Streetwise Professor

The Obama administration is planning on easing repayment terms for student loans:

The White House proposes that the government forgive billions of dollars in student debt over the next decade, a plan that cheers student advocates, but critics say it would expand a program that already encourages students to borrow too much and stick taxpayers with the bill.

The proposal, included in President Barack Obama’s budget for next year, would increase the number of borrowers eligible for a program known casually as income-based repayment, which aims to help low-income workers stay current on federal student debt.

Borrowers in the program make monthly payments equivalent to 10% of their income after taxes and basic living expenses, regardless of how much they owe. After 20 years of on-time payments—10 years for those who work in public or nonprofit jobs—the balance is forgiven.

This is a statement against interest, and the proposal is hardly surprising, considering the source but I must say: This is a horrible idea.

We are constantly lectured how higher education is an “investment.”  Sometimes it is.  That investment has a rate of return.  What’s important that capital-financial, human, the opportunity cost of student time-earn a return that covers the opportunity cost of capital.  We want individuals whose ROR exceeds the relevant interest rate to make the investment, and those whose ROR doesn’t not to make it.  This isn’t rocket science.

Tying repayments to income totally undermines those incentives.  Hey, go get a low earning degree, one that has a poor rate of return-and likely, a negative rate of return-and you will make lower payments!  What could go wrong?

This reduces the cost of pursuing low-return majors, so we will have more graduates with psych or anthro degrees who will work in retail and fast food and other low-wage occupations.   That is horrible.  The exact opposite of what we want.

Try doing this at your local bank, by the way.  Not too many I know of advertise their wonderful Loser Loan Programs: “The worse your financial performance, the lower your payment!”

Yes, I know the idea is to provide insurance against income losses due to illness, or job loss, etc., but that insurance will be rife with moral hazard.

Another example of the problems when the government intervenes in the capital allocation process.  That worked out so well in the housing market, didn’t it?  This will work out no better.  It will raise expectations and saddle people with heavy burdens, thereby contributing to disillusionment and anger.

It is also highly cynical and manipulative.  Those most likely to get hurt are those who are least able to evaluate the costs and benefits of getting a college education.  Moreover, Obama administration policy is already screwing the young in ways that could teach the Kama Sutra some things, and this will add to that, all in the name of helping those who get screwed.

It is perhaps another example of what Raghuram Rajan identified as a feature of US polices ostensibly intended to reduce inequality.  He specifically focuses on subsidizing homeownership, but this is exactly the same thing that goes on with student loans.

Education can be a great thing, if you make wise choices.  One thing I’ve been on about for years is that learning programming is an important skill.  You don’t have to be a programmer, but you should know some programming.  It is a functional skill, and also helps you learn to think logically and precisely.  So I agree with this WSJ piece.

Unfortunately, easing student loan terms along the lines proposed by the administration will not provide incentives to do that.  It will provide incentives to do the opposite, and hurt most those it is intended to help.  Like the title says, run when the government-and especially this administration-says they’re doing something to help you.

Benghazi is beginning to resemble some horror movie monster.  Obama, Hillary, and the rest of the administration had thought that they had killed it-with the active connivance of the media.  But the supposedly dead creature is coming back to life.

The cause of its rejuvenation is the testimony of 3 “whistleblowers” whose accounts flatly contradict every aspect of the Party Line.

The most eye-opening revelation was by deputy mission chief in Libya, Gregory Hicks.  Not only did he claim that he believed that the assault in Benghazi was a terrorist operation “from the get go”, he also revealed that a Special Operations team in Tripoli was denied permission to fly to Benghazi.  This flatly contradicts claims that no “stand down” order was ever given.  (Though I should note that the claim is that the “White House” gave no such order.  That does not mean DoD or the AFRICOM commander, General Ham, gave no such order.)

l had immediately discounted the account (given to Fox News) of an alleged Special Operations individual that a Special Operations team training in Croatia could have been deployed in time.  And others more knowledgeable than I discount this as bulls*t. But Tripoli is a totally different matter.  This revelation is like a bolt from the blue: there had never been any mention, to my recollection, of US operators in Tripoli.

So why weren’t they deployed?  This is the heart of the debacle, IMO.  Hicks also testified that no air assets-zero, zip, nada-were available to attack in Benghazi.  There were F-16s in Aviano, in Italy, but no tankers available to refuel them. I think that the Pentagon or General Ham was loath to reinforce failure, and to put a Special Operations team into an area taking mortar and heavy weapons fire, and under assault from a large number of insurgents, without air support.

As a tactical decision, this makes sense.  But it just emphasizes the prior, criminal failure.  A failure to have contingency plans in place, and the means available to carry them out, in the event that Benghazi was attacked.  It is said of our unpreparedness at Pearl Harbor: “At dawn we slept.”  In Benghazi, it can be said of our unpreparedness: “At dusk we slept.”

