Streetwise Professor

July 19, 2011

SWP in the WSJ

Filed under: Politics — The Professor @ 7:27 pm

Backsliding in Basel

Filed under: Clearing,Economics,Financial crisis,Regulation — The Professor @ 4:55 pm

Laurie Carver of Risk passed along this BIS/Basel Committee on Banking Supervision Consultation Paper that proposes a methodology for measuring whether a bank is a “global systemically important bank” or G-SIB.  Laurie perceptively points out that a bank’s OTC derivatives exposure is included as one of the factors in the proposed index that will be used to determine systemic significance, but that cleared derivatives exposure is not. Since capital charges will depend, under the proposal, on the index score, this means that OTC derivatives exposures will affect capital requirements, but cleared exposures will not.

This is a major mistake.  A bank’s exposure to CCPs, and perhaps more importantly, CCP exposures to banks, are of major systemic importance.  The failure of a large bank with a large book of cleared derivatives, both proprietary and client, would pose a substantial risk to the CCP, the other banks that are members of the CCP, and to the broader financial system.  Moreover, via the liquidity channel, large cleared exposures can also be destabilizing, as when a big bank needs large sums of cash in a hurry to meet margin calls on cleared trades.  Indeed, due to the rigid timing deadlines of CCP margin payments, it is my belief that cleared exposures put more stress on the liquidity channel than OTC deals.

Put differently, CCPs are a channel of contagion, and a potential source of shocks that create contagion.  What’s more, they don’t internalize all the externalities that the BIS cites to justify stricter regulation of big banks.  Indeed, as I’ve argued repeatedly, CCPs actually create some perverse incentives (in particular, moral hazards) that can increase systemic risks.

It is particularly disappointing to see this glaring oversight at this late date.  Although the proper time to debate the clearing issue was over a year ago (the Frank-n-Dodd anniversary just passed), it did seem that serious people were coming to recognize that the idea that CCPs were a panacea for derivatives-driven systemic risk was an unrealistic dream, and were therefore thinking far more seriously about how to deal with the systemic risks arising from CCPs.  Even the Basel Committee had genuflected to this understanding, and incorporated a capital charge for cleared exposures into the Basel III proposal.  Hence, the Consultation Paper seems to be a retrograde step back to the unrealistically optimistic view of CCPs as safe.

This attitude is very dangerous.  The longer it persists, and the more widespread it remains, the higher the likelihood that cleared derivatives will play a major role in creating or exacerbating some future financial crisis.

Update: Laurie kindly pointed out that my description of the implications of the G-SIB index score was misleading.  The G-SIB score affects only the systemic risk capital surcharge; cleared derivatives are included in the standard capital calculations.  Bad drafting aside, the basic point stands: the proposal implicitly assumes that cleared derivatives do not contribute to systemic risk.  Danger, Will Robinson!

Upstream, Downstream, We All Scream for Midstream

Filed under: Economics,Energy — The Professor @ 4:25 pm

ConocoPhillips’s announcement of a restructuring plan that would create separate upstream and downstream companies got me thinking again about the Seaway Pipeline, of which CP is a 50 percent owner.  Recall that the company has refused to reverse the flow of Seaway to go from Cushing to the Gulf despite the fact that Midcon prices are far below Gulf prices.

Indeed, since my earlier post, the divergence has increased. At the time, LLS-WTI spreads were about $12-$14, depending on the delivery month: now they are about $16-$18.  (Here’s a link to price quotes on LLS-WTI spread swaps.)  Since the gain to reversal is proportional to the square of the price difference, a 20 percent widening of the spread (which is conservative) corresponds to a 44 percent increase in the social gain to reversing the pipeline.  That translates roughly to about $3 million per day–at a minimum, under the assumption that reversal would completely close the LLS-WTI gap (except for transport cost).  The figure is larger if–as is plausible–the capacity on Seaway (plus Keystone, when that gets on line) is not enough to close the gap.  As I said before, from the perspective of market participants collectively, it is a no brainer as the reversal would pay for itself within days.  Days.

CP’s restructuring announcement therefore raises a very interesting question: where will Seaway go?  Will it go with the upstream operator?  If so, that firm may have an incentive to reverse, though that’s not crystal clear.  Reversal will cause Gulf prices to fall relative to Midcon and Canada: that would reduce the value of CP production in the Gulf and Texas.  If it goes with the downstream entity, that entity will still have no incentive to reverse–unless it is, uhm, persuaded through some Coasean bargain to let the oil flow free.  A third option is that Seaway could be spun off as part of the restructuring.

What will happen?  I don’t know.  The pipeline is a midstream asset, so it’s not obvious whether it sits more comfortably upstream or downstream.  I can say that the economic gains to reversal are even greater now than earlier in the year when I did my original analysis.  The restructuring provides a perfect opportunity for CP to monetize that value, through some kind of deal with producers tributary to the Midcontinent, or Gulf refiners.

A Push at Best, a Big Cost at Worst–and For What?

Filed under: Clearing,Commodities,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 11:24 am

Betting the Business (i.e., John Parsons and Antonio Mello) notes that the Coalition of Derivatives End Users has backed off its more extreme claims about the effects of clearing and margin mandates.  John and Antonio have been correct to point out that Frank-n-Dodd requirements may just result in the credit implicitly bundled in derivatives deals being unbundled, by the extension of a loan or a credit line.  (This is something that I also pointed out in my Cato piece last year).  But they have not explicitly addressed an implication that I pointed out, and specifically asked them to analyze.  Specifically, if margin requirements merely result in making implicit credit explicit, how do these requirements affect the aggregate amount of credit in the system?   This is the crucial question because the amount of leverage in the system is the first-order driver of systemic risk.

