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Streetwise Professor

February 28, 2011

Bug or Feature?, or Bootleggers and Baptists Go To Russia

Filed under: Economics,Politics,Russia — The Professor @ 9:16 pm

In 2009, Russia banned casino gambling, except in some godforsaken places far away from where actual people live in any numbers.  Surprise, surprise, surprise: As a result, illegal gambling has exploded in Russian metropolitan areas, apparently with the connivance of “law enforcement” officials.  Recently, the Moscow Region Prosecutor and several deputies were suspended for suspicion of involvement in a massive gambling ring.

Russia Profile writes that the law actually increased corruption and the strength of gambling syndicates:

The law actually served to strengthen underground gambling rings, emboldening criminal elements and serving as a greater source of rents for corrupt police, said Evgeny Goroshko, a lawyer and representative of the Gaming Business Association. “Many illegal enterprises must function with the protection of the security services. And before they instituted a law like this one, they should have thought ten times – or as they say ‘measure twice, cut once’ – because we have an extremely corrupt system and everyone understood this perfectly. I personally thought ‘why is the government regulating the gambling business?’ Well, basically to shut down the legal sector and create an illegal one.’

RP further suggests that the investigation of the prosecutors was not the result of a sudden spasm of probity, but instead the consequence of conflicts between competing investigative authorities.

It’s no shock that the law has actually encouraged lawlessness and stoked corruption.  The fact that such a result was so predictable suggests that this was part of the plan.  I have been told by people who were involved in the “gaming industry” in Russia pre-ban that even legal operations had to pay to survive.  But “banning” the activity only enhances the authorities’ opportunities for personal enrichment.  Thus, it is more than plausible that this was a major reason behind the ban: that is, many of the ban supporters didn’t intend to reduce gambling, but to increase their take from it.

No doubt there were some in Russia who sincerely believed that banning gambling was a desirable social goal.  But just as bootleggers in the American South who profited from the banning of alcohol benefited from the well-intentioned efforts of Baptists to drive out the demon rum, the sincere opponents of gambling in Russia were played, and played well, by those who cynically saw the ban as an opportunity.

Keep this in mind any time you read about any campaign in Russia to stamp out a vice.  Not just in Russia, clearly (as illustrated by the Baptists and Bootleggers parable), but given the endemic corruption of legal structures in that country, the likelihood is far higher there that any anti-vice campaign is actually a cynical ploy.

No SPiderR Sense

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 8:55 pm

The lack of a coherent Strategic Petroleum Reserve strategery has apparently been an issue for quite awhile.  John McCormack points me to something he wrote for Regulation in 1996:

Owners of above-ground crude oil and refined product inventories have an important role to play. It was just such a role that the Strategic Petroleum Reserve (SPR) was meant to serve but has not. While it has accumulated a crude-oil stockpile of well over half a billion barrels, the SPR has never had a coherent, systematic strategy for selling crude oil during periods when prices spiked upwards. Only small amounts were sold from the stockpile during the 1990-91 Persian Gulf War, and then only after prices had begun to decline from their peak. For the stock- pile to have been of any use during periods of distress, SPR managers needed to have a coherent strategy in place and should have communicated their intentions beforehand. Part of the Energy Department’s reluctance to sell barrels from the SPR resulted from fears that they would be reducing the stockpile before the shortage was greatest. They could have avoided this problem by doing time swaps that would not permanently reduce the stockpile.

The Senate Permanent Subcommittee on Investigations published a report in 2003 (almost exactly 8 years ago, in fact) that also ripped the SPR for its failure to act in a commercially reasonable way, thereby distorting oil prices.

Given that a Cato publication and a Carl Levin-chaired committee came to identical conclusions, I think it’s safe to say that SPR has not operated according to sound economic principles.

The SPSoI report also has a lot of stuff on manipulation, including a lot of quotes/cites from me before I was SWP :)  I talked extensively with one of the staffers who authored the report while he was preparing it.  I haven’t read it in years and on re-reading was kind of taken aback to see how much of what I told him made it into the final report.  So, even if I do say so myself, it’s a pretty good primer on manipulation generally, and oil market manipulation more particularly.

