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Streetwise Professor

February 20, 2011

Revisiting the Flash Crash

Filed under: Derivatives,Economics,Financial crisis,Regulation — The Professor @ 6:34 pm

The Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues has issued its findings regarding the Flash Crash and potential regulatory remedies to such events.  Overall it is a solid effort that makes a serious attempt to grapple with the thorny issues arising out of the May 6 events, and changes in financial market structure more generally.

My primary criticism is that the report assigns far too much importance to the speed of modern, electronic markets dominated by high frequency traders that are the primary liquidity suppliers.  This over-emphasis is pronounced in section I, titled “Volatility.”

The report confirms what has been pretty evident from the start, namely, that liquidity was eroding before May 6, and then virtually disappeared for a short period of time on that date.  But it does not provide any reason to believe that this was something that was driven particularly by high speed electronic trading.  The economics of market making have been the same for a long time under a variety of trading technologies.  These economics are dominated by considerations related to information–and especially information asymmetry–and risk.  These considerations are present in every trading and technology environment.  There are, moreover, informational and risk conditions in which liquidity suppliers leave the market in droves.  This happened in old-fashioned face-to-face markets: witness the fact that on 19 October, 1987 most futures market locals left the floor–or were pulled off by their clearing firms.  The Flash Crash just demonstrates that these factors are relevant in electronic markets too.

By focusing on high speed computer trading, and suggesting that it is fundamentally different from liquidity supply in the old days, the report distracts attention from the more fundamental causes of crashes.  Yes, HFT is new, but HFT market makers are responding to the same economic factors in similar ways to their old school floor trader counterparts.  The main novelty of HFT is that high frequency traders trade across markets, rather than in one or two.  The report would have done better to focus how to best mitigate the age old plagues of market making in an electronic environment.

The report discusses the advisability of imposing obligations on market makers, but wisely demurs from recommending this.  It recognizes the difficulties, though it does not acknowledge the most important problem, namely, that obligations are costly and will affect adversely liquidity supply in non-crisis periods.

The report also correctly lauds the CME’s stop functionality, and recommends it be adopted in other markets as well.  It makes constructive and reasonable recommendations about how this functionality can be tweaked to make it more robust.  In brief, it recommends what could be described a “reload” feature that would kick in if the initial application of the stop functionality failed to stem a crash.

One particularly interesting part of the report relates to “Preferencing, Internalization, and Routing Protocols.”  It is particularly interesting because it highlights an issue that I analyzed in my 2005 article “The Thirty Years War.”  In that article, I noted that the SEC had deliberately chosen an “information and linkages” approach rather than a central limit order book  (CLOB) approach to securities market structure.  I further noted that the rules adopted by the SEC did not preserve time priority across trading venues, and did not protect all limit orders in all books against execution on another venue at an inferior price to those not at best of book.  These were problematic features of the SEC RegNMS, and I was critical of both (especially the fact that only limit orders at the top of the book are protected).

The report argues that the lack of time priority inherent in the “no trade through” rule has encouraged internalization of orders, and that the lack of integration across books at prices away from the inside market can exacerbate price movements.  It therefore recommends that the SEC study the costs and benefits of changing these aspects of RegNMS.  Specifically, it recommends study of the imposition of a “trade at” rule which would effectively restore time priority.

I agree with the recommendation, but think that these issues are somewhat of a red herring with respect to the Flash Crash.  This is especially true of the “trade through” rule.  The report authors argue that the current rules favor internalization; internalizers supply liquidity; but internalizers stopped providing liquidity during the Flash Crash, leading to an additional flow of orders to public markets that stressed an already liquidity constrained situation.  Imposing a “trade at” rule that would make it impossible for internalizers to match quotes standing in the public market would encourage additional liquidity supply in the public markets.

This is no doubt true, but the report doesn’t analyze the counterfactual, i.e., how things would have worked under the trade at rule.  Yes, there likely would have been less internalization.  Thus, in normal circumstances, more liquidity would be supplied via public quotes and less via internalization.  But we saw during the Flash Crash that public market makers fled and as a result quotes disappeared.  Internalizers provided less liquidity at the same time.  But isn’t it highly likely that the liquidity suppliers that entered the public markets during “normal” times to replace internalizers would have also fled the market in conditions like those that provoked the Crash? I think so.  The report doesn’t consider this counterfactual, so it cannot support a different conclusion.

That is, I think that it is accurate to say that a “trade at” rule would shift liquidity from internalizers to public quotes during normal times, but that this does not imply that liquidity would be higher overall (across all sources of liquidity supply) during stressed periods.  The quotes that appear in public markets because quote matching becomes harder would be highly likely to disappear in Flash Crash-like conditions because it is particularly costly to provide firm quotes under those conditions–that’s why the quotes disappear.  Thus, it is worthwhile to have a debate/study about the wisdom of the trade at rule, but that debate study should recognize that just because internalizers fled when the market went crazy doesn’t mean that the new public quoters attracted to the markets when internalizers are hobbled will stick around.

