Streetwise Professor

April 29, 2016

Rounding Up the Usual Suspects, With Chinese Characteristics

Filed under: China,Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 8:32 pm

Commodity prices on Chinese exchanges, especially for ferrous metals, have been skyrocketing in recent weeks. Rebar, iron ore and coking coal have been particularly active, but thermal coal and cotton have been jacked too.

In response, the Chinese authorities are cracking down on speculation.  Exchanges have raised margins in order to attempt to rein in trading. The government is making ominous statements about speculation and manipulation. And we know what can happen to speculators who fall afoul of the government.

Ironically, prices never appear to be just right, by the lights of the Chinese authorities. Last summer, and earlier this year, speculators were allegedly causing stock prices and commodity prices to be too low. Now they are causing commodity prices to be too high.

This is a case of the Chinese authorities playing Claude Rains in Casablanca, and ordering a roundup of the usual suspects. Speculators make convenient targets, and they appear to be the proximate cause: after all, their trades produce the rapidly rising prices.

But the speculators are merely the messengers. If the Chinese authorities want to find the real culprits, they need to look in the mirror, for the speculators are responding to the most recent lurch in Chinese economic policy.

Put simply, after the economic slowdown of the second half of 2015 (a slowdown masked by fraudulent official statistics, but evident nonetheless), the government pushed the panic button and fell back on its standard remedy: injecting a burst of credit.  Some estimates put the Chinese debt to GDP at 237 percent. Since GDP is likely also an overstated measure of national income, due to fraudulent statistics and the fact that the losses on past investments have not been recognized (in part because much of the credit is pumped  into zombie companies that should be bankrupt) this ratio understates the true burden of the debt.

The surge in credit is being extended in large part through extremely fragile and opaque shadow banking channels, but the risk is ending up on bank balance sheets. To engage in regulatory arbitrage of capital rules, banks are disguising loans as “investments” in trust companies and other non-bank intermediaries, who then turn around and lend to corporate borrowers.  Just call a loan a “receivable” and voila, no nasty non performing loan problems.

There is one very reasonable inference to draw from this palpably panicked resort to stimulus, and the fact that many companies in commodity intensive industries are in desperate financial straits and the government is loath to let them go under: today’s stimulus and the implied promise of more in the future whenever the economy stutters will increase the demand for primary commodities. The speculators are drawing this inference, and responding accordingly by bidding up the prices of steel, iron ore, and coal.

Some commentors, including some whom I respect, point out that the increase does not appear to be supported by fundamentals, because steel and coal output, and capacity utilization, appear to be flat. But the markets are forward looking, and the price rises are driven by expectations of a turnaround in these struggling sectors, rather than their current performance. Indeed, the flat performance is one of the factors that has spurred the government to action.

When the Chinese responded to the 2008-2009 crisis by engaging in a massive stimulus program, I said that they were creating a Michael Jackson economy, one that was kept going by artificial means, to the detriment of its long term health. The most recent economic slowdown has engendered a similar response. Its scale is not quite as massive as 2008-2009, but it’s just begun. Furthermore, the earlier stimulus utilized a good portion of the nation’s debt capacity, and even though smaller, the current stimulus risks exhausting that capacity and raising the risk of a banking or financial crisis. It is clear, moreover, each yuan of stimulus today generates a smaller increase in (officially measured) output. Thus, in my view, the current stimulus will only provide a temporary boost to the economy, and indeed, will only aggravate the deep underlying distortions that resulted from past attempts to control the economy. This will make the ultimate reckoning even more painful.

But the speculators realize that the stimulus will raise commodity demand for some time. They further recognize that the stimulus signals that the authorities are backsliding on their pledges to reorient the economy away from heavy industry and investment-driven growth, and this is bullish for primary materials demand going forward: the resort to credit stimulus today makes it more likely that the authorities will continue to resort to it in the future. So they are bidding up prices today based on those predictions.

In other words, as long as the Michael Jackson economy lives and stays hooked, its suppliers will profit.

So yet again, commodity markets and the speculators who trade on them are merely a lurid facade distracting attention from the underlying reality. And the reality in China is that the government cannot kick the stimulus habit. The government may scream about (and worse) the usual suspects, but it is the real cause of the dizzying rise in Chinese commodity prices, and the burst of speculation.

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April 18, 2016

Corn is Chicken Feed, But the Losses from Chinese Malinvestment Aren’t

Filed under: China,Commodities,Economics,Politics — The Professor @ 6:34 pm

The WSJ reports that China could face a $10 billion write-down on the huge corn stocks that it accumulated as part of its efforts over the past years to prop up prices for farmers. Corn is chicken feed, but $10 billion ain’t.

But I think that the moral of this story goes far beyond corn. Chinese agricultural price supports are just one example of the myriad policies that the country has adopted over recent years that distort prices and lead to misallocations of resources. Indeed, the deadweight losses from ag price supports are probably chicken feed in comparison with the waste resulting from distortions in the capital and credit markets that have led to massive malinvestment in industrial capacity (note the huge overcapacity in industries like steel), infrastructure, and housing.

Perhaps the main difference is that the corn inventories are being written down. The corn counted towards national income when it was produced, and writing down the inventories will reduce national income. Alas, the vast bulk of the malinvestments elsewhere will not be marked to market, and reported Chinese national income will be too high as a result.

What’s particularly important is that although the Chinese are apparently recognizing that their agricultural policies were inefficient, they cannot wean themselves from the credit stimulus habit. About 2 years ago I gave talks where I said China faced three alternatives, two of which were bearish for commodities: hard landing, transition to a more market-based, consumer-oriented system, or continued reliance on credit stimulus to keep measured growth high. I further opined that the latter alternative would just defer the choice between the first two for some time.

I did not venture a strong opinion on which alternative would happen, because I believed (and believe) that the choice is ultimately political, and I am in no position to predict with confidence Chinese politics. My sense was (and is), however, that sustaining the status quo was (and is) the most likely outcome. This would involve cranking up the stimulus in the face of any slowdown.

