[author: Rick Jones]
With the zoftig and still mutitative Big, Beautiful Bill stumbling through an unseemly Congressional favor-trading lollapalooza, one is reminded of Ms. Pelosi’s famous quip, “We’ve got to pass this bill to know what’s in it.” That made me think about trades and strategies based upon government dysfunction. There is and always will be dysfunction and we should figure out how to profit from that certainty.
Our government, and for this purpose, let’s include county, state and local, consumes about 28% of the United States Gross Domestic Product. The federal government alone passes dozens to hundreds of new laws each year and their minions in the apparatchiki produce something in the range of 80,000 pages of regulatory text…each and every year. (Did you know the Europeans have a Deforestation Law that requires everyone selling products into Europe to assess the impact of those products on worldwide deforestation? If it could only apply to lawmaking.) The federal government employees 3 million people, and perhaps a total of 22 million people (gasp), work for all levels of government in the United States. Be assured, they’re busy doing stuff, telling us what to do and what not to do, chiding us to do what they think is best like an annoying aunt and spending lots and lots of OPM (Other People’s Money).
Every year, while all this is going on, around 20,000 US businesses file for bankruptcy. That means that thousands of businesses are making fundamental, fatal errors in envisioning or executing their business plan. Now presumably, each of these failed businesses had a single purpose. Their raison d’être is making money. If private enterprises with a such a simple and limited mandate fail with such startling and depressing regularity, what do you think is happening in the halls of our government, which, for good or ill, can’t go out of business? Our government has multiple goals, innumerable jobs to do and endless squealing constituencies to be satisfied and has to do it on a scale inconceivably larger than our largest private enterprise.
Moreover, the corridors of power are not exactly replete with the best and brightest. Look, there’s lots of smart and dedicated folks imbued with a strong sense of civic duty beavering away in our government, but it’s tough to hire the best at a ridiculously low pay scale. Would Apple thrive with the top salary at $160,000 (that’s essentially the government’s ceiling)? One could argue that, given its scale and ambition, the government needs to hoover up the very best, and it does not.
With all that said, should we not expect an enterprise that is absolutely humongous in scale, with a dearth of talent, the obligation and ambition to do innumerable complicated things, an enterprise that dominates a very significant portion of our economy, to screw the pooch pretty regularly?
There’s going to be a problem.
This is not new. Current polling suggests that only 22% of Americans have faith that our government will get it right most of the time. 22%! That’s less than those who thought Mr. Biden was sharp as a tack last year. Sixty years ago, almost 75% of the US population thought that government always or most of the time got it right. In some significant measure, I suspect this deterioration of faith reflects the simple fact that the government has gotten so damn big, so ambitious, so intrusive and so impactful in our day-to-day lives. The government’s job, writ large, is just a lot harder today than it was 60 years ago. In these circumstances, the chance of getting it wrong in ways that matter multiplies exponentially. In other words, it’s not doing a worse job than it did 60 years ago, it’s just doing a bigger job at the same level of…worst-ness?
When you start looking for examples of the government getting it wrong, the problem is not that problems are hard to find, the problem is there’s truth there’s simply too many of them. Getting it wrong falls into two categories; the first is where government initiative is simply wrongheaded. It achieved the goal, but it’s obvious that the goal was ill advised. It was a “perverse” outcome, in academic palaver.
Remember sending Covid patients back to nursing homes? Lots of dead old folks. Remember President Erdogan of Turkey (to show this as an international problem) artificially pushing the cost of money down? Harrowing inflation resulted, till they reversed course.
Think of the Brits returning to the gold standard after World War I. Currency linked to gold was supposed to restore robust economic health. Instead, they got a severe depression. Not a good trade. Smoot Hawley? We all know how that worked. Nixon’s price controls? Same bad outcome. All of these and many more are examples of policies which did exactly the opposite of what the well-intended authors of the legislation or policy prescriptions intended.
The second category of governmental dysfunction, which is a considerably larger problem, is in the domain of unintended consequences. The notion here is that we pass a law that achieves its intended purpose but that successful outcome leads, in a knock-on sort of way, to bad things which are worse than the good the policy was designed to deliver.
