Streetwise Professor

I’m in New York.  No, I’m not joining OWS down in Zuccotti Park.  Quite the opposite.  I was speaking at event sponsored by the object of their ire, at the JP Morgan Chase Commodity Forum.

I spoke about Dodd-Frank and commodity trading.  I did my shtick, and it went over pretty well: I was surprised that “Frank-n-Dodd” was something most hadn’t heard before.  The audience found the phrase amusing, and more than a few people remarked on the phrase afterwards.

Substantively, the most interesting thing I heard was said by Morgan’s head of commodities, Blythe Masters.  She noted that F-n-D imposed huge compliance and administrative burdens.  Huge.  Moreover, these are fixed costs.  So Frank-n-Dodd increases economies of scale in banking, which will favor the big over the small, and encourage the big to get bigger and the small to go away.

In other words, something ostensibly intended to address too big to fail will encourage big banks to get bigger through regulation-induced scale economies. The effect will be the exact opposite of the intent.

The road to hell is paved with good intentions.  Frank-n-Dodd just well may be the world’s largest paving company.

The CFTC voted out two rules today, one on position limits, the other on clearing.  I’ve beaten both issues to a bloody pulp over the last couple of years, so I don’t have too much to add.  Just a couple of high level comments.

Bottom line: Both rules are highly ill-advised.

Regarding position limits, some of the most inane provisions of the original proposal are gone, notably the “class” limits that constrained netting across the futures and OTC swaps.  This was a hidden constraint on market making by dealers, and made no economic sense.  Fortunately it is gone.  Also gone–for the most part–is the conditional spot month limit that treated cash-settled and delivery-settled contracts differently.  This made zero economic sense too, and it is also gone.  The one exception is that there are different limits for cash- and delivery-settled contracts for Henry Hub nat gas.  This makes zero economic sense too, and is a blatant political compromise by the Commission intended to throw a bone to ICE that lost on the conditional limit issue generally.  Laws, sausages–and CFTC rules.

My comment letter on position limits criticized both stricken provisions.  But other provisions I inveighed against, particularly those that constrain ETFs like USO and US Nat Gas funds, remain.

The partisan rancor on this issue came through loud and clear at the meeting, as this piece by Jeremy Grant makes clear.  Jill Sommers and Scott O’Malia were very outspoken:

“We went beyond the statute” by doing things like narrowing the bona fide hedge exemption, Sommers told Reuters. “Those are the things that people can use for a legal challenge.

O’Malia said: “over-reached in interpreting its statutory mandate to set position limits.”  O’Malia also emphasized the lack of empirical evidence of a need for limits, echoing my “No Theory? No Evidence? No Problem!” refrain.

As I was quoted saying in the Reuters piece, this statutory overreaching will be the basis for a legal challenge.  Not just on the hedge exemption issue, but on the more fundamental issue of whether it is necessary for the Commission to find that “excessive speculation” has indeed caused “unwarranted” fluctuations in prices, i.e., the “no evidence” point.  I would not be surprised if the cost-benefit analysis, such as it is, is not challenged as well.

The disappointing guy was Dunn, who blasted the idea of position limits, but voted for them anyways.  Not exactly a profile in courage or conviction by a retiring commissioner.

The other rule would require CCPs to admit firms with a minimum of $50 million in capital.  I think this is a terrible idea.  I understand that CCPs could potentially use excessively onerous admission requirements to reduce competition: hell, I’ve been making that point for well over a decade.  But I also understand that undercapitalized members, and members who cannot contribute constructively to the auctioning of a defaulter’s position, can undermine the effectiveness and even the safety of the clearinghouse.

There is a tension between encouraging competition, and making CCPs secure: Gensler and the majority focused on competition, and I think that is a major mistake, particularly given the fact that the clearing mandate in Dodd-Frank is intended to reduce systemic risk. Micromanaging CCP operations is a horrible, horrible idea.

Grounds for challenge?  Maybe.

No surprises here, really. Gensler is hell-bent on ramrodding through his agenda.  And that’s probably the best way to phrase it: the agenda is pretty bent, and will create some regulatory hell.

This long Zero Hedge post recapitulates William Buiter’s analysis of the leveraged EFSF “bazooka.”  It is a very detailed exposition of why this mechanism is not credible.  As Buiter lays out, it is not credible primarily because it is laden with wrong way risk.  Good object lesson in what can go wrong with a CCP, by the way.

