Streetwise Professor

June 27, 2016

MOAR! Europe

Filed under: Economics,Politics,Regulation — The Professor @ 9:30 pm

In my first Brexit post I wrote:

European leaders–Merkel most notably–are fond of saying “More Europe,” meaning more centralization and more suppression of local control. If they want Europe to survive as a political entity, they need to reverse their mantra to “Less Europe.” They need to reverse the creation of a hyper-state. They need to be more respectful of local, national sentiments and differences. Brexit shows that if they fail to do so, they are running the serious risk of having no “Europe” at all.

Are they heeding the lesson? Early signs suggest no. So be it. They are reaping what they sowed, and if they decide to sow more, so shall they reap.

The first day of the first post-Brexit week brought reports that the Euros are indeed doubling down, and moving to MOAR! Europe. From the (rabidly pro-Remain) FT:

The German, French and Italian also called for a “new impulse” to revitalise the EU. They are considering common EU-wide initiatives in security, external border control, antiterrorism measures, and in boosting economic growth and employment. Recognising the disenchantment of many young Europeans with politics, they pledged to focus on youth-oriented proposals, such as educational exchanges. “We must not simply wait for what happens. We know that must not waste a single minute,” Mr Renzi said.

Two less posh (and anti-EU) publications filled in some details. I don’t vouch for the reliability, but they do jibe with the “new impulse” theme:

The foreign ministers of France and Germany are due to reveal a blueprint to effectively do away with individual member states in what is being described as an “ultimatum”.

Under the radical proposals EU countries will lose the right to have their own army, criminal law, taxation system or central bank, with all those powers being transferred to Brussels.

The public broadcaster reports that the bombshell proposal will be presented to a meeting of the Visegrad group of countries – made up of Poland, the Czech Republic, Hungary and Slovakia – by German Foreign Minister Frank-Walter Steinmeier later today.

Excerpts of the nine-page report were published today as the leaders of Germany, France and Italy met in Berlin for Brexit crisis talks.

In the preamble to the text the two ministers write: “Our countries share a common destiny and a common set of values that give rise to an even closer union between our citizens. We will therefore strive for a political union in Europe and invite the next [other?] Europeans to participate in this venture.”

“Invite the next Europeans to participate in this venture.” Not too Orwellian, eh? Sounds like Don Corleone making an offer they can’t refuse. No RVSP necessary.

This would throw down the gauntlet to tens (and likely hundreds) of millions of Europeans who might prefer to decline the invite, thank you very much.

It brings to mind Eisenhower’s dictum: If a problem cannot be solved, expand it. By spurning the lessons of Brexit, the Eurogarchs are either going to succeed in jamming their vision down the throats of 500 million people (435 million, excluding the UK) or bring down the entire edifice trying.

And have no doubt, these “leaders” (“drivers” would be more apt) will not let anything as trivial as widespread popular opposition deter them. Consider the president of the European Parliament, Martin (“Don’t Call Me Sergeant“) Schulz:

Screen Shot 2016-06-27 at 10.04.10 PM

Clearly a gaffe by Herr Schulz: he spoke the truth. The EU philosophy is profoundly anti-democratic.

Good luck with your Fourth Reich, Marty. The first three worked out so swell.

European Union president Jean-Claude Juncker, widely blamed by eastern Europeans in particular for Brexit, has taken a similarly hard line:

Jean-Claude Juncker said on Friday: “The repercussions of the British referendum could quickly put a stop to such crass rabble-rousing, as it should soon become clear that the UK was better off inside the EU.” Britain simply has to go, on bad terms, pour encourager les autres.

“Take that, you crass rabble rousers! And to show how mad I am, I won’t speak English.”

Juncker is also supposedly about to announce a plan to force the eight EU states that are not on the Euro (e.g., Denmark, Bulgaria, and Sweden) into the Eurozone. More doubling down.

(As an aside, Juncker is a notorious drunk–it is common knowledge that it is hopeless to do business with him after 3PM, because he’ll be sloshed–and Schulz is also an alcoholic. You’re in the best of hands, Europe!)

And what will they get if they succeed in achieving their goal of a Leviathan that swallows 27 states? A perpetuation of economic stagnation due to excessive, pervasive, and absurd regulation often adopted in the name of grandiose goals. Here’s an illustration of how absurd:

The EU is poised to ban high-powered appliances such as kettles, toasters, hair-dryers within months of Britain’s referendum vote, despite senior officials admitting the plan has brought them “ridicule”.

The European Commission plans to unveil long-delayed ‘ecodesign’ restrictions on small household appliances [like kettles and vacuum cleaners] in the autumn. They are expected to ban the most energy-inefficient devices from sale in order to cut carbon emissions.

Not a sparrow falls . . .

And pray tell just how many thousandths of a degree would this shave off global temperatures? Who cares? This is virtue signaling in jackboots. Here’s the best part:

At the meeting, Jyrki Katainen, the Commission’s vice president for growth, said they should push ahead with the plans for standardised energy usage limits as they could contribute significantly to emissions targets.

The “vice president for growth.” How Orwellian is that? This is a pitch perfect example of the anti-growth effects of EU policy.

This strategy of expanding the problem will increase and perpetuate the geopolitical risk that has shaken the markets. It will intensify a confrontation between elitist and populist forces in Europe, with unpredictable results. I don’t know how it will end, exactly, except that it is unlikely to end well.

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June 25, 2016

Brexit: Epater les Eurogarchs

Confounding all elite prognostication (more on this aspect below), British voters repudiated their self-anointed better-thans and voted to leave the EU.

Market reaction was swift and brutal. The pound sold off dramatically, as did UK stocks. Interestingly, though, Continental stock markets fell substantially more. Bank stocks took the brunt. Volatility indices spiked. Oil was down modestly.

These reactions were not due, in my view, to the direct effect of a British exit from the EU, via conventional channels (e.g., increased costs of trade resulting in inefficiencies and a decline in productivity due to failure to exploit comparative advantage, resulting in a decline in incomes). Instead, they reflect a substantial increase in risk, and in particular geopolitical risk. The unexpected result increases substantially the odds of a falling apart of the EU–or at the very least, of it losing quite a few of its parts. That’s why German, French, and Dutch markets sold off more than the UK.

