Streetwise Professor

October 29, 2009

An Anniversary Worth Remembering

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 9:23 pm

From The Austrian Economists a timely reminder that this is the 50th anniversary of the second of Coase’s three great papers, on the FCC (which presaged his most important paper on social cost).  (Actually, Coase wrote more than 3 great papers by the standards of the profession, but even by his own high standards three stand out.)

It is gratifying to see a case where a scholar produced his greatest research at around age 50, and then has lived another 50 years (and counting) to observe the transformative effect of that work. (What is it about Chicago and great nonagenarian economists, e.g., Director and Friedman in addition to Coase?)

But perhaps not transformative enough, for much has been written and said on public policy and regulation in the aftermath of the financial shock could have been written or said had Coase never lived.  Which is a shame, and which means that it is highly, highly likely that the legal and regulatory changes that do occur will be pernicious rather than beneficial.

Prior to Coase, it was common for economists to argue that market failures necessitated government corrective.  In particular, those operating in the dominant Pigouvian tradition saw externalities everywhere, and recommended corrective taxes (or other mechanisms) to address them.

Coase asked more basic questions: why do externalities exist? and why, if they are so costly, don’t greedy maximizing individuals do something about them?  This led him to the insight that transactions costs are at the root of any supposed market failure; people do not internalize externalities because the (transactions) costs of doing so exceed the benefits.  This does not eliminate the possibility that government intervention can make things better, because government action may entail lower transactions costs than private alternatives.  But once one recognizes that government policy is not (transactions) costless, the Coasean logic necessarily makes any analysis a comparison between imperfect alternatives, rather than a morality play starring a flawed market and a redeeming government.

This, in turn, necessitates a thorough examination of the sources of transactions costs that make market outcomes less than ideal.  This process of examination frequently identifies underlying conditions, such as information asymmetries, that do not disappear with the passage of a law–and which may in fact be worse in a regulated environment.  In other words, it is often the case that if you are think things are bad now, just think how much worse they’ll be when we fix them!

And that is what is largely missing in the current debate.  In the case of the financial markets, among policymakers and many commentators there has been far too little effort made to answer the question implicit in all of the proposals for a root-and-branch restructuring of the system: why did greedy individuals systematically make such costly choices?  For instance, the proposals to completely restructure–and indeed, largely eliminate–OTC derivatives markets presume that market participants systematically chose the wrong institutional arrangements, at huge cost.  From the Coasean perspective, the greed meme used to justify much government policy actually cuts the other way: greedy individuals have strong incentives to find ways to reduce these costs.

In my view, such an evaluation produces several conclusions which should combine to make those eager for a legislative and regulatory restructuring of the markets far more circumspect.  First, there are strong economic justifications for many of the institutional choices.  Second, by failing to understand better why particular institutional arrangements evolved (i.e., what transactional and transactions cost characteristics affected these arrangements), policymakers run the very serious risk of imposing new institutions that are badly adapted to these fundamental characteristics.  Third, many of the most perverse choices resulted from previous regulations and policies.  (The Calomaris interview that I linked to earlier this week in the Friedman post provides several examples.)

Put differently, things as immense and complex as the OTC derivatives markets are emergent orders, complex systems with rich and inscrutable feedback mechanisms.  These orders have evolved to economize on scarce resources–including to economize on transactions costs.  Intervening to change one part of the system, or several parts of it, will have unfathomable consequences.

Before taking the (often irreversible) step of trying to reshape an emergent order by fiat, it is imperative to understand better why it has taken the shape it has.  Using Coasean, transactions cost concepts is an essential ingredient to achieving such an understanding.  It is also a good antidote to legislative and regulatory hubris.  It is, alas, almost completely lacking in the current policy debate, which bodes ill for the future.

The Stratfor Conclusions

Filed under: Economics,Politics,Russia — The Professor @ 8:01 pm

Are basically the SWP conclusions. First, “economic difficulties are affecting Russia’s political structure, and the remedy could break the whole system apart.”  Second, following the Kudrin recommendations of purging the Sechin wise guys from their corporate perches would destroy the equilibrium between the competing clans, and hence Putin is unlikely to do so.  Third, given these realities, Putin’s most realistic options are to either (a) ignore Kudrin’s proposals and retain the status quo in the hopes that the fallout from the economic crisis can be contained (or that a rebound in the world economy gets the rents flowing again), or (b) reform at the edges in order to mitigate the effect of the crisis, but maintain the essence of the system.

Commentor So? dismisses all of this as “astrology.”  I don’t agree.  But if it is, what does it say about a system that is so opaque, so unaccountable, and so (for lack of a better word) effed up, that it is necessary for observers to consult the stars to try to divine what is going on?

Tom McGuire Saves Me a Lot of Typing

Filed under: Military,Politics — The Professor @ 7:20 pm

Mr. Just One Minute shares my incredulity at the Obama Afghanistan decision making “process.” Using a WaPo piece as his jumping-off point, McGuire writes acerbically:

Obama had a strategy review  in March, with a suggestion that  some issues would be deferred until after the Afghan election in August.   Now October is winding down and the Community Organizer-in-Chief wants charts and maps of the various communities to be organized and estimates of the number of  activists troops required to do so.

