Streetwise Professor

From Econbrowser, I learned that Paul Krugman (oy) made a point that I was going to blog about, but my procrastination gene kicked in. Specifically, Krugman opined that if speculation were really driving up prices above the equilibrium level, we should also observe an increase in inventories. In energy, and in some other commodity markets, inventories have actually been decreasing. So Krugman concludes–reasonably–that this is inconsistent with the ceaselessly repeated mantra that speculation is causing prices to diverge widely from the equilibrium fundamentals-driven value.

There are historical examples of this phenomenon. The International Tin Council attempted to prop up the price of this metal. The ITC had to buy increasing quantities of tin, as the high price discouraged consumption and encouraged production. Eventually, inventories became so large that the ITC could no longer afford its scheme; tin was dumped on the market; and the price plunged. The accumulation of stocks of grains by governments (including the US government) as the result of price support programs are also good examples.

James Hamilton at Econbrowser is skeptical, noting that in the short run supply and demand for most commodities is so inelastic that prices can diverge substantially from the equilibrium value without leading to a detectable increase in stocks.

If forced to choose, I would go with Krugman on this. The speculation-is-driving-the-market (nuts) mantra has been heard for nigh onto three years, which is more than enough time to see an accumulation of stocks in the hands of speculators (and it would be speculators that hold the stocks as they are the ones allegedly willing to pay the inflated price). Yet this has not happened. Hamilton argues that yes, the last three years have been fundamentals-driven, but the January-February spike may not be. In such a short time frame, he notes, given the inelasticities in supply and demand it may be very difficult to detect any speculative distortion in stocks given their natural volatility. That’s a fair point, but I am reluctant to conclude, based on this absence of evidence that speculators did not cause a distortion, that prices were irrationally high in two months after being fundamentally driven for years during which speculative activity was also intense.

I do have one quibble with Krugman (about this issue–about politics, quibble doesn’t come close to covering it.) Krugman’s analysis is a static, supply-demand one. Any analysis of inventories must incorporate dynamic effects.

Moreover, a dynamic analysis implies that it is possible that stocks and prices can rise simultaneously even if all speculation is rational, i.e., in a rational expectations equilibrium. I sketched the argument in the 2006 post “Care to Dance the Contango?” There I conjectured that increases in uncertainty could cause the simultaneous increase in inventories, prices, and contango in the oil market. I’ve recently completed a stochastic dynamic programming model that formalizes the intuition from that post. (A working paper is in progress, but its completion will have to await my return from Europe in June.)

Commodity storage dynamic programming models posit that equilibrium speculative storage decisions maximize welfare. Given current inventories, the state of the economy, and the stochastic processes governing the evolution of this state, speculative storage decisions maximize the expected present value of net surplus (consumer surplus plus consumer surplus). Equilibrium prices adjust to provide maximizing individual agents the incentive to implement the optimal plan.

One proceeds by conjecturing a function that relates forward prices to the current state of the economy and carry-in. One then solves for the amount of carry out such that the current spot price equals the present value of the forward price; if the spot price with zero carry-out (i.e., complete consumption of inventory) exceeds the forward price, it is optimal to store nothing, and to have a “stock out.” The possibility of stockouts (which will occur with positive probability in equilibrium) leads to backwardations.

Conventional storage models typically restrict attention to a single, mean reverting (i.e., stationary), homoskedastic net demand shock. Other models I have worked on posit two mean reverting homoskedastic shocks, with different speeds of mean reversion.

In this most current work, I have two state variables: a mean reverting net demand shock, and a mean reverting stochastic volatility shock. That is, I don’t assume that net demand is homoskedastic; the second state variable in the economy is the volatility (or variance) of the demand shock.

This framework formalizes the intuition in “Dance the Contango.” And the results of the model are exactly as conjectured in that post. When there is a positive volatility shock, agents respond by increasing storage, and thereby reducing consumption. This leads to a simultaneous increase in inventory and price–a phenomenon that has mystified many commentators on the energy markets in recent years.

I presented the results of the analysis at a conference in Italy in January. Here are the slides, complete with some graphs illustrating the results of the model.