A look at the futures market bolsters this skepticism that internalization was a major contributor to the Crash itself.  The index futures markets are not fragmented, and are not subject to internalization.  The quote matching problem doesn’t exist there.  At all.  But it suffered serious liquidity withdrawals on 6 May.  Thus, in my view, internalization is a red herring with respect to Flash Crashes.  It is an important issue, but its relevance is primarily during “normal” times and that should be the focus of any study.

I was also intrigued by the report’s discussion of peak load pricing and the problems of system capacity constraints driven in part by high cancellation rates for HFTs.  This subject was, in fact, the subject of the first substantive post on SWP.*  There I puzzled as to why exchanges didn’t set traffic-sensitive price schedules for access to exchange matching computers.  I noted that the lack of pricing of capacity could lead to overconsumption of computer resources, lags in getting orders executed, and even shutdowns of the trading system.  Interesting to see that 5 years after I wrote that piece the issue is getting some attention.  I’m still puzzling, and look forward to seeing how the exchanges and regulators deal with this issue.  (The report mentions the difficulty of pricing cancellations in a fragmented market structure.  This is another manifestation of the US equity market-centric mindset of the report’s authors.  That isn’t an issue in futures markets, or foreign markets that are less fragmented.  The puzzle is not explained by market fragmentation.)

In sum, the report moves the ball forward some.  I think it gets sidetracked on some issues, but its focus on the need to encourage liquidity supply during stressed times is salutary.  A lot of work remains to be done to see just how that can be accomplished in an efficient way, however.

And speaking selfishly, that’s a good thing.  For the report confirms something I wrote in the conclusion of “The Thirty Years War”:

Therefore, the proposed rules [Reg NMS] are not the final battle in a ThirtyYears War. I fully expect that in 2075, some professor will write an article about the latest clash in an ongoing Hundred Years War over securities market structure regulation.

These market structure issues are thorny indeed, and will not be resolved any time soon.  I am sure they will not be resolved by early-2013, when my next book, Financial Market Macrostructure: The Organization of Securities and Derivatives Markets should appear.  Which should be good for sales :)

*The post was titled “VOLT”, a neoacronym (which might be a neologism) for “Value of Lost Trade.”  The idea was that in figuring out how much generating capacity is needed in an electricity market, it is conventional to assign a “value of lost load” (VOLL) to the consumption of power lost when system capacity is reached.  Similarly, when deciding how much trading capacity to build, it would be advisable to determine the value of a trade lost or delayed due to a shortage of system capacity.

Peas in a Pod

Filed under: Economics,Politics — The Professor @ 3:01 pm

An emerging response in the debate over public sector unions and Wisconsin’s attempt to constrain them is that “yes, it’s fair to ask public employees to contribute more to their health care and pensions to help address state fiscal woes, but it is not appropriate to restrict collective bargaining rights because they have nothing to do with the budget problems.”  Or, to quote University of Wisconsin economist Menzie Chinn: “collective bargaining rights do not in themselves have direct budgetary implications.”

You have to be either clueless or extremely disingenuous to make this argument.  (I’ll put Mara Liasson, who made the argument on Fox News Sunday this morning, into the former category, based on her extensive track record.)

Seriously, how did these extremely generous benefits come to be?  Did a stork bring them?  Did Moses bring them down on tablets after a conversation with a burning bush?  Hardly: they were the product of collective bargaining between public employee unions and politicians and bureaucrats subject to perverse incentives.

The incentives are perverse because (a) the public sector unions are a concentrated interest with a large stake, and their members can and do provide extensive support to those politicians who advance the union agenda, (b) those who pay the cost of this incestuous relationship–the taxpayers at large–are a diffuse, heterogeneous group, with each person having a small stake in the outcome, (c) by rewarding unions with benefits that extend far into the future, politicians can both obscure the costs of their actions and pass the costs onto many who have no voice in the process (e.g., those currently too young to vote, or those who may move into a jurisdiction at a future date), and (d) politicians have very short time horizons whereas the union employees have much longer ones.

In short, collective bargaining in the past is directly responsible for the fiscal disaster looming over just about every state and city in the country.  And no, you can’t weasel out of that reality by saying that collective bargaining rights “in themselves” don’t “have direct effects.”  Yeah, it takes two to tango–the unions and the politicians/bureaucrats.  The rights extended to the unions don’t “in themselves” uniquely determine the outcome: you need the connivance of the politicians too.  But it is clear that the existence of such rights is a necessary condition for the entirely unsatisfactory outcome we are all grappling with today.  And since it is a necessary condition, restricting these rights is an effective way of mitigating, and perhaps eliminating, the problem in the future.

You aren’t going to change politics or politicians fundamentally.  Controlling public employee compensation costs requires measures that impede corrupt bargains between politicians subject to the background condition of bad incentives and public sector employees.  Limiting the scope of collective bargaining is one way to do that.