I am not so bold as to suggest that the Afghanistan problem is even harder than getting the asbestos out of  Altgeld Gardens.   But it seems awfully late in the process for Obama to be operating at this level of detail.   If we settled on a counterinsurgency strategy in March, surely it occurred to people at the time that we ought to have a review of our prospective local partners.

Please tell me that it has not just dawned on Obama in late October that we will be working with “Afghanistan’s provincial governors, tribal leaders and local militias as potentially more effective partners” that the Karzai government in Kabul – working with the locals was a basic part of the successful surge in Iraq and had to have been a basic part of the strategy in Afghanistan.

Either Obama has known of these partnerships for months but is no longer confident delegating that level of detail down the chain of command (troubling), or this is news to Obama (terrifying).   Obama is not stupid, so I am guessing this means he has lost confidence in his generals.   That’s  Kennedyesque!   (Always a good thing for Dems.)   Another possibility is that Obama is deeply unsettled about what to do and is flailing about and micromanaging as an alternative to making a decision.

And criticism is not just for bitter right-wingers any more!  (Hi, R;-) Anthony Zinni (a noted Bush basher) publicly chided Obama for going all Hamlet.  Michael Crowley of The New Republic also expresses angst.  And I could go on.

Delaying a decision makes sense when new information is likely to arrive.  That doesn’t appear to be the case here, and delaying a decision involves many costs, not least to Obama’s credibility and reputation.

My fear is that Obama will choose the moderate course, denying the McCrystal troop request, but maintaining a sizable force in country.  As Admiral Fisher said, “moderation in war is imbecility.”  (This statement is also attributed to Macaulay.)  It’s the kind of approach that nearly turned Iraq into a complete catastrophe before it was cast away and replaced with the Surge.  The status quo leaves the initiative in the hands of the Taliban.

Some have asked, OK, smart guy, what would you do?  (Hi again, r).  I would take the initiative and go large now.  There is no guarantee that it will work, but there is a sufficiently large probability that it will to make it worthwhile to try.  If it does work–great.  If it doesn’t, we’ll know pretty quickly and can reverse course later.  Moreover, it must be remembered that there is a symbiotic relationship between what we do in Afghanistan and what Pakistan does.  The Pakistanis have become more aggressive, and are likely to be emboldened further if we take a more aggressive posture.  That’s a force multiplier.  The situation in Afghanistan started to deteriorate when Pakistan tried to reach an accommodation with the Taliban.  The situation in Afghanistan will improve in large part if Pakistan continues to press in the Tribal Territories.  There is no way in hell the will do that if we take the moderate course, not to mention if we bug out.  Given that potential for positive feedback from a more aggressive US posture, I think it is worth running the risk of following the McCrystal approach.

October 28, 2009

A Nonresponsive Response to TBTF

Filed under: Economics,Financial crisis,Politics — The Professor @ 7:02 pm

Barney Frank and Timmy! Geithner have reached an agreement on a bill intended to reduce systemic risk.  I emphasize “intended to,” because it is by no means clear that it will have that effect.

The WSJ reports that one element of the proposal “would require financial firms with more than $10 billion of assets to pay for the unwinding of a collapsed competitor.”  The Journal continues:

During the recent financial crisis, the government bailed out several large firms at taxpayer expense, fearing their collapse could sink the economy or financial markets. Policy makers hope the new rules will discourage companies from growing too large and would cushion the blow if they collapse.

A future flashpoint: Which companies will have to pay for the collapse of one of their competitors? Initially, the costs of safely unwinding a failing firm would be borne by the Federal Deposit Insurance Corp., based on borrowing from the Treasury Department. But under the proposal, the FDIC would seek to recoup the money from banks with more than $10 billion of assets — a category that includes roughly 120 U.S. banks. The FDIC would likely be able to also recoup money from broker dealers, insurers and possibly even hedge funds.

So let me see if I get this.  Banks that know that taxpayers will bail them out grow too large and take on too much risk.  But banks will be more cautious, won’t grow so large, and won’t take on so much risk if they are assured of being bailed out . . . by other banks?  Huh?  From the perspective of the incentives of the managers of a given financial institution, does it matter where the money to bail them out comes from?  Not bloody likely.

WIth 120 banks (and perhaps broker dealers, insurers, and hedge funds as well) on the hook for the failure of one (or more) of their number, this loss sharing rule will provide little additional incentive for banks to monitor the riskiness or size of other banks, or take actions that would reduce the growth or risk taking of other banks.  Why should a bank incur the costs of taking actions that penalize the risk taking of another bank when (a) it internalizes the entire cost of those actions, and (b) any benefit accruing to such actions is shared by 118 other banks?

Put differently, if there is a too big to fail problem, it is because benefits are privatized and losses are socialized.  Under the present framework, if the ad hoc, seat of the pants approach deserves such a name, losses are socialized broadly among the taxpaying public.  Under the proposed alternative, they are socialized more narrowly, among the claimants of the banks (and other entities) that are subject to being dunned by the FDIC.  Socialization occurs regardless, and as a result, the proposal does nothing to affect the incentives of financial institutions to gamble on somebody else’s dime–because they can still gamble on somebody else’s dime.  Only the owner of the dime changes. Hence my earlier skepticism that the bill will do little to reduce systemic risk.