This is particularly criminal given two facts about Benghazi.  First, it was an Al Qaeda snakepit.  Second, the US was clearly up to something in Benghazi.  Something involving weapons: no, not smuggling them to rebels in Syria, but trying to collect them to keep them from radical hands.  And likely something involving interrogations of Al Qaeda captives.

Either activity-or both-made the “consulate” in Benghazi and the CIA annex prime targets for terrorists.  The place was lousy with terrorists.  Motive plus opportunity.  It was a virtual certainty that something bad would happen there, meaning that we should have been prepared for that something.  But we weren’t.

So why was the US so unprepared for a terrorist attack?  On 911 no less? Admiral Kimmel and General Short were paragons of preparedness, compared to Panetta, Petraeus, Hillary, and Obama.  It is beyond criminal, actually.

What’s next?  Can we expect bombshells?  Holding the culpable to account?

Count me as skeptical.  Who will hold them to account? Everyone in DC is highly compromised.

The press? Please. They ran cover for Obama and Hillary and Susan Rice from day 1.  Blowing the whistle on them now is blowing the whistle on themselves.

The Senate Republicans, like McCain, Graham, and Chambliss?  Please again.  They had an opportunity in October.  They made harrumphing noises, but did not press the issue.  Why?  Because they likely knew of what was happening in Benghazi (the weapons, the interrogations), and approved of it.   They knew that blowing the whistle on Benghazi would blow the lid on what the CIA was doing there, and leave them in a more than awkward position.  McCain et al played their roles in the Kabuki theater to perfection in the fall.  They will again.

The only way that the truth will out is due to the dynamics between Obama, Hillary, and the Senate Republicans.

This is like the final scene from the Good, the Bad, and the Ugly-a three way standoff.  (Except there’s no Clint Eastwood Good guy here.)  (For a grimmer example, think Stalin, Trotsky, and Bukharin.)

Hillary has ambitions for 2016.  She and Obama are not friends or allies: Obama put her in the cabinet under the “hold your friends close and your enemies closer” theory.  It seems clear that Hillary made catastrophic decisions before and during the assault.  She is the most responsible.  But given her ambitions, power, and connections, most are loath to confront her.

Obama would be hamstrung for the remaining 40-odd months of his second term by anything that laid the fault for Benghazi at his feet.  He doesn’t like Hillary.  She would make a perfect fall gal.

The Senate Republicans can push the direction of any inquiries.  But they are likely compromised.  Who should they align with?

I don’t know for certain the equilibrium in this game, but the most likely reasoning goes as this.  Obama is president now-no changing that.  Hillary wants to be president, and is the most formidable Democrat challenger in 2016.  Siding with Hillary to shaft Obama would result in a crippled presidency during a period of international danger, and reduce the Republicans’ odds of prevailing in 2016.  Siding with Obama to shaft Hillary would help the Republicans in 2016, and give the Republicans some leverage over Obama for the next three-plus years.  So I predict that Hillary will carry the can.  Which will lead to a civil war in the Democratic Party.  This civil war-and Hillary’s existential fight for political survival-is the only way that something of the truth will come out.

Back in October I said the worst outcome would be that the Benghazi issue would be suppressed until after the election, only to resurface in a 2d Obama term, where it would create a political and perhaps Constitutional crisis.

That’s where we are now.  That is not a good place to be.

Our fundamental issue right now is that no one in power is on the side of the truth.  The Pentagon, the CIA, the State Department, the Administration, the President, the press, and the opposition “leadership”, such as it is, are hopelessly compromised. And they are all in the 202 area code, and the main interest of people in DC, regardless of party, is protecting DC.  Meaning that there is no real “opposition” to speak of.

So don’t expect the truth about Benghazi to come out, or for the responsible to be held accountable, except as the unintended effect of a war to the knife between Hillary and Obama.

How sad is that? How sad is that?

That high pitched noise you hear is the shrieks of those who are Shocked! and Disgusted! by historian Niall Ferguson’s drawing a connection between Keynes’, umm, Bohemianism and his economic views.  That moral avatar Henry Blodget (banned from the securities industry for life, by the way) describes what Ferguson says as “bizarre and offensive”:

Speaking at the Tenth Annual Altegris Conference in Carlsbad, Calif., in front of a group of more than 500 financial advisors and investors, Ferguson responded to a question about Keynes’ famous philosophy of self-interest versus the economic philosophy of Edmund Burke, who believed there was a social contract among the living, as well as the dead. Ferguson asked the audience how many children Keynes had. He explained that Keynes had none because he was a homosexual and was married to a ballerina, with whom he likely talked of “poetry” rather than procreated. The audience went quiet at the remark. Some attendees later said they found the remarks offensive.