Over the weekend, the G-20 gave an ultimatum to Europe:  Fix your problems in eight days.  I guess the Euros should have been grateful: the G-20 gave them two more days than it took God to create the universe.  Presumably they were looking forward to a rest on the ninth day.

But no sooner speaketh the G-20, than Merkel and Schaeuble speaketh: In your dreams.  Today, Merkel said that talks are moving “by the millimeter.”

Not surprisingly, the hangup is distributive: who pays?

German officials have said in recent weeks that the eurozone needed to find a solution for Greece that makes the country able to repay its debts in the long-run.

France on the other hand has been reluctant to back bigger losses for banks, since French banks are among the biggest holders of Greek government bonds.

Its position is supported by the European Commission, the EU’s executive. Commission officials said last week that technical revisions to the July deal with the banks are necessary because changed market conditions had made the deal more expensive for Greece and the rest of the eurozone.

While that could imply an upward revision of the losses for banks, cuts would likely stay far below the 50 percent to 60 percent haircut pursued by the Germans.

That’s the fun of trying to negotiate an insurance (i.e., loss sharing) deal after the accident.

But the Franco-German dispute does point out a fundamental problem.  Any realistic plan would involve a big haircut.  In rough numbers Greek debt is about 170 of GDP, and it can probably afford to support 80-85 percent.  So, a 50-60 percent writedown is ballpark: the 21 percent number negotiated in July was wildly optimistic, and no longer operative.  But a 50 percent writedown will hit some banks hard: they will be undercapitalized, most likely.  So where is new capital going to come from?  If the French government injects capital into French banks, that will hit French national credit.  So the French want to Europeanize the solution–and since the Germans are the Europeans with the most money, that means “Germanize” the solution.  Which is hardly palatable to the Germans.

So statements about forcing the bondholders–which are disproportionately banks–pay sound great, but that just relocates the problem.

And remember folks.  This is Greece, which is just the opening act.  So don’t dream about a deal by October 23.  And even if a deal gets done in the relatively near term, it won’t be the last deal.  I’m not saying that the Europeans are checkmated, but it’s just very hard to see how they can actually prevail in this game.

The things I don’t go through for you all.  I forced myself to watch some video of the the King of the Korporatists, Jeff Immelt.  He declares “President Obama has been a great partner.”  No doubt he has.  For Immelt and his ilk.

But that’s just the problem.  The symbiosis between government and particular corporations is the disease, not the cure as Immelt would have it.  It helps the GEs of the world, and the Berkshire Hathaways, and others who have access and who can influence the process.

As Adam Smith pointed out, and as Friedman emphasized repeatedly, there is a difference between supporting the free enterprise system, and supporting particular enterprises–businesses.  Supporting an open access order with a rule of law that treats all equally, or at least strives for that outcome is very different from gaining business support in exchange for some quid pro quo. A vibrant open access order promotes creative destruction–in which the old and established are ruthlessly supplanted by the new and dynamic.  The corporatist order stifles the emergence of the new in order to protect the interests of the old.

A picture is worth 1000 words.  If you want to see the portrait of American corporatism, cast your eyes on the video at about the 10 or 12 second mark.  Left to right: Immelt; Obama; Daley; Trumka.  Not a creator among them.  Rent seekers the lot of them.  That tells you everything you need to know.

In another video, Immelt says “look out for Russia!” (Those aren’t his exact words, but the title on the video.)  That’s what I say too, but definitely not in the way Immelt means it.  Quite the opposite, in fact.  Although he laughs about how tough it is to do business there, I’m sure that is a place where the likes of him can do business.  It is “business” based on political transactions.  That’s what makes Immelt comfortable with Obama, and what should make you uncomfortable with Immelt et al.

It seems like forever ago, but it was only 2010.  That year I wrote about the Citizens United case, in which the Supreme Court established that corporations–like individuals–had speech rights.  The post responded to criticisms of the decision, notably in the Stevens dissent, that cited the Founders trenchant criticism of corporations.  I noted that the corporations that the Founders–and Adam Smith–criticized were a far different thing than the modern corporation.  They were established by the crown–political favors to the politically connected.  They were a part of a “closed order” in which only a select few had access to power and wealth.  I further noted that as John Wallis has pointed out (in his work with North and Weingast on the natural state), the idea of the corporation was fundamentally transformed in the mid-19th century.  In particular, states ceased making corporations special privileges awarded to the few.  Instead, states created an “open order” in which anybody could incorporate.  Corporations in an open access system are fundamentally different than those in a closed access one.