February 27, 2011

Arithmetic Masquerading as Analysis

Filed under: Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 9:04 pm

Numerous futures markets heavyweights, including CME, ICE, and BlackRock are up in arms over a CFTC rule that would require delisting of a futures contract that had more than 15 percent of its volume traded outside the exchange’s central order book.  Their opposition–anger, really–is justified.

The Commission’s logic is that it wants to protect the price discovery process in centralized markets.  It recognizes that block trades and other off-exchange trades can mitigate price impact on large transactions, e.g., in hedging trades.  Verifiably uninformed traders have an incentive to trade off exchange because this allows them to avoid paying the adverse selection-related costs incurred in an anonymous market; it can also reduce execution risk.  Loss of some uninformed order flow reduces liquidity on the centralized market, and can reduce the informativeness of the prices on that market.

Quantifying the impact of all these changes is impossible.  Much of the effect is to transfer wealth from one group of uninformed traders (those who trade on the centralized market) to another (those who can avail themselves of the block market or other off-exchange trading venues.)  In my JLEO “Market Macrostructure” paper I demonstrate that the net effect can be positive, i.e., the benefit to the latter can exceed the loss suffered by the former.  The cost of a decline in price informativeness cannot be quantified.  Period.  Moreover, even here things are ambiguous.  A decline in the amount of uninformed trading on the central market tends to reduce the amount of informed trading–that’s why price informativeness declines.  But some informed trading is rent seeking–it involves spending real resources to acquire information in order to achieve a transfer of wealth.  This is inefficient.  Reducing this activity actually improves welfare.

In other words, nobody knows how much block trading/off-exchange trading activity is the right amount.  Least of all the CFTC.

One thing is for sure, though.  The marginal cost of block trading doesn’t become infinite when block trading volume is 15 percent of the total.  But that is what the CFTC rule implicitly assumes.  Moreover, even if the marginal cost (including all relevant costs and benefits) of block trading is positive when it totals 15 percent of volume, shutting down the centralized market if block volume exceeds 15 percent makes no sense at all.  A market with “too much” block trading activity still contributes to price discovery.  It still provides a cheaper place to trade than no centralized market at all.  Maybe its value isn’t maximized when there is too much block trading, but shutting it down sure does minimize its value.  It’s like cutting of your nose to spite your face.

Presumably the CFTC believes that no market will ever be shut down.  That any exchange facing delisting of a contract will change the block rules (e.g., increasing the minimum block size) in order to reduce block trading and avoid a shutdown.

But in adopting this change-your-rules-or-the-contract-gets-it strategy, the CFTC presumes that it knows the right amount of block trading.  It knows no such thing.  Indeed, the basis for its threshold is purely arbitrary–a joke, actually:

In the second largest category, involving 128 contracts from all asset classes which included contracts with large and small open interest, the average amount of off-exchange trading over the three-month period ranged from 0% to 15%. The Commission believes that this second category of contracts, where there was actual centralized market trading to observe, provides a reasonable basis for establishing a minimum centralized market trading requirement. Accordingly, from this second category the Commission took the upper range of the maximum average amount of off-exchange trading, and proposes that a maximum of 15% of total trading volume of a contract would be an allowable amount of off-exchange trading in order to protect the price discovery process of trading on the centralized market.

So, the staff looks at some historical numbers for historical off-exchange trading activity (including, apparently, exchange for physicals and exchange for swaps, etc.), the Commission picks a number at the top of the range, and declares it “reasonable” to apply this number to all markets going forward.  That’s not analysis: that’s arithmetic.  It involves no serious consideration of any of the relevant issues and trade-offs relating to on- and off-exchange trading.

The opposition of the exchanges is particularly interesting here.  Exchanges internalize many of the effects of their block trading and EFP rules.  To the extent that block trading reduces liquidity on the centralized market, it reduces the derived demand for trading on that market–and hence reduces the fees an exchange can charge and the quantity of trades there, which combine to reduce the exchange’s revenue from that source.  It can collect revenues from block trades; these revenues reflect the benefits that block trading provides.   Through the effects of its rules on these different revenue streams, the exchange internalizes, albeit perhaps imperfectly, the costs and benefits of those rules on execution costs and liquidity for alternative ways of completing trades.  (This is different, I would add, from internalization or third markets, where a third party “skims” uninformed order flow and does not internalize the effects on the liquidity of a central market.)  Thus, the exchange is in a much better position to know, and has a stronger incentive to know, the liquidity effects of block rules than does the CFTC.  It can balance and has the incentive to balance these effects to craft an efficient rule.  This argues strongly in favor of letting the exchanges make their own rules.

