Streetwise Professor

December 29, 2017

Remembering a Forgotten Battle: Stones River, 1862-63.

Filed under: Civil War,History — The Professor @ 6:49 pm

New Years Eve day will be the 155th anniversary of one of the forgotten battles of the Civil War–Stones River (styled Murfreesboro by the Confederates). The battle was actually fought over two days–31 December, 1862 and 2 January, 1863. It resulted in almost 25,000 casualties, but was overshadowed by other events. The Union disaster at Fredericksburg on 13 December and the subsequent Mud March fiasco in January–these events took place much closer to the political capital and media centers of the North–attracted far more notice. The destruction of Grant’s supply depot at Holly Springs on 20 December, and his subsequent retreat from northern Mississippi (thereby terminating his first attempt at Vicksburg) and the nearly simultaneous bloodying of Sherman at Chickasaw Bluffs outside of Vicksburg also detracted attention from the battle in middle Tennessee. The indecisive nature of the combat also helped doom the battle to obscurity: there was no real victor, and no major strategic outcome from all the bloodletting.

The 25,000 combined casualties ranks only 6th on that grim list for the Civil War. But it was the bloodiest major battle in proportion to numbers engaged–the percentage loss on both sides was almost one-third of the troops that fought there. In contrast, the loss rate at Gettysburg was about 28 percent. Absolute casualties were larger at the Wilderness, but more than twice as many men fought in that 1864 Virginia battle.

Yet Stones River is obscure. This is unfortunate, and a slight to those who fought there. And fight they did.

Stones River was the middle of three gruesome battles fought between the Army of the Ohio/Cumberland and the Army of Mississippi/Tennessee between 8 October, 1862 (Perryville) and 19-20 September, 1863 (Chickamauga). All three battles demonstrated the offensive prowess of Bragg’s Confederate army. At Perryville, a Rebel offensive pulverized McCook’s corps. At Stones River, the Southern assault wrecked McCook’s Corps again, and did considerable damage to Crittenden’s as well. At Chickamauga, the Confederate onslaught crushed both. Only when Union troops fought behind fortifications were they ever able to withstand an attack by the Army of Tennessee, until that attack was spent.*

But the battles also illustrated the limits of the offensive. The casualty toll suffered by the Confederate attackers, and the disorganization, physical and emotional exhaustion, and chaos resulting from even  successful assaults, made it impossible to sweep the battered Union armies from the battlefield. In each case, it was easier for the defenders to retreat and form a coherent defense than it was for the winded and bloodied attackers to regroup for a final decisive charge.

Moreover, in each battle, stalwart defenses by relatively small Union commands delayed and disrupted the Confederate attacks sufficiently to allow the Union troops to rally sufficiently to avoid annihilation. At Perryville, Starkweather’s brigade performed this vital task. At Stones River, Sheridan’s division held long enough in the cedars to permit Rosecrans to form a final line at the Nashville Pike. Further, Hazen’s brigade held the Round Forest against repeated attacks. At Chickamauga, the stand around Horseshoe Ridge anchored by Harker’s and Vanderveer’s brigades plus the detritus of many Union regiments permitted Thomas to extract the Union army from its parlous position.

And in all three battles, the failure to achieve decisive victory despite driving Federal troops from position after position, set off bitter recrimination’s in Bragg’s army. After Stones River, Bragg and division commander Breckenridge (former Vice President of the US, and eventual Secretary of War for the Confederacy) engaged in a vicious argument over responsibility for Breckenridge’s disastrous assault on 2 January. In the rest of the army there was grave dissatisfaction over the failure to achieve victory. The poisonous atmosphere hamstrung the army for the remainder of Bragg’s unhappy tenure as commander.

The performance of Confederate troops during this and the other two battles is all the more remarkable given the utterly dysfunctional command structure that ordered and led them into battle.

So take a moment to remember this forgotten contest. Those who fought and bled there do not deserve the obscurity that has characterized the battle almost since the day it was fought. It demonstrates the remarkable qualities of the private soldiers and many of the field grade and company officers on both sides–and the extreme limitations of their commanders. It was a soldier’s battle par excellence, and those soldiers deserve recognition for their stalwart performance on two wintery days in middle Tennessee.

*To this I should add the Army of Mississippi’s assaults on the first day at Shiloh, which almost succeeded in driving Grant’s Army of the Tennessee into the river from which it took its name. Van Dorn’s Army of West Tennessee smashed Rosecran’s Army of the Mississippi on the first day of the Battle of Corinth (3-4 October, 1862), and its assaults on the second day pushed back Rosecrans’ right wing into the town: the Union left was heavily fortified, and this allowed it to hold off the attack on its sector.  Some units of Van Dorn’s army, notably Moore’s Texas Brigade and the Missouri  Brigade fought with the Army of Tennessee during the Atlanta and Nashville campaigns. The counterattack of Bowen’s Division at Champion Hill, which almost brought Grant’s army to ruin in that decisive battle, is another example of the striking power of Confederate troops in the Western Theater. Most of the Confederate attacks on the first day at Chickamauga, with the exception of Cheatham’s Division’s assaults in the Brock Field Area, were initially successful, but ultimately indecisive because of the inevitable loss of impetus due to casualties and disorganization. Breckenridge’s attack on 2 January at Stones River also succeeded in smashing the Union left flank across the river, only to be repelled by the massed artillery battery (57 guns firing on the Confederate  front and flank)  assembled by Captain John Mendenhall.