The End User Coalition’s letter makes this point:

Margin lending facilities offered by banks (and especially if offered by [Swap Dealers] or [Major Swap Participants] [as will almost surely be the case], would merely re-allocate and re-label risk, but not materially reduce it.  What was formerly a derivatives exposure risk would be converted to a lending facility risk.  A counterparty default from a derivatives obligation would have the same impact on a bank as a default on a margin lending facility obligation.  In other words, changing the form of the risk does not eliminate the risk (p. 10).  [Emphasis in original.]

. . . .

Some have suggested that end-users that traditionally pledge non-cash collateral cold continue their operations by using a secured financing facility.  Like the margin lending facility discussed earlier in Section II.B.3., a secured financing facility does little or nothing to remove risks from the system.  Instead, it simply changes the name of the risk from derivatives exposure to financing facility exposure (pp. 11-12).

Exactly.  And exactly as I’ve pointed out for well over a year.

Revealed preference suggests that implicit and explicit credit are not perfect substitutes.  Indeed, the End User Coalition letter points out (on p. 12) why a secured lending facility may be an imperfect substitute for using non-cash collateral in a derivatives deal.   Thus, the imposition of the constraint will be costly for firms, and will lead to less hedging.

But the Parsons-Mello main point–and the important implication–remains unchanged: substitutions of one form of credit for another will limit, and perhaps sharply so, the effects of margin and clearing and capital mandates on the amount of leverage in the system.  Since leverage is the source of systemic risk–what’s the point?

I also think that P-M are too dismissive of contentions that the regulations as written will result in deadweight losses.  This is because the amount of margin required can be so large as to require firms to alter drastically their capital structures, and such alterations are costly and can result in some of the inefficiencies the Coalition laments.  As the Coalition letter points out, for non-cleared swaps, the margin requirement is quite onerous: the margin must be sufficient to cover 99 percent of 10 day price moves.  That’s a lot.  This will likely require firms to (a) hold far larger amounts of their assets in liquid instruments, and hence less in more productive assets, (b) reduce their derivatives usage, or (c) most likely, both.

Margins and liquidity are costly.  That’s why firms strive to manage liquidity tightly, and are quite sensitive to margin: the amount of collateral and the form in which it must be held are definitely not matters of indifference to them.  A big margin requirement, and a requirement that the margin be posted in liquid assets, will definitely be a binding constraint, and its shadow price will be non-trivial. I don’t know what it is, but I know it’s not zero–primarily because firms optimize with respect to margin costs.

All this means that, at best, the margin requirement and capital requirement rules on end users will merely lead to a relabeling of credit and will not alter the economic substance of end user’s balance sheets.  (Similar arguments hold for financial institutions too.)  At worst, the constraints will result in costly changes to these balance sheets: excessive holding of liquid assets (can you say financial repression?), deficient investments in higher returning illiquid assets (i.e., the productive assets that enhance productivity), and too little hedging.  I read M-P to mean that the margin requirements on end users will merely lead to a relabeling, and that the requirements will not alter balance sheets.  I think that is far too sanguine.

And for what, exactly?  Under the best circumstances (i.e., no change in the economic substance of balance sheets), systemic risk doesn’t change a whit.  Under the worst circumstances, capital is misallocted, risks are misallocated, and there is no reduction in systemic risk (because end users do not contribute to it in a material way).  So, in the best of outcomes: no gain and no pain; in the worse ones, all pain and no gain.

Such a deal.

One final quibble with Betting the Business.  They state:

But of course an implicit credit line embedded in the bid-ask spread has great advantages to dealer banks. It is hidden, bundled with the derivative contract sold and therefore difficult to figure out by client end-users, who never really know how much they are paying for the amount of credit extended. Welcome to the opaque world of OTC markets.

Who cares how the cost components of a derivatives deal break out?  The end user cares only about the all-in cost, and the bid or offer is sufficient for end users to figure that out.  They can solicit quotes from multiple dealers and choose the most favorable one.  They can compare the quotes to the prices of related, exchange traded instruments to evaluate the reasonableness of the prices they are quoted.

Do you really care how the cost of a gallon of gasoline breaks down between the price of the crude, refining margins, transportation, retailing margin, etc?  No: you care about what it costs you to fill up.  If one station quotes $4.60 and another $4.65 for gasoline of equivalent quality, do you care why?  Or, to use the famous example of a pencil: do you really care about what each step of the process of putting a pencil in your hands cost?  No: you care about the price of the pencil.

That’s the information economizing role of prices at work.  It works in OTC markets as it does in pencils and gasoline.