Controlling costs requires a credible constraint on the bargaining process that permits captured politicians to extract money from diffuse taxpayers and giving it to those that have captured them.  Period.  Limiting the scope of what can be negotiated between the captors and the captive is the best way to do that.

This is exactly why the unions in Wisconsin and elsewhere are making such a big deal about legislation to limit the scope of collective bargaining: that’s where the real money is.  And that’s also why they, their mouthpieces, and the useful idiots that are sympathetic to them feel obliged to concoct such disingenuous arguments that attempt to disassociate collective bargaining from the fiscal issues that have such resonance among taxpayers.  But overly generous benefits and the right to bargain collectively over these benefits with interested politicians are peas from the same pod.

For Those Who Just Can’t Get Enough . . .

Filed under: Clearing,Derivatives,Exchanges,Financial crisis,Regulation — The Professor @ 10:39 am

. . . of SWP discussing clearing, here’s a video (approx. 90 minutes) of my talk on the subject at the Law and Economics Workshop at Columbia Law School from December of last year.  You need to supply your own NoDoz.

Futility Alert

Filed under: Military,Politics,Russia — The Professor @ 10:35 am

Apparently the reduction of Russian military conscript terms from one year to two is not reducing dedovshchina, as the change was intended to accomplish:

Citing Newsru.com, Interfax and other outlets, the New Region agency reported yesterday that on Friday, the press service of the Chief Military Investigation Administration of the Russian Investigation Committee had reported that “in all military districts and in the fleets, there has been an outburst of crimes committed by draftees.”

“More than 90 percent” of these violations of military and civil law have been committed by draftees even as the number of crimes committed by officers has declined, the investigators said. And Aleksandr Sorochkin, the head of that agency, linked this upsurge to changes in the draft cycle.

When everyone served two years, he said, most crimes among soldiers were committed by the 25 percent in their last six months of service, a pattern that gave rise to the term “dedovshchina.” With the reduction in service to a year, Sorochkin said, “now almost half of those drafted consider themselves” senior enough to oppress those more junior.

At the same time, the investigator continued, some of this increase reflects the cutback in the number of training officers, a reduction that has allowed “informal leaders” to fill that gap and “affect the psychological climate in military collectives,” often in an extremely negative way.

According to an article in “Svobodnaya pressa,” the number of soldiers ready to oppress their fellow draftees has risen by a third, exactly the opposite pattern that those who argued for a reduction in the length of service said would obtain. But as the New Region agency report makes clear, it is hard to evaluate these numbers.

If one takes the report as accurate, an immediate conclusion is that a deeply entrenched culture cannot be uprooted with superficial changes.  The source of the problem lies more with officers’ abdication of control for what goes on in the barracks.  That abdication apparently hasn’t changed, and if the article is accurate, it has actually gotten somewhat more acute.

I would also suggest another possible explanation for the stories appearing in Newsru.com and Interfax.  The one year conscription term is imposing serious strains on the military’s ability to fill the ranks.  The service term reduction was intended to reduce dedovshchina.  If it is not having this effect, the military can argue that the reform is counterproductive and should be eliminated.  Thus, somewhat perversely, the military has an incentive to hype this story in order to justify an extension of the term of service.  Indeed, more sinisterly, it can even have an incentive to encourage or facilitate the brutality in order to sabotage a change it was never enthusiastic about: that could explain just why the number of “training officers” were cut back as reported at the link.

Regardless of the explanation, the Russian military manpower dilemma persists.  I say again: rather than spending tens of billions on new hardware (something that Kudrin criticized last week), the Russian military should get its software problem under control.  The best hardware is useless if the software is defective.  But I also say again: that ain’t going to happen, not least because that’s not nearly so lucrative as throwing money at defense contractors (a good chunk of which, of course, can be redirected to the pockets of the spenders).

I’m so glad that the Russian government can pour huge sums into upgrading the defenses of the Kuriles.  It’s obvious they have no better use for the money.

February 19, 2011

Flaring Some Gaz(prom) Stories

Filed under: Economics,Energy,Politics,Russia — The Professor @ 5:05 pm

A few Gazprom stories have stacked up on my desk in the last 10 days or so.

The first one is that Putin told Gazprom to open its pipelines to independent users:

Prime Minister Vladimir Putin lashed Russia’s largest and most powerful company Gazprom on Wednesday for its failure to share its natural gas pipelines with independent producers.

Putin’s criticism of the world’s largest natural gas firm came during a meeting in which Gazprom reported disappointing export numbers that showed a small 2010 decline.

Gazprom deputy chief executive Valery Golubev said the company’s gas exports fell 1.5 percent to 138.6 billion cubic metres last year.

The company attributed the drop to lower European demand but Putin accused Gazprom of being inefficient.

“You either work in an efficient manner or we will be forced to change the existing rules and move in favour of a change in the legislation,” the RIA Novosti news agency quoted Putin as saying.