No other army on either side mounted so many successful frontal attacks. (Many of the Army of Northern Virginia’s successful attacks, e.g., Second Manassas, Chancellorsville, were flank attacks, while others such as on Barlow Knoll the first day at Gettysburg or against the Emmitsburg Road on the second day involved a numerically superior force attacking badly positioned Union defenders.)

What accounts for the great shock effect of Confederate infantry attacks in the West? Sheer aggressiveness and elan has to be part of it: even attacks against breastworks that failed (e.g., Franklin, the Battle of Atlanta) were pressed with extreme vigor. (Peachtree Creek and to some degree Ezra Church and Jonesboro were exceptions). I would also surmise that the difference in performance in attacks on unfortified and fortified defenders demonstrates that the attackers’ fire was particularly accurate and heavy. Inflicting heavy casualties while advancing a defending force increased the odds of success. Entrenchments or barricades largely eliminated the ability of the advancing force to render large numbers of the defenders hors de combat.

December 27, 2017

Vova the Squeegee Man

Filed under: Economics,Politics,Russia — The Professor @ 4:21 pm

My old buddy Vova is making a rather forced and pathetic attempt to persuade rich Russians to repatriate the money they have invested (squirreled away) overseas:

President Vladimir Putin is using the threat of additional U.S. sanctions to encourage wealthy Russians to repatriate some of their overseas assets, which exceed $1 trillion by one estimate.

I call the attempt forced and pathetic precisely because Putin feels obliged to try to persuade, rather than dictate. And because he is offering inducements:

Putin said on Monday that Russia should scrap the 13 percent profit tax on funds repatriated from abroad and renew an amnesty from penalties for businesses returning capital.

And because he’s raising the bogeyman of western sanctions (from the Bloomberg piece):

“We and our entrepreneurs have repeatedly faced unjustified and illegal asset freezes under the guise of sanctions,” Peskov said on a conference call Tuesday. “The president’s initiative aims to create comfortable conditions for businesses if they want to use this opportunity to repatriate their capital.”

Heretofore, sanctions have limited the ability of the affected entities to tap western financing: they have not involved expropriation or the kind of piratical corporate and government behavior that has been seen in Russia. Investments abroad remain abroad despite the more hostile environment to Russian money in the west because it is still safer than it would be in Russia. That’s why Vova has to beg and bribe to try to get Russians to repatriate. And previous efforts have hardly been successful:

Russia rolled out a similar amnesty program during the worst of the conflict in Ukraine, which coincided with a plunge in oil prices that triggered the country’s longest recession of the Putin era. That 18-month initiative, the results of which haven’t been disclosed, “didn’t work as well as we’d hoped,” Finance Minister Anton Siluanov said. Unlike that plan, this one waives Russia’s 13 percent tax on personal income, according to Dmitry Peskov, Putin’s spokesman.

Note that the mere threat of western sanctions has not been enough: hence the tax waiver.

Insofar as piratical corporate behavior is concerned, I give you Igor Sechin, ladies and gentlemen. What do you think is more intimidating, Sechin plotting–and the system cooperating–to jail a troublesome minister for eight years, or what the US and Europe have done to sanctioned entities? Or his serial extortions of Sistema, which recently agreed to an “amicable” settlement with Rosneft/Sechin? Said “amicable” settlement involved the former paying the latter $1.7 billion dollars to settle a suit . . . over what is rather hard to say. I still don’t get the legal theory under which Rosneft even thought it was entitled payment for Sistema’s alleged past wrongs. Given that this occurred mere days after Putin called for an amicable settlement, it is pretty clear that he was taking Sechin’s side and telling Sistema to cave–and do so with a smile.

This is why Russian money will stay out of Russia, Putin’s pleas notwithstanding.

Another story gives you a partial explanation for Putin’s neediness: “Russia’s Reserve Fund to be fully depleted in 2017.” The rainy day fund is empty, and the outlook remains cloudy.

Thus, for all the hyperventilating about Putin the Colossus, the objective basis for his power is shaky indeed. He can be a pest and troublemaker, but he lacks the economic heft to be much more. Yet for selfish political reasons, Democrats, NeverTrump Republicans, and the media inflate his importance daily. Enough. Putin is rattling his tin cup, hoping that some rich Russians will drop some rubles into it. Maybe if the tax inducement isn’t enough, he can squeegee their windshields.