Irrational Rationalization

Filed under: Economics,Military,Politics,Russia — The Professor @ 10:05 am

Strategy Page has an interesting post on the Russian procurement dilemma, cleverly, ironically–and accurately–titled “The Wisdom of the Czar.”  It points out that Putin’s plan to “rationalize” the Russian defense sector by consolidating suppliers into megafirm monopolists is resulting–surprise, surprise–in these firms demanding high prices from the government:

he Russian military is buying lots of weapons again, and they don’t like the prices. So the government has told the military that they could buy foreign weapons and equipment if they found the prices for Russian equipment too high. This is in response to Russian firms believing they could charge whatever they want, secure in the knowledge that they are probably the only Russian supplier for an item, and that the higher price provides cash for bribes (to get procurement officers to sign off on the high price with no questions.) This was the case even with government owned defense companies, largely because of the corruption. The government believes the new policy will curb corruption (as foreign suppliers are less likely to offer bribes), get gear at lower prices and bring in new technology. But there are other reasons for the high prices, like inefficient or incompetent subcontractors the need for even defense firms to pay bribes to get things done.Part of this problem was caused, ironically, by a Russian effort to save their defense industries. In the wake of the post-Cold War collapse in Russian military procurement, defense companies were consolidated, with government help. The latest of these efforts puts all Russian helicopter companies into one firm; Russian Helicopters. To accomplish this, the government bought a majority of the stock in these companies. Thus Russian Helicopters now owns 75 percent of Rostvertol, 72 percent of Mil Moscow, 99.8 percent of Kamov, 60 percent of Stupino Machine Production, 75 percent of Ulan-Ude Aviation, 66 percent of Kazan Helicopters, 100 percent of Kumertau Aviation, 81 percent of Reductor-PM and 75 percent of Progress Arsenyev Aviation.

. . . .

Russia has already consolidated fixed-wing aviation companies. The situation here was, in some ways, even more desperate. Two years ago, it was determined that the company that produces the MiG-29 (and all earlier MiG combat aircraft) was worth less than a nickel (about 3.5 cents, to be more precise). This valuation was calculated by auditors who were ordered to determine the worth of the company prior to a reorganization. MiG, along with Sukhoi, Tupolev, Irkut and others, was merged into one large firm; UAC (United Aviation Corporation). Russia started UAC off on a firm fiscal footing by investing billions of dollars into the new corporation. The government does not want the money wasted, as was the case with RSK MiG (which, as of first of the year, owed $1.5 billion, and lost $363 million). Executives associated with RSK MiG are being prosecuted for corruption. In comparison, Sukhoi’s worth was estimated to be $230 million, and the firm has been making money (on brisk sales of its Su-27/30 line of jets). But that was an exception, as the other aviation firms were in bad shape, although none as dire as MiG.

Yes, many of the companies were in dire financial circumstances.  But the “solution” to that problem, created, Sorcerer’s Apprentice-like, another and arguably worse one: a decline in competition.  This raises the market and bargaining power of the now-merged groups, leading to higher prices and higher transactions costs (e.g., more rancorous and time-consuming negotiations).  Moreover, it deprives the government of valuable information, since the performance of one contractor cannot be compared to and benchmarked against the performance of others.   The prospects for ex post opportunism are also greater, because once a contract is let, the government has nowhere to turn if the contractor demands more money or delivers poor quality ex post.*

The creation of “national champions” is therefore making chumps out of the nation.

Great work, VVP!  Maybe women stripping will be a welcome distraction from a clear-eyed examination of the actual consequences of your clever ideas.

* I should note that the US is running into similar problems as a result of the consolidation of the defense sector over the last 20 years.  This is particularly noticeable in shipbuilding, with the complete FUBAR of the USS San Antonio being the most pronounced example, but not the only one.

July 18, 2011

Monopoly Leveraging in Clearing and Execution: Realistic Fear or Bugbear?

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Regulation — The Professor @ 4:53 pm

Back in the late-90s and early-00s I often remarked that it was interesting how exchanges had drawn so little anti-trust scrutiny, despite the fact that may were effectively monopolies.  I also predicted that they would get more scrutiny when they became for-profit, and more like conventional firms.

That prediction is being borne out today, and how.  Exchanges, particularly merging exchanges, are the subject of considerable attention from anti-trust authorities.  ICE CEO Jeffrey Sprecher–who ironically had hoped that anti-trust objections to the CME-CBT deal would open the door for an ICE-CBT merger–has seen the writing on the wall:

Exchanges will have to “rethink their global strategies” because of unexpectedly strong scrutiny of proposed bourse tie-ups from antitrust regulators, according to IntercontinentalExchange (ICE), one of the world’s biggest exchanges.

A string of proposed mergers has come unstuck in recent months, either through nationalist opposition in the home market of exchanges perceived as the targets of takeovers, or as antitrust authorities have moved to stymie combinations amid concerns they could reduce competition.

. . . .

Jeff Sprecher, ICE chief executive, said: “There’s been a marked change in the way regulators look at exchanges generally. The good news is that they are looking to exchanges to provide more transparency to prevent another meltdown.

“The bad news is that they want to ensure a lot more exchanges to ensure competition. So the impediments are now higher than they were a few years ago and I think it’s going to cause everyone to rethink their global strategies,” he told the Financial Times.

A major sticking point for anti-trust regulators has been vertical integration between execution and clearing.  The USDOJ Anti-trust Division’s Parthian shot at the CME from early-08 is one example of this.  Battles currently going on in Europe are another.

But the vertical silo wars have now gone beyond execution and clearing to encompass other vertical restrictions, including exclusive arrangements for use of data centers.  Last week, Swedish competition authorities raided the country’s stock exchange as part of an investigation of its deal with Verizon over exclusive access to a data center.

This area is fraught with potential for policy error, because as Sam Peltzman notes in his chapter on Aaron Director in Cohen and Wright’s Pioneers of Law and Economics, and as Posner notes in his Antitrust Law, anti-trust policy over vertical restrictions and vertical integration has long been a mess.

The brief against integration, particularly between execution and clearing venues, is that clearing is a natural monopoly, and that the operator of a clearing monopoly can thwart competition in execution by creating a vertical silo, and providing clearing services exclusively to its integrated execution arm. That is, that the clearing monopolist can leverage his market power into execution, which would otherwise be competitive.