I was in Denmark last month, speaking to shipowners. Several said that if the UK were to leave the EU, Denmark is likely to go as well: since Denmark is not on the Euro, it is easier for it to leave than Eurozone nations, and the Danes have had their fill of European immigration policy, among other things.

But there is now talk of core countries–including France–leaving. What’s more, the Brexit vote demonstrates the depth and intensity of populist, nationalist sentiment, something the elites had convinced themselves was a marginal force that could be contained by insulting it as racist and isolationist. That was tried in the UK, and failed spectacularly. Now everyone should be on notice that the smug, supercilious, and superior are sitting on a caldera.

It is this fear that the British departure creates a bad precedent that is leading some European leaders to advocate a punitive approach to negotiations with Britain. As a one-off, this makes no sense: a battle of trade barriers and regulations and red tape would harm continentals too. But if the Euros view this as a repeated game, punishment of the British to deter others from getting any notions in their heads about following their lead has some appeal.

But this is a finite game: there are only so many countries in Europe. The Euro threats make sense as a rational strategy only if there is some appreciably probability that the leadership is viewed as crazy, and will punish even when that is self-harming. Come to think of it . . .

As for the immediate effects, Brexit has the biggest potential to cause disruptions and inefficiencies in the financial sector, because of London’s dominance. Clearing is one example. How will LCH fit into the fragmented regulatory landscape? Recall the tortuous negotiations between the US and EU over recognizing each other’s CCPs. Will that have to be repeated between the UK and the EU, and under the clouds of recrimination and punishment strategies? As another example, MiFID II is scheduled to go into effect before Britain leaves. Will it be implemented, then changed? Post-exit British firms will no longer be subject to the regulatory and judicial bodies in charge of enforcing these regulations: how will they fill that breach?

Regardless of the specifics, there will inevitably be greater regulatory and legal fragmentation, and this will increase complexity and cost. But it also creates opportunities. The UK can now engage in regulatory competition with the EU (and the US), which is a different thing altogether from trying to influence regulatory policy from inside the tent (which Cameron attempted with a notable lack of success). This is constrained to some degree by supranational regulation (e.g., Basel), but London prospered quite well as a financial center post-War, pre-EU by offering regulatory advantages over the US and European countries. (Remember Eurodollars!) (One specific thought: would the UK proceed with something as inane and costly as the MiFID commodity position limits? Or applying CRD IV capital requirements on commodity traders? Since these initiatives were driven by the continentals, I seriously doubt it.)

This is all very complicated, and will be played out in the context of a larger game between Britain and the EU (and between the EU and individual EU countries). Hence the outcome is wholly unpredictable. But having Britain as an independent player will change dramatically the regulatory game. The greater competition is likely to result in less regulation, and crucially less stupid regulation. Further, even to the extent that one jurisdiction insists on stupid regulations (with the EU being the odds-on favorite here), the existence of competing jurisdictions means that many will be able to escape the stupidity.

As for the broader political lesson here, it is a decisive repudiation of a self-satisfied soi disant elite by the great unwashed. The EU has been neuralgic about democracy since its inception, and Brexit shows you exactly why their fears of it are justified. The people have spoken. The bastards. And the Euros will try mightily to make sure that never ever happens again.

There’s been a lot of commentary along these lines. Gerard Baker’s piece in the WSJ is probably the best I’ve read. This piece also from the WSJ is pretty good too.

This is a global phenomenon: the Trump insurgency in the US is another example. What is most disturbing–and most revealing–about the reaction of the elites to these outbursts of popular opposition to their direction and instruction is their lack of self-examination and humility, and their immediate resort to scorn and insult directed at those who had the temerity to defy them. Immediately after the results were clear, those voting leave were tarred as old/white/stupid/poor/uneducated/racist.

Totally lacking was the question: “If argument and evidence are so clearly on our side, why did we fail so miserably in convincing people of the obvious?” To these self-perceived elites, their superiority is self-evident and any opposition can only be attributed to mental defect or bad faith.

Not only is this superficial and immature–nay, juvenile and narcissistic–it is amazingly self-destructive. You were rejected because it was widely believed–with good reason–that you were aloof, condescending, and lacking in understanding of and empathy for the concerns of millions of people not of your social set. What better way to cement that reputation than by proceeding to piss all over those people? You think that will help them get their minds right, and vote for you next time? Think that, and you truly are delusional.

And mark well: this elite condescension is not heard just in the Midlands, but it comes through loud and clear in France, Germany, the Netherlands, and other countries in Europe. Consequently, this reaction actually increases the odds of an EU crisis. Those who refuse to respond constructively and thoughtfully to adverse feedback are likely to see things get worse, rather than better.

This condescension also helps explain the surprise at the Brexit outcome. So convinced of their virtue and intelligence, the Remain side could not comprehend that large numbers of people could take the opposite side. Secure in their bubble, talking only to one another, they had no idea of what was going on outside it. The Pauline Kael effect, with a British accent.

Further, the concerted effort in the establishment media to malign the Leavers succeeded in silencing many of them–but not in changing their minds. (Most disturbingly, the Remain side took strange comfort in the murder of Jo Cox.) They were bludgeoned into stubborn silence, which lulled the establishment into believing that the opposition was marginal and marginalized: this helps explain the pre-vote 90 percent betting odds on Remain, with the betting being dominated by those inside the bubble. But the silent bided their time and exacted their revenge.

Payback, as they say, is a bitch. But are the elites learning from this lesson? The first indications are negative.

The EU epitomizes what Thomas Sowell referred to as the Vision of the Anointed. This review summarizes the book of that title well, and although Sowell focuses on the US, what he said applies in spades to the EU, and Europhiles:

In The Vision of the Anointed, the distinguished economist and social theorist Thomas Sowell makes an important contribution to classical-liberal and conservative thought by scrutinizing the ways in which a self-consciously elite, or “anointed,” group uses ideas to maintain its power in American political life. Sowell regards American political discourse as dominated by people who are sure that they know what is good for society and who think that the good must be attained by expanded government action. This modern-liberal elite exerts its influence through institutions that live by words: the universities and public schools, the media, the liberal clergy, the bar and bench. Its dominance results from its command of the information that words convey and the attitudes that words inspire.

