Streetwise Professor

September 12, 2015

The Road to Hell is Paved With Good Intentions, German Refugee Policy Edition

Filed under: Uncategorized — The Professor @ 5:37 pm

Germany has opened the floodgates for refugees-and others impersonating refugees-into the country, and into Europe. It is a colossal blunder that will not end well, and which reflects Germany’s political defects.

Merkel’s motives are rooted in German historical neuroses and romanticism. Germany is at pains to prove that it has overcome its Nazi and racist past. As one German historian put it:

“We want to prove that we are good people. Even if no one wants to be reminded of this, the good that we do has to be seen in relation to the crimes that we initiated,” Arnulf Baring, a conservative German historian, wrote in the Bild tabloid this week.

Furthermore, Merkel and others in German (especially in the governing and culture classes) have a romantic view of refugees, more likely to see them as waifs (like the drowned boy in the photograph that marked, and arguably contributed to, the inflection point in the refugee crisis) and women fleeing war.

Other Germans advance more pragmatic justifications: Germany is aging and in demographic decline, and needs a new supply of labor to replacing the retiring and the dying. (Many in Sweden, also very open to the refugees, make the same argument.)

All of these reasons are daft, and ignore much grittier realities. Expiating past guilt seldom results in current good. Further, the romantic view of the migrants is at odds with the reality. They are disproportionately young and male, which is to be expected: young men are more able to withstand the rigors of the trek from Syria (or Eritrea or wherever), and often have little to hold them at home. Indeed, those with the fewest attachments are likely to be misfits, meaning that the migrants are being sampled disproportionately from the less desirable part of the distribution.

Furthermore, they are likely to be fertile ground for recruiting by Islamist radicals. Already German security services are leaking that Islamist recruiters are descending on refugee centers. Germany, which already has an Islamist problem (and has had so for years: witness Mohammed Atta), has just made it that much worse.

As for the labor argument, it is a damning indictment of EU labor markets and labor mobility (and capital and goods markets for that matter). It is not as if Europe as a whole lacks idle labor, and a well-functioning labor market with mobility would match those unemployed and underemployed Europeans (e.g., young Spaniards–or Greeks!) with German employers. If the grandiose European project were in fact working, Germany wouldn’t have to import gastarbeiters qua refugees to replace its retiring workers.

Moreover, this argument reflects an ignorance of, and arguably a disdain for, Germans working in factories and services. Labor is not an undifferentiated mass. Germans are much more productive than the refugees are, and are likely to be, for generations to come. Education, skills, and yes, cultural attributes mean that the refugees are a poor substitute for German labor. Looking at it in a completely mercenary way, those who think that the refugees are going to be productive enough to be taxed enough to support a growing population of pensioners are deluding themselves.

Merkel’s actions also betray the elitism and undemocratic tendencies that characterize the EU generally and Germany in particular. This was not a decision taken after any democratic deliberation whatsoever, and many Germans are decidedly unhappy about it, especially in Bavaria and the Rhineland. (The security services are furious too: why else would they leak so soon about Islamist recruiting?)

And if many Germans are unhappy about Merkel being charitable to refugees at their expense, smaller European nations are furious because the immigrant wave will hit them as well. Denmark-long a thorn in Germany’s side-hit back immediately, stopping passenger rail traffic and closing major freeways into Germany in order to stem the immigrant tide.

German statements that other European countries should accept refugees because Germany’s resources are not unlimited add insult to injury. “Hey Germany, salve your conscience on your own Euro, not ours.” This is particularly rankling given that Germany is far richer than many of the countries it wants to take more refugees, and given that many of these countries believe that the Euro has enriched Germany at their expense. But the German leaders have a tin ear on these issues, and are apparently oblivious that this reinforces every negative perception about them and their dominance of Europe.

The EU is doing its part as well, including issuing a diktat to nonmembers Iceland, Liechtenstein, Norway and Switzerland that they accept asylum seekers. Or else:

[The EC]  notes all four countries will have to accept Dublin “and its development without exception.” They will have no say or input in amending Dublin, nor will they have any say on the Commission’s relocation plan.

“They do not take part in the adoption of any acts amending or building upon the Dublin acquis”, it says.

This is going to end very badly. It will impose a substantial economic burden on Germany (and other European nations) in the near to medium term with little or no long term benefit to compensate. It will exacerbate Europe’s jihadi problem. It will reinforce already strong beliefs that the EU is remote, dictatorial, and indifferent to popular concerns. It will drive many moderate Germans (and moderate Europeans) into the arms of the far right because they will (correctly) believe that the governing class is indifferent to the impact of the wave of immigrants on them, and will dismiss their concerns–when they are not insulting them for being racists because they don’t accept the migrants with open arms.

They don’t want to pay for Angela Merkel et al‘s masturbatory do-goodism. They are willing to help, but don’t want to be inundated by alienated and culturally alien immigrants; they want a reasonable, measured response that takes their economic and security concerns into account; and they don’t want to be dictated to by their self-appointed betters. But it looks like none of that is going to happen. It is more likely that the exact opposite will. There will be a price to be paid for that. And it is likely to be a steep one, both in Euros and in social and political peace.