In some respects, its a mystery why Gazprom doesn’t exploit its status as a pipeline monopoly by merely charging a monopoly price for the pipeline, and letting anybody that wants to pay the monopoly price use the pipeline.  To the extent that other gas producers (or potential gas producers) have lower costs of gas production than Gazprom, or can market some gas more efficiently than the former Ministry of Gas, the company could earn a higher profit this way than by transporting and marketing only its own gas.

I suspect that this alternative is less attractive to Gazprom management because the present system permits them to engage in various corrupt tunneling schemes built around the marketing of gas, particularly through various intermediaries, and that such tunneling would be much harder to do through the sales of transportation services.

The politics of this are also interesting.  Why would Putin speak to Gazprom only slightly more politely than the way he addressed Mechel oligarch Igor Zyuzin back in the summer of 2008?  I see Sechin’s fingerprints on this one.

The FT asked Gazprom CEO Alexander Medvedev about this issue, but the question was lame, and the answer was even lamer and totally unresponsive.

The second story is that major European gas consumers are pushing for a move to spot pricing for gas, in lieu of long term contracts indexed to oil:

E.ON AG, Germany’s biggest gas importer, asked suppliers last year to sell it fuel at spot-market rates rather than at prices tied to oil products, two people with knowledge of the matter said this week. GDF Suez SA, operator of Europe’s largest natural-gas network, said in September it was negotiating a stronger link to spot prices for long-term purchases. North Sea Brent crude costs $55 a barrel more than U.K. gas, the most since May 3, according to data compiled by Bloomberg.

. . . .

“If E.ON is pushing for 100 percent spot indexation it suggests they believe the entire European market is moving to a fully liberalized structure as already exists in Britain and North America,” said Patrick Heren, a London-based consultant who founded Heren Energy Ltd., the European price-information service bought by Reed Business Information Ltd. to form ICIS Heren.

This would be a big deal for Gazprom, as the gap between the oil-linked price and the spot price could be on the order of 25 percent.  The increase in gas output worldwide, combined with rebounding demand for oil and stagnant production, has driven a wide wedge between oil and gas prices.

One of the objections to moving to spot pricing is that the spot market on the continent is relatively small and undeveloped.  Legal and regulatory changes, along the lines of what was done in the US in the 1980s and early-1990s could facilitate market development.  But there’s also a chicken-and-egg aspect to the situation.  Part of the reason that the spot market is small is that most gas is marketed under long term deals.  Moving to spot pricing would help kickstart the spot market, leading to increased volumes, increased liquidity, and more reliable prices.

One of the major sources of high gas supplies and depressed prices is shale.  CEO Miller is trying to cast doubts on the long-run impact of shale.  No wonder.

Medvedev says that shale gas is “a bubble.” He predicts a gas price of $8/mmBTU, whereas the forward curve out 5 years is below $6.  Since he’s talking his book, I’d discount what he says heavily.

One interesting thing in this article: Medvedev is sticking to his projection that Gazprom will supply 10 percent of the US market by 2020 (the magic year in virtually all Russian forecasts: it will soon be kicked out to 2030, I would wager).  He says, moreover, that he will supply the US from the Shtokman project, and that this project is on schedule to start deliveries in 2017.

The Russian government, however, is apparently of a different opinion:

Russia’s energy giant Gazprom may decide to delay the launch of its troubled Shtokman gas field by two more years because of the United States’ rapid development of shale gas, a report said Thursday.

The Barents Sea project has experienced repeated delays caused by the 2008 global financial crisis and the subsequent development of shale gas in the United States, Canada and other Western countries.

Originally due to go online in 2013, the field might now be only commissioned in 2018, Pyotr Sadovnik, the deputy head of Russia’s subsoil usage agency, was quoted as saying by RIA Novosti.

“There are questions being asked about delaying it until 2018, but there has been no final decision,” said Sadovnik.

“There is a risk that there will be no demand for the gas” produced at the giant field, Sadovnik said.

But here’s the really interesting part:

A source familiar with the matter told AFP that shareholders at the international joint venture in charge of the project where deadlocked over how to proceed.

“Everything is blocked,” said the source. “The (project) participants cannot make a decision on anything.”

Those shareholders would be Norway’s Statoil, French Total, and Gazprom.

Not that I’m surprised.  That’s something to keep in mind when evaluating the prospects for the BP-Rosneft tie up in the Arctic.

In a post titled “NOC! NOC! Who’s There?” I wrote in the summer of 2007 about the difficulties of joint ventures between national oil companies (NOCs) that control access to resources and the international oil majors that have the expertise and technology to develop challenging projects.   Interesting to read that Shtokman is supporting this analysis.   I put good odds on the BP-Rosneft collaboration providing more corroboration.

