Regulatory Environment Contributing to Sagflation

The Economist has devoted multiple articles of this week's edition to examining some of the issues with the regulatory environment in the US. In the February 14 article titled "Fiscal Stimulation," I argued within the framework of my Sagflation theme that there is a build up of excess capital in the economy due to an aggressive monetary policy over the past few decades, as well as recent expansionary fiscal policies. In this article I highlight the additional costs to businesses created by the regulatory environment, as well as the impact on the economy within my Sagflation theme.

My main point in this post is that I believe perversions in the legislative process are resulting in greater burdens for the US economy, which likely contributes to slowing growth in the future and compressing company margins. 

Regulatory Issues

There are plenty of examples of the burdens of poorly designed regulations, but the cause seems to boil down to a political system rigged more towards dollars than votes. Politicians spend excessive time fund raising and listening to micro interests from their donors, and less time devoted to crafting thoughtful and intelligent laws. I believe a secondary issue, either caused by the dollars or by the politicians themselves, is the effort by the legislative branch to over-step its authority and attempt to dictate to the administration how to administer the government. As a result, lawmakers create overly complex laws that attempt to cover every eventuality raised by their donors, instead of laying out broad goals and focusing only on what is strictly required to achieve the goals. Lobbyists seem to favor this system because overly-complex laws offer opportunities for special interests to insert language favorable to them, in my view. This is not a party-specific issue, in my mind, it is a systemic issue that needs to be addressed.

All this additional complexity costs money, of which there is a growing list of examples. The additional burdens of compliance with Sarbanes-Oxley has resulted in a precipitous drop in the US's share of IPOs, from 67% in 2002 to 16% in 2011. Jamie Dimon of JP Morgan Chase estimates the annual direct costs of Dodd-Frank to the bank will be around $400-600 million. The EPA estimates the cost of new mercury standards may cost businesses $10 billion per year, the interstate air pollution rule an additional $2.4 billion per year, and the ozone rule at least $20 billion per year. However, as The Economist points out, the "real costs may be found in the hard-to-calculate perversion of behavior that over-regulation causes." An example of the perversion is that some regulated companies, which have already sunk the costs into compliance, may actually encourage on-going regulation to maintain a higher barrier to entry against new entrants.

While I do not consider myself a libertarian, I do believe that the process by which laws are crafted has become perverted, resulting in growing inefficiencies within the economy. 

Incorporating Regulatory Burdens into Sagflation Theme

Putting together my previous message of sustained mis-allocation of capital with this post's message of rising regulatory costs suggests return on capital could compress significantly if growth slows. It is likely, in my view, that economic growth slows over the next few years due to austerity. Should interest rates begin to rise due to either a Fed policy change or market forces, companies would also confront a rising cost of capital. Slowing growth, excess capital, shrinking margins, and a higher cost of capital could lead to larger write-offs over the next few years than witnessed in 2008, in my view.

The Wall Street Journal points out that the P/E valuation of the S&P 500 based on Robert Shiller's 10-year average earnings calculation is potentially inflated due to the large write-offs impacting earnings after the dot-com bust and the housing bust. Excluding these write-offs, the P/E under Shiller's formula is 18.9x, about in-line with the 50-year average. I believe the market ignores these write-offs at its own peril because the write-offs are the result of the build-up of excess capital in the economy, partially reported as "overstated profits," associated with an overly aggressive monetary policy. Since the policies have not changed, why should we expect the write-offs to be "one-time?"