December 26, 2017

Agency Costs: Washington’s Augean Stables

Filed under: Economics,Politics,Regulation — The Professor @ 6:09 pm

In news that definitely added to my holiday cheer, a gloomy New York Times moaned that “[m]ore than 700 people have left the Environmental Protection Agency since President Trump took office, a wave of departures that puts the administration nearly a quarter of the way toward its goal of shrinking the agency to levels last seen during the Reagan administration.”

Given that the EPA is one of the most malign agencies in DC, every subtraction is an addition to America’s wealth–and no, this will not detract markedly, if at all from environmental quality. Or at least, any loss in environmental quality would not have been worth the cost necessary to achieve it.

The most signal achievement of Trump’s first almost year has been on the regulatory front. (The recent tax law arguably pips that.) The metastasizing regulatory/administrative state under both the Bush and Obama administrations is a detriment to prosperity, and in particular to the dynamism of the American economy. It is the engine of European-like sclerosis, and it badly needs to be brought under control.

Trump has begun–and only that–the task of cleaning this Augean Stables on the Potomac. The bureaucrats are none to happy, and are fighting back, mainly through classic bureaucratic guerrilla warfare. Unfortunately, they have advantages in this form of combat, and any progress will be achieved slowly, and only through unceasing effort. Those appointed to lead the agencies are often at a disadvantage in taming those who work for them even when they have a will to do so, and what’s more, all of the mechanisms of capture are at work here, meaning that agency political appointees are constantly at risk of going native.

The administrative state is a threat to prosperity and liberty, and a Constitutional anomaly, not to say monstrosity. Administrative agencies combine executive, legislative, and judicial functions, thereby threatening the separation of powers and associated checks and balances which are intended to prevent any single branch of government overawing the others. Indeed, in many respects the administrative state has become an independent branch of government, though not one formally established by the Constitution.

Moreover, it is not subject to the normal mechanisms of accountability. Yes, it is formally subject to Congressional oversight and some presidential control, and hence indirectly subject to the electorate, but due in large part to the scope and intricacy of the regulators’ responsibilities, there is a huge principal-agent problem: agency costs (as economists use the term) are a major issue with federal agencies. It is very difficult for Congress or the White House to control regulators. Further, information asymmetries make it inefficient to utilize high-powered incentives to get regulators to implement the wishes of those who formally control them. Civil service protections insulate bureaucrats from personal accountability for all but the most egregious misconduct (and sometimes not even then).

There is also a strong bias towards expanding agencies’ power. Several factors work in this direction, and few in the opposite way. Empire building is one such factor–regulators have a strong preference to expand their power. Congressional committees that oversee agencies also gain political power when the influence of their charges expand. (This shares some similarities with a mafia protection racket.) Government agencies attract people who are ideologically predisposed to expansive exercise of government power.

These asymmetries lead to a ratchet effect. Statist administrations–notably Obama’s, but to a considerable degree Bush’s as well–find allies in the administrative state who eagerly push their agenda. (Look at the CFTC in the Gensler years.) Less statist ones–like Trump’s–face a wearying battle of attrition to undo what had been put in place by previous administrations (and Congresses).

Legal precedents only make things more difficult. The Chevron doctrine (derived from a 33 year old Supreme Court decision) requires federal courts to defer to the judgments (I would not say expertise) of regulatory agencies in matters of statutory ambiguity and interpretation. This exacerbates greatly the agency problems, because since Congressional “contracts” (i.e., laws) are inherently incomplete (they do not specify regulatory actions in every state of the world), such ambiguities and necessities of interpretation are inevitably legion. And under Chevron, the federal courts can do little to rein in an agency. (Justice Gorsuch has criticized Chevron, and hopefully soon there will be an opportunity to reverse it or narrow it substantially.)

The administrative state is a progressive–and Progressive–creation. It reflects deep suspicion and skepticism about private ordering, and a belief in the superior knowledge and moral superiority of an expert class who should be protected from popular whims and passions, as expressed through election results, because those whims and passions are not the reflection of wisdom, knowledge, or dispassionate analysis. (If you want a sick laugh, look at Tom Nichols’ bleatings about expertise at @radiofreetom on Twitter.)  In the progressive worldview, the lack of democratic accountability is a feature, not a bug. Leave these people alone. They know better–and are better–that you!

The strongest case for some insulation of administrative agencies from more intrusive control by the Constitutionally-recognized branches of government is that this facilitates credible commitments: market participants, and citizens generally, know there will be some stability in rules and regulations, and can plan accordingly. But given the tendency to expand the scope of regulations, this translates into stability of overregulation.

There’s also something, well, Russian about a highly bureaucratic state, largely run by an unelected nomenklatura. Read Tocqueville’s descriptions of 19th century Russia and the 19th century US, and you’ll see that the administrative state leans far more towards the former than the latter.  I would also note that the bureaucracy is one of Putin’s strongest political pillars.