By itself, this provision will affect the distribution of losses from the failure of a large financial institution, but it is unlikely to affect the frequency or magnitude of those failures because losses are still socialized.  It does not affect incentives in a meaningful way; it affects how the consequences of those incentives are shared.

The relevant question is whether the share-among-120 banks (and others) rule spreads risk more efficiently than the share-it-among-the-taxpayers rule.  I have no strong initial reactions to this choice, though it does seem problematic to adopt a rule that would impair the ability of financial institutions to lend during periods of market stress, as this rule would.  A likely outcome is that the Fed (or the Treasury) would feel compelled to provide assistance to these financial institutions if the additional cost of paying for the failure of other institutions impairs their ability to lend.  Relatedly, it seems odd to fight the alleged effects of financial contagion by creating a new channel whereby the effects of the failure of one institution are imposed on others.

In sum, the first priority of an effort to reduce systemic risk should be to attack TBTF by reducing the socialization of risk.  This piece of the proposal doesn’t do that.

Rather than a serious effort to address systemic risk, this seems to be populist boob bait, a response to popular outrage against taxpayer banking bailouts, rather than a serious attempt to address TBTF.  Not a surprise, and quite understandable, but not a major improvement of incentives.

October 27, 2009

Not So Fast

Filed under: Economics,Financial crisis,Politics — The Professor @ 8:31 pm

I can’t count the number of times I’ve heard that the financial/economic crisis has discredited Milton Friedman and Chicago School economics.  This argument was raised repeatedly during the shrill debate over the creation of the Milton Friedman Center at UC, but it has been made repeatedly in other contexts as well.

I say let’s look at the record.  First consider Friedman’s scholarly work.  Note that one of his most important contributions, with Anna Schwartz in A Monetary History of the United States, was to demonstrate the salient role of the Federal Reserve in causing economic contractions–including the Great Depression.  He subsequently argued quite presciently that Fed policy during the 1960s and 1970s would cause inflation, and were the cause of the inflation that in fact occurred.

If anything, the monetary policy of the 2000s, which played a central role in the 2008-2009 crisis, provides a ringing confirmation of Friedman’s fundamental point about how a discretionary, fine-tuning monetary policy is ultimately highly disruptive and likely to end in economic misery.  The crisis of 2008-2009 would therefore be fertile ground for another chapter-or four–in an updated version of Friedman’s history.  Thus, a compelling argument can be made that the crisis is actually a testament to Friedman’s prescience in warning of the dangers of bad monetary policy.

It should also be noted that in setting monetary policy during the crisis, Bernanke was consciously striving to avoid the Fed’s mistakes of the 1930s–mistakes that Friedman pointed out long ago.  Note too that Bernanke’s own research on monetary policies and depressions owes a great debt to Friedman’s (and Schwartz’s) pioneering scholarship.

One of Friedman’s other seminal contributions–the theory of the consumption function/permanent income hypothesis–has also stood up extremely well.  The temporary tax cut in 2008 was about as close to a controlled experiment of an economic theory as you can get, and the permanent income hypothesis came through with flying colors.  (The effects of the stimulus are much more difficult to test, given that the stimulus occurred simultaneously with a massive monetary policy intervention.)  Also, the sharp decline in personal consumption resulting from the large decline in personal wealth due to the fall in housing prices is just what one would have predicted based on Friedman’s permanent income hypothesis.

Now consider Friedman’s more polemical advocacy of capitalism.  The current crisis is commonly considered to be a resounding failure of capitalism requiring government correction.  But note well: The Great Depression was also widely considered a failure of capitalism, but scholarship emanating from Chicago, much of it done by Friedman, eventually largely refuted that verdict.  As Friedman notes in his joint memoir with his wife Rose, Two Lucky People (p. 41), at Chicago

teachers widely regarded the depression as largely the product of misguided policy–or at least greatly intensified by such policies. . . . During that period, the small minority of economists who did not succumb [what a choice of verbs!] to the Keynesian Revolution consisted disproportionately of Chicago-trained economists.

Friedman’s above-mentioned scholarship on monetary policy during the Depression was instrumental in overturning the conventional wisdom, and convincing most economists that perverse monetary policy and perverse banking legislation was the primary culprit for the onset of the Depression, and its persistence.  Moreover, Friedman was also an outspoken proponent of the view that government policy during the Depression, most notably the NRA and the Wagner Act, by cartelizing the product and labor markets, also undermined normal recovery.  This view has recently received considerable support from the research of Cole and Ohanian.  This goes to show that early, facile judgments that economic crises demonstrate the inevitable failures of capitalism do not necessarily stand the test of time.