Trouble Ahead, Trouble Behind, and You Know That Notion Just Crossed My Mind

Filed under: Economics,History,Politics,Russia — The Professor @ 4:18 pm

Those who think that China’s massive investment in high-speed rail should be emulated here (now who would that be?) should find this report sobering (but probably won’t):

China’s Ministry of Railways has racked up more than $200 billion in debt, government auditors say, partly because of aggressive expansion of the country’s high-speed rail network. Experts say high ticket prices mean many of the trains on the new Wuhan-Guangzhou line run empty. Those questions are even more pertinent now with the revelation this week that the railways ministry under Mr. Liu’s stewardship has run up debts possibly in excess of 2 trillion yuan, or roughly $303 billion.The Global Times, citing a report from the National Audit Office, said in its Wednesday edition that China’s Ministry of Railways was 1.3 trillion yuan in debt in 2009, with 854.8 billion yuan in short-term debt and 448.6 billion yuan in long-term debt. The paper quoted Zhao Jian, a researcher at Beijing Jiaotong University, as saying that “the debt had at least reached 2 trillion yuan by now, and the interests of those debts have grown too large for the government to afford.”

Some experts say those debt levels are unsustainable, even for a government accustomed to running up massive infrastructure tabs, given that many of the country’s high-speed rail links are having trouble making money.

The country already has built a high-speed rail network that as of November last year stretched 7,531 kilometers, according to the ministry. By 2020 China plans to expand the network to stunning 16,000 kilometers. Yet it’s not clear whether there’s sufficient demand to support all the construction. A senior Beijing-based executive for a foreign high-speed train producer that has transferred technology to Chinese train-set makers says that on many high-speed rail routes, such as the one linking the southern city of Guangzhou and the central city of Wuhan, some trains run “nearly empty.”

China in some respects is ideal for high speed rail, due to its extreme population density.  Other factors make it less ideal, at least now.  It is still a poor country, and the opportunity cost of time is too low for most people to make it rational to pay up to get someplace faster.

You can always create something gee-whiz impressive if you spend enough money on it.  The question is whether gee-whiz is worth the cost.  Many people are obviously enamored with China’s rapid development of its infrastructure, and especially with prestige projects like rapid rail.  This report suggests that regardless how technically or aesthetically impressive this investment in rail is, the economics are far more dubious.

There’s a larger lesson here.  There has been, historically, a tendency in the US to exaggerate the economic performance and prospects of rising nations.  This is particularly true for centrally planned ones, or at least those with a heavy dose of central direction of resource allocation.  It was conventional wisdom in the 1960s, and a not uncommon belief into the 1980s, that the centrally planned USSR was more efficient that the US, and would eventually overtake the US economically.  In the 1980s, the Japanese model, which involved considerable state involvement in choosing winning industries and firms, was considered by many in the US as superior to the US model.  In the 1930s, the USSR (again) and fascist economies were held out as exemplars.  Today, China has many cheerleaders to argue that things like high speed rail and other megaprojects demonstrate that the state capitalist model is superior.

The Soviet and Japanese examples should give those singing China’s praises pause.  So should an understanding of the incentive,  information, and political economy problems that plague centralized schemes.  Indeed, the experiences of the USSR and Japan provide some good case studies of those problems.

The reports about the shaky finances of Chinese high speed rail should not be surprising to those who have a passing acquaintance with relatively recent history, and an understanding of economics and political economy.  Unfortunately, all too many policymakers and pundits who hold out China as an example for the US lack both.  Megaprojects inspire a certain kind of awe.  They are superficially appealing.  But the economics, the boring old economics, is often far less appealing–or should I say usually far less appealing?

That’s especially true where the state is heavily involved.  Heavy state involvement means that the discipline of capital markets is lacking, budget constraints are soft, and resources are allocated for political purposes (prestige, corruption, the cultivation of support) rather than economic ones.  The problem is especially acute in politically unfree, secretive states like China where information about boondoggles is readily concealed, and political feedback mechanisms like voting and a free press don’t constrain profligacy and waste.

I wouldn’t be surprised if high speed rail is just one example of such profligacy and waste in China.  Again, history, and an understanding of the defects of state-directed resource allocation would suggest that this is the rule, rather than the exception.  Moreover, you’d hope that people would view seemingly awesome developments in places like China with a more skeptical eye, given the opacity of the system and the lack of independent checks on the performance of these investments.  But such a hope would, sad to say, itself reflect a failure to heed history, for such a lack of skepticism has been all too common since the times of Mussolini and Stalin.

February 18, 2011

The Times They *Are* A Changing.

Filed under: Politics — The Professor @ 8:08 pm

The spectacle of “sick-out” teachers running amok in Madison, WI is, ironically, sickening and educational.  It also points out a fascinating paradox in progressive “thinking.”  For progressives are both big supporters of public sector unions and expansive government.  How is it possible to square that circle?

For the rationale of unions is that they are needed to protect employees from the opportunistic exploitation by their employers.  With public sector unions, the government is the employer.  So the assertion that public sector unions are essential implies that the government is opportunistic and exploitive, rather than benevolent.