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September 9, 2015

The Future of Chinese Futures

Filed under: China,Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 8:19 pm

China has created some amazingly successful futures markets in recent years. By contract volume, the top 5 ag futures are traded in Zhengzhou, Dalian, or Shanghai, as are 4 out of the top 5 metals contracts. Once upon a time, China also had the most heavily traded equity futures contracts. Once upon a time, like two months ago.

Then the crash happened, and China thrashed around looking for scapegoats, and rounded up the usual suspects: Speculators! And it suspected that the CSI 300 Index and CSI 500 Index futures contracts were the speculators’ weapons of mass destruction of choice. So it labeled trades of bigger than 10 (!) contracts “abnormal”–and we know what happens to people in China who engage in unnatural financial practices! It also increased fees four-fold, and bumped up margin requirements.

The end result? Success! Trading volumes declined 99 percent. You read that right. 99 percent. Speculation problem solved! I’m guessing that the fear of prosecution for financial crimes was by far the biggest contributor to that drop.

The stock market (led, as is usually the case, by index futures) was bearing bad news, so the Chinese decided to shoot the messenger. Then back over it a few times with a tank and bury it in cement. Just to make sure.

There is a wider lesson here. Namely, China may talk the reform talk, but doesn’t walk the reform walk. It likes one way bets:  markets when they are rising, not when they are falling. And not just the futures markets have been told to get their minds right. Chinese authorities-and by authorities, I mean security services-have told fund managers not to sell, only buy. A market with Chinese characteristics, apparently: all buyers and no sellers. Kind of zen actually, in the spirit of “what is the sound of one hand clapping?”

This urge to exercise ham-fisted control is exactly the kind of thing that will impede China’s development going forward. It will undermine the ability of capital markets to do their jobs of incentivizing the accumulation of capital and directing it to the highest value uses.

China’s predilection for control has manifested itself in futures markets in other ways. You might recall some months ago that I wrote about China’s threats against Singapore and ICE if the American exchange offered lookalike contracts on ZCE cotton and sugar at its new Singapore affiliate. Yesterday ICE announced the contracts it will launch in Singapore, and cotton and sugar lookalikes were conspicuous by their absence.

No competition for us, thank you. We’re Chinese.

This protectionism may help ensure the success of China’s new futures market initiative: an oil futures contract. Protectionism and pricing in yuan and constraints on the ability of mainland firms to trade overseas make it likely that the contract will succeed. The Chinese are overoptimistic, however, if they believe this contract will supplant WTI and/or Brent. LME and COMEX copper, and ICE cotton and sugar, to give some examples, have thrived even as Chinese markets in these commodities grew. Moreover, myriad restrictions on the ability of foreigners to trade in China and the currency issue will make the Shanghai contract impractical as a hedging and speculative vehicle for non-Chinese firms and funds: the main non-Chinese trading will likely be arbitrage plays between Shanghai, CME/NYMEX and ICE, which will ironically serve to boost to the US exchanges’ volumes.

And the crushing of the CSI300 and CSI500 contracts will impede development of a robust oil futures market. The brutal killing of these contracts will make market participants think twice about entering positions in a new oil futures contract, especially long dated ones (which are an important part of the CME/NYMEX and ICE markets). Who wants to get into a position in a market that may be all but shut down when the market sends the wrong message? This could be the ultimate roach motel: traders can check in, but they can’t check out. Or the Chinese equivalent of Hotel California: traders can check in, but they can never leave. So traders will be reluctant to check in in the first place. Ironically, moreover, this will encourage the in-and-out day trading that the Chinese authorities say that they condemn: you can’t get stuck in a position if you don’t hold a position.

In other words, China has a choice. I can choose to allow markets to operate in fair economic weather or foul, and thereby encourage the growth of robust contracts in oil or equities. Or it can choose to squash markets during economic storms, and impede their development even in good times.

I do not see how, given the absence of the rule of law and the just-demonstrated willingness to intervene ruthlessly, that China can credibly commit to a policy of non-intervention going forward. And because of this, it will stunt the development of its financial markets, and its economic growth. Unfettered power and control have a price.


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September 8, 2015

Dear Mr. President: FU. Sincerely, the Pentagon

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

The Bowe Bergdahl case largely disappeared from view, likely because it was overtaken by so many other foreign policy foulups. The Isis explosion. The Syria implosion. The Iran capitulation.

But the story re-emerged yesterday. Well, sort of re-emerged: the coverage has been muted, at best, despite the fact that the charges are sensational.