I agree with Professor Bainbridge that in the open order system, corporations have become incredible engines for the creation of wealth.  But that very success has had perverse political economy consequences.  Large, powerful, and wealthy  corporations can undermine the open order, and use their wealth and influence to receive benefits like those conferred by crowns on the corporations they created.  That is, a true open order may be unsustainable.  It bears within it the seeds of its own destruction.

Andrei Shleifer argues that regulation was adopted in the late-19th and 20th centuries precisely because the power of corporations had undermined the independence and impartiality of the courts.  Large corporations could suborn justice, and Progressives believed that the countervailing power of the regulatory state could restrain this process: the view was that the state was harder to suborn than a judge.

But regulation is not immune from being suborned.  Indeed this is the essence of the Chicago/Friedman/Stigler critique of regulation: regardless of its original or stated intentions, regulation typically confers a benefit on a powerful entity, more often than not a corporation or group of corporations. Progressive intentions to tame corporations led to an expansion of government power that was used to benefit them.  The master became servant.

This classical liberal (libertarian) critique is all the more compelling today: corporatism has grown apace with the growth of the power of the state that began in the Progressive era.  The classical liberal/libertarian response to the suborning of the regulatory state is quite straightforward: sharply limit the power of the government to regulate, thereby constraining its ability to confer rewards on the powerful.   As I said in the previous Occupy This post, corporatism requires two to play: corporations and the government.  The libertarian remedy for corporatism is not to constrain corporations in the economic sphere, but to constrain government in its ability to aid corporations (often in the guise of “public interest”).  In the classical liberal/libertarian view, this preserves the open access order, and permits corporations to achieve the economic benefits that Professor Bainbridge lays out so nicely.

But there is a nagging question: are constraints on the power of the state to confer rewards credible?  The economic benefits to concentrated interests from government intervention can be immense.  How is it possible to constrain credibility the ability of these interests to “buy” these benefits from politicians and regulators?  They are willing to pay so much, and the diffuse interests who are victimized cannot outbid them: politicians go to the highest bidder. Is it possible to prevent the auction from occurring at all?

A Stigler, or a Mancur Olson, would probably say no: it is like trying to prevent water from flowing downhill.  It will work relentlessly, and eventually erode or circumvent anything in its way.  There is not a political system that empowers the government to provide public goods or to exercise police powers that is immune to having those powers seized by rent seekers.

So what is the alternative?  Increasing government powers–the Progressive/progressive/Occupy This prescription–is completely counterproductive.  The idea of the state as countervailing power is completely chimerical, because the state is suborned by private interest: increasing its powers will only exacerbate the problems of corporatism.  A Constitution of Liberty (to appropriate Hayek’s phrase) is attractive, but likely unsustainable.

So what is a practical political program?  Perhaps the only real alternative is to wage a continuing war against the ceaseless action of the waves, like the Dutch battling the seas with their dykes and dams, knowing that some water will seep through, and that sometimes the dykes will give way.  A Constitution of Liberty is a leaky bulwark, but it is better than the alternative: to follow the progressive prescription would be to open the sluices, unleashing the deluge.

Not a happy conclusion, but methinks a soberly realistic one.

Update.  Here’s another way to state this.  I pretty much agree with Mark Pennington’s defense of classical liberalism against “market failure” arguments, communitarianism, and egalitarianism.  I am skeptical, however, about the real prospects for a “robust political economy” (the title of his book) on classical liberal lines.

The Occupy [Insert Location Here] crowd has to be the most inarticulate, inchoate, and incoherent protest movement in history.  A decidedly motley collection of progressive types, heavily laden with aging Boomers pining for their Glory Days of the ’60s protests and younger clueless wannabes.  Hard-core leftists are disproportionately represented.  Its basic messages, to the extent that it is possible to distill any, are that banks are bad and people should get more free stuff paid for by The Rich 1 Percent. The cluelessness about the way this stuff is actually created is breathtaking.

