based Quest Offshore Resources for
the American Petroleum Institute and the National Ocean Industries Association.
The
report also detailed "the near term potential of the offshore (Gulf) oil
and natural gas industry to create jobs, boost GDP and generate tax revenues at
all levels of government — if the government pursues a balanced regulatory
approach," with a conclusion that "total employment supported by the
Gulf of Mexico oil and natural gas industry in 2013 could exceed 430,000 jobs
or a 77% increase from 2010."
As
IBD reported a year ago, Minerals Management Service director Michael Bromwich
wrote a memo to Obama's Interior Secretary Ken Salazar informing him that a
six-month halt in deep-water drilling would result in "lost direct
employment" of 9,450 jobs, plus "lost jobs from indirect and induced
effects" of 13,797.” Get Out Of The Way Of The Jobs – IBD
opinion, 8/22/11.
“Last
week the Speaker asked the White House to disclose all federal rules in the
works with economic costs of $1 billion or more. Proposed or final rule-makings
are defined as “major” when their estimated annual costs exceed $100 million.
The Obama regulatory agenda for 2011 contains 219 such items. Last year, that
figure was 191, versus the combined total for the first two years of the Bush
Administration of 103. Amid this surge, Mr. Boehner’s underlying point was that
the regulatory ambitions of the Obamanauts are redefining “major”, much in the
way trillion is the new billion for government spending.” Mere
Proposals – Wall Street Journal opinion, 8/31/11.
“America's
overregulation problem is only getting worse. Right now, federal agencies are
at work on more than 4,200 rules, 845 of which affect small businesses, the
engine of job creation in our country. More than 100 are major rules, with an
economic impact of more than $100 million each.
No
business owner I know questions the legitimate role of limited government in
protecting our health and safety. Too often, however, our small businesses are
buried under a mountain of paperwork that drives up costs, prevents the hiring
of workers, and impedes economic growth.
Business
owners are reluctant to create jobs today when they're going to need to pay
more tomorrow to comply with onerous new regulations.
That's
what employers mean when they say that uncertainty generated by Washington is a
big wet blanket on our economy.” The Economy Needs a Regulation Time-Out –
Susan Collins, Wall Street Journal opinion, 9/26/11.
“The
current number of major new rules is 149, which is an historic high. Regulation
started to grow in the aftermath of 9/11, and even more with the Pelosi
Congress in 2007. Yet both the rule-making rate and number are surging to even
higher levels under Mr. Obama.” - Regulation for Dummies, Wall Street
Journal opinion, 12/14/11.
“The
Office of Management and Budget (OMB) has estimated that since 1980 federal
regulators have written more than 130,000 rules. More than 1,000 of these rules
have cost businesses in excess of $100 million just to comply, according to the
American Enterprise Institute's Nick Schulz. The OMB estimates that federal
regulation costs the economy over $1.75 trillion each year.
Initial
public offerings have proven to be a successful vehicle in this country for
capital formation. The tepid rebound of our economy can be attributed in part
to the lack of IPOs. In conversations with other CEOs, it's become clear to me
that the Sarbanes-Oxley Act has been a real deterrent to companies that would
like to go public.
Indeed,
I have had numerous conversations with CEOs of public companies that are
actively considering becoming private, and their primary reason is the
excessive regulation and compliance that are required of public companies. When
Sarbanes-Oxley was enacted in 2002, the Securities and Exchange Commission
estimated the annual cost of compliance would average $91,000 per company.
Various surveys have shown that, depending on a company's size, annual
compliance costs are actually in the millions.”–
Warren Stephens - Business Regulation vs. Growth: The View from Middle America,
Wall Street Journal opinion, 8/25/11.
“What's
the key to stimulating our economy? Consider a conversation I had recently with
a banker in Nebraska. For the first time, he said, his bank now devotes more
work hours to compliance than to lending. Specifically, he has 1.2 employees on
compliance for every one employee focused on lending and bringing in business.
Imagine
a manufacturing company that deployed more than half of its work force as
Occupational Health and Safety Administration (OSHA) compliance officers. Such
a company would be unable to grow, let alone contribute to broader economic
growth.
Yet
banks across the country are feeling a similar pull on resources as the
Dodd-Frank Act is implemented. Already federal regulators have issued 4,870
Federal Register pages of proposed or final rules affecting banks. Many more
are still to come—for a grand total of more than 240 rules. And that's on top
of about 50 new or expanded regulations unrelated to Dodd-Frank that banks have
had to absorb over the past two years.” - Frank Keating – Banking in a Time of
Over-Regulation, Wall Street Journal opinion, 8/30/11.
“Now
that Congress appears finally to have reached a compromise on what must be one
of the worst pieces of legislation in years — the temporary payroll-tax-holiday
extension — let’s survey the damage.