Examples? Think about pollution controls that result in power brownouts. As the supply of power is diminished to achieve green goals, folks suffer bad health outcomes because of excessive cold or heat (albeit with terrifically clean lungs), jobs are lost and overall US productivity is impaired. Income is diminished; poverty accelerates as jobs are lost and our manufacturing base continues to shrink.
How about keeping kids out of school as a response to Covid? That was genius and we’re still suffering the consequence of that bad decision and probably will for years to come.
Consider rent control ordinances which continue to pop up in a whack-a-mole way around the country. Rent control is supposed to make life better for the folk. Well, it may mean that some people could afford apartments that they wouldn’t otherwise be able to afford, but it causes a rapid diminution of the housing stock. Developers don’t build, projects are shelved, maintenance dysfunction ensues as landlords can’t afford to invest fresh capital in their properties. Net/net, owners take apartments out of the housing stock and new supply is suppressed. There are less places for people to live. Consider the real time example of Minneapolis/St. Paul which is a double-blind test for this silliness. Minneapolis rejected rent control while St. Paul embraced it. Housing stock deteriorated in St. Paul and there were no new starts for multi-family housing. Minneapolis thrived. Now St. Paul is rolling back its rent control ordinances, and that’s indeed a good thing for the folks.
These are hardly novel observations, social scientists have been studying it for years. Professor Robert Martin’s seminal 1936 study called “The Unintended Consequences of Purpose of Social Action” hit the nail on the head (full disclosure, I just read the summary). The good professor argued that things top of mind matter more than what follows on; a type of present bias. A willful ignorance or blindness to unintended consequences of their plan, their idea, which they are focused on with a laser-like intensity is absolutely common. Colleges banning drinking on campus? It succeeded in the narrow sense that there was less drinking on campus, but through an excess attachment to that narrow goal, those administrators missed, intentionally or otherwise, the more important outcome. College kids (who believe they have a constitutional right to drink and party…at least I did at that age), would do the obvious; they’d drive off campus to drink. Terrific result. Our little overachieving snowflakes still get drunk, and they then drive back to campus endangering themselves and everyone around them. Unintended (but arguably foreseeable) consequences.
Another recent example that is attracting some real attention across the polity right now is the consequences of enormously complex, rigorous and exhaustive permitting schemes around the construction of…well, pretty much everything. The right has been nattering about this for years, but now the progressives are catching wise. The rules which represented a well-intended effort to ensure that relevant constituencies (in modern parlance, stakeholders) are consulted and all possible risks identified and attenuated, has an obvious unintended consequence to anyone who had actually thought about it: Nothing actually gets built. A writer with serious progressive bona fides, Ezra Klein, has a new and very popular book out called Abundance. In it, he makes the case that if we can’t build housing because of an endless round of public hearings, environmental studies and the like, we’ve traded the squishy social goal of inclusion for the actual social goal of giving people some place to live. There’s something where the left and right might actually get together (but don’t hold your breath). Governor Newsom was in the news as I write this championing a reversal of California’s long-standing and almost impenetrable permitting process to finally allow someone to build housing. The folks thank you, Governor Newsom.
You can take this to the bank; you can absolutely rely on the continued proliferation of unintended consequences. It’s simply baked into the cake. As the government continues to consume a larger and larger share of our economy, it will happen at increasing scale with a concomitant increasingly material impact. This can only get worse, as legislation and policymaking are marinated in politics which is increasingly tribal. It’s hard to really think things through, consider positive and negative outcomes, when what’s really important is only the identity of the messenger. We devolve into an exchange of talking points and shrill agitprop which has the intended (or perhaps unintended…nah, intended) effect of impeding thoughtful conversations. Also, our gloriously elected representatives, and the apparatchiki that actually run our government, are overwhelmed. The scale of what our government has undertaken is simply beyond the capacity of its humanware to manage. The folks trying their best make decisions and implement policy just aren’t going to have the capacity to fully explore unintended consequences and negative externalities.