Recent experience suggests that’s the case:

China’s economy slowed further in the beginning of the year, though Beijing’s policies to revive growth with old-style tools such as lending and construction appeared to gain traction in March.

China’s gross domestic product expanded by 6.7% year-over-year in the first quarter, down from a 6.8% gain in the previous quarter, the National Bureau of Statistics said Friday. The figure, the slowest quarterly growth for China since the height of the financial crisis in 2009, was in line with forecasts.

In the past month, some confidence has returned to the world’s second-largest economy, fueled in part by sharp property-price rises in China’s major cities as well as some lessening of currency volatility and capital outflows that spilled over onto global markets last year and early in 2016. In March, China’s foreign-exchange reserves grew for the first time in five months.

Friday’s data release provided signs that a host of stimulus measures put in place over the past 15 months are having some impact—or are at least delivering some short-term gains. Industrial output, retail sales and property investment rose more than expected in March after a weak performance in January and February. Fixed-asset investment also improved.

And lending soared. Chinese financial institutions issued 1.37 trillion yuan ($211.3 billion) in new yuan loans in March, rocketing well past economists’ expectations of around 1.1 trillion yuan, and almost twice February’s volume.

This means more new malinvestment, and more papering over (with credit) the write down (and hence recognition) of past malinvestments.

This credit splurge helps explain the commodities rebound in recent months. But it also shows how tenuous the foundations of that rebound are. It is an artifact of artificially stimulated investment. Eventually, inevitably, the accumulated waste and distortions will bring the entire Chinese economy to a shuddering halt, and perhaps a crash. Eventually the accumulation of distortions becomes so great that a shakeout and rationalization is necessary, and inevitable. China is at best delaying the reckoning.

Corn is a small part of a much bigger picture. But it is a revealing part. It shows how perverse pricing policies lead to inefficient accumulations of capital that eventually become worth far less than the amount invested. Corn is relatively easy to value, and the cost of the malinvestment in corn stocks looks to be about $10 billion. When one considers how many other wasteful investments have been made in China as a result  of its interventionist policies, and the imagination staggers at what the losses would be.

Put differently, China’s performance would look far less stellar if national income accounting was accurate, and realistically marked its past investments to market. Of course, it is this very fact that induces the Chinese authorities to use every trick in the book to prevent that from happening. But there will come a day, because losses this large cannot be concealed forever.

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April 13, 2016

You Can’t Handle the Truth! Censoring Politically Inconvenient Research at the CFTC

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 2:29 pm

I had missed that the CFTC’s Office of the Inspector General had found that the Office of the Chief Economist had “prohibited relevant but potentially controversial research” on position limits. According to the OIG, during a routine interview with a CFTC staff economist, without being asked, the economist told the OIG that s/he had been prevented from doing research on position limits. According to the OIG, “several OCE economists identified position limits as an example of a topic on which economic research is no longer permitted.” One said: ”you can’t write a report on something that destroys three years of (CFTC) work.”

The basic conclusion is damning:

Several other economists confirmed their impression that OCE is now censoring research topics that might conflict with the official positions ofthe CFTC. Some ofthis censorship occurs on the part ofindividual staffeconomists themselves-when selecting potential topics, they now choose non-controversial ones. However, multiple OCE economists also reported that the Chief Economist has declined to permit research on certain topics relevant to the CFTC mission, including position limits.

Some OCE economists expressed uncertainty as to the purpose of OCE’s research program if the Office is prevented from studying topics relevant to current CFTC rulemaking. Yet OCE economists reported that the Chief Economist has rejected or delayed research paper topic ideas if tey were related to pending rulemaking or could challenge the validity of agency regulations. One OCE economist described the policymaking process as one in which a decision is made and then analysis is done in a fashion designed to support the decision. There is a perception within OCE that the ChiefEconomist is “more Commission-friendly,” and that he discourages research that might offend Commissioners.

During “multiple” discussions with the OIG, the Chief Economist at first admitted that this was so, then backtracked:

He agreed that he had initially rejected a research proposal on position limits on the basis that it was politically controversial. The Chief Economist later stated his belief that the CFTC did not have the data or the in-house expertise to do this project in any event. The Chief Economist explained that this was a matter of discretion, and that he did in fact permit research into politically controversial topics. He provided an example ofresearch into high-frequency trading and instances ofself-trading. When asked, the Chief Economist agreed that the Chairman actively supported this line ofresearch. The Chief Economist also stated that he wanted to be able to take to the Chairman and Commissioners anything he or OCE did.

Appalling.

Chairman Massad has recently rejected the OIG’s conclusion, the statements of multiple staff economists, and the initial gaffe (i.e., truth telling) by the Chief Economist. It wasn’t politics, you see. It was priorities:

“Our Office of the Chief Economist has many excellent economists, the morale there is very good and the work they produce is very good. They often produce things that might conflict with the views I have and the views other commissioners have, but we don’t have any kind of political screen on what we do,” said Massad, testifying before the Senate Committee on Appropriations on April 12.

“We do have, however, priority setting. It’s a small division and we must set priorities. We can’t always have a staff person just do the research they would like to do, as opposed to research we really need to focus on. That’s the only way in which we focus their work,” he added.

To state the obvious: priorities are inherently political. The statement about priorities therefore does not refute the belief of the staff economists that the decision to forbid research on position limits was ultimately political.

Chairman Massad’s assertion also is flatly inconsistent with the opinions expressed by multiple individuals, including his own Chief Economist (before he got his mind right, anyways). Thus, there is certainly a widespread perception in the OCE that permissible research means politically correct research. Either this perception is correct, or Chairman Massad has done a poor job of communicating to the economists the criteria by which research resources are allocated.

In a Washington where everything is politicized, and in particular where Senator Elizabeth Warren clearly attempts to censor those expressing dissenting opinions, and attempts to intimidate and slander those who dare to express such opinions, it is utterly plausible that the economists’ perceptions are very well grounded in reality. I view the economists’ complaint as facially valid, but potentially rebuttable. Mr. Massad’s testimony does not even come close to rebutting their assertions. Indeed, knowing how to decode words like “priorities” from GovSpeak, if anything his testimony buttresses the complaint, rather than rebuts it.

