Has democracy failed us or have we failed it?

By Colin Twiggs
May 30th, 2011 8:00 a.m. ET (10:00 p:m AET)

These extracts from my trading diary are for educational purposes and should not be interpreted as investment or trading advice. Full terms and conditions can be found at Terms of Use.

Regular market coverage will resume on Tuesday when US markets re-open.

Who kept the faith and fought the fight;
The glory theirs, the duty ours.

I would like to make this quote from Wallace Bruce the theme of today's newsletter on Memorial Day, May 30th. We often take for granted the institutions that our ancestors sacrificed so much to secure. Have we fulfilled our duty to preserve the freedoms that they sacrificed so much for? And have we held the members of our institutions to account for the neglect of their duties?

Some legislators only wish vengeance against a particular enemy. Others only look out for themselves. They devote very little time to consideration of any public issue. They think that no harm will come from their neglect. They act as if it is always the business of somebody else to look after this or that. When this selfish notion is entertained by all, the commonwealth slowly begins to decay.

Little seems to have changed since Thucydides made this observation in about 400 BC, a century after the foundation of democracy in ancient Athens. The fundamental weakness of democracy seems to be that those who are elected to office tend to place their own interests ahead of the interests of their electorate — and ahead of the interests of the nation. Not surprising when, as Thucydides pointed out, they believe that little harm will come from their neglect. But if enough legislators place their own interests ahead of those of the country, they will cause irreversible damage.

The First Rule of Politics is to Get Re-Elected

By placing their own interests first, I do not necessarily mean that office holders seek to enrich themselves at the expense of the taxpayer — although that does occasionally happen. Rather that they define their primary duty to their country as re-election. The pressure to get re-elected is bound to influence their thoughts and actions on almost every issue.

The Presidential Cycle

The temptation to manipulate the system to maximize your chance of re-election is too great for most politicians to resist. In fact it has become so ingrained that the whole economy, and the stock market particularly, is subject to the political cycle. Jeremy Grantham explains the presidential cycle in his last quarterly newsletter:

In the first seven months of the third year (of the presidential cycle) since 1960, Year 3 has returned 2.5% per month for a total of 20% real (after inflation adjustment).... Now, 20% is perilously close to the total for the whole 48-month cycle of 21%. This means, of course, that the remaining 41 months collectively return a princely 1%.

It's the economy, stupid

The third rule of politics is don't run for re-election during a recession. Ask George H. W. Bush who, despite successful prosecution of the first Iraq war, was beaten by Bill Clinton in 1992 with the slogan "It's the economy, stupid." (The second rule, by the way, is: never forget Rule #1)

Successive presidents/governments have failed to find a way to re-schedule elections to a time that bests suits them (despite many examples in the rest of the world). They soon, however, came up with an ingenious alternative: re-schedule the recession.

How to Re-Schedule a Recession

As soon as politicians realized they could spend future taxes as well as current taxes, the demise of the current system became inevitable. Prior to the Great Depression of the 1930s, governments were assessed on their ability to balance the books. Previous disasters with fiat currencies (continental and confederate dollars) were still fresh in the national consciousness. Only during times of war could they justify running a deficit. So much so that Herbert Hoover refused to run a deficit despite the deflationary spiral following the 1929 Wall Street crash.

When FDR lifted that constraint in the 1930s, with the acquiescence of a desperate public who were willing to try almost anything, an immense new power was born. Unfortunately with immense power comes immense responsibility — and successive governments have proved themselves unequal to the task.

Spend Future Taxes and Leave your Successor a Pile of Debt

It has become too easy for whoever is in power to spend future taxes to stimulate the economy and postpone a recession. The result is that their successor inherits a pile of debt, which if they attempt to repay, is likely to lead to a recession. So the game becomes one of pass the parcel, with each elected government adding to the debt and passing it on to the next.

If the ancient Greeks had the same power, the decline of Athens may have been a lot sooner. Their modern counterparts have demonstrated that the game cannot continue indefinitely. At some point the market will begin to question government's ability to repay, raising interest rates to compensate for the risk of sovereign default. Their fears become a self-fulfilling prophecy, with higher servicing costs increasing the burden on the already-precarious fiscal budget.

Fed Compliance

The second actor in this modern form of Greek tragedy is the Federal Reserve. Without a compliant Fed, government efforts to kick the can down the road would be largely negated. An independent Fed could put the brakes on government efforts to stimulate the economy with borrowed money, merely by acting as a counter-balance to their actions. Unfortunately the Board of Governors are political appointments, nominated by the President and confirmed by the Senate. The Federal Open Market Committee (FOMC) may be more evenly balanced with the addition of the president of the Federal Reserve Bank of New York and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis, but is still dominated by the seven Board members. You can be sure that very few mavericks are appointed as governors and that most dissenting votes come from the regions.

Washington, Inc.

Elections are an expensive business and no candidate is likely to achieve re-election without financial backers, making them especially vulnerable to outside influence. The finance industry alone made $63 million in campaign contributions to Federal Candidates during the 2010 electoral cycle, according to the Center for Responsive Politics. That will buy you a lot of influence on the Hill, but is merely the tip of the iceberg. Interest groups spent $3.5 billion in that year on lobbying Congress and federal agencies ($473 million from the finance sector). While that money does not flow directly to candidates it acts as an enticing career path/retirement plan for both Representatives and senior staffers.

The revolving door between Capitol Hill and the big lobbying firms parachutes former elected officials and staffers into jobs as lobbyists, consultants and strategists — while infiltrating their best and brightest into positions within government; a constant exchange of power, influence and money. More than 75 percent of the 363 former senators or representatives end up employed by lobbying firms, either as lobbyists or advisors.

Can the Present System Evolve?

Are we likely to experience slow decay that Thucydides predicted? The present system is entrenched and likely to resist any attempts at reform. Evolution, however, does not occur in small increments. The norm is quite the opposite, with species enjoying long periods of stability followed by violent change when threatened with extinction. The current GFC presents just such an opportunity for change. The Tea Party movement, for example, is attempting to re-define the way that the system works, while I am sure that there are many Democrats who mistrust the motives of Washington.

If they fail to succeed, there is bound to be a next time. And probably sooner than we think.

The state that separates its scholars from its warriors will have its laws made by cowards, and its fighting done by fools.

~ Thucydides (c. 460 BC – c. 400 BC).