Not only did the Pentagon charge Bergdahl with desertion: they charged him with “misbehavior before the enemy,” which could result in his incarceration for life. This is about the most serious charge that can be brought. The UCMJ equivalent of the white feather:

Article 99—Misbehavior before the enemy

Text. “Any member of the armed forces who before or in the presence of the enemy—

(1) runs away;

(2) shamefully abandons, surrenders, or delivers up any command, unit, place, or military property which it is his duty to defend;

(3) through disobedience, neglect, or intentional misconduct endangers the safety of any such command, unit, place, or military property;

(4) casts away his arms or ammunition;

(5) is guilty of cowardly conduct;

(6) quits his place of duty to plunder or pillage;

(7) causes false alarms in any command, unit, or place under control of the armed forces;

(8) willfully fails to do his utmost to encounter, engage, capture, or destroy any enemy troops, combatants, vessels, aircraft, or any other thing, which it is his duty so to encounter, engage, capture, or destroy; or

(9) does not afford all practicable relief and assistance to any troops, combatants, vessels, or aircraft of the armed forces belonging to the United States or their allies when engaged in battle; shall be punished by death or such other punishment as a court-martial may direct.” ….

Maximum punishment. All offenses under Article 99. Death or such other punishment as a court-martial may direct.

Based on what was reported about Bergdahl’s conduct, there is a colorable case that he violated (1)-(5), and (7)-(8).

The White House fought tooth and nail to stop the Pentagon from charging Bergdahl for desertion: bad optics, dontcha know, to have embraced a deserter’s family in the Rose Garden, and to have traded 5 hard core terrorists for him.

The Pentagon not only defied Obama on this: they doubled down and charged Bergdahl with desertion and cowardice before the enemy. A charge almost never used. So the Pentagon is saying: Mr. President, you embraced the family of an utterly dishonorable coward in the Rose Garden, and traded five terrorists for him.

FU, in other words.

I have been writing for some time that I suspect that there is intense conflict between the White House and the Pentagon. This event is clear evidence that those suspicions are true. (The ongoing Gitmo saga is another example.) The Bergdahl swap offended the Pentagon’s sense of honor, and this is its way of making that plain.

Unfortunately, this has largely fallen on deaf ears. There has basically been one AP story, which appeared on Labor Day. (My guess is that the administration pressured the Pentagon to bury the story on a holiday weekend.) As usual, the media covers for Obama.

It is a big deal-or it should be-when the Pentagon defies the president so flagrantly, and pugnaciously. That is the sign of a deeply dysfunctional civilian-military relationship. This is particularly disturbing when the nation faces so many security challenges simultaneously: under these circumstances, it is dangerous to have a military at odds with its commander in chief, and vice versa. This story is about much more than Bergdahl. But it is getting no coverage whatsoever. Instead, we get wall-to-wall coverage of the Trump Circus. Both are symptoms of a troubled Republic.

Update (9/9/15). For further evidence of a deeply dysfunctional relationship between civilian command authority and the military, see this article about alleged distortion of intelligence about the “war” against Isis. This administration corrupts all it touches. The VA. The IRS. The EPA. And now, the military and the intelligence community.

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September 7, 2015

Putin May Flirt With OPEC, But He’ll Never Put Out

Filed under: Commodities,Economics,Energy,Russia — The Professor @ 6:57 pm

Ambrose Evans-Pritchard reports on the remarks about potential cooperation between Russia and OPEC uttered by that tease, Arkady Dvorkovich:

Riyadh has made it clear that it will not cut output to shore up prices unless non-OPEC producers share of the burden. This essentially means Russia, the world’s biggest producer.

Mr Dvorkovich, the head of Russia’s economic and energy strategy, said his country was in constant talks with OPEC in order to bring about a “more rational policy” but was coy on whether the Kremlin would break the impasse and strike a deal with the Saudis.

“Our consultations do not imply directly that we are going to see any coordinated action. Perhaps ‘yes’, perhaps ‘no’, most likely ‘no’,” he said, speaking at the Ambrosetti forum of world policy-makers on Lake Como. “We are sending signals to each other.”

Russia insists that it cannot switch off output as easily as the Saudis, given the harsh weather in the Siberian fields, a claim dismissed by OPEC as a negotiating ploy.

For his part, our favorite mullet man, Igor Sechin, says that Russia is different than OPEC countries, and cannot play along:

“The Russian oil industry is private, with a high number of foreign shareholders,” Mr Sechin told an audience at the FT Commodities Retreat in Singapore. BP owns 20 per cent of Rosneft, the Russian state-backed oil company, which is majority owned by the Kremlin.

“The Russian government cannot administer the oil industry like an Opec country can,” he said, adding that Russia would also face technical difficulties in shutting production in regions such as Siberia, where extremely cold winters could cause wells to fracture if they were closed.

Although I agree there are real difficulties in shutting down Siberian production, the remarks about Russia’s inability to administer the oil industry is a crock. Suppress the giggle reflex about foreign shareholders, and remember that Russia levies export taxes on crude (and products) that can be used to “administer” the market. If Putin desired to reduce foreign sales of Russian oil in an effort to support price (perhaps in coordination with the Saudis or Opec), he could readily do so by increasing the export tax. Russian exports would decline, the world price would rise, and the Russian domestic crude price would fall. (Russian refining capacity would constrain how much oil can be diverted from exports to domestic use.) Thus, the Russian government undoubtedly has the policy tools to cooperate with OPEC to support the world price.

