The Rules Of The Game No Longer Apply
"I think this destruction of capital in Allergan should serve as a warning to you at home that the government can be a powerful opponent to your wealth creation. If the Treasury can change the rules after reassuring parties that it wouldn't, if it can craft rules that companies are meant to follow and then remake those rules so that a given company is suddenly violating them, then that fact makes all stocks worth a little less in my eyes."
-- Jim Cramer
If the Obama Administration wishes to cement its legacy as a serial market manipulator, it will have achieved that goal with high marks this week. For an administration that prides itself on the noble goals of "equity" and "fairness", and for a president with such an incredible background in law, it astounds me as to what lengths the current administration will go to seek to subvert the law in order to satisfy the momentary mood of the majority. Is it any coincidence that the administration would act to block the Pfizer (NYSE:PFE)-Allergan (NYSE:AGN) merger the same week as public fervor about the "Panama Papers" and corporate inversions reaches a climax?
What these latest moves - blocking the mergers of Halliburton (NYSE:HAL) and Baker Hughes (NYSE:BHI) and of Pfizer and Allergan - have taught us is that the rules of the game no longer apply. And that is a very dangerous situation indeed. Dangerous, not just in the political sense, but in the macroeconomic sense as well. Worse still, it seems that these past few decades of regulatory excess and unpredictability may merely be a taste of what is to come, if electoral politics and public opinion polls are any measure of forward guidance for the nation.
To recognize why it is Pfizer sought to pursue Allergan in the first place is key to discovering how to solve the "problem" of corporate tax inversion, in which companies buy foreign entities to adopt a lower-tax jurisdiction. It does not take a genius to figure out why this deal was being sought and why the administration sought to use its regulatory leverage to make an example of Pfizer for all the public to witness.
Because of the unique difficulties in research & development of new products, extreme competition, and other market forces, the pharma/biotech sector is highly engaged in cost savings. This is not a new concept by any means, but it is especially important to this burgeoning industry. Pfizer has already been engaged in this process, having pursued corporate inversion acquisitions in the past and having already closed numerous production plants in the U.S. (The exact math behind the acquisition loopholes is available here and already well-known to many in the industry.)
However, corporate inversion and offshoring are merely symptoms of the true problem - the corporate tax code. Of all OECD nations, the U.S. has the highest statutory corporate tax rate at 39.1% versus an average of 24.1%. This is not the effective tax rate that many companies pay due to exemptions and the like, but the rate is still high enough to encourage so many companies as of late to close up shop and move elsewhere. Of course, the real problem lies not even in the tax revenue that government collects; it is the random and sporadic actions of politicians seeking to capitalize on the anger of the mob, whetting their appetite for "justice" and "equality". And it is this slow accumulation of expenditure for social spending, regulation, and redistributive policy that requires that the state maintain such a stranglehold on private enterprise.
(Source: UNCTAD World Investment Report)
The Growth of the Regulatory Bureaucracy & Game Theory
In a previous article, I go more into detail about this frightening trend of illiberalization, but here I want to focus on the consequences of such a society where the growth of restriction/regulation outpaces liberalization/promotion of private enterprise. Dean Emeritus Bruce Yandle of Clemson University recently gave a highly illuminating lecture on this same trend in conjunction with the Mises Institute, and I hope he won't mind me appropriating some of the data he has collected in order to illustrate some of my own points as well. (You can find the lecture here.)
Now while Yandle discusses more in depth the impact of regulation on various industries and the personal philosophical impact on the individual, I think it is also important to highlight the intellectual forces influencing this trend. Game theory is a highly popular post-modern theory, and if you have ever been on a college campus in the past few decades, you have probably heard of it talked about ad nauseum. The few anecdotal references to game theory espoused by professors in Political Science and Macroeconomics classes represent the mere basics of a huge trend of behavioral sciences sweeping the intellectual sphere.
It's actually relatively easy to relate game theory back to the Pfizer-Allergan merger break-up and other such actions of this administration (and any other administrations past if you so chose to do so.) It is a process described as selective and unpredictable bargaining (otherwise known as 'picking your battles' and 'bluffing'). Bluffing - using deceit to trick your rivals when in a disadvantageous position - and other methods to create unpredictability are the key to victory in game theory. And how can one describe the regulatory actions of this current administration and administrations past as anything other than unpredictable?
"In a mixed strategy, bluffing is constant, sustained, and systematic - it takes one's advantage into account but randomizes just enough to keep that advantage working effectively. Randomization is common practice in any number of "games," from the predator-prey scenario of a squirrel fleeing a hawk to a government's approach to airport security or tax auditing. In most cases, success depends on more than a single dramatic bluff. For game theorists, the way to win is to guarantee long-term unpredictability."
-- Ehud Kalai; Kent Grayson
However, the global marketplace is not a zero-sum game; cooperation is advantageous, and if unpredictability is constant, people may stop playing altogether. Obama - as an adherent to the Hobbesian school of political philosophy - naturally has an absolutist view of humanity and of the necessity of the state. It would, therefore, not be that far off to suggest that, as a highly intelligent person with many capable staff, the president feels he is merely fulfilling his necessary role as interventionist, even if those actions create chaos, fear, and unpredictability in the marketplace. As many pre-eminent economists have warned, this interventionism, regulatory build-up, and sporadic punitive behavior has resulted in less competition, higher consumer prices, and ultimately a slower economy.
"If we were to apply the unmodified, uncurbed rules of say...our families to our wider civilization, as our instincts and sentimental yearnings often make us wish to do, we would destroy it."
-- F. A. Hayek
Unfortunately, it is this pernicious view among intellectuals of the necessity of state interventionism and restrictions that coincide with appeals to emotion that cause the problems we face today to persist. Even worse, it has spread through the populace to the young.
The People Love It!
So, where do the people stand in all of this? If public opinion polls and social media mining are to be trusted, well...the sub-title says it all. In a recent Gallup poll, nearly 70% of young people aged 18-29 and 50% of individuals aged 30-49 said they would be willing to vote for a socialist president. Voters under 30 are now more likely to view socialism more favorably than capitalism.
And that is frightening and a serious challenge for the long-term health of our economic system - for if the majority of the electorate begin to view the economic system as "rigged" and are willing to accept more restriction and more regulation down the road in exchange for promises of a better life, growth will only stagnate further and, eventually, no one will want to play the game anymore.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.