People who live by words should live also by arguments, butas Sowell richly documentsthe modern-liberal elite is not so good at arguing as it is at finding substitutes for argument. Sowell analyzes the major substitutes. Suppose that you doubt the necessity or usefulness of some great new government program. You may first be presented with a quantity of decontextualized “facts” and abused statistics, all indicating the existence of a “crisis” that only government can resolve. If you are not converted by this show of evidence, an attempt will probably be made to shift the viewpoint: outsiders may doubt that there is a crisis of, say, homelessness, but “spokesmen for the homeless” purportedly have no doubts.

. . . .

If even these methods fail to win you over, attention will be redirected from the political issue to your own failure of imagination or morality. It will be insinuated that people like you are simplistic or perversely opposed to change, lacking in compassion and allied with the “forces of greed.” (As Sowell observes, it is always the payers rather than the spenders of taxes who are considered vulnerable to the charge of greed.) [Emphasis added.]

The Anointed are a self-identified elite. They think that elite is a synonym for “meritorious,” “intelligent,” “wise,” or “morally superior.” But “elite” refers first and foremost to a place in a hierarchy, and the merit, intelligence, wisdom, and morality of those at the top of a hierarchy depends on the system. Hayek noted over 70 years ago that in a statist, crypto-socialist system the worst get to the top, i.e., the elite is a collection of the worst. The Eurogarchy shows just how right Hayek was.

For all the paeans sung to it, the EU has become far more than a means of reducing barriers to the flow of goods, capital, and people: that could have been accomplished with something as simple as the commerce clause to the US Constitution. Instead, the Anointed have constructed a vast hyper-state that controls and regulates every aspect of commercial activity, and much beyond. Cost raising and incentive sapping explicit restrictions on trade and investment across historical borders have been replaced by border-spanning onerous and minute regulations that raise costs and dull incentives: innovation has been especially hard hit. Moribund growth in the post-crisis EU should raise questions, but the Eurogarchs plunge ahead with their vast regulatory schemes.

I would approve of a supra-national organization that reduced the impediments to individuals consummating mutually beneficial bargains and exchanges. But that is not what the EU is. It is a dirigiste organization predicated on the belief that a technocratic elite knows better, and can direct and guide far more effectively than the invisible hand. Although its demise could lead to something worse, there are definitely better alternatives. Hence, the discomfort of the EU worshippers is music to my ears.

European leaders–Merkel most notably–are fond of saying “More Europe,” meaning more centralization and more suppression of local control. If they want Europe to survive as a political entity, they need to reverse their mantra to “Less Europe.” They need to reverse the creation of a hyper-state. They need to be more respectful of local, national sentiments and differences. Brexit shows that if they fail to do so, they are running the serious risk of having no “Europe” at all.

Are they heeding the lesson? Early signs suggest no. So be it. They are reaping what they sowed, and if they decide to sow more, so shall they reap.

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June 15, 2016

Where’s the CFTC’s Head AT?: Fools Rush in Where Angels Fear to Tread

Filed under: Commodities,Derivatives,Economics,Exchanges,Financial crisis,HFT,Regulation — The Professor @ 1:07 pm

The CFTC is currently considering Regulation AT (for Automated Trading). It is the Commission’s attempt to get a handle on HFT and algorithmic trading.

By far the most controversial aspect of the proposed regulation is the CFTC’s demand that algo traders provide the Commission with their source code. Given the sensitivity of this information, algo/HFT firms are understandably freaking out over this demand.

Those concerns are certainly legitimate. But what I want to ask is: what’s the point? What can the Commission actually accomplish?

The Commission argues that by reviewing source code, it can identify possible coding errors that could lead to “disruptive events” like the 2013 Knight Capital fiasco. Color me skeptical, for at least two reasons.

First, I seriously doubt that the CFTC can attract people with the coding skill necessary to track down errors in trading algorithms, or can devote the time necessary. Reviewing the code of others is a difficult task, usually harder than writing the code in the first place; the code involved here is very complex and changes frequently; and the CFTC is unlikely to be able devote the resources necessary for a truly effective review. Further, who has the stronger incentive? A firm that can be destroyed by a coding error, or some GS-something? (The prospect of numerous individuals perusing code creates the potential for a misappropriation of intellectual property which is what really has the industry exercised.) Not to mention that if you really have the chops to code trading algos, you’ll work for a prop shop or Citadel or Goldman or whomever and make much more than a government salary.

Second, and more substantively, reviewing individual trading algorithms in isolation is of limited value in determining their potentially disruptive effects. These individual algorithms are part of a complex system, in the technical/scientific meaning of the term. These individual pieces interact with one another, and create feedback mechanisms. Algo A takes inputs from market data that is produced in part by Algos B, C, D, E, etc. Based on these inputs, Algo A takes actions (e.g., enters or cancels orders), and Algos B, C, D, E, etc., react. Algo A reacts to those reactions, and on and on.

These feedbacks can be non-linear. Furthermore, the dimensionality of this problem is immense. Basically, an algo says if the state of the market is X, do Y. Evaluating algos in toto, the state of the market can include the current and past order books of every product, as well as the past order books (both explicitly as a condition in some algorithms, or implicitly through the empirical analysis that the developers use to find profitable trading rules based on historical market information), as well as market news. This state changes continuously.

Given this dimensionality and feedback-driven complexity, evaluating trading algorithms in isolation is a fools errand. Stability depends on how the algorithms interact. You cannot determine the stability of an emergent order, or its vulnerability to disruption, by looking at the individual components.

And since humans are still part of the trading ecosystem, how software interacts with meatware matters too. Fat finger problems are one example, but just normal human reactions to market developments can be destabilizing. This is true when all of the actors are human: it’s also true when some are human and some are algorithmic.

Look at the Flash Crash. Even in retrospect it has proven impossible to establish definitively the chain of events that precipitated it and caused it to unfold the way that it did. How is it possible to evaluate prospectively the stability of a system under a vastly larger set of possible states than those that existed on the day of the Flash Crash?

These considerations mean that  the CFTC–or any regulator–has little ability to improve system stability even if given access to the complete details of important parts of that system. But it’s potentially worse than that. Ill-advised changes to pieces of the system can make it less stable.

This is because in complex systems, attempts to improve the safety of individual components of the system can actually increase the probability of system failure.