To
begin with, what even minimally rational government enacts payroll-tax relief
for just two months? As a matter of practicality alone, it makes no sense. The
National Payroll Reporting Consortium, representing those who process
paychecks, said of the two-month extension passed by the Senate just days
before the new year: “There is insufficient lead time to accommodate the
proposal,” because “many payroll systems are not likely to be able to make such
a substantial programming change before January or even February,” thereby
“create[ing] substantial problems, confusion and costs.”
The
final compromise appears to tweak this a bit to make it less onerous for small
business. But what were they thinking in the first place? What business
operates two months at a time? The minimal time horizon for business is the
quarter — three months. What genius came up with two? U.S. businesses would
have to budget for two-thirds of a one-quarter tax-holiday extension. As if
this government has not already heaped enough regulatory impediments and
mindless uncertainties upon business.” The GOP’s Payroll Tax Debacle – Charles
Krauthammer, The Washington Post opinion, 12/22/11.
More
Recently.
“How
many hours will it take to comply with ObamaCare? According to Americans for
Tax Reform nearly 80 million and that doesn't even count the number of hours
needed to comply with the regular tax code…And who will bear most of the
burden? The life blood of the American economy, small businesses.” –
Hours to Comply With ObamaCare? 79,229,503 - Katie Pavlich – Townhall.com,
9/19/12.
“Using
official government sources, the National Federation of Independent Business
calculates there are more than 4,000 federal rules in the pipeline, and that
just the 13 biggest ones would, if imposed in an Obama second term, cost
businesses a total of more than $515 billion over four years.
That
tally doesn't include more than 100 still-to-be-written regulations needed to
enforce the Dodd-Frank financial reform law, or the mountain of regulations
required by ObamaCare. The health law has already resulted in thousands of
pages of rules, including 18 pages simply to define what a "full-time
employee" is.”
-
Regulatory Tsunami To Hit Business If Obama Wins Second Term – John Merline –
IBD Opinion, 9/17/12.
“Coal
company Alpha Natural Resources announced Tuesday it would be laying off 1,200
workers and closing eight coal mines to face two new challenges: cheap natural
gas and “a regulatory environment that’s aggressively aimed at constraining the
use of coal.”
“As
Of August 2012, The National Federation Of Independent Businesses (NFIB) Small
Business Optimism Index Is “Still Another Solid Recession Reading.”… 21 Percent
Cited “Unreasonable Regulations And Red Tape.” “Only 3 percent reported that
financing was their top business problem, compared to 23 percent citing taxes,
20 percent citing weak sales and 21 percent naming unreasonable regulations and
red tape.” (William C. Dunkelberg and Holly Wade, “NFIB Small Business Economic
Trends,” National Federation Of Independent Businesses, 9/11/12)” - Obama’s
Small Business Problem – GOP.com – 9/19/12.
Crony
Capitalism
Part
of the problem in our view is that many politicians are too beholden to those
that provide fiscal support to their political survival in the form of
contributions. Many rules and regulations put in place are for the sole benefit
of certain industries that, through lobbying, have the ability to manipulate
the system for their own benefit, regardless of the consequences of poor
policy. This is known as crony capitalism. Mark Levin, in his book Liberty and
Tyranny provides one of the best explanations of crony capitalism. “However,
it should be emphasized that the Conservative is not a corporatist – that is,
he is not a special pleader for oil companies or any other corporations. He
defends free markets because he defends the civil society and the
Constitution’s limitations on federal authority against the tyranny that
threatens them. Therefore, the Conservative also opposes crony capitalism,
where the Statist uses the power of government – often at the behest of a given
industry or corporation – to subsidize one favored enterprise at the expense of
another. The Statist’s purpose, as always, is to extend his own reach.”
Crony
capitalism is quite clearly evident in new laws being passed in Washington as
it relates to light bulbs. The Energy Independence and Security Act of 2007 has
required us to stop buying the incandescent light bulb in favor of compact
fluorescent light bulbs (CFLs). While there has been some pushback from
consumers and lawmakers, try finding a traditional 100 watt light bulb come October. You will not be able because they
are expected to
be
banned.
The
reasoning behind this new law is to make us more energy independent by using
bulbs that provide more light with less energy (compared to incandescent bulbs
providing the same amount of visible light, CFLs use 1/5 to 1/3 less power and
last 10 times longer). On the face of it that sounds marvelous. Having bulbs
that are more efficient than the status quo is a great example of creative
destruction as long as they are produced by the free market without government
manipulations or mandates. Most
importantly, they need to be created based on market demand. A company that
manufactures light bulbs will not go through the difficulties of creating a new
product unless consumers are willing to buy this product and the company is
able to make a profit from the sale of this product.