Well, this idea didn’t spring first from Ferguson’s fertile imagination-or febrile imagination, as his critics would have it.  Joseph Schumpeter, leaving out the gay bits, made essentially the same point in his chapter on Keynes in his Ten Great Economists From Marx to Keynes: “He was childless and his philosophy of life was essentially a short-run philosophy.”  That was written in 1951, and of course homosexuality just wasn’t mentioned then.  One could argue that ironically, the greater acceptance of homosexuality is precisely why Ferguson today could make explicit what Schumpeter only hinted at in the benighted 50s.

Schumpeter was a giant as an economist.  He knew Keynes.  He knew Keynes’s milieu. He was one of the greatest historians of economic thought.  He was also unconventional in his private life, though in a different way.  So he speaks with some authority.  Not that one should automatically defer to such authority, but when someone like Schumpeter says it, you know it’s not the unconsidered musings of an ignorant man.  It is the considered opinion of a highly knowledgeable one.

But he was also a furriner at Harvard, so that must be it.

Schumpeter attributes other aspects of Keynes’s thought to his personal history.  The quoted line is in a section that argues that Keynes was a patriotic Englishman, and that his scientific and policy works were not so coincidentally closely aligned with Britain’s interests:

Like the old free-traders, he always exalted what was at any moment truth and wisdom for England into truth and wisdom for all times and places.

Ironic, isn’t it, inasmuch as Ferguson is a rather outspoken admirer of the British Empire?

The fact that Keynes married, and that his wife apparently miscarried, does raise questions about the theory that Schumpeter advanced and Ferguson repeated (if you assume the child was Keynes’s-quite a leap in itself).  But neither gainsays the fact that Keynes’s view was, clearly, focused on the short-run, and expressed virtually no interest in the implications of his policy recommendations for future generations.

This controversy raises the question: what is the point of the biographies of intellectuals, anyways, if there is no connection between their personal lives and their intellectual works? Unless such a connection exists, intellectual biography that explores private lives is nothing more than People Magazine for eggheads.  Keynes’ biographer Skidelsky goes into lurid detail about Keynes’s private life, and concludes that it was an important part of his worldview.  (Skidelsky puts forward some thoughts on the role of intellectual biography here.)  Skidelsky was able to document in such lurid detail precisely because Keynes recorded his exploits in such lurid detail.  It was obviously something very important to him.  Given this importance, is therefore hardly outlandish to suggest that there is a nexus between his personal life and philosophies, and his professional writings.

All that said, there is a difference between understanding-or at least conjecturing about-why Keynes wrote what he wrote and determining whether what he wrote is good economics or a good guide to public policy.  Making the latter determination is a matter of logic, mathematics, and empirical analysis.  If Keynes’s inspiration came from a ouija board, but turned out to be logically airtight and empirically validated, so what?  If it turns out to be logically flawed and empirically invalidated, what possible difference could its intellectual-or psychological-origins matter?  (I am in the latter camp, obviously, regarding Keynes’s work.)

I sense that the hysterical attack on Ferguson for his views on Keynes reflects the left’s view that Keynesianism must be defended at all costs, and anything and anyone that could raise any doubts about Keynes must be terminated, with  extreme prejudice.  Add to that the very PC urge to shout down anyone who dares express the view that sexual orientation could influence worldview in a negative way-the selfsame people are often quite willing to claim that it can affect it in a positive way.  So I guess orientation can affect thought and behavior, but only in a good way.  Uh-huh.

Note that the question to which Ferguson was responding was not about the theoretical rigor or empirical content of The General Theory.  He was asked to contrast Keynes’s philosophy with that of Burke.  He answered. You can find things that Skidelsky-an ardent admirer of Keynes-has written that would support what Ferguson said.

All in all, I consider this a tempest in a teapot.  I really couldn’t care less about the connection, if any, between Keynes’s sexual orientation and lack of progeny and his theories: what I care about is the connection between his theories and reality.  And that connection is very tenuous, in my view.

This tempest has all the usual roots of a faux controversy.  Ferguson is a bête noire on the left, notorious for his muscular, and at times brutal, advocacy of conservative (more properly, classical liberal) positions.  He said something that those who despise him can jump on.  And they are jumping on it, taking offense with relish.  (By the way, I find any criticism of an argument that focuses on its alleged offensiveness to be inherently subjective, often manipulative, and revealing of an inability to attack its substance.  Highly unpersuasive, in other words.  I’d also note that he gave the remarks at a conference put on by an investment firm, and I imagine that most of the audience was high net worth individuals and their investment advisors.  Supposedly-though the source for this obviously dislikes Ferguson-the audience was uncomfortable after Ferguson’s remark, and many were offended.  So much for the rich being right wing knuckle draggers with too much money.)

I was surprised and disappointed to read that Ferguson made a fulsome apology.  I seriously thought that he wouldn’t give a flying ‘f, and would in fact double down.  But perhaps it shouldn’t be surprising, given the history at Harvard.