In sum, markets are complex systems/emergent orders. The effects of changes to parts of these systems are highly unpredictable. Furthermore, it is difficult, and arguably impossible, to predict how changes to individual pieces of the system will affect the behavior of the system as a whole under all possible contingencies, especially given the vastness of the set of contingencies.

Based on this reality, we should be very chary about letting any regulator attempt to micromanage pieces of this complex system. Indeed, any regulator should be reluctant to undertake this task. But regulators frequently overestimate their competence, and financial regulators have proven time and again that they really don’t understand that they are dealing with a complex system/emergent order that does not respond to their interventions in the way that they intend. But fools rush in where angels fear to tread, and if the Commission persists in its efforts to become the Commissar of Code, it will be playing the fool–and it will not just be algo traders that pay the price.

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June 12, 2016

Squeezing Dr. Copper

Filed under: Commodities,Derivatives,Economics,Exchanges,Regulation — The Professor @ 2:21 pm

Andy Home has an interesting piece in Reuters. He provides information that strongly suggests that the LME copper contract has been squeezed. All of the tell-tale signs are there:

What the exchange terms a dominant long position emerged on the copper market last week.

This player controlled 50-80 percent of all LME open stocks, excluding metal earmarked for physical load-out, and had bulked this up with cash positions to the point that its overall position represented in excess of 90 percent of all available stocks.

That position was being rolled forward daily, forcing shorts to pay the backwardation price as they too rolled their positions.

The cash premium over three-month metal, the backwardation, had flexed out as wide as $27.75 per ton the previous week as the long tightened its grip on the London market’s nearby date structure.

Someone, it seems, was not prepared to pay the roll price and decided to deliver physical metal against their position. [LME stocks rose almost 40 percent in a few days.]

And they did so in a way to generate the maximum bang for their buck.

It seems to have worked.

That cash premium has evaporated. As of Thursday’s close, the cash-to-three-months spread was valued at $15 per ton contango.

The ripple effects have spread down the curve, LME broker Marex Spectron noting that the July-December spread eased $10 to $35 per ton contango over the course of Thursday.

The latest positioning reports, denoting the state of play as of Wednesday’s close, show the dominant long still holding 50-80 percent of stocks <0#LME-WHL> but with no equivalent cash position <0#LME-WHC>.

All the signs are there: a large long position, here both in physical metal and prompt LME contracts; a spike in the backwardation; a movement of metal into deliverable position; followed by a collapse in the backwardation. Also, the large long apparently liquidated the bulk of his position in LME contracts, as is necessary to profit. Right out of the book.

These episodes are chronic in the commodity markets, and on the LME in particular. They impose real deadweight losses (the costly movement of copper into LME warehouses being an example), and undermine the effectiveness of derivatives contracts as a hedging mechanism. Would that regulators pursued this conduct more vigorously, rather than obsessing over spoofing games, or chasing the “excessive speculation” will-o-the-wisp.

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June 11, 2016

Washington Republicans: Subjectively Pro-Capitalism, Objectively Anti-Capitalism

Filed under: Economics,Financial crisis,Politics,Regulation — The Professor @ 8:11 pm

@libertylynx suggested to me that the GOP is primarily responsible for the current unpopularity of capitalism in the US. I agree that this is largely the case. Here’s my first stab at an explanation.

At root it is due to a yawning gap between rhetoric and action. The GOP poses as the party of small government and free markets, but it is not, really. The disconnect was somewhat present during the Reagan administration, but it became progressively (pun alert!) more pronounced starting with Bush I, and particularly during the George W. Bush administration.

Bush II in particular was a big spender. Some of it was war-driven, but he was also profligate domestically. Perhaps most importantly, given the salience of housing to the 2008-2009 financial crisis which inflicted the most grievous blow to belief in the efficacy and efficiency of markets since the Great Depression, was that the Bush administration perpetuated the bias towards investment in housing exemplified by Fannie and Freddie. A truly market-oriented administration would have terminated Fannie and Freddie with extreme prejudice, but it grew apace during the Bush II administration. When combined with an expansive Fed and a flawed banking regulatory framework, the groundwork for a disaster was in place.

In many respects, this is similar to what happened during and after the Great Depression. That event was widely viewed as a failure of capitalism and the market system, when it was actually the result of a combination of bad Fed policy and a dysfunctional banking system that was the result of a political bargain that resulted in the proliferation of small unit banks that could not withstand a broad shock: see Friedman and Schwartz for an analysis of the former, and Calomiris and Haber for an examination of the latter.  The banking system that collapsed in the 1930s was a political artifact, and would have not developed the way that it did in the absence of a regulatory framework that was tailored to benefit very specific political constituencies.

The strong bias towards housing investment in the United States in the 1990s-2000s was also the result of a political bargain: alas, the same is true today, even despite the crisis. This political bargain was based on a coalition of politically connected firms (Fannie, Freddie, major banks, and construction) and populists. This bargain created incentives that led market participants to invest excessively in housing. When this came a cropper, the blame attached to those market participants who responded to incentives, rather than the political agents and political process that created those incentives.

In DC, Republicans talked a pro-market, small-government game, but did not govern that way. Republicans in Congress liked living a comfortable life in DC. They did not have a stomach for fighting the battle that a true pro-market, small government policy would have caused. They liked the sinecures of power too much to risk them, knowing in particular that pursuing such policies would unleash a storm of media criticism and make them unpopular with the bureaucrats and lobbyists who infest the place. So they made a few symbolic gestures, and spouted pro-free market, small government rhetoric, but really did nothing. The continued existence, let alone the growth, of Fannie and Freddie is testament to that.

When the storm hit in 2008, this came back to haunt them. More importantly, it came back to haunt the cause of free markets and smaller government. Since those giving lip service to those ideals were in charge when the storm hit, it was easy to blame the ideals, even though those spouting the rhetoric had done virtually nothing to advance them. Indeed, they had perpetuated, and in fact exacerbated, the market distortion that was the ultimate cause of the crisis. This presented a perfect opportunity for those in politics (the Democratic Party) and the media (an appendage of the Democratic Party) to attack the ideals that they despised.  It would have been better had the Republicans not pretended to be pro-market, as at least that would have limited some of the damage to popular beliefs and opinions about markets.