In
the case of our new CFLs, it seems without the mandate; people are not overly
enthralled to purchase these new bulbs. For one, they are 500% more expensive
than traditional bulbs. In fact, prices for CFLs skyrocketed 37% last year when
China decided to nationalize and close several rare earth metal producers,
taking material needed for the manufacture of CFLs off the market. So much for trimming our reliance on other
nations in determining our energy needs.
Another
key deterrent is that these new bulbs are surrounded by controversial safety
issues. “The government warns that the amount of mercury in one CFL bulb is
enough to contaminate up to 6,000 gallons of water beyond safe drinking levels.
The same agency that's pitching them as a green alternative requires households
perform a small hazmat operation to dispose of them upon breakage.
The
Energy Dept. recommends numerous steps to "reduce exposure to mercury
vapor from a broken bulb," including shutting off the air conditioning for
"several hours" and even removing pets from the contaminated room. It
advises picking up debris with duct tape, enclosing it in a glass jar and
taking it to a special recycling center for proper disposal.” Think
Bulb Phaseout Is Silly? Just Wait For The Next Step – IBD opinion, 1/13/12.
While
the EPA has down-played the health risks of mercury in the home, as a citizen
one can become confused with the intentions of the EPA and their rulings.
Consider this, in the Energy Policy Act of 2005, the very same governmental
regulator BANNED mercury vapor use in street lights. They cited increased
energy efficiency and environmental protection as the primary cause. So mercury
vapor is not safe enough to keep in the street lamps but safe enough to bring
into our homes and expose our families to potential deadly toxins.
What
would entice government to make these regulations? One would think the
decisions are based on solid research and exhausting analytics. The truth is
that these rules have been promoted by some of the largest manufacturers of
light bulbs in the world. Through the use of influence in Washington, these
companies are bent on manipulating the market for personal gain. This is crony
capitalism.
“In
2007, Philips urged an incandescent ban as a way to force the market toward
high-efficiency bulbs, complaining that without such laws, "purchase price
and functional performance often take precedence over environmental
concern."
That
same year, the National Electrical Manufacturers Association, which represents
companies making 95% of bulbs sold in the U.S., told a Senate panel that a ban
was needed "to
further educate consumers on the benefits of energy-efficient products."
You
can believe if you want these companies only had Mother Earth in mind with this
ban. But more likely they saw it as a chance to fatten their bottom lines. Who
wouldn't jump at the chance to outlaw a low-margin, 60-cent product when you're
trying to hawk a high-margin $3 alternative?” Shining A Light On Crony Capitalism – IBD
opinion, 12/21/11.
The
effects of Regulation on the Economy
The
Phoenix Center released Policy Bulletin No. 28 in April, 2011. The study went
on to investigate the relationship between government regulation and economic
growth.
“For our measure of regulation (gt), we use data on the federal government’s
budget for regulatory activity, which is reported for the past fifty years in
Dudley and Warren (2010). We are interested in the size of the regulatory
influence on the economy, so we express the budget as a share of private-sector
GDP, with both series measured in real terms. For the macroeconomic series,
data is extracted from the Federal Reserve Economic Data online repository.
Economic activity is measured as real per-capita GDP (yt) less government
spending, and employment is measured by the private-sector jobs (lt). All
series are measured annually and cover the period 1960 through 2009 (50 years).
In the statistical analysis, all variables are expressed as natural logarithms.”
The
conclusions in the study are profound.
“In
this POLICY BULLETIN, we quantify the impact on GDP and job growth of
reductions in the regulatory budget. Using econometric methods, we estimate
that reductions in the federal regulatory budget have sizeable effects on both
GDP and jobs.
A 5%
reduction in the regulatory budget, which equals about $2.8 billion in
spending, increases GDP by roughly $75 billion and the number of jobs by about
1.2 million annually. A 10% cut in the regulatory budget adds $149 billion to
GDP annually and expands employment by 2.4 million jobs in each year.
In
recent years, however, the size of the regulatory budget has risen sharply,
with the Obama Administration proposing numerous new regulatory agendas. This
expansion in the regulatory budget is demonstrated here to be a drag on the
economy and job creation. Each regulator (or employee of a regulatory agency)
costs the American economy, at the margin, $6.2 million in economic output and
about 98 private sector jobs each year. Accordingly, if policymakers wish to
stimulate jobs and reduce federal spending, then responsibly trimming the
regulatory budget may be a viable option.”
Solutions
There
has been a great deal of opinions put forth as to the appropriate steps needed
to curtail excess government regulation. Many of those solutions include but
are not limited to; (a) requiring congressional approval of new major rules
promulgated by the various governmental agencies, (b) creating a Congressional
Office of Regulatory Analysis, (c) establishing mandatory sunset provisions for
all federal regulations.