Exchanges don’t directly internalize any benefits flowing from more informative prices.  Nobody does–including the CFTC.  The rent seeking argument I mentioned above means that these benefits may not even be positive–they may be negative, once the costs of information are taken into account.  Imposing an entirely arbitrary standard based on a calculation that a fifth grader could make, and which cannot–cannot–quantify even approximately the benefits and costs at issue is an act of regulatory overstretch that is far too characteristic of this Commission.  It denies those who have some information about some relevant costs and benefits–the exchanges, with regard to the effects of the rules on trading costs–from taking that information into account when establishing their rules.  It substitutes its own judgment for what is the “right” amount of off-exchange trading when that judgment is predicated on complete ignorance.

The Commission has a lot on its plate.  The Commissioners, with some justice, complain about their crushing work load repeatedly.  Here’s a suggestion: they can lighten their burden by avoiding dealing with issues about which the Commission completely lacks the information necessary to craft constructive regulations.  The off-exchange trading rule is a perfect example of that.  One can have nice philosophical arguments about these issues, but a rational regulatory triage strategy would relegate such debates to academics and focus on more pressing matters about which it is possible to get enough information and knowledge to craft sensible rules.

I’m not holding my breath.

February 25, 2011

So Just What is the Strategy of the Strategic Petroleum Reserve?

Filed under: Commodities,Economics,Energy,Politics,Regulation — The Professor @ 7:23 pm

Today’s WSJ online has a short piece quoting Daniel Yergin counseling against tapping the Strategic Petroleum Reserve in response to Mideast turmoil. Yergin argues that it is desirable to keep the stockpile untouched as a hedge against the possibility of worse disruptions in the future. Insofar as commercial storage is concerned, economic theory highlights two factors that are relevant in determining the optimal timing of adding to or drawing from inventories. My forthcoming book goes into these factors in detail.

The first is that it is optimal to draw down on storage in response to adverse supply shocks that are expected to be transitory. This means that current supply is below expected future supply, making it less desirable to hold inventories to meet future consumption needs. Well-functioning markets move things from where they are relatively abundant to where they are relatively scarce. A temporary supply shortfall means that the present has become more scarce, relative to the future, making it desirable to shift some consumption from the future to the present. When some inventories are available, this intertemporal shift can be achieved by drawing down on stocks.

In contrast, supply shocks that are expected to persist should have minimal impacts on storage decisions as such shocks do not affect supply today relative to what is expected in the future. Since scarcity today relative to future scarcity isn’t affected by a highly persistent shock, there is little or no need to change inventory to move consumption from the future to the present.

The second factor is uncertainty about fundamentals. Inventories are in part a hedge against uncertainty about future demand and supply conditions, a buffer against adverse supply or demand changes in the future. An increase in uncertainty about future supply increases the precautionary demand, leading to an increase in inventory holdings. This is the factor that Yergin emphasizes, and which I analyze in detail in chapter 5 of the forthcoming book.

In the current situation these considerations are in conflict. It is likely that the effect of the effect of the loss of Libyan production will be relatively transitory as this production will be brought back on line when the situation, which appears to be reaching a climax, stabilizes, and because other suppliers, notably Saudi Arabia, have pledged to expand output. This would tend to cause a decline in inventories. On the other hand, the risk of future supply disruptions—not excluding major disruptions in Saudi Arabia—has increased dramatically. This would tend to lead to an increase in inventories.

Movements in the forward curve suggest that the first effect is dominating. The contango in WTI has declined and Brent has also moved into a backwardation. The WTI curve has become slightly humped at the short end. Such moves are associated with declines in inventories.  That said, the effect of the increased uncertainty has probably led to smaller stock drawdowns.