It’s not sporting to pick on the dead; or put differently, the silent dead can’t resist the efforts of the living to discredit them.  I daresay that if Friedman were alive today, and in his form of the 1960s and 1970s, those who state with such assurance that the current situation is evidence of the inevitable instability of a capitalist system that requires a firm government hand to fix would have quite a fight on their hands.  And I’d put my money on Friedman.  The thought of him slicing Krugman or Stiglitz to ribbons is too delicious for words.  Alas, it is not to be.  (Not to mention the fact that Friedman had so much more class than those two.)

Friedman’s absence does not mean that the facile snap judgments are going unanswered.   There are many scholars active today that have a decidedly Friedmanesque take on the current crisis, arguing that in fact the events of 2007-2009 (and the years leading up to the explosion of the crisis) are traceable in large part to egregious government failures.  Some of these are monetary policy failures, but others relate to the perverse regulation of the supposedly unregulated banking and financial systems.  And no, I’m not talking about the repeal of Glass-Steagall, or the CFMA.

For a very clear explanation of this view, I strongly recommend this interview (by former colleague and fellow Chicago guy Russell Roberts) with Charles Calomaris.  Charles deftly destroys most of the shibboleths that dominate today’s discourse on the crisis, and makes a very persuasive case that myriad government policies were necessary conditions for the crisis.  These policies (some of the most egregious traceable directly to Barney Frank) created a perverse incentive system that made it rational for banks to do what they did.  All I can say is, listen to this and you’ll realize that the Beltway conventional wisdom is 99.99 percent unadulterated BS.  (His disquisition on Glass-Steagall is particularly choice, making it clear that people as various as Paul Volcker and Mara Liasson–whom I heard blame the financial crisis on G-S repeal last week–have no clue.  None.  Zero.  Zip.)

The Calomaris interview is long, but worth it.  If for nothing else, it is worth it to hear him tell, with considerable relish, the story of how Joe Stiglitz and Peter Orszag (now Obama’s head of OMB, who presumes to tell us the best way to reorganize the entire health care system) wrote a paper for Fannie Mae in which they confidently stated that the probability that Fannie or Freddie would ever cost the taxpayers a penny “was essentially zero.”  Calomaris says that they were right!  It didn’t cost a penny!  It cost $350 billion.

Keep that in mind the next time you hear Stiglitz bloviate on the crisis, or regulation, or the financial system, or capitalism.  Or whether the sun rises in the east.

Even though Russ Roberts is sympathetic to Calomaris’s arguments, he is a good interviewer, and challenges him repeatedly.  Another reason for listening.

As I’ve said over and over, the great lesson of the Great Depression was that people learned the wrong lessons from the Great Depression.  Milton Friedman was instrumental in helping us unlearn the wrong lessons, and grope for the truth.  There are many parallels between the thirties and the noughties, and I think that two of the most important ones are the rush to heap responsibility on the market system and the related drive to swell the power of government.  Some of the blame the market-laud the government sentiment is intellectual error; some (probably more) is an opportunistic power grab.

Those who are so anxious to dance on Milton Friedman’s grave today should remember that the easy verdicts of lazy minds about the Depression did not withstand the power of his scholarship.  They should take this as a lesson, and consider the very real possibility that their easy, lazy verdicts about the implications of the recent crisis are similarly vulnerable.


Filed under: Economics,Financial crisis,Politics,Russia — The Professor @ 4:47 pm

The Stratfor articles on the Kremlin clan wars do not break any new ground, but they provide a useful summary of what goes on under the Kremlin carpets.  Their main thrust is that the GRU-centered clan, which includes Gazprom and which is led by Vladislav Surkov, is attempting to enlist the “ciliviki”–the (relatively) liberal reformers including Kudrin and Gref (and perhaps Medvedev)–to undermine the FSB-centered clan which includes Rosneft and the big state corporations which is led by Igor Sechin.  Kudrin et al have an extremely strong economic case against the FSB goonocracy and its statist, centralized, resource rent-driven model.  Surkov, it appears, has no such basis for his opposition to Sechin and the FSB crowd; after all, he comes from the GRU (military intelligence), so he just represents the competing goon squad looking to maximize its share of the loot.

The advent of the Putin-Medvedev tandem led to much discussion of the stability of duumvirates.  But if Stratfor is correct–and it presents a plausible case–Russia is actually dominated by a triumvirate.  History suggests that triumvirates are truly unstable, as there is always the temptation for two to get together and gang up on the third.  Cf., Caesar, Pompey, and Crassus.  Or, better yet in the Russian context, Stalin/Bukharin, Trotsky, and Kamanev/Zinoviev, which Stalin played like a fiddle to eliminate first Trotsky and then Kamanev and Zinoviev, before turning on his erstwhile ally Bukharin.

It is hard to imagine the most hopeful outcome, which would involve the defeat of both security-service clans, and the dominance of the ciliviki.  I concur with Stratfor that eminence grise Surkov is merely looking to use Kudrin et al to strike at their common enemy–Sechin and his allies.  If that were to succeed, the ciliviki would be powerless before Surkov and his henchmen.  Lacking an independent power base, and importantly, control over any force structure, it is almost impossible to imagine a scenario in which the ciliviki can prevail over the two power clans.  They can be decisive in the battle of one power clan against the other, perhaps, but once that battle is decided they are vulnerable, alone, and defenseless.