As Peltzman notes, and as Director argued well over a half-century ago, this fear of leveraging one monopoly into two is commonsensical–and more often than not, wrong.   The essence of the Chicago critique is that the monopolist (in this case, the operator of the clearing service) can extract all of the monopoly rent by choosing the monopoly price for his product.  Keeping out potentially more efficient suppliers of complementary services (e.g., execution, which is highly complementary to clearing) just reduces the profit the monopolist could extract.  The monopolist wants complements sold for the lowest price possible, in order to push out the demand curve for the monopoly good as far as possible.  Thus, keeping out a more efficient supplier of the complementary good, or reducing competition in the sale of the complementary good, is counterproductive.

Chicagoans starting with Director explained vertical restrictions as a form of price discrimination (which has ambiguous welfare consequences) or as a means of addressing free rider problems (as in Telser’s model of resale price maintenance) or as a way to eliminate double-marginalization problems.  Transaction costs economists devised other efficiency-related explanations for vertical integration.

But the suspicion of vertical integration and ties and exclusive dealing and other vertical restraints lives on.  Hence the fighting over silos in the exchange space.

Post-Chicago, there have been several attempts to produce models which lead to anti-Chicago implications, i.e., to show that monopoly leveraging is possible.  In this post I will discuss those models, and show that they don’t apply to the facts of the exchange case.  In a future post, I will discuss the efficiency rationales for integration and exclusivity.

The most prominent post-Chicago leveraging model is by Whinston.  In his model, there is a monopoly good M.  Some customers want to consume that good along with another good C that could be produced by competitive firms.  But some customers don’t want to buy M.  They wish to consume C alone.

In Whinston’s model, the M monopolist may want to tie or vertically integrate into C (and not sell to other producers of C) if entry into C production requires payment of a fixed cost.  By tying/integrating, those who want to buy M have to buy C from the M producer too.  Thus, potential entrants into the C market can sell only to those who want to buy C alone.  If there are too few of those customers, or fixed costs are too high, it will be unprofitable to enter into the production of C.  Then the monopolist can sell C to the stand-alone customers at a monopoly price.

This model clearly doesn’t fit the facts in the clearing-execution case.  Those products are highly complementary.  Indeed, they are consumed in nearly fixed proportions–if you want to trade, you need to clear, and if you clear, you need to trade.  The whole point of the Whinston model is about monopolization of a product some customers do not find complementary to M. The monopolist uses his power over the customers who have strong complementarity to gain a monopoly over customers who do not experience any complementarity with M.   This is clearly at odds with the assertions of those who assert that clearing monopolies use their power to achieve execution monopolies, because those assertions rely heavily on the notion that clearing is an essential service–i.e., highly complementary to execution, and a service that all traders consume.  That’s completely at odds with the Whinston story, so it is of no help to the anti-silo crowd.

Carlton and Waldman have an interesting model that embeds complementarity, but arrives at similar conclusions to Whinston’s model.  But whereas Whinston argues that ties/integration can be used to extend a monopoly to a non-complementary good, Carlton-Waldman devise a model in which a monopolist ties a complementary good to protect his M monopoly.

C-W present a two-period model.  A firm has a monopoly over M.  It is guaranteed this monopoly for 1 period, but in the second period, a competitor can enter.  The M monopolist can also produce a good C, and a firm that can enter the M market in the second period can produce C in the first period.

In one model, the rival incurs a fixed cost to enter the C market.  By tying the complementary good in the first period, the M monopolist deprives the entrant of any sales in the first period.  The profits from producing C and M in the second period may not be sufficient to cover entry costs, meaning that with the tie entry may not occur in either market, thereby preserving the M monopoly.  In contrast, without a tie, the entrant can produce C in the first period, and make a profit that contributes towards covering fixed costs: he can make a profit because his C good is superior to that of the monopoly producer of M.  The profit from entering C production in the first period may cover fixed costs of entering the C market.  Then, in the second period, it may be profitable to enter the M market as well.  In this case, tying protects the M monopoly.

In the second model, there is customer lock in due to network effects.  By tying in the first period, the monopolist of M locks in a lot of consumers of C, and deprives the entrant of any sales in the first period.  The customer lock-in reduces the profitability of entry into M and C production in the second period, likely by enough to make such entry unprofitable.  Again, the tie protects the M monopoly.

These models work best to explain ties in highly technologically dynamic industries where monopolies are likely to be short-lived in any event.  That doesn’t seem to fit the exchange-clearing case.  Moreover, there is no legal or economic bar on entry into clearing and execution simultaneously: the necessity of sequential entry is the key driver of the C-W results.  Indeed, integrated exchanges have entered in competition with incumbents, and execution platforms have secured clearing services by contract, so simultaneous entry has occurred.

A third type of model relies on contracting externalities to explain how exclusive dealing and integration can impair competition.  One example of this is a model by Hart and Moore.  In H-M, an upstream monopolist can sell to multiple downstream retailers.  In the exchange case, the upstream firm would be the clearing monopoly, and the retailers execution venues.

In the H-M model, the upstream monopolist negotiates with the downstream firms individually and secretly.  Moreover, they negotiate over output–the quantity sold: this is a key assumption.  H-M show that under these conditions, the monopolist cannot credibly commit to sell the monopoly output Q_m.  For instance, if he sells .5Q_m to one firm, he has an incentive to sell more than .5Q_m to the other: he cannot credibly commit to selling .5Q_m to the second firm once he has sold that amount to the first firm.  Thus, total output exceeds the monopoly output and the monopolist’s profit is smaller.  Indeed, he can only achieve the Cournot duopoly profit.  If he sells to N retailers, he can get only the N-firm Cournot profit.