The foregoing relates to commercial storage decisions. SPR is not operated on a commercial basis. That said, it would probably make sense to take commercial considerations into account when making storage decisions, if only to reduce the cost to the taxpayer. The fact that SPR is not operated on commercial principles, but is a political animal with difficult to predict decisions likely has some feedback effects on commercial storage decisions; with respect to politics, some, such as MA Rep. Markey, are calling for the SPR to release supplies into the market. Commercial storers have to take into account their expectations about SPR actions when deciding how to make their own storage decisions.

It would seem to be very hard to predict what SPR will do given its political-military nature. Clarifying SPR’s operational methodology would assist private parties to make rational storage decisions that would assist in reducing price volatility.

February 23, 2011

So Much for the Honeymoon

Filed under: Economics,Energy,Politics,Russia — The Professor @ 2:28 pm

In an interview with the WSJ, Igor Sechin pointedly suggested that Rosneft would like a seat on the BP board of directors (in exchange for a seat on the Rosneft board).

Seats on the board aren’t an “oh by the way” kind of thing.  They are the kind of thing that would normally be negotiated as part of a deal, and decided definitively before the deal was finalized.   Moreover, the I’ll give you a seat if you give me one is hardly balanced, given that as part of the stock swap Rosneft gets 5 percent of BP but the British company gets 9.4 percent of Rosneft.

So what does Sechin’s suggestion mean?  Is this hardball?: “Thanks for that deal.  Now I want more.”  With the implicit threat that if the request is not met Sechin and Rosneft may not be as accommodating as BP expected.

Or could this be a response to the BP’s difficulty with its TNK-BP partners?  Sechin discussed these difficulties during the interview.  One interpretation is that the board seat is Sechin’s price for making those troubles go away.  Or at least part of the price.

And if this is what Sechin is doing, I have to wonder whether he might have a hand in exacerbating those difficulties.  Perhaps not: perhaps he is just being opportunistic.  That would be in character.  But so would playing both sides against the middle.

Regardless, this rather audacious after-the-deal-is-supposedly-done proposal suggests that all will not be smooth sailing in the Rosneft-BP relationship.

Not that that should surprise anyone, least of all BP.

February 22, 2011

Channeling Casey Jones

Filed under: Economics,Politics — The Professor @ 5:01 pm

Et tu, WaPo?  Even the Washington Post recognizes that high speed rail is a loser.  The paper recounts the Chinese problems I wrote about Saturday, and then shovels more dirt on the coffin:

Of course, if the Chinese do finish their system, it is likely to require operating subsidies for many years – possibly forever. A recent World Bank report on high-speed rail systems around the world noted that ridership forecasts rarely materialize and warned that “governments contemplating the benefits of a new high-speed railway, whether procured by public or private or combined public-private project structures, should also contemplate the near-certainty of copious and continuing budget support for the debt.”

That’s certainly what happened in Japan, where only a single bullet-train line, between Japan and Osaka, breaks even; it’s what happened in France, where only the Paris-Lyon line is in the black. Taiwan tried a privately financed system, but it ended up losing so much money that the government had to bail it out in 2009.

When it comes to high-speed rail, Europe, Japan and Taiwan have two natural advantages over every region of the United States, with the possible exception of the Northeast Corridor – high gas taxes and high population density. If high-speed rail turned into a money pit under relatively favorable circumstances, imagine the subsidies it would require here. Every dollar spent to subsidize high-speed rail is a dollar that cannot be spent modernizing highways, expanding the freight rail system or creating private-sector jobs. The Obama administration insists we dare not lag the rest of the world in high-speed rail. Actually, this is a race everyone loses.

Despite the near universal recognition that high speed rail is a colossal waste, Obama seems intent on pretending to be Casey Jones, throwing on the coal and hanging on the steam whistle.  We know how swell that worked out.

The Ghost of the Holy Alliance

Filed under: History,Politics,Russia — The Professor @ 1:06 pm

In the years after the Congress of Vienna at the end of the Napoleonic Wars in 1815, Russia (along with Prussia and Austria) set itself out as the enforcer of stability and the enemy of liberalism throughout Europe.  Russian anti-revolutionary actions climaxed with the crushing of the Hungarian Revolt in 1848 under the heels of tens of thousands of Russian boots.  Russia also crushed an uprising in Wallachia.