But let me suspend disbelief for a moment, and take Chairman Massad at his word. Just what does that imply?

First, it implies that a position limits initiative that would impose substantial burdens on the industry is of insufficient importance to justify a researcher or two to spend a portion of their time to study. Not to denigrate the value of the economists’ time, but in the scheme of things this does not represent a huge expenditure of resources. If position limits are of that little importance, what is the potential benefit of the regulation? Why does the Commission persist in pushing it if it is not even worth the time of a few staff economists?

Second, what does this say about the Commission’s commitment to carrying out its statutory obligation to conduct a cost-benefit analysis of the regulation?

Third, and relatedly, if the Chief Economist is correct and his staff does not possess “the data or the in-house expertise to do this project” how would it even be possible for the OCE, and the Commission, to perform a valid cost-benefit analysis? In particular, since the proposed research appears to speak to the issue of the benefits and necessity of limits, how can the Commission generally, and Chairman Massad in particular, credibly claim that they have determined that limits offer sufficient benefit to make them necessary, or to exceed their cost, if its own Chief Economist claims that his office has neither the data nor the expertise to perform valid research on the effects of limits?

Position limits have been a political project from Day 1. They remain a political project, as Senator Warren’s recent jeremiad (directed substantially at yours truly) demonstrates. The economic case for them remains dubious at best. Given this history and this context, the assertion that prohibiting CFTC staff economists from researching the issue was politically motivated is all too plausible.

The Risk article that I linked to quotes Gerry Gay, who was Chief Economist under Wendy Gramm in the Bush I administration. Gerry notes that prior to 1993, economics and economists had pride of place within the CFTC. It was viewed as “an economist’s shop.”

That is a fair statement. What happened in 1993? The Clinton administration took over, and (as Gerry notes) de-emphasized economics. I remember distinctly an article in Futures Magazine that solicited the opinion of many industry figures as to the changes the new administration would bring. Ex-CFTC Commissioner Philip McBride Johnson’s statement sticks in my mind. This is almost an exact quote, though it is from memory: “We can now get rid of the economists and put the lawyers back in charge.”

That’s exactly what happened then, and with a few exceptions during the Bush II years, has remained true ever since. Just as Clemenceau said that war is too important to be left to the generals, the DC set established that regulating the markets is too important to be left to the economists. What’s more, particularly in the Obama administration, starting with Gensler’s tenure as head of the Commission, it was determined that certain kinds of lawyers had to be in charge, and they had to follow marching orders from politicians. Do not forget that Gensler was only able to overcome skepticism about his Goldman background by pledging fealty to the Democratic senators on the relevant committees, and to their agenda. Truly independent regulators get crushed. (Remember the fate of FCC head Tom Wheeler when he strayed just a little bit off the party line on net neutrality?)

Keep that in mind when attempting to determine the true story of the disapproved research on position limits. It has been determined that you can’t handle the truth.

Update: Note well that the CFTC economists’ concerns about acceptable research extend beyond position limits. It is clear that several believe that policy-relevant research is discouraged, at least if it could contradict existing or pending regulations. If that’s in fact true, it would be fair to ask why the hell the CFTC has economists anyways. Economics has a vital role in informing policy on markets. The economists could pay their lifetime salaries many times over by stopping or correcting one misguided regulation, or even one misguided piece of a broader regulation. (I recall a quote from Coase that an economist could pay for his lifetime salary by just delaying a bad regulation a day.) The only real reason to have economists at the CFTC or any agency is to provide critical evaluation of pending or existing rules and regulations. It is beyond absurd to preclude economists from working on exactly those things, when they could upset some politically-driven regulation.

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April 10, 2016

What Happens in Panama Doesn’t Stay in Panama, Apparently

Filed under: Politics,Russia — The Professor @ 9:01 am

The media has been aflutter during the last week over the Panama Papers. Much of the excitement has focused on Putin’s presence-or lack thereof, actually-in the Biggest Leak Ever.

My reaction: BFD.

Insofar as what about Russia is actually in the leak: can you honestly say that it provided you with any new information? Hardly. Offshoring of dirty Russian money has been a thing since the USSR collapsed. Before, actually. Putin has actually made an issue of it. To the extent that the leak reveals anything, it shows the hypocrisy and political nature of Putin’s anti-offshoring drive. The politically favored can still do this, although with the knowledge that the Sword of Damocles hangs over their heads. If favor turns into disfavor, the offshoring can be used to destroy them.

At most, the leaks regarding Russia provide some interesting information as to how the offshoring works in practice. But this mere detail which provides no new insight on the nature of the Russian system.

The hypocrisy is also evident in China, where family members of anti-corruption crusader CCP General Secretary Xi Jinxing have been disclosed to have offshore shell corporations. But again, the hypocrisy should not be a surprise. As has been the case with autocrats since time immemorial, Xi’s anti-corruption drive has been more of a means of extending his power and control, than an idealistic effort to clean up China’s government and economy.

Insofar as Putin is concerned personally, why would anyone expect his name to be on any document detailing ownership of anything? Do you think he’s that stupid?

For all the hyperventilating by Bill Browder and others of Putin’s alleged massive fortune (which Browder puts at $200 billion), a little common sense is sufficient to discount these stories. Actually formally/legally owning things provides little benefit to Putin, but poses risks. It is all downside, with no upside.

If evidence of such a massive fortune was uncovered, it would be an embarrassment, or worse, for Putin: his very pretense of being a servant of the people who earns a very modest salary demonstrates that he believes that being revealed definitively as a plutocrat (rather than merely an autocrat) would be dangerous for him politically.