But truth be told, Russia doesn’t trust OPEC to adhere to production cuts, and OPEC doesn’t trust Russia to adhere to export cuts. OPEC has heard Sechin and Putin whisper sweet nothings in its ear before (in 2009, particularly) and have learned that flirting or no, Putin doesn’t put out.

In other news of unrequited love, there have been numerous stories of late about Russian disappointment about the failure of its dreams of a romance with China. Most notably, Putin returned empty handed from his recent trip to Beijing to witness China’s commemoration of the end of WWII. Most notably, Gazprom failed to secure financing for a gas pipeline into western China, it announced that its deal to ship gas to the east was delayed, and Timchenko (a target of US sanctions) failed to secure Chinese funding for the Yamal project. (Which may be a good thing, as it would be bringing LNG into a glutted market . . . which could explain Chinese reluctance.)

Putin was deluded if he thought that he could pivot to China and get a good deal after the US and Europe imposed sanctions. The Chinese realized that he was turning to them primarily out of weakness, and tough bargainers that they are, it was inevitable that they would exploit his weakness: the alternatives for Putin were a deal on very unfavorable terms, or no deals at all.

Market developments have only intensified Putin’s predicament. The decline in oil prices has increased his financial desperation. Moreover the fact that the decline in oil prices is due primarily to a slowdown in China’s economy means that the Chinese have less need for Russian resources, and less capital to invest: China has to focus on dealing with its own pressing problems, and helping Russia is not a priority. Putin was already deeply exposed to China risk through the resource price channel, and sanctions and his pivot only increased that exposure through an investment channel. Now that risk has crystalized, and Putin is doubly effed.

Just like Glencore, the subject of my previous post, Russia and Opec are at the mercy of China. Russo-Opec cooperation isn’t going to happen. It is devil take the hindmost among oil producers, and the individual incentive for all of them is to produce up to capacity. Price will mainly affect future investments in capacity, not utilization of existing capacity. In the near to medium term, before depletion and lower investment in the US reduce supplies, price will be demand driven, and primarily China demand driven at the margin. Russia and Putin are along for the ride, and can’t do a damn thing about it.

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Regardless of What Happens to Glencore or Noble, The Commodities River Will Keep on Rolling

Filed under: Commodities,Economics,Energy,Financial crisis — The Professor @ 4:16 pm

It is not outside the realm of possibility that my analysis of whether commodity trading firms are systemically risky-“too big to fail”-will be put to the test not once, but twice, in the coming weeks and months.

One firm that has shipped a lot of water lately is the biggest, by far: Glencore. This spawn of Marc Rich has been hit very hard by the sharp decline in copper and coal prices in particular. It’s CDS spreads have widened dramatically, tripling to 450 bp before tightening some in the last few days. Its stock price is down dramatically. S&P has changed its rating to BBB/Negative, meaning that a downgrade to junk is possible.

In response, the company has announced rather radical measures to slash debt in order to maintain its vital investment grade credit rating. It has announced a cut in its dividend and an issuance of new equity via  a rights issue (about a quarter of which  will be purchased by management). It is also shopping assets, notably the recently acquired grain trading assets acquired with the Swiss firm bought Canada’s Viterra. It has responded to the copper price decline by shutting a mine in Africa.

The market’s initial reaction to these moves has been positive: Glencore’s stock rose when it announced these measures.

Glencore’s distress is a direct result of the sharp declines in copper and coal prices, which in turn are the direct result of the slowdown in China.

Although Glencore’s origins were as a trading firm, and it is still considered a trading firm, it is in many respects the exception that proves the rule, and hence is not a harbinger of doom for other traders. As I documented in my first white paper, The Economics of Commodity Trading Firms, Glencore is the most asset heavy of the firms commonly considered traders. Moreover, its assets are concentrated in the upstream, especially in the aftermath of its acquisition of Xsrata. In its current incarnation, it is more of a mining firm with a trading firm attached, than a trading firm.

Glencore always touted that its trading operation could be an internal hedge for its upstream activities: trading profitability is driven by volumes and margins, and these are less sensitive to commodity supply and demand conditions than prices, because the inelasticities of supply and demand mean that price, rather than volume, bears the brunt of demand and supply shocks. The Glencore argument makes sense, but there is only so much that the trading arm can do to offset an upstream bloodbath. Glencore’s exposure to flat price is so large now that in the grim pricing environment of the present it swamps the ability of the trading arm to bail it out.

Will it escape insolvency? I don’t know, precisely because its fate is out of its control, and dependent on flat prices, which neither I nor its management can predict with any certainty. Events, my boy. Events. Because of its upstream exposure, Glencore is on a ride on the China train. (By the way, those who thought that Glencore was a lower risk than other miners because of some superior ability to predict flat price because it is a trader: what were you thinking?)