There are at least a couple of reasons for the Republican reluctance actually to fight the statist DC consensus, despite their rhetorical embrace of that fight.

One is the scars left by the struggles over the government shutdown in 1995-1996, and the impeachment battle that followed. Both fights were a distraction, and what’s worse, the Republicans handled both badly. They took a horrible beating in the media and elections–rightly so, in retrospect–and it got their minds right. The 1994 insurgents were supplanted by time servers and apparatchiks. Hasterts and Boehners and McConnells, and other assorted boneless wonders you’ve never even heard of. They were masters at the Kabuki performance of pretending to be pro-market and pro-smaller government, but really doing nothing to stem the tide.

The second reason is more fundamental, but in a way can explain the first. Politicians respond to incentives too. A good model for them is a pigeon in a Skinner Box. They soon learn to push the lever that results in the magical appearance of a food pellet, and not to push the lever that doesn’t.

Organized constituencies provide the food pellets in DC. There is no organized constituency for freer markets or substantially smaller government. There are constituencies for particular businesses and industries, and for government largesse. The benefits of free markets and smaller government are large, but diffuse. As Olson and Stigler and Becker and others showed long ago, diffuse and unorganized beneficiaries have little incentive or ability to influence policy. In contrast, particular businesses and industries do. Thus, careerist politicians intent on re-election and a comfortable life have little incentive to pursue market-oriented policies, but instead pursue policies that favor particular constituencies, including business constituencies.

Which means that even though many Republicans talk/talked about being pro-market, they are/were at most really pro-business. And there is a difference. A huge difference, as Adam Smith pointed out centuries ago, and Friedman repeated often decades ago. But that difference is not well-understood, which means that failures that occur when Republicans are in power tend to get blamed on the market system, or capitalism.

The S&L crisis of almost 30 years ago provides a good example. The S&L industry was the creation of law and regulation resulting from a political bargain: again see Calomiris and Haber. Inflation devastated the industry, and in response it called for elimination of restrictions on how S&Ls could invest. This was done in the name of deregulation and freeing markets, but the most important government interventions were left in place. In particular, deposit insurance remained, and government regulators refused to shut down insolvent thrifts. The mixture of freeing up the asset side of the balance sheet when (a) liabilities were insured, and (b) S&Ls had no equity, was toxic in the extreme. With insured liabilities and no equity, S&Ls had a tremendous incentive to add risk, and the deregulation of the asset side of the balance sheet gave them the ability to do so. They took on said risk, it ended badly, and taxpayers were on the hook for $200 billion or so as a result. Real money back then!

Was this a failure of deregulation, and a damning verdict on markets? I would say no: the fraught condition of the S&Ls was the product of previous government regulation and policy, and the perverse incentive to take on risk was inherent in another policy—deposit insurance. An organized political constituency (S&L operators) influenced Congress to loosen some regulations that made the perverse effects of the other regulations and policies even more acute.

In other words: they wanted to deregulate in the worst way, and they did. They did so because the deregulation was designed to benefit particular businesses, not to create a free market in banking. Pace the theory of the second best, elimination of something (restrictions on S&L investment) that would be an imperfection in the absence of other imperfections made things far worse when other imperfections (deposit insurance, forbearing regulators) remained in place.

But the narrative that came out of the S&L debacle was one of market failure, not government failure. Deregulation and markets took the blame, when what had really happened is that politicians responding to incentives (the importuning of an organized constituency) changed the laws in ways that created perverse incentives for business, and ultimately all this perversity begot something wretched indeed. The crisis was played out on Main Street, but its origins lay squarely on Pennsylvania Avenue.

The takeaway from all this is rather depressing. It means there is an inherent political bias against pro-market policies because markets, and the beneficiaries of markets, do not form an organized political force. The difficulty of voters to distinguish pro-business policies from pro-market rhetoric often used to advance them means that economic crises (the Great Depression, the S&L collapse, the 2008 Crisis) that are strongly rooted in government failure are blamed on markets instead, which perversely results in even more government intervention.

So this is why Republicans damage the cause of free markets and small government. They spout pro-market and small government rhetoric, but for reasons of political economy, really do little that actually advances free markets or reduce the size of government. But when some government policy creates incentives that lead to a bad market outcome, their rhetoric boomerangs on markets, not government.

The post-crisis years have been a period of slow growth and economic sclerosis. This is largely attributable to the explosion of regulation that has taken place since 2009. The narrative that helped spark this explosion is that markets failed. Alas, Republicans did much to advance that narrative, albeit inadvertently. But advance it they did, and the malign effects will be felt for decades to come.

In brief, Republican politicians may be subjectively pro-market and pro-capitalism, but objectively they have done grievous harm to markets and capitalism.

 

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June 8, 2016

The CFTC Puts a Little Less Rat In It

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 7:10 pm

A couple of weeks ago the CFTC voted to revise its position limits regulation. My verdict: it makes the regulation less bad. Sort of like a strawberry tart, without so much rat in it.

The most important part of the revision is to permit exchanges and SEFs to recognize certain non-enumerated hedges as bona fide hedges that don’t count towards the position limit. In the original proposal, only eight hedges were enumerated, and only enumerated hedges were treated as bona fide hedges.

This drew substantial criticism from industry, particularly from end users, because the list of enumerated hedges was quite limited, and failed to incorporate many commonly utilized risk management strategies. Thus, more participants were at risk of being constrained by position limits, even though their purpose for trading was primarily to manage risk.

The CFTC’s fix was to permit market participants to apply annually to an exchange (“designated contract market”) or SEF for a non-enumerated bona fide hedge. The participant submits information about the hedging strategy to the exchange or SEF, which reviews it and determines whether it meets the criteria for bona fide hedges and grants an exemption for positions entered pursuant to this strategy.

This does help hedgers escape limits intended to constrain speculators. But the review process isn’t free. Moreover, the process of application and approval will take some time, which limits the flexibility of market participants. They have to foresee the kinds of strategies they would like to employ well in advance of actually implementing them.

At most this mitigates a harm, and at a cost. The speculative position limit provides no discernible benefit in terms of market stability or manipulation prevention (for which there are superior substitutes), but imposes a heavy compliance burden on all market users, even those who would almost certainly never be constrained by the limit. Moreover, the rule constrains risk transfer, thereby undermining one of the primary purposes of futures and swap markets. The bona fide hedging rule as originally proposed would have constrained risk transfer further, so basically expanding the universe of bona fide hedges removes a piece of rat or two from the tart. But it’s still appalling.