And what does he gain by having his name on some legal papers documenting ownership of vast amounts of wealth? Absolutely nothing. In this current role, he has practical ownership of pretty much everything in Russia. That is, if you view ownership as a bundle of rights to use assets, Putin has ownership, regardless of whether his name is on pieces of paper or not. If he wants use of this asset or that, who is going to deny his request? Further, there are myriad ways that he can use the power of the Russian state to direct wealth to those he favors (e.g., through massively corrupt contracting practices for projects like Sochi, or through Gazprom), who in turn direct some of that to people or purposes that Putin requests. And all of this can be done with Putin not having formal legal ownership of anything.

Furthermore, Putin realizes that formal ownership would not secure him a quiet retirement of opulent luxury. His informal ownership rights exist only so long as he is in power, and as soon as he is out of power any formal ownership rights over vast assets would be too tempting a target for his successor to resist. He could never enjoy the benefits of such wealth when out of power, and doesn’t need it when in it. So what’s the point?

So I would put a different spin on it: the very absence of Putin’s name in the Panama Papers is exactly what is informative. It reveals that he is not leaving power in a vertical posture, of his own volition, because when he does, his practical ownership rights evaporate with his power. This also makes it plain why he is doing things to secure domestic control in advance of the 2017 Duma election and the 2018 presidential “contest”. The creation of a National Guard under his personal control, for instance.

As to speculation regarding who leaked and why: meh. These parlor games bore me, and are essentially forms of ad hominem argument that have no bearing on the truth or falsity of the information.

The claims by Russian authorities (including Putin personally) and Julian Assange (who first praised the leak then turned on it) that it is a CIA/State Department/Soros plot to undermine Putin and Russia are implausible. If anything, the leak was very helpful to Putin. By far the biggest casualty of the leak has been Ukrainian president Poroshenko, who was revealed to have been negotiating moving his assets overseas at the same time his army was being slaughtered in the Donbas. The already divided and shaky Ukrainian polity has become even more so as a result of the revelations, and this redounds to Putin’s benefit. Most of the other casualties have been western democratic politicians, notably David Cameron. In other words, if this was a CIA/State Department plot, it was an epic miscalculation.

Following this cui bono logic, others have swung to the opposite extreme. Most notably, Brooking’s Clifford Gaddy mooted that since Putin has benefited, this may be a Russian operation. I agree that despite the initial frenzy Putin has been a beneficiary, but believe that it is far more likely that it is just another episode in his recent streak of good luck.

As for the ethics of the leak, and how the material has been handled, the entire episode points out the ambiguities and dilemmas of this means of holding public officials and private individuals accountable. Unlike Wikileaks, the entire set of material is under control of a set of journalists and publications, and is not open for search by the public. This creates the potential for manipulative select disclosure. This is problematic, and this very possibility also creates a narrative that can be used to discredit the entire project. But since innocent private individuals’ information is also in the database, open access would impose huge collateral damage. The choice is binary (selective disclosure controlled by a group of self-selected gatekeepers who may have an agenda, or open access), and the severe downsides to either alternative call into question the utility of leaking as a means of revealing (and perhaps punishing) misconduct by government officials, or private individuals.

It also shows the costs of privacy and transparency, which highlights a fault line in the current debate. In that debate, Privacy and Transparency are both praised as ideals even though they are obviously in substantial tension. What information should be private and what should be transparent, and whose information should be private, whose information should be transparent, and who should make these choices are extremely difficult questions. Even if one can identify the ideal boundaries in the abstract, respecting them in practice is devilish hard. The Panama Papers case reveals that in spades.

 

 

 

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March 27, 2016

A Practical President, Who Believes Himself Exempt From Intellectual Influence

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

Obama caused a kerfuffle with his remarks in Argentina on Thursday. The most common interpretation of his remarks was that he was drawing an equivalence between communism/socialism and capitalism. Yes, one can interpret his speech that way, but I don’t think that’s the most accurate way to parse it.

Obama was denigrating all ideological frames as interesting subject matter for academic debate, but of little interest or relevance to practical politics:

I guess to make a broader point, so often in the past there’s been a sharp division between left and right, between capitalist and communist or socialist. And especially in the Americas, that’s been a big debate, right? Oh, you know, you’re a capitalist Yankee dog, and oh, you know, you’re some crazy communist that’s going to take away everybody’s property. And I mean, those are interesting intellectual arguments, but I think for your generation, you should be practical and just choose from what works. You don’t have to worry about whether it neatly fits into socialist theory or capitalist theory — you should just decide what works.

In short, he advocated a rigorously pragmatic approach. Or put differently, a Chinese menu theory of government: take one item from menu A, another from menu B, depending on your taste and what “works” for you.

The criticism here should be directed at his vapidity and superficiality and question begging. By what criteria are the things that “work” to be determined? How do liberty, individual autonomy, and reliance on coercion and repression come into play when evaluating what works?

Further, real world decisions always involve trade-offs. Works-Doesn’t Work is binary: trade offs aren’t.

Obama also apparently believes that it is possible to design policies without a theoretical framework. Hayek was closer to the truth when he said without theory the facts are silent. Theories are about causal mechanisms, and policies are all about manipulating cause to achieve particular effects. You can’t make a reasonable evaluation ex ante of what policies will “work” (based on your objective function) without some theoretical framework. Further, those who don’t think deeply about cause and effect when designing policies inevitably unleash unintended consequences that are usually more baleful than beneficial.

All that said, the fact that Obama apparently believes that some socialist or communist policies “work” by any criteria held by non-socialists/communists is revealing. All empirical experience is that explicitly communist and socialist systems have delivered lower standards of living (often dramatically so), less freedom, and more coercion. Further, their alleged virtue–equality–is largely chimerical. There is always a privileged elite in socialist/communist systems, and what equality there is tends to be an equality of misery. What’s more, inequality can be palliated (and is considerably even in the US) by transfer programs that fall well short of communism or socialism. The Bernie worshipping millennial idiots who point to Denmark or Sweden as socialist paradises have no clue: they are welfare states, which is a very different kettle of fish.

The examples from Cuba that Obama cited as things that “work” in a communist system are something of a joke. Non-communist/socialist systems deliver better education and health care than Castro’s Cuba.