In sum, although a simultaneous increase in stocks and prices could be a consequence of speculative distortion–but this is not necessarily the case. I would surmise that the absence of inventory accumulation is strong evidence against the excess speculation hypothesis, but that the existence of inventory accumulation when prices are rising does not imply that speculation is distorting prices.

I understand that this is not an especially satisfactory conclusion, but it illustrates that it is very difficult to identify implications that definitively distinguish the competing hypotheses. Methinks, however, that it is necessary to go beyond the crude correlation=causation argumentation that dominates the current debate about the impact of speculation: “There is a lot of speculation. Prices are high. Therefore the speculation caused the high prices.” The exact mechanism by which this works is seldom specified. Krugman is on the right track to point out that the excess speculation hypothesis should have implications for quantities as well as prices. His Micro 101 analysis is a good place to start, but when considering storable commodities, it is necessary to model the dynamics. When one does so, one finds that his test may generate false positives. That is, in a world where the amount of fundamental uncertainty is itself random, a simultaneous increase in stocks need not be definitive proof that speculation is distorting prices. It may instead show that speculation is in fact ensuring that resources are being allocated efficiently.

It is this very difficulty of coming up with empirical tests that cleanly distinguish between the rational speculation hypothesis and its irrational speculation alternative that make it so difficult to resolve this debate. Which is why it has raged for centuries, and will continue to rage into the foreseeable future.

Interdealer broker behemoth ICAP has announced an initiative to create an alternative to LIBOR. The ICAP alternative, dubbed NYFR for New York Financing Rate, will measure the 3 month and 1 month funding rates paid by New York banks. This is deemed desirable due to the apparent divergence between rates in the US and rates in Europe/London.

ICAP will survey 40 banks. Rather than asking what each bank pays, ICAP will ask each bank to assess what a “representative” bank would pay for funds. So, it’s sort of like . . . I have this friend, and he’s paying 3.625 pct for one month deposits.

This is supposedly intended to improve the accuracy of reporting by not putting banks in the potentially embarrassing position of choosing between lying about the rate that they pay, or revealing that they are sufficiently desperate for funds that they are willing to, and have to, pay a high rate.

Well, maybe this is an improvement, but if so, it’s not much of one. It would be much, much better to have a rate based on actual transactions. This is technologically feasible, and indeed, ICAP sees enough of the deal flow to make such a calculation based on real numbers rather than relying on this version of a Banker’s Anonymous meeting in which participants talk about their, ahem, issues, in the third person.

View this link for numerous pictures of the preparations for Russia’s Victory Day military parade. Each of the numerous photographs has the same caption, which ends with a reference to “Russia’s resurgent military might.” Repetition does not make it so. For as these two articles (and many others) show, behind all the military pyrotechnics, if you pull back the curtain you will find that the Wizard of Rus’ is all humbug. First, the hollow army:

GENERALS OF SAD CAREERS
MILITARY REFORMS WRECKED, COSTS OF CONTRACT SERVICE SOAR SKY-HIGH
Author: Nikolai Dzis-Voinarovsky
[Transition to contract service: vast sums expended with nothing
to show for it.]

Judging by official reassurances, almost 40% of privates and sergeants in the Russian Armed Forces are contract servicemen. Experts meanwhile unanimously claim that the military reforms have been wrecked. The Russian Armed Forces have lost advantages of service by conscription and never gained benefits of contract service. Funding of the transition to contract service rose to 99 billion rubles over the last three years but all these colossal sums were spent on anything but salaries of the Russians signing contracts with the Defense Ministry.

Colonel General Vasily Smirnov of the Main Directorate of Organization and Mobilization of the General Staff maintains with a straight face that a contract serviceman “is paid much more than 35,000 rubles a carman takes home every month.” Had Smirnov been telling the truth, all carmen would have already been in the Army and Navy. In fact, many others would have been seriously pondering service by contract because the sum Smirnov mentioned is way above the average per capita income in Russia (13,773 rubles).

Most men in Russia actually refuse to even entertain the idea of military service - by conscription or contract. According to Public Opinion Foundation sociologists, 51% of respondents view the situation in the Armed Forces as bad, 29% as so-so, and 6% as good. Specialists of the Transition Period Economy Institute checked Smirnov’s words and ended up with a picture not even
nearly as rosy as the general had painted.