If it goes insolvent, will it matter? Well, it’s creditors will mind. But beyond that, the arguments I made in my other white paper, Not Too Big to Fail, imply that the knock-on effects will be minimal. Industrial and mining firms can fail, and go through insolvency/bankruptcy without larger systemic effects.

The possible Viterra sale illustrates another point I made in the paper. Namely, that the financial distress of a commodity trader does not mean that the supply of commodity transformation services will decline. The distressed firm’s assets can continue to operate. One way to ensure that they continue to operate efficiently is to sell them to others. The wheat, canola, and barley that go through Viterra’s elevators don’t really care whose name is on the door. Nor, for the most part, do the farmers upstream or the consumers downstream.

What about other commodity traders? The purer traders they are (i.e., the less upstream asset exposure), the better off they are. Indeed, the lower price environment in oil in particular facilitates the contango trade because contangoes tend to widen when prices decline. BP’s trading arm announced lower profits in Q2 precisely because the contango play was not as profitable: I would expect that to turn around in Q3 and Q4 if prices remain low and the contango remains fat. As another example, Vitol made a well-timed purchase of the remainder of a Dutch oil storage company, presumably to allow it to exploit such plays.

The other firm that could test my arguments is the Hong Kong firm Noble. Nobles issues are somewhat different than Glencore’s. Noble’s accounting has come under sharp questioning, by a rather mysterious outfit called Iceberg (which Noble claims is basically the blog of a disgruntled ex-employee).

The issue is Noble’s aggressive booking of profits on long term deals. Something like 90 percent of the book value of its equity is attributable to these accounting items, whereas for other firms the figure is more on the order of 5-10 percent. Iceberg has also questioned Noble’s reported leverage, alleging that it has engaged in various off-balance sheet repo transactions (a la Lehman repo 105) to conceal debt.

The market has taken these charges seriously.  Noble’s stock has taken a pounding. It rebounded some recently, when Mitsubishi announced the acquisition of a 20 percent share of Olam, another Asian commodity firm whose accounting had been challenged, attracting some aggressive short sellers. But even with the rebound, Noble is flirting with dangerous territory and is at serious risk of insolvency or illiquidity if its bankers get sufficiently concerned (which amounts to insolvency for a commodity trader, which is very dependent on access to credit). Noble’s CDS spread reached 700+ bp in mid-August.

In the event of the worst happening, I again would expect that the pain would be limited to the creditors. Other firms, likely Japanese or Chinese trading firms, would pick up the pieces, and perhaps the whole caboodle. The commodities Noble moves would be moved by somebody else. Banks would eat a loss, but that’s part of their business. Other commodity traders’ accounting would get more scrutiny, from their creditors in particular. And that’s not a bad thing.

Commodity firms have come and gone over the years. (Everybody remembers Enron. Anybody remember Cook Industries? Andre Cie?) But the big commodities river keeps on rolling along.

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September 6, 2015

If You Are Going to Talk Smack About a Four Star, You Better Back it Up: John Schindler Doesn’t

Filed under: Military,Politics — The Professor @ 8:07 pm

Twitter is a strange place, part information gold mine, part cesspool. One of the distinctive phenomena is that of the Twitter exhibitionist who tweets incessantly, and gains a following of acolytes who retweet and tweet sick-making praise to him (or her). The exhibitionist often has some expertise, but usually gains a following more through repetition, bravado and the ignorance of the followers, who often don’t know any better.

One such exhibitionist is John Schindler, who in addition to being a Twitter exhibitionist, is one in real life: he had to resign his position at the Naval War College in disgrace because he texted below-the-belt selfies to a woman, who (a) did not appreciate it, and (b) was not impressed. Normal people would go under a rock and hide after such humiliation. But not Schindler. He laid low for a while, but soon returned to Twitter with a vengeance. He has parlayed his Twitter fame into appearances on Fox News and guest pieces at various publications, including the Daily Beast and the L.A. Times.

He is a nasty piece of work, as a look at his timeline shows. Recently he leveled a very bitter attack on the retiring Army Chief of Staff, General Raymond Odierno:

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Odierno’s sin? At the time of his mandatory retirement, he signed on as an advisor to Jamie Dimon at J. P. Morgan. So this apparently makes him a sellout and a whore.

What was he supposed to do? Take up needlepoint? Commit seppuku for “fucking over soldiers” and “losing wars”?

And let’s look at Schindler’s accusations. As for being a “mouth breather” and “idiot”, Odierno has a masters degree in nuclear effects engineering. A subject a little bit more rigorous than Schindler’s (history). It’s not a subject for dummies. (One of the most impressive profs I had at Navy was a Marine Corps major who was a nuclear effects engineer whom I called Major Mohawk. Smart guy.) Odierno also has a degree from where Schindler used to teach before his photography hobby got him into trouble.

