(Leverage: amount of debt that a company uses in its capital structure.  This is called leverage because it effectively multiplies, or leverages, the equity owners’ gains or losses.)  Over the last few years we have seen firsthand how over-levered companies can create an unstable environment.  Heavily levered firms such as investment banks, AIG, General Motors, and a number or other smaller companies have either declared bankruptcy or created serious risk for equity owners and others after the downturn in the economy.  So why are these companies so heavily levered?  Don’t the equity owners have an incentive to keep leverage lower to protect their positions?

The tax code in the United States calls for high corporate and personal tax rates, but partially offsets these high rates with deductions that corporations are allowed to take to lower their tax exposure.  Whether taxed at the corporate level (C-Corporations, think of most publicly traded companies) or only the personal level (S-Corporation, LLCs, LPs, et cetera, think of most small companies), the United States tax code allows companies to deduct interest expense from loans to the company from their earnings to lower their tax-basis.  As such, the more interest companies pay, the less they pay in income taxes.  This strategy, to offset the interest expense of debt with tax savings, is referred to as the debt-tax-shield (DTS).

For example, if a company borrows money at a 10% interest rate in a nation with no income taxes, the cost of the debt is 10%.  However, if the company borrows money in the United States with marginal income tax levels at 35%, the effective cost of debt is 6.5%.  The lower effective interest rate is a result of the income tax.  This lower effective interest rate inspires companies to borrow more money than they otherwise would because the cost of borrowing that money is lower, in relative terms, than it should be.  Furthermore, the higher the tax rate, the more incentive companies have to take on debt.  Consider a 50% marginal tax rate, under which out 10% debt would effectively cost 5%.  This artificially increased debt load encumbers companies and the entire economy with more risk.

This is just another instance where the government serves to distort markets.  This is by no means a call to remove interest expense from taxable deductions, as that will do nothing since companies will find other creative ways to reduce their cost of capital under whatever tax structure may be in place.  Instead we should be rid of income taxes, or at least lower the income tax rates.

Remember how everyone told us that investment banks were trading securities, more specifically derivatives, which are so complex that not even Warren Buffet or Alan Greenspan understood them and this led to the downfall of the economy?  Well, there is no longer any need to concern yourself with any of that.  You see, even though Warren Buffet doesn’t understand derivatives trading our friends in Congress understand it perfectly.  In fact, they understand it so well that they have produced and passed a 2000+ page bill outlining new regulations on derivatives trading among other massive financial regulation.

The three most visible minds behind the new financial regulation were Chris Dodd (D – Connecticut Senator), Barney Frank (D – Massachusetts Representative), and Harry Reid (D – Nevada Senator and Majority Leader).  To say that these men are completely inexperienced and uneducated with regard to the world of finance would be a gross underestimation.  Dodd did his undergrad in English literature, Frank in history, and Reid went above and beyond with a degree in political science.  All three men went on to achieve law degrees.  Chris Dodd has the impressive distinction of holding a complete monopoly on the threesome’s private sector work experience with two years under his belt as a lawyer at a private firm.  Neither Barney Frank nor Harry Reid worked one day in the private sector in their professional careers.  What’s more, none of these men has spent one day in the financial sector and not one studied finance in school.

This is not an atypical cross-section of the people that are governing us today.  “Politician” has become a profession in this nation – no longer a service.  If, for a minute, we even assumed that the world does need protection from financial risks (which I would strongly argue it does not), this is like the blind leading the blind.  Dodd, Frank, and Reid would have us believe that they are somehow protecting you and me from the evils of Goldman Sachs and John Paulson.  However, they do not even know what they are protecting us from.  What Dodd, Frank, and Reid do know is how to win votes (though they seem to be losing their touch).  They can stand at a podium and tell the world that they are protecting them from the evil robber barons on Wall Street.  Because most of the populous does not understand financial derivatives any better than their congressmen, people are duped into buying ill-advised protection rather than face the free market head on.

How many of you got burned on your derivative investments over the past two years?  If you did get burned, how much of that was attributed to fraud or some other criminal act versus a bad investment decision?  Even though most people (particularly congressmen) do not understand derivatives, they are not beyond the human realm of understanding.  Mr. Buffet, though he claims derivatives can be harmful, trades in derivatives every day in his insurance concerns.  You own a derivative on your automobile called insurance.