Stratfor suggests that Putin would like to continue to balance Surkov and Sechin, and that makes perfect sense.  What makes this much more complicated is the economic and financial crisis, which Kudrin and his allies (including Medvedev, at least in words) have forcefully argued reveals the ultimate unsustainability of the statist model.  But siding with Kudrin and striking against the Rosneft-state corporation nexus would undermine the Sechin clan, and destabilize the entire edifice.

My guess is that for lack of a better option, Putin will try to maintain the status quo.  Even if he believes that Kudrin is right, and the current model dooms Russia to a dismal economic future, acting on his advice and attacking the Sechin interests would almost certainly spark chaos and conflict that could result either in a bloody stalemate, or the dominance of one security clan or the other.  Conversely, if there is some possibility that Kudrin is wrong, and the system can muddle along without economic collapse, such conflict can be avoided.  Put differently, attacking Sechin will result in destabilization and conflict with a probability near one, whereas muddling through will result in such an outcome with a smaller probability, where that probability is in large part dependent on factors outside of the control of anybody in Russia, including the world economic recovery and hence the prices of raw materials, and the willingness of foreign investors to return to Russia.

Such is the logic of the natural state.  Accepting stasis and stagnation, with the likelihood of pronounced decline, while reducing the potential for conflict, is preferable to taking actions that are economically sensible but which would upset the delicate political equilibrium that keeps violence in check.

Why Orwell Was Born

Filed under: Politics,Russia — The Professor @ 3:43 pm

The furor over the paean to Stalin in the refurbished Moscow Metro has officials scrambling for balance.  And what better way to balance one mass murderer with another!  And a syphilitic one, no less!  The quote chosen (from the 1943 Soviet anthem–also the source of the Stalin wet kiss) is priceless: “Through tempests shone on us the sun of freedom,/And the great Lenin lighted the way.”

Freedom!  With Lenin lighting the way!

Come to think of it, Orwellian doesn’t seem to quite cover it.

Bonus content:

Thinking about shafts of light in the darkness, and VD, brings to mind this snippet from the classic Monty Python Oscar Wilde skit:

Yes, thank you. Right, Your Majesty is like a stream of bat’s piss.


It was one of Wilde’s.
It sodding was not! It was Shaw!
Well, Mr. Shaw?
I, um, I, ah, I merely meant, Your Majesty, that, ah, you shine out like a shaft of gold when all around is dark.
Oh, ho-ho, very good.
Right. Your Majesty is like a dose of clap.


Before you arrive is pleasure, but after is a pain in the dong.
I beg your pardon?
It was one of Wilde’s.
Well, Mr. Wilde?
Come on, Ozzy.
Uh ….. uh, wha-, wha- …..
Come on, Ozzy, now, tell us all about it.
Wha-, what I meant, Your Majesty, uh-h-h …..

(general heckling from the crowd)

Let’s have a bit of the old wit then!
What, what-
I’m waiting.
What I-, what I meant was …..
Come on, Ozzy, …..
Give us a bit of the wit, Oz.
Um, w-w-what I meant, Your Majesty, w-was ….. oh …..  (blows a raspberry)

October 26, 2009

Excellent Observations From a Couple of My Faves

Filed under: Economics,Politics,Russia — The Professor @ 8:47 pm

The always excellent Richard Fernandez at Belmont Club echoes a theme that I addressed in my post on the Critical Review’s special issue on the financial crisis, to wit, how government regulation tends to impose a variance-reducing standardization that by reducing diversity perversely increases systemic risks:

One of the arguments for centralizing power in government is that it reduces variance. People get ‘standard’ care, which is ‘equitable’ and predictable. This is contrasted with the wider distribution of outcomes when the same decisions are left to individuals. In the health care debate for example, there are people who obviously get great health care and others who get relatively bad insurance. Wouldn’t it be better if the variance were reduced by a government program?

Left out of this argument is the idea of systemic risk. Leaving decisions to individuals makes it unlikely that they will all get it right but it equally implies they almost never get it all wrong. Society based on individual choices has a diversified portfolio of outcomes. In contrast if a government gets it wrong, it goes spectacularly wrong. Let’s forget about Fannie Mae and Freddie Mac for a moment; turn our eyes away from Barney Frank and look across the Atlantic to the UK’s ironically named  Office of the Public Guardian.

Just so.

Mark Steyn poses a question that I’ve thought about too: what explains the disconcerting contrast between the Obama administration’s Alinsky-esque heavy-handedness in confronting its domestic opponents (or is it enemies?) and its  pusillanimity in dealing with avowedly anti-American regimes abroad?:

Who are the real “Untouchables” here? In Moscow, it’s Putin and his gang, contemptuously mocking U.S. officials even when (as with Secretary Clinton) they’re still on Russian soil. In Tehran, it’s Ahmadinejad and the mullahs openly nuclearizing as ever feebler warnings and woozier deadlines from the Great Powers come and go. Even Obama’s Nobel Peace Prize is an exquisite act of condescension from the Norwegians, a dog biscuit and a pat on the head to the American hyperpower for agreeing to spay itself into a hyperpoodle. We were told that Obama would use “soft power” and “smart diplomacy” to get his way. Russia and Iran are big players with global ambitions, but Obama’s soft power is so soft it doesn’t even work its magic on a client regime in Kabul whose leaders’ very lives are dependent on Western troops. If Obama’s “smart diplomacy” is so smart that even Hamid Karzai ignores it with impunity, why should anyone else pay attention?