I am counting down the seconds until the demands that he be banished from Harvard start flying, apology or no.  Liberal in Good Standing Larry Summers was defenestrated as Harvard President, for crissakes, of uttering a politically incorrect remark.  And this after he groveled.  If they can drive out the President of the university, and a former Treasury Secretary in a Democratic administration, eliminating the mere Tisch Professor of History, a conservative no less, should be child’s play.

While they’re at it, maybe they should posthumously de-tenure Schumpeter. But why stop there? For having the temerity to utter such a politically incorrect statement, by all rights they should re-enact what was done with Cromwell upon the Restoration.  You know, dig up his corpse, and draw and quarter it.  For what he said, he obviously deserves nothing less.

Today is the sesquicentennial of the 3d day of the Battle of Chancellorsville.  Jackson’s flank attack on 2 May, 1863 is usually the focus of accounts of the battle, and indeed, it was a daring and brilliant achievement.  But it did not win the battle for Lee and the Confederacy.  Lee only prevailed after a brutal slugging match on this day, 150 years ago.  Wave after wave of Confederates, under command of Jeb Stuart, repeatedly assailed the western side of a Federal salient surrounding the Chancellor house.  And wave after wave was beaten off by Union soldiers of the Third and Twelfth Corps.  What proved decisive was a disastrous decision to evacuate the high ground at Hazel Grove, made by the Union commander, Joe Hooker.  The Confederates seized this commanding terrain, and the artillery planted there proved decisive.  It was perhaps the only time in the war that Confederate artillery decided a battle: there were several fields where Union artillery proved decisive.  Confederate artillerist and memorialist Porter Alexander said of the abandonment of Hazel Grove: “There has rarely been a more gratuitous gift of a battlefield.”

Chancellorsville is often called Lee’s Masterpiece.  And it was, in many ways.  But it also illustrates the ultimate futility of the Confederate cause.  Even after the rout of the Eleventh Corps on the 2d, the Union forces far outnumbered Lee’s and were in a position to carry out a vigorous defense.  Even with the gratuitous gift of Hazel Grove, the Army of Northern Virginia suffered huge casualties to drive the Federals from the environs of the Chancellor House and Fairview.  The casualties were particularly devastating at every level of command.  The battle was a virtual holocaust of division and brigade commanders, field officers, and company officers.  As a result of the battle, Lee had to undertake a wholesale reorganization of his army, and many of those promoted to fill the positions of those killed or maimed on May 3d proved overmatched two months later, on the fields of Pennsylvania.

In brief, even to execute a “masterpiece”, and one facilitated by numerous errors by his opponent Hooker, Lee had to spend lives at an unsustainable rate.  One wonders how it would have been possible to prevail, since even victory was impossibly costly.

Indeed, even the action of the 3d was not decisive.  The Army of the Potomac retreated from the Chancellorsville salient to a more compact position abutting the Rappahannock River, and entrenched it strongly.  It is highly unlikely that it could have been dislodged by an attack by Lee’s spent force.  But Hooker, who had already suffered a loss of confidence and courage on 1 May, and who had been severely concussed by a shell on the 3d, wanted no more of Lee.  Even though a majority of his corps commanders favored fighting it out on the new line, Hooker decided to retreat.  The ultimate victory was due more to Lee’s psychological dominance over an addled Hooker that proved decisive, than to the military dominance of the ANV.

And this worked on Lee’s psychology too, and not in a good way.  Chancellorsville contributed to a hubris that proved disastrous at Gettysburg.

Meanwhile,while Lee was triumphing at Chancellorsville, events were developing far to the west, in the heart of Mississippi.  After months of frustrated attempts to get at Vicksburg, Grant was on the east side of the Mississippi River.  He had beaten back a Confederate force commanded by John Bowen at Port Gibson on 1 May.  He was advancing east, towards Jackson.

Lee fought a masterful battle in early May.  Grant fought a masterful campaign over three weeks of that month.  The campaign proved far more decisive than the battle, as I’ll discuss in future posts on Jackson, Champion Hill, and Big Black Bridge.

Oh, there are a lot of candidates who are just begging for the Red Queen treatment, but that’s not whom I referring to.  I’m referring to the band.  Headed out to see them at House of Blues Houston tonight.  Just what I need.  Some spiritual, uplifting music.

The FSB is contemplating designating commodity trading firms like Cargill and Glencore as systemically important.  No, not that FSB: The Financial Stability Board, a group of global regulators established in the wake of the financial crisis.

The reason for this is, apparently, that these firms are engaged in shadow banking.  The linked Reuters story mentions two types of activity.

First, commodity trading firms extend trade credit and working capital to their customers.  Second,  some use securitization to raise funding.

The FSB is rightly concerned about shadow banking, but the kinds of activities that commodity trading firms engage in is quite different from some of the activities implicated in the crisis.