A lack of understanding in Washington DC is making the financial system into a mass of molasses where nothing can be done without jumping through the hoops of regulation.  This serves to make finance more expensive and a game that only the behemoths can play in because of the exorbitant expense of jumping through said regulatory hoops.  The consumers and the small business people will end up paying for this.  It is already reported that banks will do away with free checking and many branches, instead charging $10 per month for a checking account and requiring you to deposit checks at ATMs instead of bank branches.  Loans will become more expensive as the costs of administering those loans within the government’s guidelines increase.  Lending to small businesses and consumers will become less frequent as financiers are unable to hedge their risks with derivatives.  Food production will become more expensive as farmers are unable to sell derivatives on their crops at the same prices.

Government has grown too large and it is stifling the people of this once great nation.  We no longer believe in free enterprise and efficiency, but rather rules and safety nets.  The only way this nation or any nation will prosper is to afford its citizens liberty – something that is lost on our politicians.  This election season take this nation back from the career politicians and those that would rather security (in all forms, not just militarily) than liberty and let’s start on the path to rebuilding the prosperous, free society that made this nation so great.

“Any society that would give up a little liberty to gain a little security will deserve neither and lose both.” -Ben Franklin

I, like many of you, have always wondered why it is that liberal economics dominate the ranks of well-educated, intelligent, financially well-off people.  Why people that would benefit from welfare and other transfers of wealth would vote democrat is self-explanatory.  However, the reasoning behind a wealthy businessman, an educated and well paid college professor, or a young person in college or recently removed from college to vote democrat can be perplexing.  These people would generally benefit from free markets and are likely to be well educated enough to understand the negative consequences of government control.  So why do they consistently vote for the left?

In 2005 the Washington Post reported a story entitled, “College Faculties A Most Liberal Lot, Study Finds.” The study points out that 72% of all college professors polled identified themselves as liberal.  Not shockingly, of those professors teaching at “elite” schools, 87% identified themselves as liberal.  If you follow politics and the world of economics you will be well accustomed to hearing of liberal policy and politicians coming out of Yale, Harvard, etc.  Most of the professors at these elite institutions are incredibly accomplished academics and have few real monetary concerns.  Most of them must be well informed on the benefits of free markets and the pitfalls of government, so why do they lean so far left?  This incongruity baffled me for some time, but I believe I have the answer: they are more intelligent than most other people, and they know it.  Because they are so smart, they feel that they are better equipped to make decisions than people with less intellectual ability.  To some degree, they are right; I would rather a Yale economics professor manage my investment portfolio than Jim-Bob from West Virginia (no offense, Jim-Bob).  Regardless, the problem arises when they believe that they can design macro decisions that replace the countless micro decisions that are made in a free market.  No one person, or group of people, is more intelligent or can dictate a more efficient system than the market.  Despite all the brain-power that is held by this select group of people at these elite education institutions, the market’s knowledge, intelligence, and efficiency dwarfs the intellect at Yale, Harvard, and the rest of the Ivy League combined.

Why are college students, typically from well-off families or at a very minimum intelligent enough to make their own way in the world without the help of the government, so rampantly left-leaning?  Here I think there are a few reasons.  The obvious reason stemming from the paragraph above: college campuses are typically more liberal because of the ideals that are taught by more liberal college professors.  But, it goes deeper than that.  Most college students have yet to see the real world.  They have yet to rely completely on their own paycheck and see a huge percentage of it taken away by Uncle Sam.  They have yet to see firsthand the demise of the entrepreneur at the hands of the government.  Perhaps most importantly, they are generally accustomed to having a safety net.  Most college students live in relative squalor, but they still know that if push came to shove they could depend on help from their parents or other family members.  This leads to a fear of not having a safety net and a belief that everyone should be entitled to a safety net of their own.  This is not to say that every college student has a safety net, but most do and I believe a lot of the liberal beliefs of college students stem from said safety net.  One last piece of influence on college students is social issues.  That is, college students generally have more liberal social ideals and believe that gay people should be able to be married and women should be able to have abortions should they choose to do so.  I was in a boat similar to this in my earlier college years.  Like many college students, I was not terribly concerned with the economy because the economy didn’t have any impact on my college student life, so I focused on the social issues.  One nice thing about college “lefties” is that many of them change their opinions.  In fact, as more and more of them learn about economics and the importance of the topic, they tend to shift more toward libertarianism, which satiates their desire for free societies while ensuring free markets.

Now for the real challenge: why does big business love democrats?  We are always told by the media that democrats are trying to reign in big business; the picture is painted of big business going head to head with liberals.  This is one of the greatest misrepresentations in our world today.  As a sort of cliff-hanger, I am going to address this issue in my next article, “Why big business loves big government,” so check back often!