Russian fondness for the “stability” of authoritarian rule apparently has passed from Alexander and Nicholas to their modern day imitators.  Yesterday Igor Sechin, arguably Putin’s closest ally, blasted Google for its role in catalyzing the overthrow of Mubarak in Egypt:

Prime Minister Vladimir Putin’s deputy blamed Google Inc. in an interview published on Tuesday for stirring up trouble in the revolution that ousted Egyptian leader Hosni Mubarak.

“Look what they have done in Egypt, those highly-placed managers of Google, what manipulations of the energy of the people took place there,”Russian Deputy Prime Minister Igor Sechin told the Wall Street Journal.

Such strong comment from one of Putin’s most trusted deputies is a clear signal of growing concern among Russian hardliners about the role of the Internet in the unrest which has swept across the Arab world.

One can hope the last sentence is true, that is, that uneasily lies the head that wears the crown.  (And no, I don’t mean Medvedev.)  I have my doubts, but know that Putin is likely to err on the side of caution.  As I’ve written many times, he at least intuitively understands that mass protest and revolution require overcoming a coordination problem.  This is why he is so intent on controlling the traditional media, cracking down on even the smallest opposition protests, and encouraging the atomization of Russian society.  A demonstration of the coordinating potential of the internet and social media may lead him and his minions to recalibrate their strategy of atomization.  It will be interesting to see whether the siloviki change their approach to the internet, which has been until recently relatively hands off.  I would anticipate an attempt to shape, constrain, and monitor the internet along the lines of what is done in China.  (Funny story.  One time while teaching in China I attempted to reach SWP–but the Great Fire Wall prevented me from doing so.  I was so flattered.)

I wrote quite a bit during the crisis about the coordination problems inherent in any mass anti-government activity.  Interestingly, one theory about the lack of revolutionary activity in Russia in 1848 while the rest of Europe was exploding was that the tyranny of distance and the tyranny of the secret police combined to prevent coordination.  No doubt then, and today, the relative inertness/passivity meant and mean that achieving coordination was/is harder in Russia than elsewhere.

For an interesting take on the role of the internet in facilitating coordination and facilitating revolution, take a look at this article which sets out Daron Acemoglu’s views.

Never Ascribe to Malice

Filed under: History,Military,Politics,Russia — The Professor @ 11:44 am

The earlier mini-post on Gorbachev prodded me to write a post I’d been planning to do for the last several days but which kept getting put to the bottom of the file.

The post idea came from this cutting and incisive analysis by Yuri Maltsev, an economist who was on Gorbachev’s reform team until leaving for the US in 1989.  Reading it reminded me of my contemporary views on Gorbachev.

I liked him a lot.  Not for the same reason that sent so many in the West into gorbasms.  No, I didn’t like him because he was a new, sophisticated, westernized Soviet leader whom the US could work with.  I liked him because it was clear to me that he was a Sorcerer’s Apprentice whose “reform” efforts were accelerating the collapse of the USSR.  It was evident that his understanding of economics was laughable, and that his attempts to tinker around the edges of the planned economy while retaining a belief in a Leninist core was the best way to exacerbate the internal contradictions (to steal a Marxist phrase) of the Soviet system.  He ripped at the bailing wire and duct tape that was so prevalent in the Soviet economy, not realizing that it was all that was holding the contraption together.

It was, in short, a good thing to have a Useful Idiot on the other side–especially since he was in charge.

Maltsev goes into detail about the idiocy of the Soviet economic system, and  about how Gorbachev’s economic ignorance–rooted in his firm Leninist beliefs–led him to careen from disaster to disaster.  Maltsev’s description of the effects of the ban on alcohol sales is priceless, and the rest of the piece is good too.

And for those who have the impression that Gorbachev was a humane idealist, I suggest you read William Odom’s The Collapse of the Soviet Military, which makes it clear that Gorbachev was more than willing to use force to preserve the USSR, and did it in the Baltics, Azerbaijan, Armenia, and Georgia.  Moreover, Odom shows how duplicitous Gorbachev was in his attempts to conceal his role in these actions.  Odom also delves into Gorbachev’s ambiguous relationship with the plotters of the August, 1991 coup.