The revision also clarifies the definition of bona fide hedge, eliminating the “incidental test” and the “orderly trading requirement.” As currently proposed, to be a bona fide hedge, a position must reduce price risk. (I deliberately chose that particular link for reasons that I might be at liberty to share sometime.) That is, it cannot be used to manage other risks such as logistics or default risks. This is what the statute says, and was the way that the old regulation 1.3(z)(1) was written and interpreted.

Perhaps the most important result of this process is that it stands as a rebuke to Elizabeth Warren for the calumnies and slanders she heaped upon the Energy and Environmental Markets Advisor Committee, and me personally. One of the main complaints of participants in the EEMAC meetings was that the bona fide hedging rule as originally proposed was unduly restrictive. I dutifully recorded those complaints in the report that I wrote, which caused Senator Warren to lose it. (I cleaned that up. Reluctantly.) (The report is circulating in samizdat form. I will find a link and post.)

Well, apparently all of the Commissioners, including two strong supporters of the position limit rule, Massad and Bowen, found the criticisms persuasive and, to their credit, responded constructively to them. So, Liz, if supporting a broadening of bona fide position limits makes one an industry whore, that epithet applies to the Democratic appointees on the Commission. I presume you will take it up with them in your tempered, reasoned way.

But I note that Ms. Warren has been notably silent on the Commission’s action. Go figure.

It is now likely that the position limit rule will finally slouch its way into the rulebook. This is unfortunate. All that can be said is that due to this action it isn’t as bad as it could have been, and as bad as it is, it is nothing compared to the monstrosity that is being created in Europe.

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June 2, 2016

The Smelly Little Orthodoxy of Warmism, Hating Free Intelligence and Free Debate

Filed under: Climate Change,Economics,Energy,Politics,Regulation — The Professor @ 7:01 pm

One of the most disreputable tactics of those who sound alarms about anthropogenic climate change is to conscript any weather-related disaster to advance their cause. Case in point: the recent wildfires in and around Fort MacMurray, Alberta, Canada:

Experts say climate change is contributing to the wildfires raging across Canada, and the increasing frequency of such fires may overwhelm one of Earth’s most important ecosystems, the boreal forest.

In just over a week, an out of control blaze has charred more than 2,290 square kilometers (884 square miles) of land and forced the evacuation of 100,000 people from Fort McMurray in Alberta, Canada.

Dominated by conifers like pine and spruce, the boreal forest sweeps across Canada, Russia, Alaska and Scandinavia making up about 30 percent of the world’s forest cover, and absorbing a big chunk of carbon from the atmosphere.

As crucial as the boreal forest is at reducing the impact of human-driven fossil fuel emissions, it is also increasingly fragile, and expected to become hotter, drier, and more prone to fires in the future.

“Western Canada, including in particular the region in Alberta containing Fort McMurray, has warmed quite a bit more than the global average,” said scientist Michael Mann, author of “Dire Predictions: Understanding Climate Change.”

With the Arctic region warming twice as fast as the rest of the planet, climate model projections place central and western Canada in the “bullseye of enhanced warming,” he told AFP.

Michael Mann. Of course.

The past months have seen a strong El Nino which has caused anomalous weather throughout the world, and in the western hemisphere in particular. It has brought heavier than normal rains to some areas, and drought to others. My immediate suspicion was that El Nino contributed to the warm dry conditions, low snow pack, etc., that set the stage for the Alberta fires. And indeed, that’s the case.

It’s also necessary to put this in perspective. Even in normal years, there are fires in the boreal forests of Canada. Indeed, about 29,000 square kilometers burn in Canada each year. When I looked at the height of the fires, the Fort MacMurray fire had consumed about 2900 square kilometers, or about 10 percent of the annual average in Canada. This also represents about .015 percent of Canadian boreal forest area.

The fire got attention not so much because of its size, but because it occurred in a populated area (something of a rarity in that area), and one that happens to be a major oil producing center.

But the cause is too important to let facts interfere with the narrative. The fires were dramatic, and to the credulous it is plausible that global warming is to blame. So Mann et al could not let this opportunity pass.

Exploiting weather to raise alarms about climate is not the only disreputable tactic these people employ. Another is to attempt to intimidate through the legal process those who dare challenge their orthodoxy. This tactic has reached a new level in California, where a bill with the Orwellian title “California Climate Science Truth and Accountability Act of 2016” has cleared committees in the state Senate:

“This bill explicitly authorizes district attorneys and the Attorney General to pursue UCL [Unfair Competition Law] claims alleging that a business or organization has directly or indirectly engaged in unfair competition with respect to scientific evidence regarding the existence, extent, or current or future impacts of anthropogenic induced climate change,” says the state Senate Rules Committee’s floor analysis.

What does “engage in unfair competition with respect to scientific evidence” even mean? As an industrial organization economist by training, and practice, I know that the concept of “unfair competition” is slippery at best even in a straightforward economic context, and (speaking of Orwellian) that unfair competition laws have been used primarily to stifle competition rather than promote it. How unfair competition concepts would even apply to scientific debate is beyond me.

But that’s not the point, is it? The point of this law is to utilize another law that has proved very convenient at squelching competitors in the name of competition in order to squelch debate about climate change and climate policy. This is antithetical to science yet is done in the name of science: it is also a perfect example of the thuggery that the warmists routinely resort to when they cannot prevail in an open discussion.

When writing about Dickens, Orwell said something that relates to this issue as well:

It is the face of a man who is always fighting against something, but who fights in the open and is not frightened, the face of a man who is generously angry — in other words, of a nineteenth-century liberal, a free intelligence, a type hated with equal hatred by all the smelly little orthodoxies which are now contending for our souls.

The smelly little orthodoxy epitomized by Michael Mann and Kemala Harris (the AG of CA, and soon to be Senator, who is a leader of the movement to prosecute climate change dissenters) indeed hates free intelligence, and free debate. And nineteenth century liberals, for that matter.

Have the progressives (particularly in California) who shriek about Peter Theil using the legal system to go after Gawker uttered a peep of protest against the employment of the far heavier hand of the state to silence debate about climate change? Not that I’ve heard. Free speech for me, but not for thee, is their motto.