By integrating, or selling to only a single retailer, the monopolist effectively commits to the monopoly output.  This may come at a cost.  For example, there may be diseconomies of scale in retailing, or retailers may be differentiated and service different customer clienteles.  But the gains from eliminating the commitment problem may exceed the costs arising from diseconomies of scale or underproduction of variety/customization.

The monopolist obviously has incentives to avoid the commitment problem that drives the exclusionary result.  For instance, he could charge the monopoly price, post that price publicly, and let the downstream firms buy as much as they want–which would be .5Q_m.  This would require the avoidance of secret price discounts.  Reputation may ensure this in a repeated game.  The retailers could monitor competitors’ sales to see if the monopolist were cheating.

Moreover, this doesn’t seem to match up well with the mechanics of the exchange case.  “Output” is not the choice variable; prices are.  And trading volumes are readily observable, making it possible to detect whether a clearing monopolist were offering secret price cuts.

A similar model is one in which a downstream monopolist buys from two upstream suppliers who compete in an input market in which the supply curve for the input slopes up.  Similar commitment problems preclude achievement of the monopsony outcome in the input market.  This model has the same choice variable problem as the H-M model, and what’s more, it is difficult to imagine what the relevant input with the upward-sloping supply would be.  Computer programmers?  Servers?  Again, it doesn’t fit the exchange case well at all.

Another model of anti-competitive integration is by Ordover, Saloner, and Salop.  In that model, two downstream firms D1 and D2 compete, as do two upstream firms U1 and U2.  If D1 and U1 integrate, and the integrated firm refuses to sell to D2, D2 now has to buy an input from a monopoly supplier U1.  D2 pays a higher price for the input, which makes it a less formidable competitor for the integrated firm, which therefore becomes more profitable.

This model is quite fragile.  What’s more, an example in a related paper by Riordan and Salop makes it hard for me to take the theory seriously.  Their example of how this could work is that the purchase of Autolite–a spark plug maker–by Ford could raise the price of spark plugs to GM and Chrysler, thereby allowing Ford to raise the price of cars.  Really.  They couldn’t come up with a better example.  (Posner snarkily dismisses the applicability of this theory by pointing out the complete absence of credible examples.)

Moreover, it doesn’t fit at all the arguments of the anti-silo advocates.  Their premise is that clearing is a natural monopoly.  But the OSS model depends crucially on integration reducing competition upstream (i.e., in clearing).  That can’t happen if clearing is already a monopoly.  OSS is not a theory of monopoly leveraging.

In brief, there are a variety of rather special models that arrive at anti-Chicago conclusions, and which suggest that vertical restrictions and vertical integration can be anti-competitive.  None of these models, however, fit the facts of securities or derivatives trading.  Moreover, many are completely at odds with the arguments made by those who claim that integration between clearing and execution is monopoly leveraging.

Which means that the anti-silo forces are on very shaky intellectual ground.  There is no existing, rigorous, logically consistent theory that is (a) consistent with the facts of the exchange case, and (b) rationalizes their conclusion that integration is anti-competitive monopoly leveraging.

In his industrial Organization text, Tirole warns:

Few topics in industrial organization are as controversial as market foreclosure.  . . . Though market foreclosure is a “hot” issue among those concerned with anti-trust proceedings and with regulation, economists still have a very incomplete understanding of its motivation and effects.  Nor can they always explain successfully why a particular tool is employed to achieve foreclosure.  (Tirole, The Theory of Industrial Organization, p. 193).

True, that.  And given that Tirole is hardly a wild-eyed libertarian, those convinced that vertical silos in exchanges are anti-competitive foreclosure should take his words as cautionary.

Posner once upon a time was more of a libertarian than Tirole, but his words are also worth considering:

The general prohibition in section 2 of the Sherman Act against monopolizing is adequate to deal with the rare case in which a firm imposes a tie-in with the purpose or likely effect of monopolizing the market for the tied (or for that matte the tying) product.  A special tie-in doctrine, inevitably with a life of its own, is unnecessary and inappropriate.  (Antitrust Law, 2d. Ed., p. 207). [Emphasis added.]

Whinston recognizes that many of the models of vertical exclusion are quite special cases, limited primarily to “triangular” situations (i.e., two upstream firms and one downstream, or two downstream firms and one upstream).  Thus, like Tirole, he cautions against drawing strong conclusions on the basis of special models.

In his “Should Antitrust Be Modernized” (J. Econ. Perspectives, 2007), Dennis Carlton cautions that rules intended to identify anti-competitive exclusive acts “could potentially challenge a wide array of core competitive behaviors” and hence become “dangerous” (p. 170).   Peltzman, in the chapter on Director I alluded to earlier, takes a more benign view of the effects of errors in precluding certain types of vertical restrictions.  Sam explains courts’ hostility to vertical restrictions by a monopolist to the belief that it is unlikely that outlawing such restrictions is unlikely to have a serious detrimental impact on competition, that any benefits of the restriction are likely to be indirect, and that courts typically discount any such indirect effects.  Transaction costs economics suggest that these benefits may be large, however, so such discounting is problematic at best.

In sum, the existing models that demonstrate that vertical restrictions can leverage monopoly don’t fit the facts of the clearing-execution case and are so highly stylized that even their developers caution against taking them too seriously in practical situation.  Moreover, thoughtful analysts of anti-trust discount their applicability.