So the news that a few bureaucrats at the EPA are so disenchanted by Trump that they’ve up and quit is encouraging, but it’s at most a small victory in a big war. I have been encouraged by few other wins (e.g., on net neutrality), but the most I hope for is an elimination of some of the most egregious excesses of the Obama (and to a lesser degree Bush) years. The overall trend is towards a more powerful, insular, and unaccountable administrative state, much to the detriment of America’s freedom, dynamism, and prosperity.


December 21, 2017

Not Exactly What I Asked Santa For, But I’ll Take It

Filed under: Derivatives,Economics,Politics — The Professor @ 10:13 pm

Miracle of miracles, Congress has passed, and Trump will sign (perhaps after the New Year) a tax bill. It’s hardly perfect, but it’s an improvement on the existing system, and is about the best we could expect to get in the current political climate.

What do we want from a tax system, and how does this bill get us closer to that? One goal of the tax system–and the one that I prioritize–is to minimize the deadweight cost of raising the necessary revenue. All real world taxes involve distortions–deadweight losses–because they warp incentives at the margin. For instance, a tax on labor income drives a wedge between the marginal benefit of working an hour (the after tax wage) and the marginal cost (the value of lost leisure). This induces people to work too little and to consume too much leisure (or equivalently, consume too much leisure and too little goods and services) because they don’t capture the full benefit of their labor. Really inefficient tax systems are rife with such distortions. The US tax code provides numerous examples.

Taxes on capital or the returns to capital–taxes on dividends, corporate profits, and capital gains–are highly distorting. Steven Landsberg explains this as intuitively as anyone. The basic idea is that capital taxes are a form of double taxation that distort incentives to save and invest vs. consume. As Landsberg puts it, it is a surtax. With capital taxation, we have an incentive to consume too much and save and invest too little.

For about 30 years, economists have understood that in certain circumstances, the optimal rate of tax on returns to capital is zero. That is, a consumption tax is optimal.

There are caveats to this conclusion. Information-driven considerations can lead to a positive capital tax rate. For example, if people can disguise labor income as capital income to escape the income tax on labor earnings, a positive capital tax can be efficient in conjunction with a personal income tax. Disguising consumption as investment (is a new personal computer an investment or consumption?) can lead to a similar result. Distributive considerations (which inherently involve value judgments, I should note, whereas efficiency considerations do not) can also make it desirable to tax capital.

But even given these caveats, it is almost certainly the case that an efficient tax system imposes relatively low taxes on capital.

This efficiency effect is also related to another (possible) goal of the taxation system–to affect the distribution of income/wealth/consumption. For the impact of the tax on capital returns on investment affects who actually bears the burden of the tax.

This is an example of one of the issues that non-economists have a devil of a time understanding: tax incidence. Who bears the burden of a tax is not necessarily the party on whom the tax is levied. Taxes on labor aren’t necessarily paid by workers. Sales taxes assessed on firms aren’t necessarily paid by those firms. Who bears the tax burden depends on elasticities of supply and demand for the thing that is taxed.

Capital tax incidence is particularly unintuitive because there is a dynamic element to it. But the basic point is that even though a capital tax is formally levied on the owners of capital (or the return streams), over a long enough horizon the burden falls almost entirely on labor.

This is due to the impact of the capital tax on investment mentioned above. Tax capital, you get less investment. With less investment, there is less capital. With less capital, labor is less productive. Lower productivity translates into lower wages. Meaning that even though no supplier of labor writes a check to Uncle Sam to pay for the tax on capital, s/he pays it nonetheless, in the form of lower real wages.

The impact tends to increase over time, because the capital stock does not adjust immediately in response to a capital tax that depresses after-tax returns. But in standard models, the long run equilibrium after-tax return on capital is a constant (determined by the marginal utility of consumption, time preferences, and the long run growth rate of the economy). So if you raise capital taxes, a constant after-tax return requires a rise in the pre-tax return, which requires a fall in the capital stock. That’s what causes wages to fall. And the quicker the capital stock can adjust, the more rapidly the capital tax rise reduce wages.

And of course this works in the opposite direction if you cut capital taxes: the after tax return to capital initially rises, spurring investment, which raises productivity and hence wages.

Indeed, under some fairly standard assumptions, the a cut in capital taxes cause wages to rise more than the lost revenue in capital taxes. Meaning that in the long run, labor pays more than 100 percent of a tax formally levied on capital.

Again, these effects are not immediate, but if you see a surge of investment in the next couple of years, you can surmise that wages will surge too over that time frame.

This result can be expressed in elasticity terms. The supply of capital is perfectly elastic in the long run. Perfectly elastically supplied inputs do not bear any burden of a tax, even if that tax is formally levied on those inputs: instead, the burden is paid by the suppliers of other inputs (e.g., labor) or consumers (in the form of higher prices).