Obama was not revealing that he is a closet commie, although he clearly does not think communism is inherently a bad thing. In fact, he was being an old school progressive, making arguments old school progressives have made since Wilson and through FDR. The New Dealers were of a similarly pragmatic bent, and like Obama, openly advocated using policies adopted by fascist or communist countries if they “worked.” Stalin, Hitler, and Mussolini all had admirers among the New Dealers, who believed that they had found better policies than voluntary contract and exchange, and open competition.

When I read Obama’s remarks, I immediately thought of FDR’s speech at Oglethorpe University in May, 1932 (while he was running for president):

Do not confuse objectives with methods. When the Nation becomes substantially united in favor of planning the broad objectives of civilization, then true leadership must unite thought behind definite methods.

The country needs and, unless I mistake its temper, the country demands bold, persistent experimentation. It is common sense to take a method and try it: If it fails, admit it frankly and try another. But above all, try something. The millions who are in want will not stand by silently forever while the things to satisfy their needs are within easy reach.

“Bold experimentation” is basically a prescription to try anything and see if it “works.” If one thing doesn’t “work,” (i.e., “if it fails”) try something else. Once the “broad objectives” are defined, any method that achieves those objectives is fair game. Roosevelt in Georgia, like Obama in Argentina, was saying that all methods should be open for consideration and evaluated on purely pragmatic grounds.

Roosevelt was also making a favorable reference to planning, which at the time was associated with the USSR. Like Obama, he was saying don’t rule out a particular policy just because it originates in communism.

Of course, the implementation of this theory of government in the New Deal led to a confused hodge-podge of policies that largely failed to achieve their stated objectives, and indeed, in many cases worsened the nation’s economic crisis: that is, these policies were rife with unintended consequences.

This provides an excellent example of Hayek’s dictum. Those operating based on standard microeconomic (e.g., capitalist) principles/theories rightly predicted that cartelizing product and labor markets would not lead to higher output, and they were right. Contrary to Obama, “capitalist theory” was more than an intellectually interesting subject for classroom debate: it was a very useful guide to evaluating the practical effects of policies, which the New Dealers ignored, to the nation’s detriment.

And those progressives like Wilson, FDR, and now Obama who touted the superiority of pragmatism, and claimed their practicality and independence from theoretical abstractions and systems, were largely fooling themselves. The Pragmatism (note the capitalization) that has infused progressive thought for well over a century isn’t a-theoretical or a-ideological. It is an ideological and philosophical system developed in Germany in the 19th century. Not that Obama gets that.

No, Obama seems to be exactly the kind of man that Keynes so trenchantly described in the General Theory 80 years ago:

Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.

What Keynes describes is a form of intellectual conceit common among politicians, and especially progressive ones. That conceit, rather than some soft spot for socialism, is the problem with Obama’s “do what works” nostrum.

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March 25, 2016

Killing the Marine Corps With a Theory

Filed under: History,Military,Politics — The Professor @ 7:03 pm

The United States Marine Corps is one of the most, if not the most, exceptional and effective military force of its size in history. I dare you to identify an organization with as long and storied a record of bravery, sacrifice, and victory under the most trying conditions. From the decks of the USS Constitution to Tripoli, Mexico City, Belleau Wood, the jungles of Central America, Tarawa, Guadalcanal, Cape Gloucester, Saipan, Peleliu, Iwo Jima, Okinawa, Inchon, Chosin, I Corps, the berms of Kuwait and Kuwait City, Fallujah and many other battlefields the USMC has compiled an unrivaled combat record.

This record is the product, first and foremost, of a unique military culture. Often marginalized and frequently forced to fight for its existence, not on the battlefield, but in the halls of Congress, the Marine Corps over more than two centuries has developed a unique esprit de corps  that would be impossible to recreate from scratch today.

Read Eugene Sledge’s With the Old Breed, and you will understand.

When I was at the Naval Academy, I knew I could never be a Marine in a million years, largely because I knew I could not subsume my identity into that of the Corps.  And that is what the Corps demands. But I was, and am, damn glad that there have been millions of Americans who have been willing to do so. The Marines have performed the amazing feats that they have precisely because they demand the surrender of individuality. It’s not for everybody, but that is fine, because the Marines don’t need and can’t take everybody. Over the centuries, there have been enough.

This is a unique institution which should be defended and preserved. It makes an irreplaceable contribution to the defense of this nation.

But precisely because the Marines’ military culture is a glorious anachronism, a thing from another time, it is hated and despised by the politically correct, and the gender warriors in particular. The Marine Corps has fought the Obama administration’s ideologically-driven campaign to gender-integrate all combat units and specialties. It fought with data. It has insisted that only one metric matters, success on the battlefield, and has concluded that by that metric complete gender integration fails miserably.

This resistance has drawn the ire of arguably the most execrable high ranking member of the Obama administration (quite an accomplishment that), Navy Secretary Ray Mabus. Mabus responded to the Corps’ resistance by ordering the gender integration of Marine basic training–which will be an unmitigated disaster–and further demanded that the Corps rename all job titles to remove the word “man”. Now, there is an official plan to impose “cultural change” on the Corps.

Again, I commend you to read With the Old Breed. Time and again Sledge states bluntly that the only reason that he and his fellow Marines were able to fight and win appalling and grinding battles was the Spartan ethos and unrelenting training that the Marines underwent before hitting the beaches. He hated doing it, but he knew it was the only thing that made it possible for him to come out alive. It is inevitable that gender integration will undermine that ethos, and the rigor of the training.

The Marine Corps–and other branches of the military–should have one overriding objective and one only: to fight and win wars. The unique culture of the Marine Corps has ensured that it has been able to achieve that objective under the most trying conditions imaginable. Why in God’s name would anyone who takes the national defense seriously contemplate changing such an exceptional culture?

The answer, of course, is that people like Mabus and many others in the Obama administration and Congress are more interested in fighting and winning culture and gender wars than shooting wars. This is despicable.