But government benevolence–or something close thereto–lies at the heart of the argument that an expansive state is necessary to protect the weak against the predations of the strong.  So if the government is benevolent, there should be no need for public sector unions.

But we see progressives sing paeans to public sector unions and an expansive government.  A completely contradictory worldview based on a schizo theory of government.

Public sector unions facilitate a conspiracy between public employees and the politicians who “negotiate” with them.  Their effect is almost uniformly malign: they bring a wonderful combination of higher costs and lower performance.  The case is particularly clear with teachers’ unions.  My thesis advisor, a brilliant empirical economist, Sam Peltzman demonstrated this with some excellent papers in the mid-1990s.  He showed that one can date the commencement of declining academic performance in a state quite precisely: the declines in a state began when its teachers became unionized.  The result is robust, and holds for both college-bound and non-college bound students.

I am actually quite encouraged by the protests in Wisconsin.  The protesters are so clueless.  They fail to understand how their antics are just going to turn even more people against them, and intensify the opposition of those who are already unfavorably disposed.  The more they whine about the benefits they are losing, and the “rights” that they are giving up, the more the hoi polloi who are footing the bill will recognize how generous those benefits and rights are.  The suckers who pay will say: “I don’t get that good a deal.  I am looking at a more straitened future.  Why should these people get a better deal than I do?  Especially since the performance doesn’t match the pay?  I was a sucker before, but no more.”

In short, temper tantrums and hissy fits by the privileged only stoke anger against them.  So go for it, boys and girls!

Obama, of course, couldn’t resist butting in.  His operatives and union allies are coordinating and funding protests.  He has come out and criticized Wisconsin Governor Scott Walker for attacking unions.

This is all understandable, I guess.  Buffeted by one failure after another, Obama sees an opportunity to rabble rouse–sorry, I meant to write “community organize”–and says: “Hey, THIS is something I can do!”

But again, this is good news.  For being associated with the Insane Clown Posse will only damage Obama further.  And a posse of insane clowns is what it is.  The sight of the Democrat State Senators fleeing the state in order to prevent a vote on a measure that would limit public employee collective bargaining rights is proof enough of that, as is the collection of signs, chants, etc. that the “protesters” have brought to the Capitol.  The New Civility didn’t last long, did it?

Some years ago (’03 or ’04 if memory serves) Texas Dem legislators fled the state to stop a vote on redistricting.  Some wags put pictures of the vote evaders on milk cartons.  Wisconsin is the Dairy State, so it would only be fitting to repeat the feat here.  Amazing, isn’t it, that elected representatives shirk their responsibilities in a democratic/republican system, and at the same time thunder against the governor’s anti-democratic actions?

Like I wrote Monday.  It’s not 1995 any more.  People who think that the same tricks, the same tropes, and the same rhetoric will work in 2011 have failed to recognize that the situation of the country is far different, and the mood of the country definitely is.   The protestors are singing the same old protest songs (the has-been Jesse Jackson parachuted in to (a) get his face on camera, and (b) lead a chorus of “We shall overcome”), not realizing that they are now the establishment and the times are in fact changing, and not in a way that they will like.  The clowns in Madison will keep pushing, because that’s what they do.  The difference this time is that a helluva lot more people are going to push back.

February 16, 2011

Micro Prudence=Macro Danger

Filed under: Clearing,Derivatives,Economics,Exchanges,Politics,Regulation — The Professor @ 4:31 pm

There are a lot of jokes about economists that go something like: “An economist and a physicist are on the top floor of a skyscraper.  Someone runs in screaming: ‘The building is on fire. The stairways are all blocked.’  The physicist immediately panics, then looks at the economist, who is amazingly calm.  The physicist says: ‘How can you be so calm?  We’re all gonna die.’  The economist smiles wanly and says: ‘No we’re not.  First, assume a 100-story ladder.’”

That genre of joke came to mind when reading this:

Clearing houses for derivatives can help reduce risk to the financial system, Federal Reserve Governor Daniel Tarullo said in written remarks prepared for House Financial Services Committee testimony tomorrow.

“If properly designed, managed, and overseen, central counterparties offer an important tool for managing counterparty credit risk, and thus they can reduce risk to market participants and to the financial system,” Tarullo said.

Translation: “First, assume a properly designed, managed and overseen central counterparty.”

Yes, if we assume all those things are true, our assumed world is wonderful indeed.

But as I’ve written for the past two-and-a-half years (and I think I can honestly say “you read it here first!”), all that is easier assumed than done.

Reading an article by Samuel G. Hanson, Anil K. Kashyap and Jeremy C. Stein in the most recent issue of the Journal of Economic Perspectives helped crystalize a thought that is implicit in what I’ve written, but which I have not made as explicit as I should.

