The Daily Reckoning November 23rd

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How Government “Works”, Part II

In the case of Egypt, people listened and obeyed — at least, as much as they did — because Pharaoh was, in theory, a god. In the case of Rome — with the exception of Caligula’s claims — and the Mongol empires, the theory was similarly simple, though different. Tamerlane made no claim to divinity. He merely made it clear what he would do to you if you resisted him. Towns that submitted were generally governed passably, according to the standards of the day…and taxed, but not razed to the ground. Those that contested his authority were destroyed, often with all the inhabitants killed.

In Rome and out on the steppes, those who controlled the ‘government’ were in the favored position. They could reach out and impose their will on those who were not favored. Which is exactly what they did. As long as they were able, the insiders took from the outsiders. In both cases, the outsiders were literally outside the ruling group and its homeland.

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This is perhaps a good place to point out that government is a phenomenon, not a system. It is best understood as a fight between the outsiders and the insiders. The insiders always control the government…and use it to conquer and control the outsiders. Why do they want to do so? The usual reasons. Wealth. Power. Status.

Everybody — or everyone who isn’t either feebleminded or a saint — wants wealth, power and status. And the easiest, fastest way to get it usually is to take it away from someone. That is government’s role. Only government can take something away from someone else lawfully. Why? Because governments make the laws.

We’ve already seen how a small group of Romans were able to reach beyond their home town, for nearly 1,000 years, taking wealth from people on the outside. One tribe fell under their control. Then another. Then, one town. And another. And always the power, prestige and wealth flowed back to Rome.

But not all Romans benefited in the same way. Rome itself was divided. During the Republican period, the insiders were the leading families who controlled the Senate. Then came the dictators, the emperors, and the scalawags who were able to get control of the government. Often, they were military men, popular or cunning generals who rose through the ranks, murdered their rivals, and took the reins of power for themselves. Each brought in new insiders…and kicked out some of the old ones. Rome sizzled with intrigue…and sometimes erupted into open warfare, with one group of insiders battling it out with another.

After Rome fell, barbarian tribes swept over Europe. Local strongmen were able to set up their own governments. There was little theory or justification involved. They used brute force to take what they wanted. Then they settled down to govern. One local lord provided protection from other local lords. All demanded payment, tribute, wealth and power. In the largely un-moneyed economies of the Dark Ages, taxes were in the form of a share of output…and/or days of labor. A serf typically worked one day in 10 for his lord and master.

The local warlord and his entourage were the insiders. They took from the outsiders as much as they could get away with. Or as much as they thought it prudent to demand. Some even asserted a droit du seigneur, known in France by the more carnal expression “the right to the thigh.” The local chief demanded the right to deflower the brides of his peasants. Even as recently as the beginning of the last century, Kurdish chieftains claimed the right to bed Armenian brides on their wedding night.

As the Dark Ages progressed, government became less locally peculiar. Across Europe, serfs, lords, and vassals knit themselves together into the feudal system. One governed a small area and was in turn governed by another, who governed a bigger one. At the top was the king, who owed his allegiance to God himself.

Justifying and explaining the phenomenon of government also evolved. How to make sense of it? Why was one man powerful and rich and another weak and poor? Europe was Christianized by then. All men were supposed to be equal in God’s eyes. How come they were so different in the eyes of each other?

Reaching back into antiquity, the doctrine of the “Divine Right of Kings” was developed to explain it. Scholars did not maintain that kings were divine, because that would undermine the foundations of Judeo-Christian monotheism. Instead, they claimed that kings had a special role to play, that they were appointed…and anointed, by God (through his ministers in the church of St. Peter)…to rule. Some people thought the kings were descended directly from the line of Jesus Christ. Others thought that God gave kings a “divine” right to govern in His name.

In the fixed order of the world, each person had a job to do. One was a hewer of wood. Another was a drawer of water. A third was a king. Each man did his duty.