As for losing wars, Odierno served in a variety of positions in Iraq from the invasion in 2003, where his 4th Infantry Division was part of the follow on force (because Turkey denied it from being deployed to launch a planned assault from Turkish soil). Odierno’s role in the occupation was subject to some criticism for overaggressiveness, but the division has in the middle of the hornet’s nest of the Sunni Triangle. He subsequently was in operational command of The Surge, which was far more successful than the efforts that preceded it.  He didn’t lose Iraq. In fact, he was instrumental it creating the possibility of saving it, before that was thrown away.

As for “fucking over soldiers”, which Schindler insinuates he saw: well, if you make a charge like that, you better back it up with credible evidence. Schindler does not.

As for working after retirement, it’s not uncommon for generals and admirals. Omar Bradley was chairman of the Bulova Watch Company. Matthew Ridgeway, a true American hero in WWII and Korea (whom I compared to Petraeus at the onset of The Surge), was on the board of Gulf Oil. Many flag officers have served on corporate boards after retirement.

The public record clearly does not support Schindler’s accusations, which border on slander. Odierno has had a distinguished public career. If you talk smack like Schindler did, you have to bring more than a Tweet to the game.

So what explains Schindler’s attack? That Odierno went to work for a bank (as an advisor, mind you)? Maybe: Schindler exhibits some Occupy tendencies, admitting that he is a socialist who believes the “power structure” is unjust. But the vitriol seems very personal, even for someone as routinely nasty as Schindler. I’m guessing that Odierno does not suffer fools, and that in his interactions with Schindler at NWC he made that plain, and it left a mark on Schindler.

As for the bulk of Schindler’s Twitter output, he cashes in (figuratively!) on his stint working for the NSA years ago. Kind of ironic, isn’t it, that a guy who blasts a four star general with decorations out the wazoo for trading on his government service does the same. Though for a lot less money. Come to think of it, that may be part of the issue here. Schindler brags about his counterintelligence expertise, which begs the question: if he was so good, why did he punch out? I am also skeptical about people who are so vocal about their work in intelligence: the real pros don’t brag.

His commentary on Twitter and on his blog is rather tedious and not that insightful. I guffawed at his presumptuous tweets announcing how he has to keep telling people that the US Secretary of State is a target of foreign intelligence services. Who knew? What would we do without such penetrating insights?

And I have to say that I have to doubt Schindler’s counterintelligence genius based on events that came to light after his scandal. For some months prior, Schindler had been trolled hard on Twitter by someone who trolled me as well, on Twitter and here on the blog: this troll appeared in comments on SWP as Mr. X (whom I am sure long-time readers remember with fondness!) and a variety of other incarnations every time I blocked the source IP. On Twitter, this troll had one account (before being banned) that had a handle based on Schindler’s XXCommittee blog name. This individual also emailed me a few times, including one in which she included a picture of a hanged Nazi war criminal and insinuated that come the revolution I would be dealt with by citizen’s justice.

It turns out that Schindler was engaged in an email exchange with said troll, which came to light as result of a FOIA request to NWC. I figured out who the troll was. I know Schindler was told who the troll was. One clue that it is the same troll is the reference to the Hatch Act, which featured in Mr. X’s comments as well as in one of the emails in the linked piece. But he apparently never figured it out. So yeah. He’s your man to ferret out GRU agents (whom he sees behind every tree, BTW).

So go ahead, fanboys. Follow your hero. Retweet him. Even though he slanders far better men than he on zero evidence whatsoever. When he’s not engaged in art photography, that is.




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September 5, 2015

Amateurs Talk Tactics. Professionals Talk Logistics. And Idiots Talk BS.

Filed under: Military,Politics,Russia — The Professor @ 5:46 pm

The last couple of days have seen a frenzy of excitement about the possibility of an imminent Russian intervention in Syria. The hive buzzed very loudly when the Pentagon said it had seen reports of increased Russian activity in Syria. This means only that they read the linked article and other stories appearing in places like Ynet, not that they are providing confirmation based on US intelligence.

Yet, connecting a few dots, the journalist behind the story claims to have discovered a heretofore unknown Rembrandt.


I have no doubt that Russia has an interest in propping up Assad. That it has, and may be reinforcing, regime protection, intelligence, and advisory elements on the ground in Syria. That perhaps even a few Russian pilots are reprising the role of their “Honcho” forebears in the Korean War. But as for a major Russian ground intervention in Syria, not even Putin is that crazy. An expedition to Syria would make the Soviet Afghanistan adventure look like Napoleonic or Alexandrine genius.

Put aside for a moment the bloodletting the Russians would put themselves in for. Let’s just look at the logistics, and remember that while amateurs talk tactics, professionals talk logistics.