Specifically: Historically clearinghouses have been microprudential institutions, with the responsibility of ensuring that a particular set of claimants get paid what they are owed due to the default of a single trader or firm, just as bank regulation has been microprudential in its focus on ensuring that depositors get paid in the aftermath of the failure of an individual bank.  But Dodd-Frank and all of the other initiatives around the world give CCPs huge macroprudential responsibilities.

As Hanson et al show, there can be substantial tensions between microprudential and macroprudential regulation: some things that are prudent microprudentially are very dangerous from a macro/market-wide/systemic perspective.   I do not believe that Frank-n-Dodd, Geithner, Gensler, the EC, you name it were or are fully cognizant of the difference.  And therein lies the danger.

Here’s the most obvious example.  CCPs utilize margins–collateral–to control counterparty exposure.   That’s sensible microprudentially.   But as I argued beginning in 2008, and as Brunnermeir and Pedersen formalized in 2009, collateralization and rigid mark to market can be systemically destabilizing.  I referred to this as the “collateral death spiral.”  Prices change a lot, imposing big MTM losses on some parties, who liquidate their positions, exacerbating the price moves, which leads to more liquidations.  This positive feedback mechanism is what creates serious systemic risks.

Brunnermeir and Pedersen emphasize that a purely mark-to-market system that bases margin calls only on price moves, and makes no effort to distinguish between fundamentals-based price moves and those that result from mispricings or liquidity effects are the most systemically dangerous.  And that’s exactly how CCPs work.  They are ruthlessly mechanical. If you talk to people in the futures business, that is a feature, not a bug.  I can’t count the number of times I’ve heard about the virtues of the “discipline of a rigorous daily mark-to-market system.”  Microprudentially–agreed.  Macroprudentially–not true, and more than that, dangerously misleading.

So, there is a fundamental disconnect between Timmy!’s and GG”s paeans to rigid collateralization and mark-to-market and their assertion that mandatory clearing will eliminate the prospect that derivatives will be a source of systemic risk.  Indeed, evaluated properly, the reverse is more likely to be true.  In times of market stress, rigid collateralization can be a doomsday machine.

That is a reality that can’t be assumed away–but has been.   And don’t count on that ladder saving our collective rear ends when–when, not if–the next financial firestorm occurs.


February 15, 2011

Animal Stories

Filed under: History,Military,Politics,Russia — The Professor @ 8:26 pm

Sergei “The Tarantula” Lavrov recently ripped the Japanese for their “undiplomatic” response to various Russian actions in the disputed Kurile Islands off the coasts of Siberia and Japan.  This is rich–even for Lavrov–given that Russian actions and words regarding the Kuriles have been in-your-face and deliberately provocative, far outside of any recognized diplomatic norm.

When this spiral of insults began some months ago, I wrote that the Russians smell Japanese weakness, and can’t help but try to exploit it.  It seems almost natural.

And I’m sure that getting back for that 1904-1905 thing only adds to the excitement.

This piece by Chatham House’s James Sherr suggests that this jackal-like instinct to attack those that the Russians sense are in decline, and against whom they harbor historic grudges, is not limited to Japan (h/t Robert Amsterdam).  Sherr argues that Russian truculence towards Britain has similar causes:

The Russian Federation, like the Soviet Union, has based its relationship with the West on two pillars: Washington and Berlin. As Moscow sees it, the UK seeks an influence out of proportion to its post-imperial importance; worse, it sometimes gets it. The UK is an Atlanticist power at the top table of the EU; Moscow wants a superpower relationship with Washington over the heads of Europe and a ‘Europe for Europeans’. This makes the UK an irritant by definition.

The tenacity of this zero-sum perspective has frustrated the desire of successive British governments to shift the focus onto new ground: trade, investment and cooperation against common threats. Far from viewing British military and intelligence services as partners in the struggle against terrorism and organised crime, Moscow views them as mainstays of British influence in NATO and adjuncts of US ‘hegemonic’ policy. Moscow would like to transform British business into Russia’s lobby and UK investment in Russia (15 per cent of the foreign total) into a security of ‘good relations’ as Moscow defines them. Issues deemed important to British business confidence – human rights and rule of law – are regarded by Moscow as ‘vulgar’ intrusions into domestic affairs.

These are differences of purpose and outlook, not obstacles to ‘normality’. To many inside Russia, Britain is cast in a hypocritical, even devious light. It is not Russia, it is argued, but the UK that has halted anti-terrorist cooperation thanks to the Alexander Litvinenko affair; the UK has given asylum to 30 individuals who Russia wanted extradited for terrorism and organised crime; the UK-hosted Nordic-Baltic summit is not about ‘economic growth, enterprise and job creation’, but another anti-Russian project.

By these remorselessly geopolitical standards, Britain’s influence is shrinking, not growing. The Deepwater Horizon and Lockerbie affairs have damaged the special relationship with the US. The UK’s Strategic Defence and Security Review has gutted the capabilities that monitor Russia’s expanding naval and air activity in Britain’s northern waters. And, the savaging of the BBC Russian and Ukrainian services has further diminished Britain’s profile. Russians are acutely aware of their economic deficiencies relative to the UK. But they are increasingly less impressed by the UK’s ability to convert economic strength into political influence.