My reasoning behind this article is indeed exploratory, but there is also an ulterior motive.  We should not base our political ideologies or votes on what is believed or said by people that seem more intelligent, knowledgeable, and successful than we are.  Develop your ideologies based on what you think is right and what you are able to reason.  With the rise of reason we will have an increasingly great society.

Coca-Cola | Starbucks | McDonald’s | Google | Microsoft | Intel | U.S. Department of Housing and Urban Development

Which of the listed groups do you think has the highest annual budget?  You probably guessed right because it sticks out like a sore thumb – the United States Department of Housing and Urban Development (“HUD”).  HUD has a higher budget than Coca-Cola and Google combined.  Starbucks takes care of over 5 million patrons per day (2006 stat) and sells packaged coffee beans and numerous other goods, and does it for a little over $9 billion per year in operating expenses.  Google handles more internet traffic than any other website on earth (over 4% of the internet’s entire traffic), builds software for computers and mobile phones, and does a slew of other money-making ventures and it spends a little over $16 billion per year, which comes out to about 1/3 of the amount that HUD plans to spend in 2010.  HUD spent over $40 billion in 2009 and plans to up that by a modest $3 billion to over $43.7 billion in 2010 and was rated the worst landlord in the United States in 2006.  On a per working person basis, that is over $291 that each of us will spend on HUD next year.  I can get a Playstation 3 or a laptop computer for less than that.

There is nothing special about HUD that made me choose it for my example.  They are no more inefficient than any other department of the federal government and they could have easily been replaced by one of the other countless departments and agencies that our government has developed (full list: http://en.wikipedia.org/wiki/List_of_United_States_federal_agencies).

The inherent inefficiencies in government lead to dramatically greater levels of spending.  There is no incentive for a government agency to run efficiently, in fact there is an incentive to run inefficiently.  By bloating their spending, government agencies can secure more funding for the next year.  If, however, they run efficiently and go under budget, that money will be stripped from them the next year and reallocated to an inefficient program.  Furthermore, as an agency grows and hires more people, legislators become afraid to disband the agency because they will then be “killing jobs.”  Conversely, private people and organizations have incentives to spend as little as possible while producing as much as possible.  These capitalistic efficiencies, not government spending, are what have made the United States so prosperous in its brief history.

Would you rather have Shaun Donovan (HUD Secretary most of us have never heard of and has a higher budget than the Microsoft CEO, Steve Ballmer) spend your $291 next year, or would you rather spend it yourself?  Every dollar that the government spends is one less dollar that each of us can invest or use to buy food and clothing.  If the government really wants to improve employment and housing, they would be best suited to get out of the way and let the people of this nation spend their own money in far more efficient manners than the U.S. Government will ever be able to spend our money for us.

Let’s, for the sake of argument, assume that HR 3200 is completely revenue neutral and that no one will be taxed a single extra penny, because, for the purposes of my discussion below, it doesn’t matter whether this is true or not. If you comment on this article and say anything about revenue neutrality or no increased taxes (on people making less than that magical number of $250K/year, of course), I will simply laugh at you for not reading the article and shouting out talking points.

It has been established that insurance companies struck a deal with Washington. The deal: You (Washington) force everyone to buy an insurance plan and we (the big bad insurance companies) will support a plan to insure people with preexisting conditions.

That sounds great, right? I mean, it’s just like auto insurance. The reason auto insurance is so cheap (I pay more for car insurance than I do for health insurance… so figure that one out for me) is that the auto insurance companies have a better risk pool because both good and bad drivers are forced to buy insurance.

You see, what would happen if not everyone were forced to buy auto insurance is that people who are not risk averse and feel that they are great drivers would buy either a watered-down policy or no policy at all. The bad drivers (knowing that they are bad drivers or otherwise accident prone) and the risk averse would pay a higher premium for better insurance. The insurance company would really have very little way to tell who was buying the better packages because he is just a bad driver and who is simply risk averse. This problem is known as adverse selection, which often occurs in situations where there is an asymmetry of information, meaning one or both parties have information that the other does not have.

Because of this problem of adverse selection, the insurance companies would charge a very large premium for the bad drivers (i.e. the policies with more coverage) and a very small premium for the good drivers (i.e. the policies with less coverage).

Now, when the government steps in and forces EVERYONE to buy a certain minimum level of coverage, what happens? Well, now the insurance companies know that some of the drivers are very good drivers who will rarely, if ever, make a claim, while some are the bad drivers who will constantly be making claims, probably in excess of the premiums they pay. But, because of the risk pooling now in effect, the insurance company can charge the bad drivers a smaller premium than before because the good drivers are making up the difference. In other words, the good drivers are subsidizing the bad drivers’ insurance premiums when they are forced to buy a minimum coverage in excess of what they would have without the law forcing the purchase of a minimum coverage policy.