Contract soldier’s basic salary is 8,000 rubles. There are bonuses and so on, of course, but even with all of them accounted for a soldier in Chechnya may only count on 15,000 rubles a month. Engine driver in metro in the meantime is paid between 35,000 and 55,000 rubles.

The Defense Ministry reported federal target program “Transition to contract service in units and formations” for 2004-2007 implemented. The initially drawn plans stood for an increase of contract servicemen in the Armed Forces from 22,100 to 47,758 men by 2008. The figure was eventually reduced to 138,722. Before the spring conscription campaign this year, the same Smirnov was already talking about “100,000 contract servicemen or so”. Funding set aside for the federal target program went up from 79 to 99 billion rubles (in 2003 prices). The additional finances were spent on propaganda and research but “not a ruble was spent on salaries of contract servicemen”, specialists of the Transition Period Economy Institute say. The Auditing Commission discovered misuse of 164.1 million rubles by the Defense Ministry earlier this month.

Specialists view low salaries as the key factor that determines success or failure of the military reforms.

Service by conscription is down to twelve months now. Combat readiness of the Armed Forces is down too. Most deferments have been annulled. Crooks alone benefit from these results of the federal target program. Experts in the employ of the INDEM Foundation say that conscription is the third worst corrupt sphere in the country, after health care and education.

The Defense Ministry is energetically drafting people with higher education into the Army and Navy. They amounted to 1.8% of
the numerical strength of the Army and Navy in 1985, 3.1% in 1999,and amount to 21.7% nowadays. “This withdrawal of specialists from national economy cannot be excused. Instead of drafting former students, the Defense Ministry had better concentrate on educational level of its career officers,” to quote Yevgeny Gontmakher of the Center for Social Studies and Innovations.

The Defense Ministry’s ability to provide tenements for the military is highly questionable too.

As a matter of fact, low salaries of contract servicemen have already resulted in dire consequences. According to Military Prosecutor General Sergei Fridinsky, privates and sergeants serving by contract committed over 3,500 crimes in the first ten months of 2007 (a 25% rise against the figure logged the year before).

Traditionally enough, state officials prefer talking of the cloudless future to doing something to remedy the currently problematic situation. Officials promise to up an average salary in the Russian Armed Forces to $3,375 by 2020. Gontmakher warns that the state cannot deliver what it is promising…

And the hollow navy:

Russia ‘no longer uses’ nuke sub deterrent

WASHINGTON, April 28 (UPI) — Russian nuclear submarines conducted only three patrols last year, indicating Moscow may have effectively abandoned their use as a deterrent, says a new report.

The Federation of American Scientists published its Nuclear Notebook this week, revealing that the number of deterrence patrols conducted by Russia’s 11 nuclear ballistic missiles submarines decreased to only three in 2007 from five in 2006.

In comparison, U.S. nuclear subs conducted 54 patrols in 2007, more than three times as many as all the other nuclear-weapon states combined.

Owing to “changed strategic circumstances” Moscow has apparently concluded “they don’t need this (submarine deterrent capability) for their security,” the federation’s Hans Kristensen told UPI, citing principally the end of the Cold War nuclear standoff.

For such a deterrent to be fully credible, at least one sub has to be on patrol — evading detection in open waters — at any given time, ready to launch unstoppable ballistic retaliation for any nuclear first strike.

But the Russian patrol figures reveal “that Russia no longer maintains a continuous (nuclear ballistic missile submarine, or SSBN) patrol posture like that of the United States, Britain, and France, but instead has shifted to a new posture where it occasionally deploys an SSBN for training purposes,” Kristensen wrote on the federation’s Web site.

He added the shift became apparent “when then Defense Minister Sergei Ivanov declared … that five SSBNs were on patrol at that time.” Later he learned that those five patrols were the only ones conducted that year.

“Combined, the two sources indicated a cluster of patrols at approximately the same time rather than distributed throughout the year.”

Kristensen told UPI that the new posture was likely to damage the strategic capabilities of the SSBN fleet.

“If you talk to U.S. submariners, they will tell you you need to be out on patrol all the time to maintain your readiness. … You can’t just switch back from an occasional deterrent posture to a full-time one.”

Shaun Waterman, UPI Homeland and National Security Editor

This examples could be expanded ad infinitum.