Based on this, antitrust authorities–and those who criticize integration between clearing and execution, or between exchanges and data centers, for that matter–should be much more circumspect in their attacks on silos: the cases in which integration or vertical restrictions are anti-competitive are the exception, rather than the rule.  This circumspection should be all the greater because there are compelling efficiency rationales for vertical integration and other vertical restrictions involving clearing and execution.  I’ve laid out some of those rationales in working papers, and will devote a future post to the subject.

Only Suckers Enter Into Unenforceable Bargains–Especially If They Are “Grand” Ones

Filed under: Economics,Politics — The Professor @ 2:52 pm

The character Wimpy in the old Popeye cartoons was famous for the line: “I’ll gladly pay you Tuesday for a hamburger today.”  Wimpy Obama would never play for such piddling stakes as hamburgers, or promise to pay as soon as next Tuesday.  His version is: “I will gladly make a two trillion dollar spending cut in 2020 for a trillion dollar tax increase today.”

The obvious problem with such “grand bargains” is that they a) they involve one party performing first, by making a commitment that is hard to reverse (by raising taxes, which is costly to reverse),  and b) have no mechanism to enforce the promise by the other party to provide something of equivalent value at a later date.  Only suckers make deals with Wimpy to pay today exchange for the promise of getting paid back in the (distant) future, when that promise cannot be enforced.

In commerce, the development of credible legal systems, or private enforcement mechanisms (e.g., commodities and securities exchanges), or private arrangements to enforce performance (e.g., exchange of bonds or collateral) was required to support a viable trade in asynchronous promises, such as credit arrangements or forward contracts.  And even in the presence of such institutions, many deals that would be mutually beneficial if consummated and performed do not get done because these mechanisms are too costly.  For instance, some kinds of obligations are non-contractible, because courts cannot verify performance.  So those deals don’t get done.

In politics, long term deals involving asynchronous performance are much more difficult to achieve because it is much more difficult–and often impossible–to enforce them.  Current political actors can seldom bind future ones: tomorrow’s Congress can just reverse a decision made by today’s, for instance.

A famous paper by Marshall and Weingast argues that many features of Congress, such as dominance by committees, can be explained as mechanisms that make trades between Congressmen more enforceable.  (Not that that’s necessarily a good thing, because many intra-Congressional bargains are deals between A and B to steal from C.)  But even these mechanisms cannot support all mutually beneficial bargains, and what’s more, as Marshall and Weingast note, institutional changes in the 1970s undermined the power of the committee system and therefore shrunk the set of deals that could be enforced.

In the current debt limit standoff, the problems of enforceability are insuperable.  There is no way in hell to make Obama or the Congressional Democrats or future Congresses or future presidents live up to promises to cut future expenditures.   And to put it mildly, Obama’s incentives to promise today and renege tomorrow are huge.  He wants a deal today to reduce the salience of debt and deficits as a campaign issue in 2012.  If that succeeds, and he is reelected, he has every incentive to renege.

Which means that the only feasible deals are those that involve contemporaneous performance–e.g., raising taxes and reducing spending in this year.  Feasible for non-suckers, that is.  And if that deal is not acceptable to Obama, then there should be no deal whatsoever.  It would be better to raise the debt ceiling with no strings attached, and fight it out on the tax-and-spend issue in 2012.

And it is pretty clear that Obama is not serious about contemporaneous spending cuts.  All of his programs–including idiocies like high speed rail and his various greendoggles–are sacrosanct.  He has offered up a risible $2 billion in specific cuts for 2011.  He keeps bleating about how any cuts will throw the nation into some sort of Dickensian nightmare.  Funny, I lived when the government spent 19-20 percent of GDP, and it didn’t seem all that Dickensian to me.  My grandmother wasn’t ejected into the cold.  And kids went to college.  Really!  I’m pretty sure about that, having taught them in their multitudes well before government spending totaling 25 percent of GDP was considered the bare minimum for a humane society.

No, Obama operates under the ratchet theory of government.  Once ratcheted up, spending cannot ratchet down.  Spending that was not missed yesterday is imperative tomorrow, once it has been adopted today.  Which means that doing any deal based on Ratchet Man’s promises that he will cut future spending is a mug’s game.

Addressing the nation’s long term–and not really that long term, actually–danger of government insolvency cannot be done in the context of annual budgeting.  The crux of the problem is entitlements, and attacking that problem requires fundamental restructuring of the programs, where this restructuring will likely require features (e.g., supermajority requirements) that make it difficult for future Congresses and administrations to renege on the commitments inherent in the legislation mandating the restructuring.

That will not happen while Obama is in office.  Period.  Which is exactly why 2012 is the only thing that matters, and that doing a deal today or forcing a triggering of the debt ceiling that will have extremely unpredictable economic and political consequences is foolhardy.   Unfortunately, those who desire most ardently to cut back on government and its growth are those who most ardently press for a deal or a showdown that could lead to a shutdown.  Although the frustration is understandable, this is short sighted and counterproductive.  It is vital to keep the big things in mind, and to avoid battles that risk the war.

July 16, 2011

Pity the Poor Furniture Salesman

Filed under: Military,Politics,Russia — The Professor @ 7:26 pm

The good news–for the Russians–is that there was another successful launch of the Bulava missile.  It looks like the weapon may be usable after all, and that the program need not be scrapped as feared.

