American Banking System is a Branch of the Federal Government

You probably know the old Chinese curse, "May you live in interesting times." I heard it first 30 years ago from an economics professor - my mentor, in fact. He was lecturing about the problems Austrian economic models predict when banking is controlled by government.

There are, I know, politicians and pundits who blame the financial crisis on a "lack of regulation." Frankly, anybody who says that has failed the IQ test, or perhaps the ethics test. For all practical purposes, the American banking system is a branch of the federal government. It has been for decades.

Without government guarantees, backed by taxpayers, Fannie Mae and Freddie Mac could not have attracted the level of investor trust they did. The subprime mortgage and housing bubble wouldn't have been funded. Nor would politicians have had the leverage to pressure banks into offering bad loans. Perhaps most importantly, financial institutions would have had no reason to lavish huge campaign contributions and cushy make-work jobs on the political classes.

The banking crisis, however, is not my primary concern right now. It's happened, despite numerous warnings for years from rational economists and commentators. And it will pass. It is a structural problem, and restructuring is happening even now.

The so-called bailout will delay the emergence of new institutions, but it won't stop it. Alternative institutions are rising that will avoid many of the past mistakes. Some are likely to be offshore. Even Vladimir Putin is talking about metal-backed currencies. It is ironic evidence that others are learning the lessons our political class has forgotten.

My concern at the moment is the federal budget and ongoing deficits. This new expansion of government spending and debt is not some one-time event that markets can repair. According to the Congressional Budget Office, current annual deficits have quadrupled. Independent CBO economists forecast that they will level out in a decade to about triple pre-stimulus levels.

Frankly, I failed to predict the magnitude of these budget increases coming. I expected increases and never believed candidate Obama when he promised to cut net spending. Neither, however, did I imagine he would increase it as much as he has.

It is inevitable, however, that this level of spending will be reduced. It will happen for a variety of reasons. For one, such levels will slow the economic growth Americans are used to. It will stifle productivity and reduce income tax revenues. As it always has before, this will send the political pendulum swinging away from big government.

Incidentally, claims that the spending increases are either a "bailout" or a "stimulus" are bilge. No one has ever seriously tried to explain how spending that does not take place currently can appreciably stimulate the economy in the short run. Still, less than 24% of the stimulus will occur this year. That other 76% stimulates nothing but advocates of government spending.

So today, I want to take the time to deal in some depth with the effects all this will have on breakthrough technologies. I realize, incidentally, that some of my comments may be interpreted as partisan. They shouldn't be. I was a critic of President Bush's spending record as well, though it pales compared with current levels. And for the record, I don't think I've ever registered with either major party, even when I was working with a candidate in the last presidential campaign. He was a Republican, but he understands Federalist principles that would have limited the power of the GOP.

I would gladly vote for the sort of tax-cutting Democrat my father was. Ours was a loyalist Democratic household and my parents revered John F. Kennedy - one of America's great tax cutters. His across-the-board tax cuts were greater proportionately than those passed during the Bush administration. They were enormously successful in promoting spending and economic growth. Give me a Kennedy over a Nixon any day.

Nevertheless, I am prepared for e-mail from those who mistake my criticism of destructively high taxes for partisanship. It's not. Honestly. Economics is called the "dismal science" for a reason. And it often falls to rational economists to play the role of parent, explaining that we just can't afford all those cool toys people want right now.

The term "dismal science," by the way, was coined by a Victorian historian describing the work of Thomas Malthus. Malthus set the standard for doom and gloomers. An Anglican minister and a terrible economist, he predicted the imminent destruction of civilization, if not humanity itself, in the late 1700s. Despite our survival and amazing progress since then, others make similar predictions to this day.

I am, in fact, optimistic about the long run. The economy will not only recover. It will continue to grow exponentially when it does. That doesn't, however, mean that we don't face serious challenges in the short to medium run. This, however, is a unique time historically, with unprecedented opportunities for patient farsighted investors. Rahm Emanuel and Hillary Clinton have both said that you should never let a good crisis be wasted. Though my means of exploiting the crisis are quite different than theirs, I agree with the general sentiment.

There will, however, be delays in technology development. Because so many of the emerging breakthrough technologies today are related to health and longevity, I take those delays personally. While the economy will recover, there are people who will miss out on lifesaving therapies because new technologies are not being funded. This irritates me.

Nevertheless, we need to look at the situation clear-eyed and figure out how to profit from it. And in the process, we may help move some of these revolutionary new technologies forward. There is another Chinese proverb about crises creating opportunity, and this is no exception.

Now, to business.

The most onerous impact of excessive federal spending is the absorption of capital. When finite capital is appropriated through taxation and federal debt creation, this necessarily reduces the level of funding available for research and development.

This simple math is ignored by those who believe it's a good thing to tax the rich, the people who direct most investment capital into emerging technologies. Historically, overall economic well-being is best accomplished through the promotion of new technologies and businesses. Kennedy made that point with his famous statement that "rising tides lift all boats." Right now, the deficit is lowering the tide. Until this sapping of our R&D lifeblood is rectified, transformational technologies will face challenges.

Typically, we know, investors abandon unproven sectors for traditional stability when things get scary. This includes even venture capitalists. New data from PricewaterhouseCoopers, the National Venture Capital Association and Thomson Reuters verify that this is the case.

In the first quarter this year, US venture capital investments fell 61%. In the same quarter a year ago, venture investments were $7.74 billion. This year, the total was barely $3 billion. This is the lowest level in 12 years. Acquisitions of venture-backed companies fell by nearly half from last year. There were no venture-backed IPOs. None.

The one notable bright spot in this picture is health care services. Venture capital investment there is actually up somewhat. As I wrote on several occasions while we were waiting for the train wreck, health care is countercyclical. When times gets tough, the last thing consumers cut back on is medical services.

This is one reason that my Breakthrough Technology Alert portfolio is so heavily weighted with medical biotech today. It's not the only reason, however. It is simply true that a huge percentage of the biggest and most profitable technologies on the near horizon are medical. Significantly longer healthy life, i.e. "time," is the product they will deliver.

Economists talk about the "backward-bending demand curve." It refers to the fact that we max out on stuff. Eventually, if we get enough of something, we value additional units less. Demand for life, however, is unlike any other good or service. It is, in effect, infinite.

Regards,

Patrick Cox
for The Daily Reckoning Australia

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