There is definitely reason to criticize and protest the unseemly nexus between business (and finance particularly) and government, but for the most part the #OWS types seem to be completely unaware of the fact that their calls to enhance government power will only strengthen and deepen the nexus.   Corporatism needs two players: corporations and the government.  Because of its monomaniacal focus on corporations, and its call for increasing the power of government, if it were actually to succeed Occupy Whatever would actually bolster the corporatism its members deplore.  Libertarian and even anarchist criticisms of the prevailing system are largely coherent and internally consistent: Occupy is notable for the complete disconnect between its diagnosis and proposed cure.

What is most interesting is that the entire Obama administration–starting at the top–is aligning itself  with this movement.  The Washington Post reports that “President Obama and his team have decided to turn public anger at Wall Street into a central tenet of their reelection strategy.” But this is particularly cynical, given the joined-at-the-hip relationship between the administration between the administration and companies like GE and Monsanto.

Moreover, key figures in the administration have come out and expressed their sympathies with the movement.

Figures like Timmy! Geithner. You know, the former head of the NY Fed, which just happens to be deeply enmeshed in the Wall Street banking establishment which Occupy identifies as the locus of evil in the universe, and formerly of the IMF, which is also a linchpin in the current finance-government web. 

Or like Bill Daley, Chicago corruptocrat extraordinare, famous intermediary between big corporations (like JP Morgan and SBC and Merck and Fannie Mae) and the government: note well that his corporate jobs have been with companies that are heavily regulated.  Not a creator.  A rent seeker: the operator of a protection racket.

One’s jaw drops at the chutzpah of people like Daley and Geithner going all populist given that they are made men in the corporatist system.  They are avatars of the incestuous relationship between government and government regulated corporations.

So what explains Obama’s decision to align himself with such a cretinous assemblage?  I can think of several, not mutually exclusive, alternatives:

• Given the objective economic conditions, Obama feels desperate politically, and knows that he cannot win using a conventional campaign.  So he is throwing in with a disruptive force that could upset conventional political dynamics and calculations.  A go-for-broke, put himself at the head of the mob strategy.  These strategies can work, but they are very risky–and often end up devouring the would-be leaders–for once destablizing forces are unleashed, they are extremely difficult to control. [Update: I note that the pivotal moment in Obama's 2008 victory was the Lehman collapse and subsequent panic. He was fading before that, but the crisis propelled him to victory.   He benefited from chaos in 2008: why not create his own in 2011-2012?]
• A realization that the ultimate result of a success of this movement would be to strengthen the government’s power–and not coincidentally strengthen the corporatism from which the Daleys etc. profit.
• A recognition that this is a way to shakedown Wall Street for campaign contributions which have been less forthcoming than in 2008.  Remember Obama’s “my administration is the only thing standing between you and the pitchforks” remark in 2009?   Translated: pay up or I’ll get out of the way.

2012 was already shaping up to be an ugly and angry campaign.  By going all in for a class warfare, us against them, strategy, Obama is making it all the uglier.  One interpretation is that he is choosing the Sampson option:  If I go down, I’ll bring everything down with me.

There will be immediate economic consequences of this as well.  Just as FDR’s attacks against “malefactors of great wealth” contributed to the regime uncertainty that retarded recovery in the Great Depression, Obama’s strategy will contribute to intense volatility over the next 13 months, and this volatility will hardly be conducive to hiring and investment.

For the past three years, I’ve wondered aloud whether we are going to relive the ’70s or the ’30s.  It’s looking more like the ’30s all the time.  And as bad as the ’70s were, that’s not a good thing.

Update.  UH student Steven Ray Christopher wrote a very similar analysis in the Daily Cougar last week.  Very nicely done: give Steve’s piece a read.

Igor Yurgens discusses what Russia needs to do to address its capital flight:

Although the Russian economy is the 10th largest in the world, it is regulated in a way that does not suit investors’ preferences. That is why the regulation issue outweighs the potential advantages that a speculative portfolio investor could have given the high oil prices we’re seeing. In addition, in order to attract short-term direct investment, the country needs investors to be confident in their future, property rights, simple relations with the state, as well as a number of investment factors. We lack some of them, like a predictable tax burden. The absence of quality human capital and skilled labor has also depressed investment.

Investors seek more politically stable havens and financial markets in periods of panic or plain old anxiety. Nor do investors enter a market until they completely understand the country’s foreign investment strategy.

Do you think that the capital outflow we’ve seen since the beginning of the year can give way to capital inflow?

Yes, once all the factors I mentioned change, once Russia becomes investment-friendly for both domestic and foreign investors, once we carry out a sort of regulatory revolution, and neither small or medium-sized businesses are assaulted by law enforcement and raiders.