Some forms of securitization contributed significantly to the crisis.  Most of the most dangerous forms involved significant maturity transformation, and direct ties to big banks.  SIVs that funded portfolios of mortgage securities with short-maturity corporate paper, that were backed by liquidity puts provided by sponsoring banks are the prime example of this.  When investors began to doubt the value of the underlying assets, there were runs on the SIVs: they could not rollover their paper, and sponsoring banks ended up taking the now toxic assets back onto their balance sheets.  This was a big problem because the banks were highly leveraged; their main business is to provide credit; and they are essential components of the payment system.

The securitizations that commodity trading firms have engaged in, like the Trafigura program mentioned in the Reuters piece, are (a) far more limited, and (b) very different.   In particular, these structures do not involve the kind of maturity mismatch that was the Achilles heel of the SIVs.  Indeed, if anything, to the extent there is maturity transformation it is the opposite of the type that proved problematic in the crisis.  The underlying assets are very short dated (such as receivables) and/or very liquid (like inventories of aluminum in LME warehouses).  The assets typically have shorter maturities than the liabilities issued to fund them.  Indeed, one of the challenges of these structures is to replenish the assets as they mature.  Traditional SIVs had to rollover their liabilities: commodity trade securitizations have to replenish their assets.  The former is far more problematic than the latter because the run risk is far greater.

Moreover, historically the default rates on the trade receivables that are securitized are very, very small.  The extent data are for all trade receivables, not just commodity trade receivables, but the credit losses are trivial.

I also find little reason to be unduly concerned over the  the granting of trade credit and extension of working capital funding through prepayments and other arrangements.  Consider prepays, where a trading firm may provide funding to a refiner, say.  The commodity trader may fund the input (crude oil), and in exchange receive refined products.   The refined product is essentially collateral for the financing provided to buy the input.  Moreover, the value of this collateral can be hedged in most cases, limiting the credit exposure of the commodity firm extending the credit.   This is often quite different than extending credit to fund illiquid, hard to value, long maturity assets that cannot be hedged.

The commodity trading firm has a comparative advantage in marketing the output.  Moreover, due to its knowledge of the industry and the particular firms involved, it likely has information that makes it the most efficient creditor.  It knows more about the market and the particular borrowers than most banks.

The foregoing suggests that the credit risk and maturity transformation risk involved in commodity trading firm shadow banking activities is far less than that involved in the kinds of shadow banking that proved highly problematic during the crisis.  But credit losses are conceivable.  What would happen if commodity trading firms suffered big credit losses?

It’s hard to see how this could seriously threaten the stability of the financial system or the global economy.  Commodity trading firms aren’t that big: if Glencore is too big to fail, so is Kraft, or a similarly sized company.  Their assets are dwarfed by those of the big SIFI banks: they are about as big as many middling banks you’ve probably never heard of.  Moreover, the commodity trading firms are far less leveraged than big banks.  Furthermore, their capital structures are far less fragile, because they involve little maturity transformation: their short term liabilities are largely matched against short term assets, such as hedged commodity inventories.  The firms provide financial intermediation, but unlike banks, that’s not their primary function, so they are not as vital to the credit supply process as banks.  They are not essential elements in the payments infrastructure.

Commodity firms provide valuable logistical services, but the assets, human and physical, that they utilize are readily redeployed.  If one company goes bust, its assets can be redeployed so that the trade in commodities can continue.

Some of the shadow banking activities that commodity firms engage in actually take risk out of the banking system.   A major reason for the development of securitization in commodity markets was that big banks-especially French banks facing difficulties in securing dollar funding-cut their funding to commodity firms.  So the firms turned to securitization and thereby transferred the risk to the capital markets.  And unlike the case with SIVs sponsored by banks, there isn’t a backdoor by which this risk can make its way back to bank balance sheets.

I would also note that commodity trading firms do not benefit from deposit insurance, and so don’t pose the same moral hazard concerns as banks that do.

So I find few parallels between the kinds of shadow banking that proved so dangerous during the crisis, and the kinds of shadow banking that commodity firms engage in.

Commodity firms are first and foremost logistics specialists that engage in financing transactions to facilitate that business. A couple of other historical experiences suggest that such logistical intermediaries are not systemically important.

In 2002, the entire merchant energy sector in the US imploded.  These firms-companies like Enron, Dynegy, Mirant, and Williams-were primarily logistical intermediaries that provided financing and risk management services to their clients, just as global commodity trading firms do.  Not just one of these firms imploded.  The whole industry did: the stock prices of the firms in this business fell by about 90 percent between April and July of 2002.  But gas and power continued to flow. The impact on the US economy was barely measurable.