The bad news–for the Russians–is that the military procurement system is so dysfunctional that the prospects for actually going into serial production are dismal:

Russian Defense Minister Anatoly Serdyukov is caught between conflicting orders. President Dmitry Medvedev is trying to reduce corruption in the military, and has ordered Serdyukov to make it happen. But in doing that, Serdyukov has withheld payment to many military suppliers, because these firms refuse to explain why prices have suddenly increased. That has created problems with Medvedev, who is also demanding that defense industries produce the quantities of weapons agreed on, and according to promised delivery dates. That will not happen as long as Serdyukov is putting contracts on hold to deal with corrupt practices. President Medvedev has to decide, but in the meantime he has asked for more details. This might speed corruption investigations, but will definitely be interesting no matter how it turns out.

The problems Defense Minister Serdyukov went public with, also impact weapons exports. For example, a Russian shipyard recently revealed that it would be late delivering three Talwar class frigates (ordered five years ago, for $1.6 billion) and wanted another $100 million (from the government, which handles arms exports) to complete construction. Problems like this have led to record low approval ratings for the national government. President Dmitry Medvedev and prime minister (and former president) Vladimir Putin have run the country for over a decade and have done a lot to clean up corruption and economic problems. But corruption has proved resistant to reform efforts, and popular anger at the continued corruption is linked to  dissatisfaction with politicians in general.

The designer of the Bulava–who was dismissed from heading up the program because of the repeated test failures–leveled a broadside against Medvedev, though not referring to him by name:

Ostensibly about defense budgeting and the state of the Russian strategic arsenal, the interview was actually a stinging attack on President Dmitry Medvedev’s leadership in one of Russia’s most politically and internationally fraught arenas: strategic nuclear weapons. The Russian commander in chief emerged from Solomonov’s portrait as a bad strategic planner, an inept manager, and a Khrushchev-like shoe-banging blusterer who is making Russia’s already weakened position in global politics even more perilous.

Solomonov’s barrage may be revenge for his dismissal, but maybe not.

Surdyukov’s head must be spinning:

Russian Defense Minister Anatoly Serdyukov faced a very public upbraiding from Russian President Dmitry Medvedev after it emerged the submarine manufacturer Sevmash had missed the target on the delivery of a submarine for the Russian navy.

Further angry exchanges followed complaints about the inflated prices demanded by military manufacturers, alleged corruption and malpractices at different levels of the defense manufacturing infrastructure.

Sevmash is the acronym favored by the giant shipyard Severnoye Mashinostroitelnoye Predpriyatie Northern Machine-Building Enterprise based in the White Sea port of Severodvinsk. The company employs about 27,000 people and specializes in building ships, submarines and other military equipment for the Russian navy.

. . . .

The comments raised an uproar during which the president “blew up” at Serdyukov for disruption of the state defense order, Itar-Tass reported.

In later comments, the Novye Izvestia quoted Medvedev denouncing Solomonov.

“You well know how scaremongers were treated in war times — they were shot,” Medvedev said, adding he was authorizing the defense minister to “fire everyone.”

Serdyukov earlier acknowledged the ministry was having difficulty concluding contracts with manufacturers because of inflated prices. He complained of a “wild growth” in defense contract prices, one of the reasons why the ministry had trouble signing contracts.

More than $3.57 billion in contracts for defense spending in 2011 remain unsigned, he said.

Itar-Tass cited corruption was aggravating the situation.

The Komsomolskaya Pravda said it was the fourth time in six months that Medvedev had lashed out and demanded punishment for those putting Russian defense manufacturing in jeopardy.

So Medvedev has ordered Surdyukov to spend a lot of money to build a lot of weapons fast, and then is furious when Surdyukov balks at overpaying defense contractors who are trying to take advantage of the government’s haste to spend money and buy weapons now, Now, NOW!  Try walking into a car dealer sometime, and say: “I’ve got money burning a hole in my pocket.  And I need to buy in a hurry.”  That usually doesn’t work out well.

Surdyukov, a former furniture salesman and director of a furniture company, is under orders to root out corruption in defense contracting and also under orders to expedite procurement.  These are effectively incompatible goals.  Not to mention the fact that the defense base is so eroded that it is doubtful that it could meet the lofty objective of making up for 20 plus years of a virtual standstill in procurement in less than 10 years.

As Solomonov puts it:

Solomonov began by describing the technological base of the Russian missile industry with a degree of frankness not heard from a Russian in a position of authority since the halcyon days of glasnost. Russia, he said, is utterly dependent on imports from the West because there are technologies that it “cannot make itself.” We “simply don’t have anything,” Solomonov told Kommersant. (According to Solomonov, the share of high-tech in Russia’s total exports is one-fourth of 1 percent.) One ought not be surprised that Russia is “looked down” on, he continued; for the West, Russia is just a “territory with a lot of nuclear weapons.”

The 2010 defense procurement order has fallen through, and Medvedev only now, “half a year later,” got around to holding a meeting with government officials and industry figures to look into what happened. Small wonder then, that, according to Solomonov, the 2011 defense plan is also a failure: The defense industry cannot possibly fulfill it.

This just provides further evidence of the insanity of Putin’s and Medvedev’s goal of restoring the Russian military to a semblance of its (or more properly, the Red Army’s) former glory.  The system is corrupt.  The defense base is decrepit, with both its physical and human capital highly degraded.  Even if weapons are procured, the personnel available to operate them are few in number, taken disproportionately from the left tail of a small demographic cohort, unmotivated, brutalized, poorly led, and in service for just about enough time to figure out how to clean their weapons.