  • Operations outside of bases would require the deployment of thousands, and perhaps tens of thousands, of troops just to defend the lines of communications of those operating at the pointy end of the spear.
  • A major expeditionary effort would require massive supply, and the Russians would have to operate at the end of a very long logistical tether.
  • The most direct supply line would run through the Bosporus and Dardanelles, that is, through Turkish waters. Turkey is Assad’s inveterate enemy. Would you run an operation which would require you to place your logistic jugular under your ally’s mortal enemy’s knife?
  • The alternative, through the Baltic, North Sea, Atlantic, and Mediterranean, is very long, and also requires passage through narrow straits.
  • Russia’s navy is craptastic. It has extremely little sealift capability, and use of civilian vessels is problematic. This is what you need to support overseas expeditions. Russia has nothing even close.
  • Port capacity in Syria is limited, and it would be extremely vulnerable to sabotage and direct attack from the myriad anti-Assad forces. Again, large numbers of men and materiel would be required just to defend the ports. Tartus has four piers (and then only if floating piers are operational), and it can only handle four medium-sized ships: it is too small to handle even a Russian frigate or destroyer. You can’t support major ground operations through that soda straw.

Then there are other considerations, such as:

  • Russia is already militarily committed in Donbas, and has precious little additional capacity to deploy in Syria.
  • Russia has never, ever, engaged in a major overseas expedition, analogous to what the US has done routinely for the past 75 years. Syria is not Donbas, Abkhazia, or Transnistria.
  • The Russian economy is already in dire straits, and cannot afford to commit to a bleeding ulcer campaign in a peripheral region.
  • Another well-known military adage is: Don’t reinforce failure. Assad is failing.

Other than that, it makes total sense for Russia to go large in Syria to bail out a tottering client. Total sense!

The US should actually hope that Putin is this stupid. But he’s not.

To put things in perspective, one of the things that got the hive buzzing was the transit of a couple of Ropucha class amphibious ships, each with a cargo capacity of a whopping 450 tons (8-10 tanks), and an Alligator class gator, with a cargo capacity of 1000 tons. Hardly enough to support a major operation, which requires capabilities such as this. (And by the way, I saw Russian amphibious ships-sides streaked with rust-transiting the Bosporus on my visits to Istanbul in 2013 and 2014. This is like a shuttle run.)

And let’s consider the source, shall we? The story is being flogged by Michael Weiss. Based in large part on geolocators operating in mom’s basement, Weiss has predicted six out of the last zero times that Putin has mounted an invasion of Ukraine. (Full disclosure: I thought Putin was likely to invade last fall. I was wrong. I confess to having little confidence in my ability to predict his next steps there. But Weiss never betrays any contrition at his previous failed predictions.)

And the other things I could tell you, relating to Weiss’s The Interpreter’s mysterious funding (including its relationship with Khodorkovsky), and its use of anonymous sources and unverifiable sources that it translates. And there are some other things that are even more bizarre. But you’ll have to take my word for it.

So yes, Russia will provide materiel support to Assad. It will do what it can to facilitate Iranian and Hezbollah resources flowing to Syria. But a major intervention? We should be so lucky.


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August 30, 2015

Don’t Get Carried Away By Political Rhetoric on Carried Interest Taxation

Filed under: Economics,Politics — The Professor @ 7:12 pm

The tax treatment of “carried interest” for private equity and hedge fund general partners is something pretty much everyone loves to hate. Politicians particularly. Several major candidates, including Hillary, Sanders, and Trump, have said that they will scrap it.

Their argument is simple. Carried interest is taxed at the lower long run capital gains rate  (20 pct), instead of the rate for earned income (39.6 pct). Obviously unfair!  Private equity and hedge fund managers are greedy bastards who do nothing to earn their money! (Trump says they just push paper around.) They don’t deserve a break! Restore fairness to the tax code!

Tax professionals are largely against the treatment too, though their reasoning is a little more sophisticated. Carried interest is income properly attributable to labor or service provision, and is not a return on capital. It therefore should be taxed as labor income.

A little reflection shows that both arguments are simplistic. I can’t say 20 percent is the right rate, but I am highly confident that 39.6 percent is too high. And that’s because carried interest treatment does affect returns on capital, and this should be taken into consideration when figuring out the proper tax treatment. Capital taxes are a bad idea generally, and the effects of carried interest on returns to capital should be taken into consideration when deciding how heavily to tax it.

First, what is carried interest? Private equity and hedge funds typically have limited partners as investors, and general partners who manage. These entities employ incentive mechanisms. The general partners get a percentage (overwhelmingly 20 percent) of all gains over a benchmark, and get zero incentive comp if they fail to reach the benchmark. This is incentive compensation is carried interest, and is taxed as a long term capital gain.

So what would be the effect of increasing taxation on carried interest? Basic tax incidence analysis applies here. Tax incidence analysis basically shows that the costs of a tax are paid not just on whom it is levied (PE and hedge fund GPs in this instance), but are also paid in part by those who buy from or sell to the taxed entity.