Knowing the government will almost always fail to fully understand what it’s doing creates opportunities. We can capitalize on this reality.
When the Bank Term Funding Program passed in 2023 in response to the Silicon Valley bank disaster, an unintended opportunity opened up for the quick and nimble. In an effort to ensure adequate liquidity, the Fed, allowed banks to use Treasury securities as collateral for loans from the Fed. The interest rate on these loans was extraordinarily low. Smart banks figured out that they could borrow from the Fed under this new funding program and send the proceeds as deposits back to the Fed where they received a higher interest rate than the coupon on the borrowing. Some liquidity, perhaps. Baked in profits for sure.
Not that long ago, the federal agency in charge of food safety decided that sesame seeds and sesame oil were a risk to well…somebody and imposed an extremely elaborate and complex testing and reporting regime on bakers to capture the extent of sesame products in their bread. Breadmakers, concluding that the cost of figuring out whether sesame was in their products was astronomically high and understanding that the failure to get it right created liabilities, did, for them, a very smart thing; they added sesame to their products and reported, “Yep, there was sesame here.” A wildly better outcome for the bakers, albeit perhaps not terrific for those who had a real problem with sesame.
Risk retention is another example that comes to mind. Does anyone really think a 5% risk retention slice impacts underwriting, impacts the safety and soundness of the capital markets? I don’t. Any drag from retention was just priced into the deals. Vertical risk retention is barely worth the energy required to utter those words. It’s silly. However, risk retention did create a lot of profitable work for lawyers and accountants (not a bad thing) and gave rise to an enormous new opportunity for B-piece buyers. It’s great to be a buyer when the seller has to sell. But that’s not what it was all about, was it? It’s just what actually happened.
Do rent control ordinances create distress opportunities, create premium opportunities for development in adjacent communities? Yep. Green everything is a cornucopia of opportunities. (I was going to go off on Section 899 of the Big, Beautiful Bill Act which would have allowed the imposition of revenge tax on nondomestic lenders and investors which would create an uneven playing field for domestic and favored non-domestic investors. The White House has sensibly killed it.)
What’s going to happen if the government barfs Fannie and Freddie out into private hands? The policy notion behind this gets its energy from the right of center ideological commitment that lenders ought to be private enterprises, and not wards of the state. When ideology is in the driver seat, watch out! Consequences, unintended and otherwise, be damned. The doing of this will be incredibly complex. We may find the “N” state confounding. Double down? Buy a license? Hah! Buy pre-GFC bonds? Buy the remaining equity in private hands? How will the relationship between the mortgage banking community and the GSEs change and what happens if there’s only one surviving multi-family entity? What happens if our geniuses in Treasury decide we’re better off having ten of the federal home loan banks? All the lending programs these agencies have are likely to change. But how? Is it time to consider some level of rotation away from the GSE trade? I don’t know how this is going to play out, but I am absolutely certain that it will not roll out as its planners and designers intend.
This is perhaps an overlong proof that opportunity lies in governmental dysfunction. These examples argue for investment by thoughtful and sophisticated investors in really understanding each new piece of legislation, each new government initiative, each new policy that may affect the sector in which you operate.
There are dividends to be paid in investing time, energy and capital in a deep dive. Take each piece of regulation, legislation or policy, pick it apart bit by bit. Turn it around in your head and ask what reaction should be expected from affected constituencies. Go full Talmudic on the text. Small variation between text and legislative history, small variations between prior exposure drafts and final drafts can have major import. God bless the English language, but words often have multiple meanings. Word choice can matter if you can make them matter. One needs to look for second and third tier consequences of change standing in the shoes of all potentially impacted constituencies. Build decision trees. Keep asking “what if.” Yes, this takes money. It takes time and some not immaterial resource. Finding these opportunities won’t be easy. Think of it as the intellectual equivalent of the oil exploration business where you need to price in dry holes. Perhaps to beat the analogy to death, there’s plenty of oil out there for those who are thoughtful and disciplined, those who can persevere and be analytically creative. That’s you, isn’t it?
Start digging.