“To
protect Americans and the economy against runaway regulators under any
Administration, additional oversight is necessary. Specifically, Congress
should take several steps to increase scrutiny of new and existing regulations
to ensure that each is necessary, and that costs are minimized. Congress
should:
1 -
Require congressional approval of new major rules promulgated by agencies.
Under the 1996 Congressional Review Act, Congress has the means to veto new
regulations. To date, however, that authority has been used successfully only
once. Under legislation introduced in the House by Congressman Geoff Davis
(R–KY) (H.R. 10) and in the Senate by Senator Rand Paul (R–KY) (S. 299), the
review process would be strengthened by requiring congressional approval before
any major regulation takes effect. Such a system would ensure a congressional
check on regulators, as well as ensure the accountability of Congress itself.
2 -
Create a Congressional Office of Regulatory Analysis. Congress needs the
capability to review proposed and existing rules independently, without
reliance on the Office of Management and Budget or the regulatory agencies. A
Congressional Office of Regulatory Analysis, modeled on the Congressional
Budget Office, would provide an important backstop to, and check on, the
executive branch’s regulatory powers. Such an office would also help Congress
better evaluate the regulatory consequences of the legislation it enacts. While
it is easy to blame regulators for excessive rulemaking, much of the problem
stems from overly expansive or ill-defined statutory language. A congressional
office to review legislation before adoption could help address the problem.
3 -
Establish a sunset date for federal regulations. While the President has asked
agencies to review their existing rules and eliminate those that are
unnecessary, these requirements are insufficient. Even the best plans for
periodic review will fall short if there are no consequences when an agency
fails to adequately scrutinize the regulations it has imposed. The natural
bureaucratic tendency is to leave old rules and regulations in place, even if
they have outlived their usefulness. To ensure that substantive review occurs,
regulations should automatically expire if not explicitly reaffirmed by the
agency through a notice and comment rulemaking. As with any such regulatory
decision, this re-affirmation would be subject to review by the courts."
Conclusion
"Despite
the weak economy, the Obama Administration has continued to increase the
regulatory burden on Americans in the first half of FY 2011, with 15 new major
regulations imposing $5.8 billion in additional annual costs, as well as $6.5
billion in one-time implementation costs.
From
the beginning of the Obama Administration to the end of March 2011, a
staggering 75 new major regulations, with costs exceeding $38 billion, have
been adopted. While the President has acknowledged the need to rein in
regulation, the steps taken to date have fallen far short. The President cannot
have it both ways—having identified overregulation as a problem, he must take
real and significant steps to rein it in. At the same time, Congress—which
shares much of the blame for excessive regulation—must step in, establishing
critical mechanisms and institutions to ensure that unnecessary and excessively
costly regulations are not imposed on the U.S. economy and the American people.
Without such decisive steps, the costs of red tape will continue to grow, and
Americans—and the U.S. economy—will be the victims.” Backgrounder
Published by The Heritage Foundation – Red Tape Rising: A 2011 Mid-Year Report
on Regulation by James L. Gattuso and Diane Katz.
Risks
to our Investment Thesis
Increased
government regulation beyond beneficial and into intrusive will encumber a
healthy economic recovery and that of course will affect the stock market (not
in that order, the stock market is a leading indicator). Given the stage of the
political cycle and having two individuals that will be going head-to-head to
become the leader of the free world, we thought it wise to publish, in their
words their thoughts on regulation. We will close with quotes from our
President, Barack Obama and his opponent Mitt Romney.
“Despite
a lot of heated rhetoric, our efforts over the past two years to modernize our
regulations have led to smarter—and in some cases tougher—rules to protect our
health, safety and environment. Yet according to current estimates of their
economic impact, the benefits of these regulations exceed their costs by
billions of dollars.
This
is the lesson of our history: Our economy is not a zero-sum game. Regulations
do have costs; often, as a country, we have to make tough decisions about
whether those costs are necessary. But what is clear is that we can strike the
right balance. We can make our economy stronger and more competitive, while
meeting our fundamental responsibilities to one another.” Toward
a 21st-Century Regulatory System – President Barack Obama, Wall Street Journal
opinion, 1/18/11.
“Excessive
regulation that slows the creation of new businesses and the expansion of
existing businesses, as Friedman notes, “tends to hurt most the very people it
is supposed to protect.” At the same time, in order to provide the structure
and predictability that business needs and to protect against abuses, we need
dynamic regulations, which are up-to-date, forward-looking, constantly applied,
and free of unnecessary burden.” No Apology, The Case for American
Greatness written by Mitt Ronmey, 2010.
- Joseph S. Kalinowski, CFA
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