Scholars in the middle ages spent a lot of time on the issue. As a theory of government it seemed coherent and logical. But there were traps and dead ends in it. If the right to rule were given by God, man could not contradict Him. But men did. One divinely-appointed ruler met another divinely-appointed ruler on the field of battle. Only one could win. What kind of game was God playing?

And if God granted a man the right to rule other men, did that mean that every order he gave must be obeyed, just as though it had come from the mouth of God himself? And what if the king seemed not to be doing God’s work at all? Adultery was clearly a no-no. God disapproved of it. But kings often made it a habit and a sport. Did not the king defile his body and betray his Lord? In an effort to explain away the problem, scholars put forth the idea that the king actually had two bodies. One sacred. One profane.

But which was which?

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“The Divine Right of Kings” was a theory of government that held water. But you had to put the water in the right container. You had to believe in God. You had to believe that He gave out job assignments. You also had to believe that He didn’t mind when His employees and agents made a mess of things…or even when they contradicted His own orders. Looking at the history of the monarchs who were thought to have been given this divine authority, you would have to conclude that God was either a very tolerant task-master, or a very negligent one. Adultery, murder, thieving, lying — there was hardly one of God’s commandments they obeyed.

As a theory of government, the ‘divine right of kings’ would have been okay had it not been for the kings themselves. Some were reasonable men. Others were tyrants. Many were incompetent, largely irrelevant and silly. Taken all together, it was very difficult to believe that they had been selected by God, without also believing that God was just choosing His most important managers at random. Kings were not especially smart. Not especially bold or especially timid. Not especially wise or stupid. For all intents and purposes, they were just like everyone else. Sometimes smart. Sometimes dumb. Sometimes good. Sometimes evil. And always subject to influence.

Towards the end of the 18th century, the ‘divine right of kings’ lost its following. The church, the monarch and the feudal system all seemed to lose market share. The Enlightenment had made people begin to wonder. Then, the beginning of the “Industrial Revolution” made them stir.

In 1776, Adam Smith published his “Wealth of Nations,” arguing that commerce and production were the source of wealth. Government began to seem like an obstruction and a largely unnecessary cost. Its beneficial role was limited, said Smith, to enforcing contracts and protecting property.

The school of laissez-faire economics maintained that government was a “necessary evil,” to be restrained as much as possible. The “government that governs best,” as Jefferson put it, “is the one that governs least.” This is, of course, another way of saying that government — like every other natural phenomenon — is subject to the law of declining marginal utility. A little government is probably a good thing. The energy put into a system of public order, dispute resolution, and certain minimal public services may give a positive return on investment. But the point of diminishing returns is reached quickly. For reference, here is the ‘take’ by modern governments today.

Government — according the Liberal philosophers of the 18th and 19th century was supposed to get out of the way so that the ‘invisible hand’ would guide men to productive, fruitful lives. Smith thought the arm attached to the invisible hand was the arm of God. Others believed that not even God was necessary. Men, without central planning or God to guide them, would create a ‘spontaneous order,’ which would be a lot nicer than the one created by kings, dictators or popular assemblies.

This idea of government, such as it is, leads to what we know of today as “libertarianism.” Libertarians argue about how much authority the government should have. They scrap among themselves over what the government should do and how big it should be allowed to get. But all libertarians agree with Jefferson. And all agree that the governments in the world circa 2011 are much too big.

The libertarians are concerned about their loss of freedom. But what we’re concerned about is the downside. When the point of diminishing returns is passed, the payoff from further investment of resources in policing and wealth re-distribution declines. Then what happens? We’ve already seen what happened to Germany in the ’30s and ’40s. Hitler was elected. But then, the Reichstag burned and he suspended democratic institutions. Perhaps more robust, modern democracies can adapt more readily and thereby avoid the downside?

We’ll see…in the next section.

Regards,

Bill Bonner
for The Daily Reckoning

How Government “Works”, Part II appeared in the Daily Reckoning. Subscribe to The Daily Reckoning by visiting signup for an Agora Financial newsletter.