Furthermore, the experience of the Fukishima earthquake and tsunami suggests that even if the failure of one or more major commodity firms did disrupt commodity logistics for a time, the implications of this for the global economy would likely be small.  The earthquake and tsunami created huge disruptions in supply chains, especially in automobiles and electronics.  Trade was severely disrupted.  But the impact on the global economy was almost immeasurably small.  Studies undertaken by several governments found that the Japanese disaster shaved a tenth of a point or two off global GDP growth.  The financial aftershocks were minimal, even in Japan.  If the world economy can survive such a literal seismic shock that seriously disrupted supply chains in high valued manufacturing, it can almost certainly survive the failure of a big commodity trader.  Or two. Or three.  Especially since the Fukishima disaster destroyed or disrupted physical assets in a way that the financial distress of a commodity firm with redeployable assets would not.

I’d be more persuaded by the FSB’s concerns if it would provide a description of the mechanism by which commodity trading firms can be the source of financial contagion, or the channel through which contagion can be communicated from the financial sector to the real economy.  As those who have read my writings on clearing can attest, I can have a pretty vivid imagination about how contagion can propagate, and despite giving this considerable thought, I haven’t found a plausible mechanism.

In some sense, it seems that the FSB is like Mark Twain’s cat that wouldn’t sit on a hot stove after it had been burned, but it wouldn’t sit on a cold one either.  Once burned by shadow banking of one kind (the kind tightly tied into the banking system), it seems afraid of any kind of shadow banking.

And I have a pretty good idea who is stoking those fears.  I know, as the result of personal experience, that major banks involved in commodity markets are chafing under the restrictions imposed on them, and resent the fact that commodity firms that are their competitors in certain activities are not subject to the same restrictions.  I know they have been importuning the FSB to identify commodity trading firms as systemically important, and to impose bank-like disclosure and capital requirements on them.  All the better to hamstring the competition.

How I know this, I can’t say.  But I’m just sayin’.  You can take it to the bank, as it were.

Too big to fail is a self-fulfilling phenomenon, in large part.  It would be far less of a problem if governments could credibly commit not to bail out certain firms.  It becomes much harder to make such credible commitments when those firms are identified as systemically important.  Therefore, regulators should be very reluctant to confer the “systemically important” label.  Very reluctant.   Objectively, there are few reasons to consider big commodity trading firms-even the biggest ones-systemically important. All the more reason to eschew conferring that designation on them.

In other words, sitting on a cold stove isn’t dangerous.  The FSB should be smarter than the cat in Puddin’ Head Wilson.

The most recent controversy over HFT stems from this WSJ story about the CME.  In a nutshell, computerized traders receive confirmations of their trades before information about those trades is disseminated to the market at large.  As in a few milliseconds before.  But in an electronic world, a few milliseconds can be decisive.

One example of a particularly informative trade is when an away-from-the-market limit order is executed.  This means that a market order of sufficient size to blow through the quote size at the inside market was submitted.  Given that orders and communicate information, and that the bigger the order, the more informative it is, knowing before anybody else that such an order has been executed can provide valuable information.

The implications of this depend on how the information is used.  A trader (or, more accurately, a bot) that gets this information can use it to take liquidity aggressively.  For instance, it can use information gleaned from a big, price-moving crude oil buy to submit an aggressive order in heating oil or RBOB, thereby picking off resting limit orders that cannot adjust to the new information.  Or, as the WSJ article suggests, the bot can use the information derived from the NYMEX CL trade to take liquidity from ICE Brent or NYMEX lookalike futures.

This kind of trading exacerbates information asymmetries, and all else equal, increases spreads, reduces depth, and increases trading costs for the uninformed.

But the “all else equal” part of the statement doesn’t necessarily hold.  This presumes that the amount of capital devoted to HFT is constant.  But that’s not true in the long run.  If these sorts of advantages generate profits, that will attract more capital into HFT.  Moreover, note that the strategy just outlined involves placing limit orders, and then reacting when those limit orders are executed.  Competition to get the information advantage will lead to more aggressive quotes, and quotes in bigger size.  In the long run equilibrium, this competition will dissipate the rents from the information advantage.

Therefore, if there is any reason to reduce this speed advantage (either by slowing down some traders or speeding up the dissemination of trade execution information to the market at large), it is to prevent the investment of excessive capital into HFT.  The effect on spreads and depth in equilibrium is ambiguous.

Moreover, there are other possible uses of the information advantage that are clearly socially beneficial.  An HFT market maker-who is likely making markets in a variety of contracts-can utilize the information to revise limit orders either in the market in which the execution occurred, or in other markets, especially those that are closely related (again, consider the CL/HO or CL/RB example).  Using the speed/information advantage in this way reduces the HFT market maker’s vulnerability to getting picked off, and makes it willing to supply liquidity more aggressively.  This tends to reduce trading costs, and does not lead to the rent seeking that in the long run equilibrium tends to result in an inefficiently large HFT presence.

We also need some perspective here.  I consider it beyond hilarious that the WSJ has a video embedded in the online version of the story that has many images from the floor.  (And these days, one of the floor’s main functions is to provide visuals for stories on trading-especially the trader’s-head-in-his-hands shot on days when the market falls a lot.  Pictures of servers aren’t nearly so dramatic.)