The Russian military needs to redefine its mission and aspirations based on current realities, rather than dreams of past glories (and those rather exaggerated in the retelling).  It needs to start by fixing its software problems, both in the uniformed services and the defense industry, and only then turning to its hardware issues.  It’s very easy to spend money.  It is much harder to get anything for it.

Medvedev’s impatience is quite interesting.  It suggest that the defense issue is an acute pressure point for him.  Putin keeps making the promises, but Medvedev is on the hook for delivering on them.  Good luck with that.

All at Once, Everybody: Awwwwwwwwww

Filed under: Energy,Politics,Russia — The Professor @ 2:32 pm

The German Quadriga Foundation has cancelled this year’s ceremony during which Vladimir Putin was to receive the foundation’s reward standing for freedom and democratic change.”  Apparently many German politicians, members of the German human rights community, and former recipients of the reward had somehow gotten into their silly heads the idea that Putin didn’t deserve a reward for “commitment to innovation, renewal, and a pioneering spirit through political, economic, and cultural activities,” and for those “whose courage tears down walls and whose commitment builds bridges” and who serve as “role models for Germany” and are “role models for enlightenment, dedication, and the public good.”

Yeah.  You say all that stuff and I assure you that the first name that pops into my head is “Vladimir Putin.”

Former recipient Olafur Eliasson (a Danish-Icelandic artist) handed in his prize in protest yesterday.  Vaclev Havel said he would return his if the foundation indeed gave Putin the reward.

As for the political backlash in Germany, it was intense:

Government human rights commissioner Markus Löning said the choice undermined the Quadriga award, which will be handed out on the Oct. 3 national holiday celebrating German unification in 1990, and others questioned Putin’s democratic credentials.

“It is downright cynical to award Putin the Quadriga prize and put him in the same group with Mikhail Gorbachev and Vaclav Havel,” Löning, a member of the Free Democrats who rule with Chancellor Angela Merkel‘s conservatives, told Der Spiegel magazine’s online edition. “It devalues the prize.”

Former Soviet leader Gorbachev and former Czech President Havel are among previous winners of the award.

Löning’s objections were echoed by a senior lawmaker in Merkel’s conservatives. Merkel herself has criticized Putin over human rights in the past.

Erika Steinbach, chair of the parliamentary committee on human rights, said she worried about lasting damage to the award first presented in 2003. It was inspired in part by former U.S. President Bill Clinton during a visit to Berlin.

“If the award’s committee doesn’t send a strong signal for human rights and revoke its decision, the Quadriga prize will be permanently devalued,” Steinbach said of the award that is popular in Germany but little-known abroad.

The initial decision represented Germany at its at-your-feet worst, which, sadly, is all to characteristic of its relationship with Russia, as this long RFE/RL piece makes abundantly clear.  The explanation has to be largely psychological, rather than economic.  Yes, there is energy, but a rational response to that dependence would be to take steps to mitigate it, but Germany–even under Merkel–have time and again done the exact opposite.  The irrationality of this actually reinforces the psychological interpretation.  And insofar as economics is concerned, Germany is a colossus, and Russia a dysfunctional dwarf.  If you think the latter statement is an exaggeration, consider this:

Germany sells more to the Czech Republic alone than to Russia, while imports from the Czech Republic, Poland, Slovakia, and Hungary amount to 40 billion euros ($56 billion) a year, compared to only 15 billion euros from Russia, including its energy [emphasis added].

French dealings with Russia are largely venal.  German dealings are far different–and far more cringe-inducing–than that, but apparently giving an award to Putin was going too far.  It’s a start, anyways.

July 15, 2011

Flying? Boating? Driving? Then Death is Always an Option

Filed under: Russia — The Professor @ 8:47 pm

The tragic–not to say criminal–sinking of the Bulgaria on the Volga, with the loss of approximately 130 lives, brought to mind a memory of my experience on a Russian river boat in August, 2005.  The European Finance Association meetings were in Moscow that year, and the EFA arranged a dinner cruise on the Moskva River.  When the boat returned to the riverside at the end of the cruise, the crew could not get the gangway over the side of the vessel to the shore.  Not that they were trying particularly hard.  There was no one ashore to help with the disembarkation.

Due to the bumpers protecting the side of the craft, there was a rather yawning gap between the rail and the riverbank.  The crew was utterly unhelpful, the captain nowhere in sight.  Eventually one sour-faced and rather squat crew-woman (who had been serving hors d’oeuvres not long before) gestured that the passengers should jump the gap.  Then she did so herself–and walked away, lighting a cigarette.  One or two other crew members followed her, and the rest were nowhere to be seen.  So 100-odd passengers jumped awkwardly onto the shore, aided only by other passengers, and wandered off to their hotels.  (In my case, to the beautiful Hotel Rossiya–blessedly demolished seven months later.)

The memory of the incompetence and indifference of the crew of that vessel came back to me upon reading the accounts of the Bulgaria sinking.  The crew was unprepared to handle the disaster, and one key fact suggests strongly they did not even try: 28 percent of the passengers survived, but 69 percent of the crew did.  Reports also suggest that conditions were unsafe for the vessel–but it departed anyways despite the rough seas.  Two other vessels passed by the passengers in the water, but failed to stop to rescue them.  The captains of these ships have been arrested–an exercise in futility.

My experience on the Moskva was a minor inconvenience, but it revealed attitudes and practices that make it all to easy to understand how the anything but minor catastrophe on the Volga took place.  With such attitudes and practices, it is no surprise at all that to travel on Russian transport is risky business indeed.

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