And it is not just the military. Recently Russian government spokesmen have been trumpeting a demographic turnaround. But myriad independent sources–including Russian demographers–cast serious doubt on these claims. Indeed, the consensus independent forecast is that Russia faces a worsening demographic outlook in the first years of the next decade, and that crippling declines in the working population are almost inevitable.

Thanks to the commodity price boom, Russia has a window to make inroads into its myriad health and social problems. This window is likely to be short-lived, because commodity booms often are. The country has already squandered several years, and shows no inclination to do anything different with the next several. Instead, we see bullying of neighbors; continual whining about enemies and the lack of respect paid Russia; Potemkin parades; propaganda masquerading as progress.

Indeed, the Red Square parade is deeply symbolic of Putin’s Russia. Boastful preening and display, mimicking past glories, all to distract attention from an all too often shambolic present and a bleak future–a future that could be a far brighter one, if only the country’s leaders could conceive a future different than an imagined past. But perhaps this is too much to ask, perhaps the habits of rule are too ingrained, for as Richard Pipes has written of governing Russia since the time of Peter the Great:

But once it had been decided that the interests of the country required the existence of a citizenry conscious of its collective identity and of its role in the country’s development, then certain consequences inevitably followed. It was clearly contradictory to appeal to the public sentiments of the Russian people and at the same time to deny them any legal or political safeguards against the omnipotence of the state. A partnership in which one party held all the power and played by its own rules was obviously unworkable. And yet this is exactly how Russia has been governed from Peter the Great to this day. The refusal of those in authority to grasp the obvious consequences of inviting public participation generated in Russia a condition of permanent political tension which successive governments sought to attenuate sometimes by loosening their reins on the realm, sometimes by tightening them, but never by inviting society to share the coachman’s seat.

The parade and the Sochi Olympics and myriad other things are “appeal[s] to the public sentiments of the Russian people.” But the sham of the recent voting, the consolidation of power into one party (United Russia), and the continued absence of a rule of law, which allows those in power to “play by [their] own rules,” all serve “to deny [the people] any legal or political safeguards against the omnipotence of the state.” As Pipes states, this will engender in the populace political tension, when, as is almost inevitable, it becomes clear that the fat years have not been used to address Russia’s chronic and debilitating structural problems in any serious way.

I read somewhere that Jethro Tull released a song titled “Living in the Past” in the early-70s. The Russian military should make this its theme song, if one believes Alexander Golts:

Serdyukov’s initiative to strip the military’s journalists, lawyers and doctors of officer rank is a clear attempt to decrease the number of officers. The army now has 400,000 officers out of a total 1.2 million service personnel. That comes out to one officer for every two soldiers. In most countries, officers constitute not more than 16 percent of a military’s total personnel. In Russia, the bloated number of officers resembles an inverted pyramid, with nearly as many colonels as lieutenants.

But the generals argue that a large number of officers is necessary to maintain a mass-mobilization army — one that could call up millions of reservists to fight a war against NATO. In answer to the charge that the number of colonels has nearly outstripped the number of lieutenants, the generals counter that someone must be available to lead the divisions of reservists.

Regarding the military’s enormous property holdings, generals argue that, while these assets might be superfluous in peacetime, they will be essential in the event of a major conflict with NATO. In defending their mass-mobilization strategy, which is still stuck in an old Soviet mindset, the generals complain about the incompetence and ignorance of civilians running the Defense Department.

First, as I have argued time and again, it is utterly fantastical to imagine a major war breaking out with NATO. One doesn’t know whether the Russian military command knows this and just uses it as a rationalization for their resistance to change, or whether Russian generals are delusional to a man.

Second, granting their delusions that a war with the West is a realistic prospect, basing plans for a conflict with NATO on a mass conscription army completely ignores the lessons of the last 30 years. Mass armies of poorly trained conscripts hurriedly assembled for battle are no match for highly trained professional forces. Period. You’d think that Russia would have learned from Chechnya that conscript forces are a disaster waiting to happen–Russian conscript armies were badly bloodied by nondescript gangs of Chechens with no armor or airpower. They would stand no chance against highly trained American troops with first rate armor, nonpareil air forces, excellent intelligence resources, smart weapons, etc., etc., etc.