The strange disparity between the heavy-handed community organization at home and the ever-cockier untouchables abroad risks making the commander-in-chief look like a weenie — like “President Pantywaist,” as Britain’s  Daily Telegraph has taken to calling him.

The Chicago way? Don’t bring a knife to a gun fight? In Iran, this administration won’t bring a knife to a nuke fight. In Eastern Europe, it won’t bring missile defense to a nuke fight. In Sudan, it won’t bring a knife to a machete fight.

But, if you’re doing the overnight show on WZZZ-AM, Mister Tough Guy’s got your number.

Not one of Steyn’s best columns (admittedly compared to a very high standard), but a fair point nonetheless.

Sausage Making

Filed under: Commodities,Derivatives,Energy,Exchanges,Financial crisis,Politics — The Professor @ 8:26 pm

The amendment that would have limited dealer ownership of clearinghouses to 20 percent  has been stripped from Barney Frank’s OTC derivatives bill:

In a bill passed last week by the House of Representatives’ financial services committee to reform the  over-the-counter derivatives markets, an amendment was inserted at the last minute by Massachusetts congressman Stephen Lynch that appeared to limit the stake banks could collectively own in a clearing house to 20 per cent.

. . .

Susan Milligan, special counsel at the OCC, said it was “purely anti-competitive” and would have favoured for-profit clearers compared with quasi-utility clearers like the OCC.

Steve Adamske, spokesman for the financial services committee, said on Thursday the 20 per cent limit had intended to limit dealer control of clearing houses but legal experts had decided it was invalid as it conflicted with another amendment.

The bill would, however, limit to 20 per cent the voting rights of dealers for “designated contract markets, exchanges and alternative swap execution facilities” – and not for clearing houses.

Wonderful, isn’t it, to observe the careful deliberation with which our Solons weigh decisions that affect trillions of dollars of risk exposures?  Just throw a bit of offal into the grinder–who’ll notice?  And at whose behest was this inserted?

Legislators react with high dudgeon to bankers’ cavalier attitudes towards risk and limited accountability, but they run far greater risks with other people’s money with virtually no accountability every day.  They have no room to talk.  Whatsoever.

October 25, 2009

Prestigious, But Singularly Unpresuasive

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 10:27 am

New York University Stern School of Business professors Aarya, Engle, Figlewski, Lynch, and Subrhmanyam (AEFLS) contributed a chapter advocating centralized clearing of credit derivatives in the recent volume Restoring Financial Stability: How to Repair a Failed System edited by Acharya and Richardson. Although the authors are a distinguished lot, they utterly fail to make the case. Here are a few of the problems with their analysis:

  • Their argument rests on the propositions that (a) due to the interconnectedness of the financial system and the implicit public subsidy of systemically important financial institutions, the default by a CDS transactor can impose costs on others, and (b) a clearinghouse can internalize this externality. As a matter of logic, second best considerations imply that even if these propositions are true, they do not support the claim that creation of a clearinghouse (central counterparty) for some derivatives products is efficiency enhancing. As I discuss in more detail momentarily, AEFLS’s propositions imply that such externalities are present in every transaction that systemically important institutions undertake. In such circumstances, it is well known that internalizing one of many externalities can reduce efficiency, rather than improve it.
  • Indeed, second best concerns may be most acute when a CCP addresses only one narrow segment of the market—e.g., CDS—as AEFLS do.
  • Even under the AEFLS proposal of mandatory clearing of some of the risks that big financial institutions undertake (i.e., the clearing of only some derivatives), the CCP will only see a sliver of the risk exposure of its member firms. Given that overall portfolio risk determines the systemic risk posed by a financial institution, a CCP will have neither the information nor the incentive to price risk (through its collateral or position limit choices) efficiently (which would require understanding and pricing all of the externalities). Indeed, raising the price of default/counterparty risk on one sliver of transactions can induce banks to substitute to other transactions that impose equal or greater external costs. [The analogy to multitasking agents is apt here. Giving high-powered incentives to such an agent on one dimension can have extremely perverse effects on the allocation of effort. ]
  • That is, the AEFLS argument proves too much. Or put differently, under the AEFLS theory, every loan, every investment, every dollar of interbank borrowing, every capital structure choice by a big financial institution is beset by externalities. Their logic, in a sense, compels them to conclude that market-based allocation of capital through financial intermediaries is inefficient, and that a centralized mechanism is required to ensure that financial institutions do not take on inefficiently large risks. Everything through a clearinghouse!
  • Now, there is some merit to the view that in a world of Too Big To Fail or other implicit or explicit subsidies to bank risk taking that there are (potentially large) externalities. But the foregoing means that a CCP, and especially a CCP focused on a relatively narrow range of products, is a highly defective means of addressing this externality problem. It is defective because it is incomplete, and in a world with multiple externalities, or multiple decision margins with external effects, partial and incomplete internalization does not necessarily enhance welfare.
  • Instead, if externalities in financial intermediation are an important concern, it is preferable to devise policies that either (a) eliminate the common source of the externalities (i.e., eliminate the TBTF subsidies that encourage the excessive risk taking), or (b) price all risks consistently across all decision margins and all decision makers. With respect to (b), this would entail theoretically setting capital charges or risk haircuts based on the entire portfolio of systemically important institutions. I say “theoretically” because measurement issues make this impractical. What’s more, institutions themselves will almost certainly have better information about portfolio risks, and crucially, the marginal contribution of a given transaction or class of transactions, to portfolio risks than will the regulators that set the capital charges/haircuts. This gives rise to adverse selection problems in which institutions load up on risks that they know are underpriced and avoid ones that they know (based on their private information) are overpriced. Moreover, as demonstrated with the Basel requirements that made it very attractive to invest in AAA CDOs, incorrect, centrally-set, universally applicable capital charges can induce institutions to engage in highly correlated investment strategies that exacerbate systemic risk.
  • [Parenthetically, some (including the EC and the US Treasury) propose applying different capital charges to OTC and cleared deals. This is mystifying. If a deal with given characteristics is executed by financial institution A, the effect of that trade on default losses (across all deals that A does) is the same, regardless of whether the deal is cleared or not. Clearing merely affects the allocation of those losses. Indeed, the clearing can exacerbate the systemic consequences of A's default. For in a clearing structure, the members of the clearinghouse bear the effects of A's default, whereas in an OTC structure, counterparties do. Since CCP members are likely to be systemically important institutions, clearing can actually increase the financial cost of a default by A to these other institutions. That is, if A deals with hedge funds OTC and defaults, the hedge funds lose. If A deals with hedge funds, and those deals are cleared, when A defaults the hedge funds are protected, but the CCP members incur a cost.]
  • AEFLS also fail to come to grips at all with the information asymmetries and heterogeneity-induced collective action problems that CCPs must face when setting collateral levels.  I’ve beaten that horse’s corpse to a pulp, so I’ll just suggest that those interested in the argument enter “clearing” into the search bar and while away too many hours reading what pops up.
  • To put it as succinctly as I can, AEFLS ignore altogether any analysis of the challenging problem of understanding how CCPs will act in practice, given the information and incentive issues that they must confront.  Instead, as is sadly too often the case in CCP advocacy, in AEFLS clearinghouses are a deus ex machina that descends on the financial stage to resolve all of the dilemmas confronting the financial markets.
  • AEFLS assert that it is desirable to establish margin levels that “ensur[e] minimal, near zero counterparty risk.” They have no basis whatsoever for concluding that zero CP risk is efficient. Indeed, it is almost certainly not the case, just as it is not the case that it is efficient to ensure that flying is perfectly safe. Reducing risk is costly. The necessary task is to balance the costs and benefits of risk reduction. For instance, in a clearing setting, setting margins equal to the maximum possible loss would eliminate counterparty risk. But collateral is costly. As a result of draconian margins, transactors would forgo some trades—including some trades that could reduce systemic risk (e.g., hedging trades that transfer risk efficiently). It is imperative to avoid such simplistic “zero risk” thinking of the type that AEFLS indulge in. The real world is about trade-offs, and those trade-offs must be acknowledged and considered in evaluating public policy.
  • AEFLS recognize that they have to have an explanation as to why CCPs must be mandated if they are such a great thing. They make a rather limp effort on p. 258, stating that “[l]arge players benefit from the lack of transparency in OTC markets since they see more orders and contracts than other players do.” They seem to be arguing that the lack of transparency generates higher profits for dealer firms, and this induces them to resist clearing. Indeed, they have to argue that this private benefit from opacity is so large that it exceeds the benefits that these firms could obtain through better pricing of counterparty risk, netting, etc. (Not that I agree that these benefits exist—that AEFLS do is the point.)