Those who claim that science is undeniably on their side should have no fear of debate, and should not feel compelled to use coercion to stifle that debate. That they do means that they lack confidence in the truth of their message and their ability to persuade. It also means that they have a hearty disrespect for the ability of the American people to listen to and evaluate that debate with intelligence and fairness. In other words, what we are seeing in California is another example of a self-anointed elite that heartily disdains the hoi polloi, believing that it is their right and obligation to use any means necessary to impose their beliefs.

This is a recipe for social strife, especially since the climate change debate is by no means the only place where this attitude is regnant. This is precisely why battle is now raging between elitism and populism. Sad to say, that battle is likely to become even more intense in the coming months and years.

 

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May 29, 2016

To the NYT It Would Be News That Socialism Causes Economic Catastrophe

Filed under: Climate Change,Commodities,Economics,Energy,Politics,Regulation — The Professor @ 2:05 pm

Venezuela is on the verge of economic collapse and social disintegration. Here’s the NYT’s diagnosis:

The growing economic crisis — fueled by low prices for oil, the country’s main export; a drought that has crippled Venezuela’s ability to generate hydroelectric power; and a long decline in manufacturing and agricultural production — has turned into an intensely political one for President Nicolás Maduro. This month, he declared a state of emergency, his second this year, and ordered military exercises, citing foreign threats.

Do you see what’s missing? Not a single mention of socialism, Chavism, Bolivarian socialism, etc.

Other countries have suffered similar shocks without descending into dystopian chaos like Venezuela. Many countries in South America, for instance (notably Columbia and Brazil), have suffered from the decline in commodity prices and the drought, and are doing poorly economically, but are not plagued by empty store shelves, myriad shuttered factories and stores, and the imminent threat of social violence. Brazil has suffered from a lack of hydropower due to the drought, but has imported LNG to keep the lights on. Venezuela can’t afford to.

Further, Venezuela’s descent into catastrophe started long ago, and serious problems were clearly manifest in 2014 and before when the price of oil was over $100/bbl and the drought had not reduced hydropower output.

Venezuela’s current crisis had its roots with Chavez’s triumph in the 2002-2003 general strike, and the subsequent firing of 18,000 PDVSA employees. In the years that followed, foreign investors were expropriated, as were domestic businesses, all in the name of socialism. The government has imposed price controls on an every widening array of goods. As shortages increased and inflation spiked, the government increased the scope of price controls and enforced them in a draconian way, including through the dispatching of red shirted goons to seize offending businesses.

The results of all this should have been eminently predictable: shortages and a collapse of economic activity. It is those policies that caused the “long decline in manufacturing and agricultural production.”

If the NYT read it’s own freaking archives, it might have realized that this problem was looming well before the oil price decline and the drought:

Venezuela is one of the world’s top oil producers at a time of soaring energy prices [hahaha], yet shortages of staples like milk, meat and toilet paper are a chronic part of life here, often turning grocery shopping into a hit or miss proposition.

Some residents arrange their calendars around the once-a-week deliveries made to government-subsidized stores like this one, lining up before dawn to buy a single frozen chicken before the stock runs out. Or a couple of bags of flour. Or a bottle of cooking oil. (Emphasis added.)

Mind well the date of the article: April 21, 2012. Four years ago. When the Brent price was about $118/bbl.

This title of the NYT piece is hilarious: “With Venezuelan Food Shortages, Some Blame Price Controls.”

Hey, NYT: by “some” do you mean people with an economics IQ of above 80? (A category which would exclude the editorial staff and most of the news room.)

What is happening in Venezuela is a perfect illustration of something that Adam Smith recognized 240 years ago. It takes perverse government policy to turn an adverse supply or demand shock into shortages and economic catastrophe:

Whoever examines with attention the history of the dearths and famines which have afflicted any part of Europe, during either the course of the present or that of the two preceding centuries, of several of which we have pretty exact accounts, will find, I believe, that a dearth never has arisen from any combination among the inland dealers in corn, nor from any other cause but a real scarcity, occasioned sometimes perhaps, and in some particular places, by the waste of war, but in by far the greatest number of cases by the fault of the seasons; and that a famine has never arisen from any other cause but the violence of government attempting, by improper means, to remedy the inconveniences of a dearth. (Emphasis added.)

That is a perfect description of what is happening in Venezuela.

But various economic morons on the left (but I repeat myself) like Bernie Sanders, Jeremy Corbyn, Sean Penn, and Danny Glover (to name just a few) have been cheering Chavism and Bolivarian socialism for attacking the inequalities spawned by capitalism red in tooth and claw. In a perverse way, it has indeed succeeded in reducing inequality–by making everyone largely equal in their abject misery.

Perhaps there is a silver lining to the food shortages. They reduce the need for toilet paper, which ran out long ago (due to price controls, naturally).

The New York Times prides itself on carrying all the news that’s fit to print. Apparently the news about the impact of price controls hasn’t reached it yet, even though observant folks picked up on it about the time of Diolcetian’s Edict on Prices, a mere 1715 years ago.

This economic cluelessness by the NYT is precisely why its criticism of me doesn’t bother me. Such boundless economic ignorance (which is shared by a vast swathe of its readers, including notably Elizabeth Warren) renders its criticism meaningless. Anyone so stupid, or so ideologically blinded, that they fail to recognize that Venezuela’s problems have everything to do with perverse government policy has nothing to say about economics that is worth paying the slightest heed.

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May 13, 2016

Surprise, Surprise, Surprise: Guess Who Squeezed (and May be Squeezing) Brent

Filed under: Commodities,Derivatives,Economics,Energy,Regulation — The Professor @ 7:44 pm

Cue Gomer Pyle. It is now being reported that Glencore was not just bigfooting fuel oil in Singapore, but it was the firm stomping on Brent as well. It took delivery of 15 or more cargoes of the 37 available for June loading. There is also talk that the firm had accumulated a position in excess of the 37, and had already had contracts to sell Brent to refineries in Asia and Europe.

Thus all the elements of a squeeze were in place. A position bigger than deliverable supply, and a grave pre-dug to bury the corpse. It was able to liquidate some of its position (25 cargoes or so, or more than 15 million barrels) at an artificially high price (as indicated by the flip from contango to backwardation in the last couple of weeks of trading).