China’s $3.8 Trillion Hemorrhage

As we covered yesterday, China is starting to hemorrhage money.

How much?

Over the past decade, about $3.8 trillion has left China illicitly. The trend, if you’ll recall yesterday’s discussion, is accelerating. Somewhere around $50 billion per month is flooding out of China.

Today I want to cover the final ramifications of this monetary hemorrhage, and why it matters to your investments and your wealth…

At the individual level, what’s a Chinese saver to do? Over the past decade, the Chinese have sought wealth preservation, if not investment returns, in China’s stock market, as well as in Chinese property markets. These ideas worked out well for some Chinese investors, but not for others. Plus, as I mentioned yesterday, the Chinese buy gold — lots of it.

In addition to investing in Chinese assets — stocks, property, gold, etc. — there’s long been anecdotal evidence of Chinese moving funds offshore in shady ways, as illustrated by the Vancouver story about suitcases full of cash. In other times and other places, I’ve heard similar stories of Chinese suitcase money: in Russia, across the Middle East, in Africa and South America.

There’s an old saying in the field of statistics that “The plural form of the word anecdote is data.” And recently, a number of investigators have gained access to much more hard data about how much Chinese money has moved overseas. The amount of money is huge, to the point of shocking.

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When it comes to funds that have moved away from China — and the fate of the individual owners is something else entirely — we’re dealing with what The Economist magazine recently called a form of “voluntary exile.”

The bottom line is that large numbers of Chinese are moving money offshore, by hook or by crook. According to Hurun Report — a Shanghai-based service that caters to a very upscale clientele — the average wealthy Chinese (defined as having a net worth over 10 million yuan, or about $1.6 million) holds 19% of his assets overseas.

Meanwhile, per Hurun, 85% of wealthy Chinese plan to send their children to school outside China, while 44% have plans to emigrate at some point in their life. In and of itself, that’s hardly a ringing endorsement for the future livability of China.

Also, according to a report issued Oct. 25, 2012, by the Washington, D.C.-based Global Financial Integrity (GFI) group, almost $3.8 trillion (yes, trillion!) illegally exited the Chinese economy between 2000 and the end of 2011. About $602 billion left China in just 2011, so the trend is accelerating.

Indeed, if about $50 billion per month ($602 billion divided by 12 months) left China in 2011, it’s no wonder that, for the past year, we’ve seen market-moving reports that China’s economy is slowing down. Perhaps China’s economy isn’t so much “slowing down,” in many respects, as it’s decapitalizing due to illicit outflows.

Naked Officials and Hot Money

What’s the source of these illicit funds? According to GFI, some of the proceeds are outright ill-gotten lucre from bribes to officials, or raw government corruption. Chinese Internet bloggers have coined a term for modestly paid officials who move their families, and/or large piles of assets, abroad: “naked officials.”

Other capital that flees China may be money that was earned initially through legitimate business means. However, these funds then moved out of China in defiance of law, regulation and other capital controls, usually hand in hand with evasion of applicable taxes. It’s often called “hot money,” a term that originated in Hong Kong.

Right away, this hot money puts other entities at a competitive disadvantage, especially Western companies that must go to extreme lengths to obey tax and banking laws on an international scale.

For example, one big headache for every international U.S. business and bank manager is complying with the U.S. Foreign Corrupt Practices Act (FCPA). Noncompliance with FCPA can bring severe corporate and personal penalties on any company subject to U.S. jurisdiction.

Now consider the difficulty a Western business might have in competing with a Chinese business. The Western business has to conduct itself transparently, while obeying a long list of home-country laws and regulations. Meanwhile, the Chinese business has access to cheap and hot money and operates under a business plan that’s based on nominal underpricing of goods and services, made up with accounting shenanigans.