I have often quoted Jefferson Davis’s epitaph for the Confederacy: Died of a Theory. Ray Mabus, Obama, and the other cultural/gender warriors who dominate Washington are hell bent on killing with a theory, an ideology. In this instance, they are hell bent on killing a military culture that has served this country gloriously, and which has produced millions of ordinary leathernecks and jarheads who have fought and bled and died while winning this nation’s wars.

“Died of (or killed by) a theory” is more than a metaphor in the case of the USMC and the Obama administration. People will literally die because of the imposition of a politically correct ideology that will inevitably compromise military effectiveness. And for what?

But those who will die cannot be identified now. They do not have names or faces. For most, they are not even abstractions. And when they die Obama and Mabus and the others will not be held to account. Indeed, they will receive accolades from many for making another successful march through American institutions, in this case, the most successful military institution in the nation’s history.

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March 23, 2016

Our Peevish President Dismisses Terrorism, and Bolsters a Repressive Regime

Filed under: History,Military,Politics — The Professor @ 6:30 pm

The latest terrorist atrocity, this time in Brussels, proves yet again that Europe is infested with dens of vipers, which it is largely powerless to control. Perhaps this should be expected in a country like Belgium, which cannot execute raids between the hours of 10 PM and 5 AM, and must ring the doorbell when they do.

Obama’s reaction to these appalling events was appalling in its own way. The most peevish president was obviously immensely annoyed that ugly reality intruded on his Cuban victory lap/holiday. He grudgingly spared a grand total of 51 seconds to address the subject during a scheduled speech in Havana. He then proceeded to take in a baseball game, during which he did the wave with his new besty Raul Castro.

Obama’s remarks, such as they were, displayed his impatience with and indifference to the issue of terrorism. It consisted of the standard bromides, including the old standby of a promise to help bring the perpetrators to justice.

Um. The perpetrators were suicide bombers. They blew themselves up. They are quite clearly well beyond the reach of human justice.

When pressed on the issue today in Argentina, Obama responded with his by now familiar petulance and irritation at the topic.  He has a lot on his plate, he said, by way of rationalizing not giving the matter more attention. Further, in a reprise of another well-worn theme, Obama stated that terrorism is not an existential threat to the US.

This is Obama’s typical false choice/straw man rhetoric in action. There are very few existential threats: if presidents were bound to respond only to existential threats, their plates would be quite empty. Plenty of time for golf and ESPN. Come to think of it . . . . Seriously, though, although Obama thinks Americans are irrationally obsessed with a terrorism threat which in his mind ranks somewhere below the risk of drowning in the bathtub (no, really), although not existential, it is a sufficiently great danger that a more aggressive posture is fully warranted.

It should be said that Obama is doing more than he lets on. But that in itself is a problem. For the second time in recent months, only the death of an American serviceman has forced the administration (though not Obama personally, for he floats above it all, unquestioned by the press) to admit a more extensive involvement in combat in Iraq and Syria. This time, the death of a Marine in an ISIS rocket attack on  firebase in Iraq compelled the Pentagon to concede its existence, which it had previously not acknowledged: if the Marine hadn’t died (with eight more wounded) the firebase would remain a secret. From Americans, anyways. In response to questions arising from the Marine’s death, SecDef Carter was forced to concede that US personnel numbers in Iraq exceeded, by about 50 percent, the authorized number.

So this means that the war against ISIS is more robust than Obama admits. That’s good in a way, but the secrecy is disturbing. It is not for operational reasons: after all, ISIS clearly figured out the base was there, and took it under fire. It is purely to protect Obama personally. Acknowledging more robust campaign would be an admission that his past inaction on ISIS was a mistake. And Obama is constitutionally incapable of admitting error. Sadly, a press that would be baying like hounds on the trail of a fox if a Republican president had done this is silent, and thereby complicit in concealing military action from the American people.

Obama’s terrorism remarks were only one of many low points on his two day visit to Cuba. He spewed one leftist shibboleth about the Communist country after another. It was an extended exercise in moral equivalence between the US and Cuba.

For instance, he said the Cuban Revolution and the American Revolution were quite similar, in that they were both fighting oppression. Even overlooking the fact that the philosophical and political foundations of the two revolutions could not be more different, the obvious difference is that the Cuban Revolution replaced one tyranny with a far worse one, whereas the American revolution gave (in Lincoln’s words) a new birth of liberty. It is deeply insulting to compare the American founding generation to the murderous thugs who led the Cuban uprising, and who continue to grind the country under their geriatric heels almost 60 years later.

Further, Obama said that Cuba had things to teach the US about human rights (!), specifically citing universal health care. Where to begin? Identifying health care as a human right is typically progressive, but leave that aside for the moment. Cuba’s “universal health care” is a sick joke. The elite gets far better treatment than the vast majority of Cubans, who universally get crappy medical treatment: they are equal in the primitiveness of the treatment they get.

The low point in the visit was a photo op in front of the Cuban Interior Ministry, complete with a huge portrait of mass murdering, racist Che looming in the background. Given the meticulous planning that goes into presidential visits, this had to be deliberate: leftist trolling at its worst.

The boycott of Cuba is an anachronism. It is justifiable to jettison it, and to restore relations with Cuba. But that does not require doing what Obama did: validating, and arguably celebrating, a vicious, oppressive regime, while insulting and apologizing for the country that did him the honor of electing him president twice.

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March 22, 2016

Shocking! Physical Oil Traders Profit From *LOW* Prices! Who Knew?

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 1:25 pm

Major oil traders have profited handsomely from the low price environment. Today Gunvor released results, showing a big increase in profits to $1.25 billion. A big part of the increase was driven by profits on sales of its Russian assets, but the company’s news release states that earnings from continuing operations were up 10 percent. Gunvor’s results were driven by a 24 percent increase in traded volumes.

Timing is everything. No doubt Gennady Timchenko is cursing US sanctions even more now than in March, 2014. The sanctions preceded by a few months the epic oil price collapse which has boosted oil traders’ profits.

Vitol also released some limited information about its 2015. It did not release profits numbers, but the FT reports that in the 9 months ending September, its profits were $1.25 billion, about 40 percent more than in the comparable period of 2014. Vitol’s volumes were up 13 percent.