In other words, pretty much everything must change.  Things that have remained largely unchanged for 20 years.  The prospects for a “regulatory revolution” that protected property rights and stamped out raiding were dim enough under Medvedev’s presidency, and while there was a chance that he might actually proceed with something resembling modernization: these return of Putin–who has never shown the slightest interest in any of these things, and who has actually worked against them in crucial instances–means that the prospects are now non-existent.

So if Yurgens has in fact identified the necessary conditions for vibrant foreign and domestic investment in Russia–and his list is a reasonable one–the only conclusion is that the prospects for vibrant foreign and domestic investment in Russia are pretty much non-existent.

One element of Obamacare, the CLASS program (a long term care program) has flatlined.  HHS Secretary Kathleen Sebelius, officially acknowledged what had been known since the get go: the program was not economically feasible.  So she pulled the plug.

CLASS was one of the myriad pieces of legislative-financial legerdemain used to make believe that Obamacare would actually reduce future deficits.

The budgetary impacts of Obamacare were made up out of the whole cloth: CLASS was just the most egregious example of that.  To create the fiction that Obamacare would save money, Congress and the administration resorted to budgetary and accounting tricks that were so outrageous that even the Greeks would have blanched at the thought of using them when presenting their fiscal numbers in to qualify for the Eurozone.

Yes.  That bad.

Obamacare is not only a policy disaster, it is a fiscal time bomb.  One would hope that the premature detonation of CLASS will put Congress and the country on warning, and result in the defusing of the rest of the whole dangerous mess.  That, unfortunately, will have to wait until January 2013, at the earliest.

This exchange between Wolfgang Munchau and Iain Begg provides an interesting counterpoint to my weekend analysis of the Euro sov debt crisis.  My post first discusses the theory behind “bazookas” as a means of preventing or deterring runs against sovereign debt (and a similar analysis holds with respect to banks too).  I then point out that the credibility of the bazooka/backstop is of crucial importance.

Begg’s reply to Munchau sets out the bazooka theory.  Munchau’s argument is that the EFSF bazooka is not credible.  It is not credible primarily because is based on the premise that countries like Italy will fund it, but countries like Italy are causing the problem too.  That is, the EFSF is beset with wrong way risk.  The Europeans are in effect aiming the bazooka at their own heads.  That isn’t the most credible deterrent against runs.

Indeed, the structure is highly unstable.  If, say, Italy can’t perform on its obligations because it is the one being bailed out, that increases the burden on France, which could put France into jeopardy.

I generally agree with Manchau.  Biggs has it right when it comes to how a backstop can prevent liquidity crises, but that backstop has to be credible: I agree with Manchau that the EFSF mechanism is not credible, given its wrong way risk problem.

Taking things to the next level, as I did in my post: what is the likelihood of negotiating a credible mechanism?  Here I am again skeptical, for political economy reasons, as expressed in the post.  On this issue, I was intrigued to see two posts touching on this issue in general.  Tyler Cowen dismisses IS-LM in part because it ignores altogether political economy issues, which he identifies as a first-order macroeconomic factor.  I agree completely.  Indeed, it is kind of bizarre to discuss sovereign debt crises, banking crises in which there was a strong regulatory dynamic, and fiscal crises (all components of Financial Crisis I and II) without discussing political economy.  Peter Boettke follows up on Tyler’s post, and emphasizes the centrality of political economy to macro problems, and in particular macro policies.

I agree that political economy is the linchpin, and not just in macro policy but all of the regulatory issues that are currently of pressing importance.  The reason that I am quite concerned about Europe is precisely because  political economy issues there make it very difficult to devise a mechanism for allocating sovereign debt losses (and potential banking losses connected thereto).  It is always hard to devise such sharing mechanisms, particularly after a chunk of the losses has already been realized.  It is even harder given the institutional structure of the EU, which by design makes it difficult (and arguably illegal) to shift losses on one state’s debt to other member states.

You will hear many plans of bazookas in coming weeks.  All will differ in details.  What you should focus on is whether these mechanisms are in fact credible, and politically feasible.  The things we’ve seen so far, not so much–as Manchau emphasizes.  Incredible political creativity–and perhaps, duplicity–will be required to create a credible mechanism.   The economic destination is pretty well understood, but the political road to get there is unmapped, and indeed, is likely yet to be built.