The July contract has also flipped into a backwardation, suggesting that the play is on again.

Two (and perhaps three, if Glencore is behind what’s going on now) squeezes in short order is pretty audacious, even for Glencore. Makes me wonder if this is part of the company’s resurrection plan. Trading needs to perform in order to offset the carnage in the mining operation. That means taking more risks. Including regulatory and legal risks. Though truth be told, both the UK and Singapore have been quite supine in responding to market power manipulations for years. For instance, with all the squeezes that have taken place on the LME over the years, what have UK regulators ever done? What have they ever done in Brent? Or in the softs, where some pretty big squeezes have taken place in cocoa and coffee in recent years?

Inspector Clouseau would be proud.

The bigger risks are economic and commercial. Squeezes can be very profitable, but they can go horribly wrong. Recall that Glencore’s qua Glencore’s genesis was Marc Rich’s failed attempt to squeeze the LME zinc market in 1992. Marc Rich & Co. lost around $200 million, which resulted in a coup led by Ivan Glasenbeg that ousted Rich, and the renaming of the company as Glencore.

But desperate times sometimes call for desperate measures. Yasuo Hamanaka comes to mind. When his massive rogue trading operation was teetering on the precipice, needing a big profit in a hurry he carried out a massive corner of LME copper in December 1995. He wrote his co-conspirator “this is our last arms” (quoting from memory). In other words, do or die.

I’m not saying that Glencore’s problems are at all similar to Hamanaka’s, but the company does have big issues, and a need to make a lot of money in a hurry. The kind of issues that can lead big risk takers to take bigger risks, and push the envelope. The envelopes in Brent and Singapore fuel oil are pretty expansive, but Glencore seems to be pushing them nonetheless. Not part of the official resurrection plan, but most likely part of it nonetheless.

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May 10, 2016

Glencore Mucking About in the Dirtiest Market in the World

Filed under: Commodities,Derivatives,Economics,Energy,Regulation — The Professor @ 5:30 pm

The WSJ has an interesting story about Glencore big-footing the Singapore fuel oil market:

In a lightly trod corner of the oil market, Glencore PLC is leaving a big footprint.

During two of the past five quarters, the commodities trader has bought up large volumes of fuel oil at Asia’s main trading hub in Singapore at a time of day when it has an outsize effect on an Asia-wide price benchmark.

Trades made during the daily “Platts window”—the final few minutes of trading—are reported to Platts, an energy-price publisher, which uses the data to calculate a daily benchmark used to price millions of barrels of fuel oil across Asia.

In the first quarter, Glencore bought 20.7 million barrels of Singapore-traded fuel oil in the window—44% of all the Platts-window buying—according to the publisher, which is owned by S&P Global Inc. During that period, fuel-oil prices in Singapore rose 7.5%, according to Platts, outpacing Brent crude oil, up 6.2%, and U.S.-traded crude oil, up 3.5%.

“The fuel-oil bull play has been a fairly regular feature of the market-on-close window for many years,” said John Driscoll, chief strategist at JTD Energy Services in Singapore and a former fuel oil-trader. “Singapore is the world’s largest marine-fuels market and serves as the central pricing hub for petroleum products east of Suez. These conditions tend to favor bullish traders who have the resources and conviction to aggressively bid the window for a sustained period of time.”

The Journal soft-pedals what is going on here:

Some traders, shipbrokers and commodity experts say Glencore’s purchases have hallmarks of a trading gambit sometimes employed in the lightly regulated world of fuel-oil trading. In it, traders buy large quantities of physical fuel oil to benefit a separate position elsewhere, such as in the derivatives market or elsewhere in the physical market.

I’ll be a little more blunt. Yes, this looks for all the world like a manipulative play, along the lines of my 2001 Journal of Business piece “Manipulation of Cash-Settled Futures Contracts.” Buy up large quantities in the physical market to drive up the price of a price marker that is used to determine payoffs in cash-settled OTC swaps. (It’s possible to do something similar on the short side.) This works because the supply curve of the physical is upward sloping. Buy a lot, drive the market up the supply curve thereby elevating the price of the physical. If you are also long a derivative with a payoff increasing in the cash price, even though you lose money on the physical play, you can make even more money on the paper position if that position is big enough.

It’s impossible to know for sure, without knowing Glencore’s OTC book, but it is hard to come up with another reason for buying so much during the window.

Those on the other side of the OTC trade (if it exists) know who their counterparty is. It is interesting to note the “ethos” of this market. Nobody is running to court, and nobody is shouting manipulation. The losers take their lumps, and figure that revenge is the best reward.

Platts reacted with its usual blah, blah, blah:

“The Singapore refined-oil-product markets are highly liquid, attracting dozens of buyers and sellers from across the world, and our assessments of those markets remain robust,” Platts said in a statement. “It’s worth highlighting that our rigorous standards in our oil benchmarks are fully open to public scrutiny, and a result of information provided to us on a level playing field.”

As a transactions-based methodology, Platts windows are not vulnerable to some kinds of manipulation (e.g., of the Lie-bor variety) but they are definitely vulnerable to the large purchases or sales of a big trader looking to move the price to benefit an OTC position. The most that Platts can do is provide more delivery capacity to make the supply curve more elastic, but as I show in the 2001 paper, as long as the supply curve is upward sloping, or the demand curve is downward sloping a trader with a big enough derivatives position and a big enough pocketbook has the incentive and ability to manipulate the price.

Once upon a time, in the 90s in particular, the Brent market was periodically squeezed. Platts (and the industry) responded by broadening the Brent basket to include Forties, Oseberg, and Ekofisk. For a while that seemed to have made squeezes harder. But the continued decline of North Sea production has made the market vulnerable again. Indeed, all the signs suggest that the June Brent contract that went off the board last week was squeezed: it went into a steep backwardation during the last few days of trading, and the market returned to contango as soon as that contract expired.

The fact is that market power problems are endemic in commodity markets. The combination of relatively small and constrained physical markets and big paper markets create the opportunity and the incentive to exercise market power. It looks like that happened in Brent, and looks like it is a chronic problem in Singapore FO, reputed to be one of the dirtiest markets in the world.

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