This is great for bad drivers, and terrible for good drivers. Not only is it bad for good drivers because they pay more, but there are more bad drivers on the road because the good drivers are subsidizing their bad driving practices! And, on top of that, some of the good drivers who would have bought less expensive policies and then either not repaired minor cosmetic issues that are pricey to repair, or would have paid out of pocket because their plan didn’t cover it will start getting those repairs done, increasing both demand for and, therefore, cost of auto repairs.

Back to health care:

The health insurance lobby is not entirely stupid. They understand what’s at risk here. Either they cover preexisting conditions, or they face competition against a “public option” which will most certainly cover preexisting conditions at a fraction of the cost, being backed by the seemingly bottomless purse of the United States Treasury (ultimately, this is tax payers’ money… and mostly “rich” tax payers’ money). So, they cut a deal with Washington.

The health insurance companies know that if they can create a better risk pool by forcing young, healthy people into plans with certain “minimum standards”, then they can offer lower insurance premiums to older, sicker people and they can offer to cover preexisting conditions. The solution is clear: get into bed with Washington.

Just like auto insurance, this is great for those who will use their health insurance the most: the sick and the old. This is a terrible deal for those who wouldn’t typically use their health insurance all that much: the young and the healthy.

This is a massive transfer of cost from the sick to the healthy. And, because the healthy will be forced to buy more expensive policies, they will be more apt to use the policy, increasing the demand of and, therefore, the cost of health care.

It all sounds like a good deal to anyone with a heart. However, when you look at the unintended consequences, you have to ask yourself if it’s right. The people who will be disproportionately hurt by this deal are the young, healthy people in our economy. It will become more expensive to ensure low wage earners (who are typically younger, healthier workers), and it will cost those young people who are either unemployed or self-employed a considerable amount more money to buy health insurance, because they will be forced into buying more expensive coverage to meet minimum coverage standards.

Ultimately, this will cost young, healthy people their jobs as they become more expensive to insure. It will keep unemployment rates higher among the very people this bill is aimed to help: the poor (low income earners) and the unemployed.

For those of you who have preexisting conditions and think this is a great thing, I only ask that you say out loud what you are truly asking for: “I want to force healthy people to pay more money so that I can pay less. I want to take from the healthy for my benefit.” Don’t try to make this seem like some nobel purpose you are pursuing – some right to which all Americans are entitled. You are in this for yourself. You are as greedy as Bernie Madoff, but you are trying to use the government to force people to give to you, whereas Bernie Madoff just committed fraud. You both have the same end goal: more for yourself at the expense of others.

Freedom creates optimal efficiencies because it demands the best from people and the best is always the outcome.  However, one of the byproducts of efficiency is creative destruction.

Take, for example, the typewriter.  At the height of the typewriter industry there were two notable typewriter manufacturers (there were more than two, but I am only referring to two in this example).  Both companies grew into large corporations and bought out competitors in an effort to ramp up growth.  Eventually the personal computer was invented and an entirely new degree of competition entered the typewriter industry.  One of these two companies did not have the foresight to adapt to the changing free market – it kept producing mainly typewriters.  The company eventually declared bankruptcy in 1995.  That company is Smith Corona – most of you have probably never heard of them.  The second company in our example decided to diversify and enter the high-tech world of manufacturing computers and computer parts as well as a number of other industries.  That company is still around today and recently it sold its computer manufacturing division in an effort to slowly exit the manufacturing industry and expand itself into the consulting industry.  That company is one of the largest American companies today – International Business Machines Corporation (IBM).  The point of this exercise is to point out that freedom demands the best and creates the best.  IBM boasts revenues of about $100 billion each year because it has provided some spectacular services and products to its customers.  Smith Corona declared bankruptcy and is still struggling producing only two models of type writers because they have failed to adapt to the market and are not providing their customers with the best products for the lowest prices.  Just take a look at the two companies’ websites (www.ibm.com and www.smithcorona.com) to get an idea of what I am referring to when I say “best.”  This example of how freedom fosters the best of all things and weeds out those things that are inefficient and unproductive ends with a happy ending – IBM continues to operate and has probably provided more for Corona Smith’s old customers and employees than they would have ever had if it had not been for IBM.  Most importantly, the government did not get involved.