It is my impression from my reading and talking to Russians that the modal impression of Gorbachev in Russia is that he was a CIA plant.  How very Russian.  Such views are understandable, I guess, because it is quite plain that Gorbachev was indeed the author of the demise of the Soviet Union at that time: it would have died eventually, but he certainly accelerated the collapse.

But whereas Russians are disproportionately are prone to view things in conspiratorial terms, and almost always ascribe result to intent, I think Napoleon’s statement “never ascribe to malice, what can be explained by incompetence” is quite appropriately applied to Gorbachev.  He didn’t intend to destroy the USSR.  But his incompetent attempts to save it did just that.

Lastly, it is more than a little ironic to read Gorbachev criticize Putin’s vanity.  Not because Putin isn’t vain–ha!–but because if there were ever a case of the pot calling the kettle black, this is it.  But that vanity too had its salutary effects, because it encouraged him to plunge ahead on his creatively destructive course.  I often wonder whether Thatcher and Reagan, who praised Gorbachev repeatedly, did so out of legitimate conviction, or because of a shrewd judgment that by doing so they were empowering and encouraging the man that would destroy their most dangerous adversary from within.

And His First Clue Was?

Filed under: Politics,Russia — The Professor @ 9:43 am

February 21, 2011

Thanks, Krugman!

Filed under: Economics,Politics — The Professor @ 10:42 am

In his most recent screed, er, column, Paul Krugman inadvertently validates my two previous posts.  First, he flogs the new meme (that I discussed yesterday)  that collective bargaining has nothing to do with the fiscal Armageddon facing states:

For what’s happening in Wisconsin isn’t about the state budget, despite Mr. Walker’s pretense that he’s just trying to be fiscally responsible.

Indeed, Paulie Nuts feels so strongly about this, he is compelled to repeat it:

Why bust the unions? As I said, it has nothing to do with helping Wisconsin deal with its current fiscal crisis. Nor is it likely to help the state’s budget prospects even in the long run: contrary to what you may have heard, public-sector workers in Wisconsin and elsewhere are paid somewhat less than private-sector workers with comparable qualifications, so there’s not much room for further pay squeezes.

As for the last line:  Ha!

Yesterday I wrote that only the clueless and the disingenuous could push this meme.  Given his record of serial recidivism, I must put Krugman in the latter category.

But in his haste to hurl himself in the defense of public sector unions, Krugman neatly impales himself on the second horn of the progressive dilemma that I wrote about in my Friday post.  Specifically, most of Krugman’s column is a jeremiad against the capture of government by “oligarchic” interests, which he claims that unions are necessary to counter.

But you can’t be a little bit pregnant, Paul.  (Sorry: very frightening mental image.)  Once you have bought into the public choice premise that government is suborned by the pressure of private interests, the entire case for a powerful, active and minimally limited state collapses.  That case you have trumpeted for years, Dr. Conscious Conscientious Liberal, without paying the slightest attention to the public choice problems that you hyperventilate about in this column.  Your strident defense of unions undermines completely your other progressive sermons on the virtues of big government.

Thanks for that, giving such a lurid demonstration of the progressive paradox that I wrote about Friday.  You can get dressed now.

Krugman sets out a Galbraithian vision in which the influence of countervailing powers, organized labor and organized capital, are offsetting, and an activist government wisely directs the polity and the economy.  As if.  In practice, what occurs instead is corporatism of a sort described by Mancur Olson, in which concentrated and organized interests exploit the power of the state to extract rents from diffuse consumers, investors, entrepreneurs and taxpayers.

Thus, Krugman’s unwitting endorsement of the public choice perspective torpedoes his own defense of public sector unions.  Because they are just organized groups that exploit the power of the state for their own benefit and impose costs on those lacking such privileged influence.  Once it is admitted that that’s the way the game is played–and Krugman jumps into that puddle with both feet–the immediate conclusion is that it is imperative to constrain the power of such bodies, and the power of the state that they exploit for their gain and to our detriment.

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