And even to the extent that owners of capital benefit in the short term, they are people too. And yes, many of them are wealthy, but many are workers who are also capitalists due to their participation in pension plans or 401Ks.

The focus of the recently passed tax bill is the reduction of capital taxes, most notably through reductions in the corporate tax rate to 21 percent (from 35 percent–very high by world standards), and through the immediate expensing of some investment expenditures.  This is the main reason the tax bill is a big improvement. Yes, I would prefer a Full Monty consumption tax, but this reduction in capital taxation is a movement towards a more efficient tax system, and one that will increase wages over time more rapidly than under the existing rates.

An efficient tax system should also focus on broadening the tax base and reducing marginal rates, because it is marginal rates that distort decisions to work and save. The current bill does a little on this dimension.

Tax preferences for certain kinds of consumption or investment are also usually a bad idea. The mortgage interest deduction is a classic example of this: the non-taxation of employee health insurance premiums paid by employers is another. The former encourages excessive consumption of/investment in housing. The latter favors employer-provided health coverage, which distorts labor markets (e.g., through job lock).  It also induces overconsumption of health care as compared to other goods and services.

The tax bill trims–but does not eliminate–the favored tax treatment of mortgage interest. So that’s good, but not great. It does nothing  on the health care premium issue, which is unfortunate.

The tax bill also limits corporate deductions of interest payments on debt. This is desirable, because it mitigates the incentive to finance with debt rather than equity. The bill should have gone further.

One largely hidden bad in the bill is the elimination of operating loss carry backs and limits on operating loss carry forwards. I understand the motivation here–it was done to offset revenue losses from other tax cuts. However, this will deter risk taking and lead to more hedging designed to reduce the variability of corporate income solely for the purpose of reducing taxes.

This effect is a little subtle, so I’ll try to explain. With no carry backs or carry forwards, them marginal tax rate when a company loses money is zero, and the marginal tax rate on positive corporate profits is the full corporate rate (now 21 percent). Thus, if a company has a positive probability of losing money, its marginal tax rate is non-decreasing with income, and increasing over some range. Due to Jensen’s inequality, this increasing marginal tax rate means that expected tax payments are increasing in the variance of corporate income.* Thus, increasing risk is costly because it transfers money (on average) to the government. Therefore, firms are more likely to pass up higher returning but riskier projects, and more likely to pay bankers to design hedging products to reduce corporate income volatility (which uses real resources, i.e., causes a deadweight loss), or to engage in diversifying mergers that reduce returns on average but also reduce the variability of corporate income.

In contrast, carry backs and carry forwards reduce the disparity between the marginal tax rate on gains and losses. This means that expected tax payments are less sensitive to the variance of corporate profits, which reduces distortions in risk taking and risk management decisions.

Another negative in the bill is the retention of tax subsidies for electric vehicles and renewables.

But even despite these negatives, all in all, I say two cheers–or maybe 1.5 cheers-for the tax bill. It’s not exactly what I asked Santa for, but it’s better than a sharp stick in the eye.

But from the wailing on the left, you’d think that’s exactly what happened to them. In both eyes, in fact.

The left’s reaction is hysterical, in both senses of the word. It is hysterical in the sense of:

a psychological disorder (not now regarded as a single definite condition) whose symptoms include conversion of psychological stress into physical symptoms (somatization), selective amnesia, shallow volatile emotions, and overdramatic or attention-seeking behavior.

Especially the “shallow volatile emotions, and overdramatic or attention-seeking behavior” parts. Several Democrats (notably Nancy Pelosi) referred to the tax bill as “Armageddon.” Talk about overdramatic hyperbole. A common shriek (especially on Twitter) is that the tax bill will KILL thousands (or is it millions?) of Americans. People on the left seem to be in a competition to show who can be the most OUTRAGED OVER THIS OUTRAGE.

A good deal of this idiocy reflects a basic misunderstanding of tax incidence (which I discussed above). The left confuses who writes the tax check (corporations) with who actually foots the bill (in the medium and long run, wage earners). Another good deal of this idiocy reflects the bill’s limitation on the deductibility of state and local taxes, which hits high tax states like New York, New Jersey, Connecticut, and California–which also happen to be solidly Democratic. So this is a matter of whose ox is gored.

This is rather amusing, because these same Democrats claim to favor making the rich pay more taxes. But not their rich people, who will be hit hardest by the limits on SALT deductibility. I guess income redistribution should be achieved by taxing all those rich rednecks in Mississippi more heavily.

The left’s reaction is hysterical in the other sense of the word, meaning “extremely funny.” The reaction is so overwrought, so over-the-top, so disproportionate, so emotional, and so lacking in intellectual seriousness that it makes me laugh.