Other endings are not so happy.  Let’s consider the example of our automobile industry.  Since the beginning of our automobile industry many automobile manufacturers have opened and closed their doors.  Some names include Pierce-Arrow, the American Motor Car Company, Hudson Motor Car Company (acquired by American Motors Corporation), American Motors Corporation (nearly bankrupt and acquired by Chrysler and rebranded as Eagle), and Eagle (defunct since 1998).  Despite all of these companies closing their doors, the American economy continued on and the people that used to manufacture these vehicles found new jobs.  The exits of these companies were at the hands of competitors that offered superior products at lower prices, just as the troubles of GM and Chrysler in today’s day are at the hands of competitors offering superior products at lower prices.  However, because people all have big hearts (or disgustingly crooked intentions, depending on your angle) and look out for their fellow man, the elected officials of the United States Government decided we simply could not put all of the GM and Chrysler employees out of work (even though most of us clearly did not like what they were producing).  As such, the government stepped in and decided to tax us all to “prop-up” these companies.

In the United States, our freedoms have been trampled by people with the very best of intentions.    Most of the United States citizens in favor of “bailing out” GM and Chrysler (excluding congressmen, senators, anyone in the executive branch, any employee of GM and Chrysler, and any UAW member or representative) believed we should spend tax dollars on taking over the companies and redistributing the equity how President Obama saw fit because it would help the employees of these companies.  Some even listened to the politicians’ nonsense and believed that taking over these companies would somehow improve the economy.  Either way, most people believed that it would help their fellow Americans to nationalize two thirds of the United States automobile industry.  They had good intentions; they just did not have the knowledge to foresee that their actions would actually harm most Americans.  Most tragically, it would harm innocent Americans that had previously had no stake in GM or Chrysler and would still pay the price of nationalizing them.

Each dollar you spend is a type of vote.  You are voting that the product or service you acquire is better than its competitors.  When you buy a ticket to The Hangover rather than Paul Blart: Mall Cop, you are voting that more movies be made like The Hangover than Paul Blart.  Similarly, when Americans went out and bought Toyotas, Hondas, and Fords, they were voting that more vehicles be produced like those they bought than those produced by GM and Chrysler.  Now we do not have the freedom to decide.  Now the government decides for us.  We are each taxed (some more than others) and we have all therefore given our money to GM and Chrysler, even though they created inferior products.  Furthermore, this occurrence puts a big vote in from all of us that it doesn’t matter what kind of filth you put out of your factories – if you employ enough people the government of the United States will tax its citizens more to pay for your company’s shortcomings.  What do you suppose this will do to the research and development of these companies?

Because the auto-industry has been the focus this year it is easy to pick on, and I will continue picking.  Consider the subsidies the government gives buyers of hybrid vehicles.  These also come from the best of intentions (for most people).  Generally, the supporters of this subsidy want less vehicle emissions to enter our atmosphere in hopes of keeping the air clean and somehow (this is also bullshit . . .) cool our planet (apparently a cold planet is better than a warm one and I don’t think anybody knows why they feel that way).  No matter your politics, it is clear that most of these people have good intentions.  However, they are stripping the rest of us of our freedom and they are tampering with creative destruction.  They are effectively making each of us pay for part of a hybrid car, whether or not we want one.  Furthermore, they are making people that may not otherwise buy a certain model or brand of car, buy said car.  This creates a situation whereby people are voting for one type of car with their dollar because it is now cheaper (because we are all pitching in) than the car they would have otherwise purchased, even though the other car would otherwise be superior for that given price.  This then tells the automobile manufacturer to make more of the subsidized car and less of the car that is actually superior.  If the hybrid cars truly were superior cars for the price then people would naturally be lining up to buy them.  I can’t be certain because they are already subsidized, but I am confident that if there were not subsidies for hybrids that the Toyota Prius would still sell well because it gets great gas mileage for those people that are concerned with that.  We do not need the government to tell us (or “nudge” us as Cass Sunstein would say) what we should buy, sell, do, or believe.  If a product is better and cheaper then it will prevail.  If it is overpriced and lousy then it will be driven out of the market.  The same can be said for all things, not just automobiles.

These are but a couple small examples, but the lesson holds true to all things.  One of the most beautiful parts of a free society is that it embraces the best and discards the worst.  It is only when the government steps in to press its will upon the citizens of that society that things go wrong.  No matter the intentions of those people that push for new laws and regulations, one thing stands true about them: they feel they can run your life better than you can run it yourself.  I disagree.  I believe we are all capable of making decisions for ourselves.  Sometimes you and I will be wrong and we will pay our own price for being wrong and, likewise, we will reap our own benefits from being right.  But, no matter how often we are personally wrong, with enough people acting freely the world will inevitably improve and each and every one of us will be better off in the long run.

Please Comment: I’d like to hear if any of you can come up with a situation in which creative destruction is more destructive than creative.