  • I made a similar argument over a decade ago, positing that resistance to clearing could be due to a “raising rivals’ cost” strategy.
  • I am far from persuaded by these arguments, however, both on theoretical and empirical grounds.
  • Theoretically, well hell, big players in every industry want to maintain market advantages that allow them to reap market-power profits. That’s why GM dominates the car business today, and is enormously profitable. Just kidding.
  • Taking AEFLS seriously, they posit that the existing market structure inflates the costs of those trading with dealers relative to costs that could be achieved by trading in a more transparent structure. This creates an incentive for institutions offering more transparent mechanisms to enter the market, thereby reducing trading costs for the dealers’ current customers, and inducing them to trade on the new transparent mechanism rather than the more costly dealer market. Indeed, note that exchanges with central clearing have tried to compete with dealers in CDS trading—and failed miserably even in relatively simple index products.
  • One could argue (though AEFLS do not) that this could reflect the effect of network externalities which create a coordination problem; an alternative system is more efficient than the incumbent (dealer) system if it attracts enough traders to supply liquidity, but it is costly to coordinate the necessary movement of such a number of traders, leaving the inefficient incumbent in place.
  • However, in other segments of the derivatives market, there are exchange traded instruments that are close substitutes for OTC products, yet the OTC market has maintained or increased market share. Eurodollar futures and interest rate swaps are one example. Ditto many FX products and equity derivatives, including equity options. For these markets, there is a closely related, highly liquid exchange traded product, but many prefer to contract in OTC markets instead. Why would market participants agree to be screwed by dealers if the dealer structure is so inefficient, and if dealers profit at their customers’ expense due to opacity and reduced competition? It is incumbent on those advocating a forced change in market structure to answer that question forthrightly and persuasively. AEFLS don’t. Nor do most of the mandate mandarins in Congress, Treasury, or the EC.
  • Relatedly, note that bilateral dealings prevail in many markets where margins are extremely thin, and dealer profits are commensurately small. For instance, bilateral dealings are quite common in vanilla interest rate and FX and equity derivative trades where spreads are very small. In vanilla IR swaps, about 50 percent of interdealer trades are cleared, and since dealer-customer trades are typically not cleared, less than a majority of vanilla IR swaps are cleared. Clearing of vanilla FX swaps is non-existent, and many equity derivative trades are not cleared. Given the competition in these markets (where a large number of institutions actively bid and offer to trade vanilla swaps), the “we don’t adopt clearing to protect profits” hypothesis is quite dubious.
  • That is, although low margins appear to be a necessary condition to result in a migration of products to clearing, they are not a sufficient condition. This calls into question the theory that the failure to adopt clearing is the result of the exercise of market power by self-interested dealer firms looking to preserve their profits.
  • It must also be noted that neither opacity or systemic risk externalities related to TBTF are necessary to explain failures to adopt clearing.  As I noted in an FTAlphaville article over the summer, the CBOT steadfastly refused to adopt clearing for 35 years even though it operated a highly liquid, transparent, centralized exchange.  The same was true of the LME; it failed to adopt clearing until forced to do so even though it also operated a transparent auction market.  Moreover, neither the CBT members nor the LME members were TBTF institutions benefiting from implicit or explicit public subsidies.
  • The experience in energy markets, in which post-2003 (and post the 2002 merchant energy meltdown) the market by its own devices migrated to clearing also demonstrates that there are not insuperable obstacles to the organic development of clearing, sans mandate.
  • Thus, a serious attempt to understand why clearing has not been adopted more widely by voluntary consent must at least contemplate the possibility that bilateral dealings offer some efficiency benefit that must be traded off against alleged external costs when determining whether compulsory adoption of clearing is justified. This AEFLS—and the rest of the mandate mandarins—signally fail to do.
  • Several other issues in AEFLS deserve comment.
  • First, they assert, rather than prove, that the correlation in financial institution CDS spreads demonstrates the existence of a contagion effect (p. 256—the use of the “interconnectedness” concept in this context is the key). This is a hypothesis (at best), not a fact. Exposure to a common risk can do so as well. Indeed, Jean Helwege (in a recent Regulation Magazine piece) argues persuasively that the contagion effect is vastly overstated, and the common-risk exposure effect is the real explanation for the CDS spread correlation that AEFLS discuss. As I mentioned before, virtually all major financial institutions made correlated investments in AAA MBS CDOs.  When these tanked, so did the banks (and AIG).  No need to invoke contagion.  Indeed, this raises the very real possibility that more centralization and standardization can increase systemic risks.  Since clearing entails just such an increase in centralization and standardization . . .
  • Second, they use the difference between the CDS spread and an equity implied spread produced by Hayne Leland based on a particular model to argue for the existence of “counterparty risks and clearing concerns.” To which I say: when given a choice between the market and a model, I choose the market every time (with all due respect to Hayne Leland). Moreover, this could just be a manifestation of the market price of risk which causes deviations between default rates implied by CDS (which are the default rates in the equivalent, pricing measure) and default rates in the true, “physical” measure.  Given the non-linearity of a CDS exposure, and its strong correlation with overall market conditions, it is very plausible that the market price of risk was large and increasing during the period of the crisis.  (A CDS on a Goldman or other big financial firm was akin to a short put on the market.  Such an instrument has a very high systematic risk exposure, which will lead to a substantial divergence between default rates in the true and pricing measures.)
  • Third, they use the AIG episode repeatedly. They ignore the equilibrium implications of the alternative histories that they contemplate (unlike what I have done in It’s a Wonderful Life: AIG Edition and in a recent comment in Regulation.) And again: the plural of anecdote is not data. Moreover, one episode is insufficient to base a restructuring of an entire system based on one episode, and even if this particular episode is so egregious, it is necessary to consider alternative ways of preventing its recurrence. This AEFLS do not do.

In sum, AEFLS fail completely in making a coherent economic case for mandated clearing, especially for a subset of OTC derivatives like CDS. They ignore crucial economic considerations and blithely overlook fundamental trade-offs. If there is a case for mandated clearing, I’d love to hear it. I haven’t heard it yet—least of all from this distinguished group of NYU-Stern professors.

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