These results come on the heels of earlier good trading results from Glencore and Trafigura. Both companies showed large increases in volumes, up 22 percent in the case of Trafigura.

Revenues of all oil traders have declined because price declines have more than offset the effect of rising volumes. But that  just points out that what matters to traders is volumes, not flat price. Indeed, low flat prices can be a boon, because (a) to the extent they are driven by higher output, they are associated with increased volumes, and (b) they reduce working capital burdens.

The increase in trader volumes far outstripped increases in output of crude or refined products. This raises the question of what is driving the increase. It could be that a higher fraction of output is traded now. Alternatively, or additionally, each barrel may turn over more frequently. I don’t know the answer, but I am going to make some inquiries to learn more.

These bumper profits in the face of an oil price collapse proves, as if further proof is needed, the idiocy of David Kocieniewski and other non-specialist journalists and politicians (yeah, Liz, I’m taking the risk of turning to stone, and looking at you). Kocieniewski, you may recall (I sure do!), said that my opposition to position limits and my support of speculation in commodity markets was tainted due to my writing of a white paper for Trafigura, a notorious speculator that profits from high prices:

What Mr. Pirrong has routinely left out of most of his public pronouncements in favor of speculation is that he has reaped financial benefits from speculators and some of the largest players in the commodities business, The New York Times has found.

. . .

While he customarily identifies himself solely as an academic, Mr. Pirrong has been compensated in the last several years by the Chicago Mercantile Exchange, the commodities trading house Trafigura, the Royal Bank of Scotland, and a handful of companies that speculate in energy, according to the disclosure forms.

Except that as the events of the past couple of years demonstrate, physical traders aren’t speculators and don’t have an interest in (let alone the ability to) drive prices higher.

But why let the facts stand in the way of a good story, right?

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March 21, 2016

The Seen and the Unseen, Hedging Edition (With a Bonus Explanation of Why Airlines Hate Speculators)

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 8:16 pm

Most media coverage of hedging is appalling. It tends to focus on the accounting, and not the economics. Unfortunately, managements and analysts too often fall into the same trap.

This WSJ article about hedging by airlines is a case in point:

After decades of spending billions of dollars to hedge against rising fuel costs, more airlines, including some of the world’s largest, are backing off after getting burned by low oil prices.

When oil prices were rising, hedging often paid off for the airlines, helping them reduce their exposure to higher fuel costs. But the speed of the 58% plunge in oil prices since mid-2014 caught the industry by surprise and turned some hedges into big money losers.

Last year, Delta Air Lines Inc., the nation’s No. 2 airline by traffic, racked up hedging losses of $2.3 billion, while United Continental Holdings Inc., the No. 3 carrier, lost $960 million on its bets.

Meanwhile, No. 1-ranked American Airlines Group Inc., which abandoned hedging in 2014, enjoyed cheaper fuel costs than many of its rivals as a result. “Hedging is a rigged game that enriches Wall Street,” said Scott Kirby, the airline’s president, said in an interview.

Now, much of the rest of the industry is rethinking the costly strategy of using complex derivatives to lock in fuel costs, airlines’ second-largest expense after labor.

Roughly speaking, hedgers “lose”–that is, their derivatives positions lose money–about half the time. If the hedge is done properly, that “loss” will be offset by a gain somewhere else on the income statement or balance sheet. The problem is, it’s not identified specifically. In the case of airlines, it shows up as a lower cost of goods sold (fuel expense), but it isn’t identified specifically.

The tendency is to evaluate the wisdom of hedging ex post. But you cannot evaluate hedging that way. You hedge because you don’t know which way prices will go, and because a price move in one direction hurts you more than a price move in the opposite direction of the same magnitude helps you. If you knew which way prices were going to go, you wouldn’t need to hedge.

That is, hedging is valuable for an airline if reducing the variability of profits attributable to fuel cost changes raises average profits. How can this happen? One way is bankruptcy costs. If an airline loses $1 billion due to a fuel price spike, it may go bankrupt, and incur the non-trivial costs associated with bankruptcy: this is a deadweight loss. The airline receives no bonus equivalent in magnitude to bankruptcy costs if it gains $1 billion due a fuel price decline. Therefore, reducing the variability of fuel prices reduces the expected deadweight losses (in this case, expected bankruptcy costs), which is beneficial to shareholders and bondholders.

As another example, an airline that becomes more highly leveraged because of an adverse fuel price movement may underinvest (relative to what an unleveraged firm would) due to “debt overhang”: it underinvests because when it is highly leveraged the benefits of investment accrue to bondholders rather than shareholders. Again, there is unlikely to be a symmetric gain when the company becomes unexpectedly less leveraged due to a favorable fuel price movement. Here, reducing variability reduces the expected losses due to underinvestment.

Hedging can also reduce the costs of providing incentives to management through tying pay to performance. Hedging reduces a source of variability in performance that is outside of managers’ control: since they are risk averse they demand compensation for bearing this risk, so hedging it reduces compensation costs, and makes it cheaper to tie pay and performance.

The problem is, none of these things show up on accounting statements with the clarity of a 9 or 10 figure loss on a derivatives position put on as a hedge. The true gains from hedging are often unseen. The true gains are the disasters avoided that would have occurred in the absence of a hedge. There’s no line for that in the financial statements.

The one saving grace of the WSJ article is that it does mention a relevant consideration in passing, but doesn’t understand its full importance:

Another factor in the hedging pullback: a round of megamergers, capacity cuts and more fuel-efficient aircraft have fattened the industry’s profits, leaving carriers in better financial shape—and less vulnerable to a spike in fuel prices.

Two of the factors that make hedging value-enhance that I mentioned before (bankruptcy costs and underinvestment) are more relevant for highly leveraged firms that are at risk of financial distress. Due to the factors mentioned in foregoing quote, airlines have become less financially distressed, and need to hedge less. But that should have been the focus of the article, rather than the losses on previously undertaken hedges.