Evading “Normal” Export Channels

Let’s look at some examples. Consider the rare-earth (RE) business, which concerns a set of exotic elements crucial to modern industry — electronics, magnetics, optics, the auto sector and more. The RE biz is about 95% controlled by China at the source.

Over the years, I’ve heard stories from reputable Western buyers about procuring raw RE supplies — of Chinese origin — in places like Thailand and Myanmar. The RE materials come in poorly labeled bags of product (I’ve actually seen examples!) and are hauled in rickety trucks through uncontrolled mountain passes down from China. It’s hardly a “normal” export channel.

I’ve also heard reports of Chinese sellers mislabeling RE elements as, say, a low grade of steel scrap. The scrap gets exported to, say, Japan or Korea, using bills of lading that dramatically understate the value of material. Then the “scrap” buyer pays a second bill for the RE elements using a wire transfer to a numbered bank account somewhere far from China. Again, it’s hardly a “normal” export channel.

The GFI report highlights other shady export practices — far beyond what happens with RE elements — that serve to hide the true cost and/or price of products moving through otherwise legitimate export channels. That is, GFI identified chronic levels of “mis-invoicing” of Chinese exports to the U.S., ranging from $49 billion in 2000 to $59 billion in 2011.

Specifically, Chinese companies are known to cook the books in a way that understates export value out of China versus income from sales at the destination. The “missing” funds pass through any number of tax havens, where there’s no physical value added but where business secrecy is sufficient for markups and profit skimming.

According to GFI, Chinese products most susceptible to trade mis-invoicing include power equipment (even nuclear reactors), boilers, machinery, electrical and electronic equipment and electronic circuits — think of all those “Made in China” products that fill the shelves of Wal-Mart, Target, Best Buy and other stores. GFI identified $84 billion of such mis-invoicing in just 2007–2011.

Big Money Offshore

Along the way, GFI located almost $596 billion of cash deposits and/or financial assets (such as stocks, bonds, mutual funds and derivatives) that landed in tax haven jurisdictions from 2005–2011.

According to GFI, just the British Virgin Islands — with a population of 28,000 — accounted for over $213 billion in officially reported investment in China in 2010. One might say that the British Virgin Islands glow at night from all that Chinese hot money.

The situation with the British Virgin Islands illustrates another point. Some of that hot money actually goes back into China disguised as “foreign” investment, despite being owned by Chinese nationals, with the value-added originally generated in China.

Thus, this hot money isn’t really “new” investment. Instead, we’re just looking at a very roundabout, economically inefficient way for Chinese business owners to recover a return on their original investments. It’s a strange way to grow an economy.

Meanwhile, rampant capital outflow from China greases wheels within a shadow global financial system. Not to paint with too broad of a brush, but it’s accurate to say that illicit funds have been found in proximity with all manner of improper and illegal activities. These include crimes like drug running, human trafficking, arms smuggling, trade in contraband (such as “blood diamonds”) or stolen goods (high-end cars, for example), environmentally damaging land use and much else.

Ticking Time Bomb

In the GFI report, the authors state that there are “serious questions about the stability of the Chinese economy.” Furthermore, per the report, “If outflows continue to ratchet upward, adverse repercussions on social and political stability cannot be ruled out.”

In other words, the massive, illicit capital outflows from China contribute to a growing sense of economic inequality, as well as pervasive corruption. The principal author of the GFI report, Dev Kar, formerly of the International Monetary Fund (IMF), opined that “The Chinese economy is a ticking time bomb. The social, political and economic order is not sustainable in the long run given such massive illicit outflows.”

The Chinese system is “not sustainable”? Now, that’s a problem.

That’s all for now. Thanks for reading.

Byron King

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China’s $3.8 Trillion Hemorrhage appeared in the Daily Reckoning. Subscribe to The Daily Reckoning by visiting signup for an Agora Financial newsletter.

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avatarThe Daily Reckoning - The Daily Reckoning posted Friday, November 23rd, 2012.

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