Third, demographic realities make creation of a large mass conscript army simply impossible. Russia can barely find enough healthy conscripts to fill the ranks of its peacetime army, let alone field a force twice or three times as large (a size that would be consistent with the bloated complement of colonels.)

I would wager that most Russian generals are not delusional; they know that a war with NATO is the least important of Russia’s potential security challenges; they realize that mass conscription armies are an anachronism; and they understand that even if they wanted to raise a mass conscription army, they don’t have the population to do it. So the most reasonable explanation for their living in the past is that it is comfortable and profitable. Change is hard–and if they know that Russia really faces no military threat, why do the hard work? Moreover, as Golts notes, the military is rife with corruption, and change threatens to derail the gravy train.

Fighting the last war is dangerous if you really have one. Preparing to fight the last war is not so deadly if no conflict is in prospect. The Russian leadership acts as if that is the case, and feels just fine about living in the past.

Austin Bay takes apart piece-by-piece the media’s rush to judgment on recent events in Basra and elsewhere in Iraq.

Remember the Iraqi government’s Basra offensive, launched a month ago and quickly declared a failure by an overwhelming majority of the talk show and editorial commentators? “Basra Blunder” was the headline of a column that received wide distribution; the column described Iraqi Prime Minister Nouri al-Maliki as an inept, impulsive figure “in way over his head.”

Today, Maliki and Iraqis in general have earned the right to sneer at such instant and shallow media negativism, for Knights Charge (code name for the anti-Shia gang offensive in Basra and southern Iraq) is proving to be an extraordinarily significant political and military operation with rather heady long-term payoffs.

“Instant and shallow media negativism.” That’s hitting the nail on the head. Read the whole thing.

RFE/RL has a nice piece discussing the proposal that NATO expand beyond its current membership orientation to include democratic nations such as Japan and Australia, and change its orientation to act more proactively around the world. This is the kind of idea that drives Putin and his coterie into apoplexy. All of the whining about NATO going outside its traditional space (e.g., to Afghanistan) and expanding to include new members is grounded fundamentally in a fear that such an organization will render the UN–and the Russian veto in the Security Council–irrelevant. This would severely limit Russia’s ability to use its veto to thwart the initiatives of the US, Europe, and others in order achieve its largely negative goals.

If this happens, or if some other formal or informal concert of democratic nations develops, Putin and the Russian establishment will, again, have no one to blame but themselves. Russia’s reflexively oppositional policies, be it in Iran or Iraq or Kosovo or Bosnia or North Korea, have perhaps achieved some short term benefits. Russia matters. People must pay attention to Russia. Blah, blah. More substantively, oppositionism has actually encouraged and fomented conflict and unrest in places like Iraq and Iran and the Middle East generally, and encouraged North Korea, Serbia, Abkhazia, and Ossetia to resist the solution of conflicts. This has vexed the US and Europe, and has stymied the possibility for progress on myriad issues. Patience is running out. If the Security Council and other international bodies cannot facilitate negotiation and compromise, ideas like a super-NATO will become more attractive, and are more likely to be implemented. Just further evidence, as if it were needed, that Russia’s myopic policies may provide immediate gratification, but will inevitably lead to the very marginalization that its leaders dread.

Here’s a lovely piece from Strategy Page:

Early on, it was believed that Storm [a highly destructive Botnet] was owned by a Russian criminal syndicate, but once more detailed proof was available, the Russian government refused to cooperate, treating Storm like some kind of secret military resource. And to the Russians, that’s apparently what Storm is. Meanwhile, the investigation indicates that the Storm crew have some American members, and now the search is on for them, or any other non-Russians who worked on Storm, and are not inside Russia.

China is known to play similar tricks, and Estonia was almost certainly the victim of a massive web assaulted coordinated from within Russia. If the Russian government was not involved, it has certainly done nothing–qui tacet consentit. Russia’s sheltering of internet criminals, and the serious possibility of government/military/intelligence complicity in their actions, is yet another indication of the chekists’ malign intent and effects.