The irony, of course, is that Russia’s power–and most notably its military power–is contracting.  Outside of nuclear weapons, whatever influence it wields is disproportionately dependent on energy directly (as a means of blackmail or reward) or indirectly (to finance its military).  As the financial crisis demonstrated, reliance on a single lever of power like energy is as much of a source of vulnerability as of strength.  Moreover, its demographic problems, the associated manpower problems in the military, and the pathetic stabs at “reforming” its armed forces mean that Russia hardly has the ability to venture abroad to find new dragons to slay.  Preying on the declining may seem like enjoyable sport, but if you’re declining yourself–and indeed are fundamentally weaker and with a bleaker future than those you are trying to exploit–such adventurism is likely to culminate in disaster.

Recent Wikileaks disclosures reveal the disdain in which NATO military observers hold Russian capabilities.  Recent US military strategy appraisals almost completely ignore the Russians, dismissing them with a mere two sentences.  Given the quite obvious weaknesses, a more rational, considered policy would focus on addressing more pressing needs, and not on chasing imperialist fantasies in attempts to recapture past–and almost wholly imagined–glories.  But that would require the leopard to change its spots.

Russian history often seems like a succession of self-inflicted disasters.  It is on its way to adding to the list.

February 14, 2011

It Ain’t 1995

Filed under: Economics,History,Politics — The Professor @ 8:05 pm

The Obama administration released its budget proposal today.

To reprise an expression from the Reagan years that Democrats routinely used to greet every one of his budgets: DOA.

This is not a remotely serious proposal.   I don’t know what color the sky is on the planet where this was formulated, but it ain’t the same as what I see out my window.  There is no recognition whatsoever of the existential fiscal situation the country now faces.  ”What, me worry?” doesn’t even come close to describing this.  No spending restraint whatsoever.  Projections of large tax increases and large revenue increases that will never–never–be realized.

The budget is chock-full of silliness, like a vast increase in funding for the Department of Education.  (Motto: “There’s No Problem We Can’t Make Worse With More Money!”)  Or especially the high speed rail boondoggle.  ”High” is right.  The only thing that is missing in the administration salesmanship of this turkey is Robert Preston returning from the dead to perform a reprise of his role as the Music Man.  This is a con of the first order.

Apparently, the administration is attempting to reincarnate the budget showdown of 1995, in which Clinton regained his political balance by forcing a budget battle with the Gingrich-led Republicans.

If that’s indeed the case, it is typical Bourbon learned nothing-forgotten nothing reasoning.  The situation now is so different from from 1995.  So different.  Economically–not even close.  Orders of magnitude different–literally, when it comes to the deficit and debt.  Politically–again, not close.  Yes, there was a firestorm in 1994, but this pales in comparison to 2010, and what is happening now.  Clinton could do a passable imitation of a fiscal conservative–Obama isn’t even trying.  Clinton was blessed in the enemy lottery; Gingrich’s bombast, egotism and overreaching the election mandate played right into the President’s hands.  Today’s Republicans seem to have learned from Gingrich’s mistakes, and are not tied to a figure with historical pretensions and delusions of grandeur.  Fighting the last war is seldom a good idea, especially when conditions are so radically different.

Moreover, it is disappointing in the extreme that Obama is responding to such a serious situation by playing small-ball (but mega-dollar) politics, rather than exhibiting  real leadership.  Not that I’m surprised, but even given my very low expectations it is rather discouraging to see a good swathe of the political class–with Obama at its head–proceed as if this is just about their political fortunes, rather than about the nation’s future.  Many Republicans in the House and especially the Senate are not much better, but even there the business-as-usual types are getting some pushback and are responding.  And you should never expect leadership from the legislature in any event.  All Presidents–including this one–talk about leadership.  Not all of them exhibit it–this one most conspicuously, and most conspicuously now.

The contrast between the atmosphere in Washington, and in the White House in particular, and many of the states is stark and telling.  Newly elected governors like Ron Johnson Scott Walker in Wisconsin are manning up.  Texas is proceeding with dramatic, not to say draconian, budget cuts to close the fiscal gap.  And it’s not just Republicans.  Andrew Cuomo in New York is grabbing the bull by the horns.  Hell, even Jerry Brown in California is acting more like an adult than Obama.  When Jerry Brown appears more tethered to reality, you are truly out there.

Obama’s unrealism and Bourbonism means that he is unlikely to prevail in this budget battle, and that he will not be able to leverage it into a political gain.  But that’s cold comfort, for the time lost in this pointless contest is extremely costly.  The time for action is now, but time’s a wasting.  Rome is afire, and Obama is fiddling.  I needn’t tell you who is going to get burned.

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