And I guess that’s another reason to support it. If those people think it’s horrible, it must be pretty good, right?

In all seriousness, evaluating the bill using some basic economics rather than what you might learn in primal scream therapy, it’s not bad, especially considering the source–a dysfunctional ruling class in DC. It mitigates some of the worst inefficiencies in the existing tax code. It could go further, but the fact that it goes anywhere at all is rather amazing, and a welcome holiday present.

*For those who said “WTF?” when they read “Jensen’s inequality” perhaps an example will help. Consider a company that has two investment opportunities. One pays $100 for certain. The other pays -$100 with a 50 percent probability, and $310 with a 50 percent probability. The expected return on the risky project is actually higher ($105 vs. $100), so from an efficiency perspective, that’s what we’d like the company to choose.

But it won’t if the corporate tax rate is 35 percent on gains, but the firm receives no payment from the government if it loses money: this means that the marginal tax rate on gains is positive, but the marginal rate on losses is zero. With this tax system, the after-tax return of the certain project is $65. The after tax return of the risky project is .5x-$100+.5x.65x$310=50.75.

The difference here is that the expected tax payment is higher when income is riskier. The expected tax payment in the certainty case is $35. In the risky case, it is .5x.35x$310=$54.25.

Carry backs and carry forwards allow the company to use the losses to offset gains in other years. If the firm faced the same payoff structure year after year, it could always carry back or carry forward the -$100 losses from bad years to offset gains in the good years. Thus, tax payments in the good years would fall to .5x.35x$210=$36.75, and its average after tax return would be $105-$36.75=$68.25>$65. So the company would take the project with the higher return.

Of course, the distortion attributable to the elimination of carry backs and limitation on carry forwards is greater, the higher the corporate tax rate. Thus, the reduction in the statutory rate to 21 percent dampens the effect of the reduction in the carry backs/forwards. But since the corporate tax rate is still positive, risk taking and risk management decisions are still distorted.


December 4, 2017

Bitcoin Futures: What? Me Worry?

Filed under: Clearing,Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 9:53 pm

The biggest news in derivatives world is the impending launch of Bitcoin futures, first by CBOE, then shortly thereafter by CME.

Especially given the virtually free entry into cryptocurrencies I find it virtually impossible to justify the stratospheric price, and how the price has rocketed over the past year. This is especially true given that if cryptocurrencies do indeed begin to erode in a serious way the demand for fiat currencies (and therefore cause inflation in fiat currency terms) central banks and governments will (a) find ways to restrict their use, and (b) introduce their own substitutes. The operational and governance aspects of some cryptocurrencies are also nightmarish, as is their real resource cost (at least for proof-of-work cryptocurrencies like Bitcoin). The slow transaction times and relatively high transaction fees of Bitcoin mean that it sucks as a medium of exchange, especially for retail-sized transactions. And its price volatility relative to fiat currencies–which also means that its price volatility denominated in goods and services is also huge–undermines its utility as a store of value: that utility is based on the ability to convert the putative store into a relatively stable bundle of goods.

So I can find all sorts of reasons for a bearish case, and no plausible one for a bullish case even at substantially lower prices.

If I’m right, BTC is ripe for shorting. Traditional means of shorting (borrowing and selling) are extremely costly, if they are possible at all. As has been demonstrated theoretically and empirically in the academic literature, costly shorting can allow an asset’s price to remain excessively high for an extended period. This could be one thing that supports Bitcoin’s current price.

Thus, the creation of futures contracts that will make it easier to short–and make the cost of shorting effectively the same as the cost of buying–should be bearish for Bitcoin. Which is why I said this in Bloomberg today:

“The futures reduce the frictions of going short more than they do of going long, so it’s probably net bearish,” said Craig Pirrong, a business professor at the University of Houston. “Having this instrument that makes it easier to short might keep the bitcoin price a little closer to reality.”

Perhaps as an indication of how untethered from reality Bitcoin has become, the CME’s announcement of Bitcoin futures actually caused the price to spike. LOL.

Yes, shorting will be risky. But buying is risky too. So although I don’t expect hedge funds or others to jump in with both feet, I would anticipate that the balance of smart money will be on the short side, and this will put downward pressure on the price.

Concerns have been expressed about the systemic risk posed by clearing BTC futures. Most notably, Thomas Petterfy sat by the campfire, put a flashlight under his chin, and spun this horror story:

“If the Chicago Mercantile Exchange or any other clearing organization clears a cryptocurrency together with other products, then a large cryptocurrency price move that destabilizes members that clear cryptocurrencies will destabilize the clearing organization itself and its ability to satisfy its fundamental obligation to pay the winners and collect from the losers on the other products in the same clearing pool.”

Petterfy has expressed worries about weaker FCMs in particular:

“The weaker clearing members charge the least. They don’t have much money to lose anyway. For this reason, most bitcoin interest will accumulate on the books of weaker clearing members who will all fail in a large move,”

He has recommended clearing crypto separately from other instruments.