Strategy Page also reports that the “stability” in Chechnya is based on a deal with the Devil, or more accurately, multiple deals with multiple Devils that could collapse into violence any minute:

In Chechnya, Russia finally established peace (at least by local standards) by putting the toughest warlords in charge. This is an old tactic, and has worked in the past. One problem was that the Russians did not want to divide the province into smaller parts, each run by a different warlord. So, as a compromise, Ramzan Kadyrov, and his allies, were put in charge of the Chechen Republic (province) government (via elections, of course.) Meanwhile, the other major gang, led by the three Yamadaev brothers (and clan), were put in charge of the Vostok Battalion. This outfit, with a strength of 300-400 men, is largely composed of rebels who have accepted the amnesty. To separate the Vostok Battalion from the government, it was attached to the Russian Army’s 42nd Motorized Rifle Division, which was stationed in Chechnya.

There was still friction between Kadyrov’s provincial police and counter-terror forces, and the Vostok Battalion (which was, technically, a counter-terror unit that worked for the army, not the provincial government.) The Vostok guys did not get along with the provincial forces, and in mid-April, weeks of growing tensions erupted into a daylong gun battle in the town of Gudermes. The Vostok Battalion called on the 42nd division to send reinforcements, which didn’t happen. Instead, the Russians prevented the provincial forces from getting reinforcements, and eventually got both sides to stop shooting. At least 18 were killed, and many more wounded.

Both sides accused each other of running criminal operations (kidnapping, extortion, prostitution and so on). Both sides were right, and the hostility was the result of turf battles. Who should be the chief criminal in what part of the province? The Russians have to sort all this out, otherwise, the fighting will resume.

Good luck with that.

The inimitable Mark Steyn riffs on the connection between personal independence and firearms ownership:

As for “gun-totin’,” large numbers of Americans tote guns because they’re assertive, self-reliant citizens, not docile subjects of a permanent governing class. The Second Amendment is philosophically consistent with the First Amendment, for which I’ve become more grateful since the Canadian Islamic Congress decided to sue me for “hate speech” up north. Both amendments embody the American view that liberty is not the gift of the state, and its defense cannot be outsourced exclusively to the government.

I think a healthy society needs both God and guns: it benefits from a belief in some kind of higher purpose to life on earth, and it requires a self-reliant citizenry. If you lack either of those twin props, you wind up with today’s Europe — a present-tense Eutopia mired in fatalism. A while back, I was struck by the words of Oscar van den Boogaard, a Dutch gay humanist (which is pretty much the trifecta of Eurocool). Reflecting on the Continent’s accelerating Islamification, he concluded that the jig was up for the Europe he loved, but what could he do? “I am not a warrior, but who is?” he shrugged. “I have never learned to fight for my freedom. I was only good at enjoying it.”

Sorry, it doesn’t work like that. If you don’t understand that there are times when you’ll have to fight for it, you won’t enjoy it for long. That’s what a lot of Keith Reade’s laundry list — “gun-totin’,” “military-lovin’” — boils down to. As for “gay-loathin,’” it’s Oscar van den Boogaard’s famously tolerant Amsterdam where gay-bashing is resurgent: the editor of the American gay paper the Washington Blade got beaten up in the streets on his last visit to the Netherlands.

God and guns. Maybe one day a viable society will find a magic cure-all that can do without both, but Big Government isn’t it. And even complacent liberal Democrats ought to be able to cast an eye across the ocean and see that. But then he did give the speech in San Francisco, a city demographically declining at a rate that qualifies it for EU membership. When it comes to parochial simpletons, you don’t need to go to Kansas.

In fact, the connection is quite an old one. In The Military Revolution and Political Change, Brian Downing (no not the former Angels and White Sox catcher) wrote:

A second military impetus to constitutional form came from militias. . . . Prevalent throughout England and Sweden, village levies demonstrate a close link between citizenship rights and military service. The village hundreds, themselves important in constitutional development in Scandinavia, levied infantry formations from the male population, who, in return, were given voice in popular assemblies. As if to underscore the relationship between military service and participation in local government, members of the assembly arrived with their weapons and indicated assent to a motion by raising their spears. Furthermore, contracts were made in a ritual during which each party demonstrated free status by bearing arms.

Read that, and you should have a better understanding of the real meaning of the phrase “a well organized militia” in the Second Amendment. There is a clear link between a self-reliant and independent citizenry and its ability to bear arms. Free and responsible people can carry arms. Societies in which this right is denied or sharply circumscribed are less free in many ways.