Why hilarious?  Well, the floor was the epitome of time and space advantages to a select few.  A select few who paid for the privilege.  I remember distinctly a trader telling me: “Why do I spend $500,000 on a seat? Because I get to see the price before anybody else.”

Exactly.  The floor was the meat version of colocation.  Or the carbon based life form version, if you like.  Those on the floor could see the execution prices, and bids and offers, and order flows, that those off the floor could not.  They profited accordingly.  Which is why the marginal guy on the floor-the least efficient trader-was willing to pay hundreds of thousands of dollars in some cases to get on the floor.

In 2002 or so I wrote a paper titled “Upstairs, Downstairs” (still a working paper) which showed that floor traders earned a rent as a result of their time and space advantage: upstairs traders could not supply liquidity as effectively as floor traders due to their information disadvantage, and this meant that floor traders faced limited competition in supplying liquidity.  Moreover, exchange limits on membership meant that entry could not dissipate these rents.  But by reducing the time disparities between liquidity suppliers advantage, electronic trading increased liquidity supply: upstairs traders were no longer operating under a time and space handicap.  Trading costs and rents decline. And that decline in rents is precisely why floor traders fought electronic trading so fiercely for years.

So yes, in today’s electronic markets some traders have a speed advantage.  But this disparity is nothing when compared to that which existed in the floor days.

Which is why I can’t really get all that spun up over the WSJ story, or most of the other stories about how unfair markets are.  Everything is relative.  No, the playing field isn’t perfectly level today, and along the lines of yesterday’s post, it may be in the interest of the CME to take measures to make it more level.  They say that they are.  But arguably the field is more  level than it has ever been.  It’s certainly far more level than in the heyday of the trading floors.  Don’t get nostalgic for the days when market makers were meat, not machines.  The table was tilted in their favor, bigtime.  Much more than today.

Krugman and others have been doing a victory dance, claiming that the Reinhart-Rogoff work on the relationship between debt and growth has been repudiated.  Hardly.  The R&R spreadsheet error (but I repeat myself) is embarrassing, but of minor consequence.  The other criticisms leveled by Thomas Herndon, Michael Ash and Robert Pollin are matters of judgment and interpretation, not definitive error.

James Hamilton has a balanced overview, as do Betsy Stevenson and Justin Wolfers.   Matthew Klein dissects the matter of New Zealand, which proves pivotal in the analysis.

Not surprisingly, Niall Ferguson is quite scathing in his criticism of Krugman’s gloating.  Ferguson just points out the obvious.  There is a limit to debt, and accumulation of too much debt leads to either default or inflation.  You can’t borrow a trillion (or about 6 percent of GDP) forever, or even for a modest period, without coming a cropper.

The most interesting part of Ferguson’s analysis draws an analogy I’ve used before: between governments and Enron.  (And Niall is nice, not pointing out that Krugman took Enron’s checks as an “advisor.”)  What do they have in common?  Hiding huge liabilities off balance sheet.  Well, that’s not really correct.  Governments don’t have proper balance sheets.  ”Government accounting” is something of an oxymoron.  But in the main, the point holds.  The debt that was on Enron’s books was only a fraction of its actual liabilities, and the official debt of the US government (and most governments, for that matter) is only a fraction of its (and their) actual liabilities.  Indeed, Medicare, Social Security, loan guarantees, and so on are so large compared to official debt that the US government makes Ken Lay and Jeff Skilling and Andy Fastow look like petty grifters.

So debating whether debt greater than 90 percent of GDP results in a substantial reduction in growth is really a sideshow.  The US is around that level now (somewhat over it when all government debt is counted, somewhat under it when only debt in public hands is)-but when you tote up only Treasury bonds, notes, and bills.   When you add it the off-balance sheet items, 90 percent looks like the epitome of prudence and thrift.

Of course the government has off-balance sheet assets too-like its taxing power.  How do you value that? (Which is perhaps one of the reasons governments don’t keep formal balance sheets.)  But that taxing power is not unlimited.  What’s more, due to the deadweight costs of taxation, it is precisely using that “asset” that can be a drag on growth.

All in all, though, when you consider the true state of US government finances and count all the liabilities, the academic debate over whether there is a growth threshold when debt hits 90 percent of GDP appears, well, academic.

HSBC’s Gary Dunn said something at the ISDA AGM that I think is very important:

Dunn pointed out the risk characteristics of a CCP are very similar to that of collateralised debt obligations, the tranched credit products that were prevalent in the run-up to the 2008 financial crisis.

In the CCPs default waterfall, the initial margin payments from clients and default fund contributions from clearing members are comparable to the equity or first loss and mezzanine tranches of a CDO. In other words, these are the first sources of funds that get eaten into to cover any losses.

According to Dunn, the super senior tranche (which in the case of CDOs tended to attract Triple A ratings, but often subsequently sustained losses during the credit crisis) is the additional steps the clearing house might take when all other funds are exhausted, whether it is haircutting, asking for more capitalisation from clearing members of possibly even a government bailout.