These concerns are overblown. In terms of protecting CCPs and FCMs, a clearinghouse like CME (which operates its own clearinghouse) or the OCC (which will clear CBOE’s contract) can set initial margins commensurate with the risk: the greater volatility, the greater the margin. Given the huge volatility, it is likely that Bitcoin margins will be ~5 times as large as for, say, oil or S&Ps. Bitcoin can be margined in a way that poses the same of loss to the clearinghouses and FCMs as any other product.

Now, I tell campfire horror stories too, and one of my staples over the years is how the real systemic risk in clearing arises from financing large cash flows to make variation margin payments. Here the main issue is scale. At least at the outset, Bitcoin futures open interest is likely to be relatively small compared to more mature instruments, meaning that this source of systemic risk is likely to be small for some time–even big price moves are unlikely to cause big variation margin cash flows. If the market gets big enough, let’s talk.

As for putting Bitcoin in its own clearing ghetto, that is a bad idea especially given the lack of correlation/dependence between Bitcoin prices and the prices of other things that are cleared. Clearing diversified portfolios makes it possible to achieve a given risk of CPP default with a lower level of capital (e.g., default fund contributions, CCP skin-in-the-game).

Right now I’d worry more about big markets, especially those that are likely to exhibit strong dependence in a stress scenario. Consider what would happen to oil, stock, bond, and gold prices if war broke out between Iran and Saudi Arabia–not an implausible situation. They would all move a lot, and exhibit a strong dependency. Oil prices would spike, stock prices would tank, and Treasury prices would probably jump (at least in the short run) due to a flight to safety. That kind of scenario (or other plausible ones) scares me a helluva lot more than a spike or crash in Bitcoin futures does while the market is relatively modest in size.

Where I do believe there is a serious issue with these contracts is the design. CME and CBOE are going with cash settlement. Moreover, the CME contract will be based on prices from several exchanges, but notably exclude the supposedly most liquid one. The cash settlement mechanism is only as good as the liquidity of the underlying markets used to determine the settlement price. Bang-the-settlement type manipulations are a major concern, especially when the underlying markets are illiquid: relatively small volumes of purchases or sales could move the price around substantially. (There is some academic research by John Griffen that provides evidence that the settlement mechanism of the VIX contracts are subject to this kind of manipulation.)  The Bitcoin cash markets are immature, and hardly seem the epitome of robustness. Behemoth futures contracts could be standing on spindly cash market legs.

This also makes me wonder about the CFTC’s line of sight into the Bitcoin exchanges. Will they really be able to monitor these exchanges effectively? Will CME and CBOE be able to?

(I have thought that the CFTC’s willingness to approve the futures contracts could be attributable to its belief that the existence of these contracts would strengthen the CFTC’s ability to assert authority over Bitcoin cash exchanges.)

What will be the outcome of the competition between the two Chicago exchanges? As I’ve written before, liquidity is king. Further, liquidity is maximized if trading takes place on a single platform. This means that trading activity tends to tip to a single exchange (if the exchanges are not required to respect price priority across markets). Competition in these contracts is of the winner-take-all variety. And if I had to bet on a winner, it would be CME, but that’s not guaranteed.

Given the intense interest in Bitcoin, and cryptocurrencies generally, it was inevitable that an exchange or two or three would list futures on it. Yes, the contracts are risky, but risk is actually what makes something attractive for an exchange to trade, and exchanges (and the CCPs that clear for them) have a lot of experience managing default risks. The market is unlikely to be big enough (at least for some time) to pose systemic risk, and it’s likely that trading Bitcoin on established exchanges in a way that makes it easier to short could well tame its wildness to a considerable degree.

All meaning that I’m not at all fussed about the introduction of Bitcoin futures, and as an academic matter, will observe how the market evolves with considerable fascination.

December 3, 2017

Please Reconcile This: The Kremlin Is Hermetically Sealed to Outsiders, But They Told All to Christopher Steele

Filed under: Politics,Russia,Uncategorized — The Professor @ 7:45 pm

This article caught my eye last week: “At the epicenter of the Russian election manipulation story, reporters can’t report.”

As tensions rise, Ferris-Rotman finds reaching sources inside the government all but impossible. She says foreign correspondents based in Moscow can’t just pick up their phone and text or call an official.

“Russia is a very closed place,” she says. “It’s not like the U.S. where, you know, over years or over some time you can develop a source in the White House — someone who you can trust and that you trade information with. Basically (the Kremlin) is a sealed up institution and there’s no way for us to get into it. “

The Kremlin is a “sealed up institution,” but we are supposed to believe that Christopher Steele was able to get multiple sources within the Kremlin to repeat highly sensitive conversations involving the highest personages in the Kremlin, including Putin himself.