Nor is Downing alone. Max Weber wrote:

The basis of democratization is everywhere purely military in character; it lies in the rise of disciplined infantry, the hoplites of antiquity, the guild army of the middle ages. . . . Military discipline meant the triumph of democracy because the community wished and was compelled to secure the cooperation of the non-aristocratic masses and hence put arms, and along with arms, political power, into their hands.

On Econbrowser, the University of Illinois’ Scott Irwin presents an interesting analysis of the remarkable developments in the grain/oilseed basis (the difference between the cash price and the futures price) in the past couple of years. Scott (reporting work done with colleagues Darrel Good, Phil Garcia, and Gene Kunda) shows that the basis has widened dramatically in recent years, and considers various explanations.

One he entertains, but does not strongly endorse, is that the entry of speculative interests, most notably long only funds, has driven this development. I am extremely skeptical that speculators can cause the basis to become abnormally wide during the delivery period. In particular, long only funds almost invariably roll their positions forward prior to the delivery month. (As an example, the GSCI Index rolls forward contracts that are about to expire the month prior to the delivery month.) Funds that roll forward prior to the delivery month obviously cannot be inflating prices during the delivery month.

So what is causing the periodic basis blowouts? Squeezes are one possibility. But, squeezes would be associated with (a) sharp drops in cash prices immediately following contract expiration, (b) very large deliveries, (c) a dramatic narrowing in the deferred basis (i.e., the difference between the cash price and the next-to-expire futures price), and (d) a widening of spreads between delivery locations (e.g., on the Illinois River) and non-delivery locations (e.g., central Iowa). The Irwin piece doesn’t mention whether these things have occurred.

As some of the Econbrowser commentors note, absent a squeeze, the wide basis would seem to represent a substantial profit opportunity to those operating the regular warehouses and shipping stations (the facilities where delivery actually occurs.) These firms, which include agbiz giants such as ADM and Cargill, could buy cash grain, sell futures, make delivery, and capture the basis. So why don’t they do so?

In essence, commodity trading is the business of making transformations in form, location, and time. The operators of river shipping stations regular for delivery against CBT soybean and corn contracts are in the business of transforming these products in space–from the farm to the barge on its way to the Gulf for export, primarily to Asia.

Of course firms incur costs to make this transformation. The question is: is the marginal cost of delivery so large that it equals the inflated basis? Irwin is skeptical.

Absent the exercise of market power by those who operate regular delivery facilities, however, the basis measures the marginal cost of making delivery. (By reducing throughput through their facilities to less than the competitive amount, the facilities operators would depress cash prices, elevate futures prices, and thereby cause the basis to widen to a level in excess of marginal cost. This would, however, likely require collusion among them.) So, absent evidence of manipulation or collusion, or some other exercise of market power, the basis will equal the marginal cost of the transformation from farm to barge; if the basis is above the marginal cost, competitive firms would sell futures, make delivery, and buy cash grain, thereby driving up the cash, driving down the futures, and narrowing the basis.

It should also be noted that there is somebody willing to pay the futures price and stand for delivery to obtain a shipping receipt. If the taker was not receiving something of value commensurate with the futures price, he would sell futures. (And I am very highly confident that it is not long only funds, or even hedge funds, that are standing on delivery.)

What could cause the marginal cost (and marginal value) of delivery to be so high? Here’s one conjecture that is worth some investigation. Consider corn and soybeans. These contracts are satisfied via delivery of shipping receipts. (I was on the committee that helped design these contracts in 1997.) The contract rules state that the owner of the facility issuing the shipping receipt give priority to the holders of these receipts in determining whose barges get loaded. That is, by issuing a shipping receipt, the owner of a shipping station on the Illinois River (which could be Cargill, ADM, Louis Dreyfus, Zen-Noh or one of a couple of other firms) gives up control of its facility. Put differently, by making delivery, the owner of a facility gives the taker of delivery the option to control the shipping receipt issuer’s facility. The taker has the option to choose the timing to load out the grain. The taker will behave so as to maximize the value of this option. That is, he will exercise the option to use the facility to load out grain when it is most valuable to do so–which is just when it is most costly for the operator of the facility to give up control. That is, the owner of the shipping receipt has the option to transform grain from farm to barge when that marketing opportunity is most valuable–which is just when the owner of the delivery facility would find it valuable too, but cannot exploit it because he has shorted a call on his facility by issuing a shipping receipt.