And that should be what is driving airlines’ decisions to hedge, although the statement of American Airlines’ president Kirby doesn’t provide much confidence that that is the case, at least insofar as AA is concerned.

Airlines are interesting because they have historically been among the biggest long hedgers in the energy market. This is true because they are one major consumer of fuel that (a) cannot pass on (in the short run, anyways) a large fraction of fuel price increases, and (b) are big enough to make justify incurring the non-trivial fixed costs associated with hedging.

Fuel costs are determined by an airline’s routes and schedule, and fuel consumption is therefore fixed in the short to medium term because an airline cannot expand or contract its schedule willy-nilly, or adjust its aircraft fleet in the short run. Thus, fuel is a fixed cost in the short to medium term. Furthermore, the schedule and the existing fleet determine the supply of seats, and hence (given demand) fares. Since supply and hence fares won’t change in the short to medium term if fuel prices rise or fall, airlines can’t pass on fuel price shocks through higher or lower fares, and hence these price shocks go straight to the bottom line. That increases the benefits for financial hedging: airlines have no self-hedges for fuel prices.

This is to be contrasted to, say, oil refiners. Refiners are able to pass on the bulk of oil price changes via product price changes: pass through provides a self-hedge. Yes, crack spreads contract some when oil prices rise (higher prices->lower consumption->lower utilization->lower margins), but refiners are able to shift most of the crude price changes onto downstream consumers. This reduces the need for financial hedges.

Further, many downstream consumers–gasoline consumers like you and me, for instance–don’t consume in a scale sufficient to justify incurring the fixed costs of managing our exposure to gasoline price changes. Therefore, a large fraction of those who are hurt by rises in the flat price of energy don’t benefit from financial hedging.

Conversely, those hurt by falls in flat prices, firms like oil producers and holders of oil inventories, don’t have self-hedges: they are directly exposed to flat prices. Moreover, they are big enough to find it worthwhile to incur the fixed cost of implementing a hedging program.

This leads to an asymmetry between long and short hedging, which is evident in CFTC commitment of traders data for oil. This asymmetry is why long speculators are essential in these markets. Without long speculators, the (predominant) short hedgers would have no one to take the risk they want to get rid of. This would put downward pressure on futures prices, and increase the risk premium embedded in futures prices.

Which is why airlines have been in the forefront of those hating on speculators. Not because speculators distort prices. But because long speculators compete with long hedgers like airlines to take the other side of short hedgers like oil producers and traders holding oil inventories. This competition reduces the risk premium in futures prices.

This makes it costlier for airlines to hedge, but their higher costs are more than offset by lower hedging costs for producers, stockholders, and other short hedgers. This is why speculators are vital to the commodity markets, and thereby raise prices for producers and reduce costs for consumers.

But apparently this is totally lost on Elizabeth Warren and her ilk. But as the WSJ article shows, ignorance about hedging–and hence about the benefits of speculation–is widespread. Unless and until this ignorance is reduced substantially, policy debates will generate much more heat than light.

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March 15, 2016

A Prudent Gambler Cashes in His Chips

Filed under: Military,Politics,Russia — The Professor @ 3:08 pm

Putin has disconcerted many with his abrupt and unexpected announcement that Russia would be removing its “main forces” from Syria. Just what this means is unknown, for he also made plain that it would maintain its main bases there, an air station in Latakia Province, and the shambolic Tartus naval facility. What residual capability will remain is unclear, and it must be noted that planes that fly out today can fly back at some future date, which distinguishes this from the US withdrawal from Iraq.

I consider it somewhat amusing that those who shrieked loudest about Putin getting into Syria are now shrieking loudest about his getting out. I guess they are upset that he will not be so stupid as to get bogged down in a pointless and bloody war that does not advance his strategic objectives.

As someone (surprisingly to some) who was not fussed about Putin getting into Syria, I’m equally indifferent as to his departure. Having no emotional or ideological investment, it is of interest mainly as an opportunity to evaluate his strategies, and his prudence in executing them.

The most obvious explanation is that the risk-reward trade-off no longer favors Russian involvement. On the reward side, Putin has achieved his main objective, and staved off Assad’s destruction. Putin may well prefer that Assad (and Iran) not win decisively: a stalemate may (cynically) advance Russian interests by continuing to make Assad dependent on Russia, and preventing Iran from getting too big for its britches.

The direct costs of this intervention, though not large when compared to American expenditures in the ISIS campaign (let alone what was spent in Iraq and Afghanistan) are nonetheless material given Russia’s straitened economic circumstances. It is not just a choice between guns and butter. Russia has already announced a sizable cut in military procurement, so there is an element of a choice between expending weapons and buying new ones. Putin clearly believes that new weapons will give him leverage in the future, so he is husbanding his limited resources for that purpose, rather than spending a few millions daily to continue high tempo operations in Syria.

On the risk side, pushing the campaign to the point where Assad is on the verge of decisive victory would increase greatly the probability of an open confrontation with Turkey. This would pose large military risks (and costs) even viewed narrowly, and would also result in a highly unpredictable situation with Nato, the US, and the EU. The upsides in such a situation are hard to see, but the downsides are clear and large. Then there are the normal risks attendant to any military operation, including the risk of some strategically irrelevant but spectacular and embarrassing terrorist operation targeted at the Russians. Furthermore, continuing the campaign aggravates relations with the Saudis, which creates economic complications by infusing a geopolitical calculus into delicate negotiations over oil output (which is a first order economic issue to Putin).

Smart gamblers know when to cash in their chips and go home. Putin came to the table with limited objectives, and has achieved them. He can claim victory: why risk losing these gains, when few further gains are in prospect?

Just like his going in was a lot less complicated than people made it out to be, so is his departure: he is leaving because he achieved the limited objectives he set out in October. As for the war in Syria, it will likely continue to grind on and on, in part because Putin wants it that way. His is a cynical move, but since “victory” by either side would likely result in a retaliatory bloodbath (and a war among the “victors” if Assad is toppled), as horrific as the current situation is, it is not demonstrably worse than the alternatives on offer.

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