The dossier itself is bad enough, but its handling in the US–specifically by the FBI and the intelligence community–is downright sinister. This is even more evident after it was revealed that the FBI agent who was responsible for handling the dossier was a pro-Hillary/anti-Trump partisan who was fired by Mueller for exchanging anti-Trump texts with his lover, also an FBI agent. (Not that Mueller told us that this was why he was fired when it happened months ago. I guess he didn’t have time because he was so busy leaking.) Moreover, this same individual allegedly has been interfering with the House Intelligence Committee’s attempts to get to the bottom of the story of the dossier.

But there’s more: the same FBI official led the investigation of Hillary’s emails.

As the expression goes: the fix is in! Although here, it is necessary to use the plural: the fixes are in!

Boy, if only there was a Republican attorney general who could get control of a rogue FBI and get some answers about the dossier–how it was obtained, and how it was used by the FBI.




Filed under: Politics,Russia — The Professor @ 7:29 pm

Friday was a bonanza for dry cleaners, as the media and the political class collectively wet themselves in glee at the news that ex-National Security Advisor Michael Flynn plead guilty to lying to the FBI.

Alas, their fondest desires ran well ahead of the reality–which is the norm for this lot.

As was the case with Manafort, Flynn plead guilty to lying but not to any underlying crime, least of all a conspiracy with the Russians. The most reasonable inference for this is that there WAS no underlying crime and no conspiracy.

Indeed, Flynn will testify that he lied about two conversations with the Russian ambassador, Kirlyak, neither of which was illegal or even unethical.

In the first conversation, he spoke not just to Kirlyak, but to the ambassadors of every nation on the United Nations Security Council, including Senegal, Egypt–and wait for it–Ukraine. The subject was not Russia, but the stink bomb of an anti-Israel resolution that the outgoing Obama administration supported  but the incoming Trump administration opposed.

And it was the incoming Trump administration, because this conversation took place in December, 2016.

Flynn allegedly contacted the ambassadors at the direction of Jared Kushner.

So this contact is about Israel, not Russia. Flynn talked to Russia only because Russia was on the UNSC. As it (or the USSR) has been since its creation in 1945.

But the breathless media coverage was almost all headlined “Flynn spoke to Russia,” insinuating that his plea showed that Trump was canoodling with Putin.

In econometrics, omitting variables leads to biased inferences. Here, omitting that Flynn also spoke to every other nation on the UNSC about an issue that had noting to do directly with Russia definitely led to biased inferences. And that was exactly the intention, which demonstrates the bad faith of virtually the entire journalistic establishment.

The other conversation was about Russia directly. Specifically, Flynn asked Kislyak that Russia not overreact to Obama’s out-the-door sanctions on Russia. Trump wanted to avoid an escalatory dynamic, which is perfectly reasonable, especially given the fact that Obama almost certainly levied these sanctions with the intent of making life difficult for Trump.

Since these events happened after the election, they did not advance the collusion narrative. The media and the political class dealt with this in two ways.

First, they just lied. Brian Ross of ABC News reported–and the rest of the media repeated–that Flynn was going to testify that he had spoken to Russians during the campaign. WRONG. He will merely say that the Trump team had discussed plans to improve relations with Russia post-election. Big difference.

But this is a classic case of Twain’s dictum about a lie getting around the world before the truth got its boots on. And isn’t it funny how all the lies are in the same direction?

This is in fact a huge benefit to Trump, because what better illustrates his assertions that the mainstream media is a firehose of fake news?

Second, they harrumphed about the Logan Act, a likely un-Constitutional historical curiosity dating from January 30 . . . 1799–and which despite its longevity has never resulted in an indictment, let alone a conviction. The law forbids private individuals from negotiating with foreign states in a dispute with the US. About its only relevance to today is that it was adopted in fevered political times (the wars of the French Revolution, which also spawned the infamous Alien and Sedition Acts) which bear some similarity to today’s febrile political climate.

Further, it is common–and indeed imperative–for incoming administrations to establish contact with foreign governments, including–and perhaps especially–those with whom the US is experiencing tense relations. Indeed, the Trump team received permission from the Obama administration to make such contacts, and an administration spokesman said publicly that Obama had no objection to such contacts, including specifically with Russia.

So if anything, the Flynn plea actually substantiates what Trump et al have been saying all along, and provides no evidence of pre-election collusion, let alone an illegal pre-election conspiracy.

The main conclusions here are: (1) Flynn was an idiot for lying about something that was perfectly legal and ethical, and (2) to avoid outbursts of idiocy, when the FBI comes knocking, don’t talk–there’s no upside, and a big potential downside.

As for the conspiracy theory that excites the imaginations of today’s McCarthyites and Birchers, it is a big fat nada. Zip. Zero.

But that will not deter them. They are so invested in this theory that nothing will disprove it in their eyes. They will react exactly the same to the next hyped non-event, and dry cleaners everywhere will cheer.

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