“If you start modelling the risks of a CCP as a CDO, you realise the correlation risks in a CCP aren’t at the moment fully appreciated, very much like they weren’t when we had CDOs and CDO squareds,” said Dunn.

“The probability of a CCP failing is still relatively low, but there is a reasonable probability that people or banks lose money even if a CCP doesn’t fail,” he added.

I can hear you saying: “Where have I read that before?”  Or: “When have you said that before?”  In January, 2011, now that you ask

Let’s see how this relates to CCPs, and in particular to the default funds of CCPs that are the ultimate backstop of cleared contracts.  Default funds are analogous to protection written on supersenior tranches.  The collateral (margin) that firms must post to CCPs when they hold derivatives positions absorbs most of the losses due to movements in market prices.  Indeed, margins are usually set to absorb 95-99 percent of market moves.  Beyond margin, CCPs often have their own financial resources to cover the losses associated with the default of any member firm not covered by margin.  If the margin and CCP-resource elements of the CCP “waterfall” (note the similarity of terminology used to describe tranched structures and CCPs) are breached, then the members must absorb the remaining default losses, up to some pre-established commitment level.

This means that CCP members must cover defaults only in extreme circumstances, just like writers of protection on supersenior tranches must cover defaults only under extreme circumstances.  Indeed, the oft-touted features of CCPs, such as collateralization create the seniority/out-of-the-moneyness that gives rise to wrong way risk if the pre-requisite dependencies also exist.

So it seems that CCPs are potentially vulnerable to wrong way risk.  They are effectively financial structures of a type that can, given the right (or wrong, depending on your perspective) dependence, give rise to a serious wrong way risk problem.  Which raises the question: are the dangerous dependencies likely to be present?  That is, are the contributors to a CCP default fund likely to be in bad financial straits just when their contributions are needed to absorb default losses? Are those that are insuring default losses (through mutualization) likely to be in dodgy condition precisely when they are most likely to have to pay off on that insurance?

This is a big deal. Wrong way risk is particularly poisonous, and a source of systemic risk in systemically important institutions like big CCPs. Policymakers have been largely oblivious to this very important problem.  I’ve been on about it for over two years, but we see how that matters.  Maybe if people like Gary Dunn start raising the alarm this issue will get the attention it deserves.

But, of course, Anat Admati, etc., will dismiss this as self-interested scaremongering by banks, and will criticize me as being some sort of tool (which she has, by the way).

I understand perfectly that such self-interested scaremongering occurs.  But I also understand that sometimes there is a wolf.  This is one of those times.

There are all sorts of proposals out there to rein in HFT.  The Europeans in particular-and in particular, particular, the Germans-want to do so.

I’ve long argued that there is good HFT and bad HFT, and that trading platforms have an incentive and the information to adjust fee structures and trading protocols in order to mitigate the latter.  For example, some exchanges have cracked down on excessive cancellations or the entering and canceling of orders far away from the current inside market.

Today’s FT reports another example, and a rather dramatic one.  One of the biggest FX trading platforms, EBS, is jettisoning the venerable time priority (“first come-first served) system with continuous trading.  Instead, it will collect orders that arrive during a period lasting a few milliseconds, and then execute them in a batch.  Instead of a continuous market, it appears to be a high speed sequence of call markets.  This eliminates the advantage of getting your quote in a millisecond sooner than someone else.  Perhaps it will also deter forms of gaming, such as strategies that (allegedly) attempt to create and exploit latency.

Will it work?  Who knows?  But that’s the point.  Markets facilitate the process of discovery.  Market participants compete to find solutions to problems.  EBS has identified a problem, and are trying to fix it using a fairly innovative change to the matching process.  If they’re right that some kinds of HFT are detrimental to market performance (and thereby reduces the demand for to trade on the platform), and their replacement of continuous trading with high speed calls impedes this detrimental HFT without impeding the good kind, they’ll make money.  And others will likely imitate, or take the basic idea and try to improve on it.

Or maybe it won’t work as planned. In which case they can try something else, or lose business to a platform that devises a better protocol.  The point is that a trading platform identified a problem with HFT, and is doing something about it, on its own.

All of this is far superior to top-down, one-size-fits-all government mandated “solutions” that are driven by political economy considerations first, efficiency considerations second . . . or third . . . or Nth.  Trading platforms may not internalize all the costs and benefits of better trading rules and fee structures, but their information and incentives are far better than regulators or legislatures.  Between competition among HFT firms, and the efforts of trading platforms to optimize the demand for their services, it’s likely that HFT’s rough edges will be smoothed out.  And if trading platforms don’t adopt such measures, you have to doubt seriously whether there’s a problem in the first place.  Because if there is a problem, they’d be the ones in the best position to know, and the best position to fix it.