This option is valuable to the taker of delivery, and costly to the maker of delivery. Therefore, the regular firm that can issue shipping receipts will do so only if the futures price compensates it for the value of the option it provides to the taker of delivery. Asset and infrastructure owners in all commodity markets are becoming increasingly aware of the inherent optionality in physical assets used to transform commodities in space, time, and form. They are explicitly valuing these options, and making trading, investment, and resource allocation decisions based on these valuations. Thus, I would expect that operators of regular facilities take option values into account when making delivery decisions. Similarly, takers of delivery surely take these values into account.

Are option values sufficiently high to explain the wide basis? Skepticism is warranted, to be sure. It must be said that it has often been the case that “real options” theory has been used to rationalize wildly inflated valuations (see energy trading, circa 2000.) Nonetheless, it is possible that optionality has contributed to the level of, and variations in, the basis. If optionality is important, the basis should fluctuate with changes in volatility. Volatility of what? Volatility in the value and cost of making the transformation from farm to barge. Thus, higher volatility in export demand and higher volatility in domestic demand for processing should contribute to higher option values and higher basis levels. A spike in domestic processing demand (driven, e.g., by an increased demand for ethanol) reduces the derived demand for barge loading facilities; a drop in domestic processing demand increases the derived demand for these facilities. Export shocks have similar effects. Transportation cost shocks also matter. Changes in fuel prices that change the costs of shipping grain also affect the derived demand for these facilities. Variability in all these shocks, and the correlations between them, contribute to the volatility that can create option value.

Spreads–such as the basis–price bottlenecks in the transformation process. Therefore, bottlenecks are the first thing to look for when trying to explain anomalously large spreads. Sometimes these bottlenecks can be created through the opportunistic, strategic behavior of traders (as in a squeeze). Sometimes they result from unusually high demand, or disruptions in supply. The analysis presented herein suggests when there is uncertainty, spreads can price in contingent bottlenecks. Speculators will affect spreads only to the extent that they exacerbate or mitigate bottlenecks; given that most commodity funds do not participate in the delivery process, they cannot be contributing to the price of a delivery month bottleneck.

I would mention one historical case that comes to mind; it was discussed in Chapter 2 of my book (with Roger Kormendi and Phil Meguire), Grain Futures Markets: An Economic Appraisal. The cash futures delivery month basis became very wide in July, 1988 for corn, wheat, and soybeans. This was the time of a historic drought, and the operators of Chicago elevators brought in massive quantities of old crop grain in order to protect their hedges, knowing that they would not be able to attract large quantities after a shrunken 1988 harvest. Delivery warehouses were chock-full, and the Chicago cash-futures basis became very wide. In this case, the basis was pricing a bottleneck in storage space.

Today’s Wall Street Journal reports that the LIBOR rate spiked up on the British Bankers’ Association’s announcement that it was accelerating its investigation of whether banks have been systematically misreporting the LIBOR rates they pay to acquire funds on the interbank market.

This reminds me of the effect of the release of the Christie-Schultz study showing that NASDAQ dealers did not quote odd-eighth spreads, and speculating that this may have reflected collusion among the dealers. The narrowing of spreads upon release of the study was damning evidence that something was indeed amiss. The banks’ raising their reported LIBOR rates is similarly suspicious. Haven’t these guys heard the old line: “That’s my story and I’m sticking to it?” Changing stories when the old one is questioned is tantamount to confession.

My prediction: this will result in a class action bonanza, and perhaps other individual lawsuits. The CME’s Eurodollar futures contract–the largest in the world–is settled against LIBOR. Systematic downward biased reporting of LIBOR rates post-credit crisis could have cost those short Eurodollar futures immense sums. Similarly, those short swaps would have received smaller cash flows if LIBOR rate rates were misreported. The OTC swap markets are immense, and even a few basis points of skewing of the LIBOR rate could cost those short swaps huge amounts of money.

When will these people ever learn? And does it take the prospect of huge legal costs to get them to clean up their acts?