There is a supply and demand for the services of PE and HF managers. Investors are willing to pay for managers because the managers can earn a higher return than the investors could earn by investing themselves. Like the demand for anything, the demand for management services is downward sloping: the lower the cost of managers, the more capital will be invested with them because at a lower cost PE and HF outperform more competing investments.

Since these industries are likely highly competitive, the supply curve of services reflects the marginal costs of managerial services. The supply is upward sloping, mainly because some managers are more efficient than others. To expand the industry requires some managers to expand beyond their efficient scale, and also requires the entry of new, less efficient (i.e., higher cost) managers.

Taxes imposed on managers increases their costs, and shifts up the supply curve of managerial services. As the supply curve moves up and to the left, its intersection with the demand curve moves up and to the left. At the new, post-tax equilibrium, less funds are under management (which is crucial), and the cost paid by investors is higher. Thus, some of the burden of the tax is borne by the investors. The rise in the price of managerial services is typically small rather than increase in the tax, however, meaning that managers’ after tax income declines. Thus, the burden of the tax is shared between investors and managers.

How the burden is split depends on how steep the supply and demand curves are. Only if the supply of managerial services is vertical (“perfectly inelastic”) will all of the burden of the tax fall on the PE and HF bastards. This occurs only if all managers are equally efficient, and all are willing to supply the same amount of services at any price. If the supply of their services is very flat (i.e., a small decline in the price of their services leads to a large decline in the quantity supplied), virtually all the burden of the tax is paid by investors.

Thus, like all taxes, the tax on carried interest drives a wedge between the price paid by consumers (investors in PE and HF, in this instance) and suppliers (PE and HF managers).

The fact that investors pay some of the tax means that the carried interest tax is in part a tax on capital, except in the edge case (perfectly flat supply of PE and HF management). This is true because investor returns are depressed by the higher pre-tax compensation that must be paid to managers. Further, note that except in the edge case, investment in PE and HFs will decline, and thus they have less capital to invest. Although things are complicated by the fact that capital may be diverted to other investments, it is likely that total investment goes down. This means that even if the services managers are providing are deemed “labor” or “services”,  taxing carried interest reduces returns on some capital, and likely leads to a reduction in overall investment.

Since there are strong economic arguments that capital should not be taxed, and certainly not taxed as high as labor income if it is taxed, this in turn implies that taxing carried interest exactly the same as earned income is not likely to be optimal. I don’t know what the tax rate should be, but is plain wrong to analyze carried interest as pure labor income. It impacts returns on capital and this needs to be considered when deciding the right tax rate.

There are some other considerations that bolster this conclusion. In particular, carried interest is like a call option on managerial performance: managers’ compensation increases with performance only once the “strike price” is exceeded. They underperform, they get no incentive comp.

Why choose this form of compensation? To align the incentives of managers and investors. High powered incentives expose managers to a lot of risk. They tend to be more risk averse than investors. In particular, investors shouldn’t care about idiosyncratic, diversifiable risk, but managers with incentive-based fees bear that idiosyncratic risk, and may be less well diversified. They will therefore tend to be more averse to that risk than investors: this creates a conflict of interest between investors and managers.

Option-like compensation mitigates this problem, because the value of options is increasing in risk (volatility). Thus option-like carried interests offsets managerial risk aversion, and tends to align the interests of managers and investors. It induces managers to invest in some higher risk projects that investors prefer because they offer higher average risk-adjusted returns.

Increasing taxes on carried interest reduces the after-tax payoff to the managerial option, but this effect is asymmetric: it only reduces payoffs when managers perform well, but doesn’t affect compensation when they perform badly. They have a weaker incentive to take risk because they get less of the upside, and have the same downside.

Put differently, the tax reduces the alignment of incentives between investors and managers. Managers will tend to make investments that are less risky than investors would like. Thus, increasing the tax on carried interest will tend to impact riskier investments disproportionately, and lead to underinvestment in them. In particular, investments with high idiosyncratic risks (which are likely to include many tech investments, for instance, whose performance depends on the success or failure of a technology, rather than the performance of the overall economy) are disproportionately punished.

(This can also be fit into the tax incidence analysis. With a higher tax rate, it is costlier to provide incentives to managers, and this drives down returns on capital, especially for high idiosyncratic risk investments.)

If the politicians and tax professionals are right about carried interest, raising the tax on it won’t reduce returns on capital and reduce investment, or divert investment away from risky but high average return projects. The foregoing analysis demonstrates that this is not correct. Tax incidence analysis, and a consideration of the effect of carried interest taxation on the incentive for managers to invest in high risk, high return projects that investors favor, show that raising this tax will reduce returns, reduce investment, and divert investment away from high risk projects.

And let’s remember why taxation on capital is harmful: it reduces wages. Less capital means lower productivity. Lower productivity means lower wages. So although the seen effect of higher capital taxation will be on the Gnomes of Greenwich, the unseen costs will be paid by those on whose behalf Hillary, Bernie, and Donald claim to be speaking. Funny how the middle class can get wet when the politicians try to soak the rich.

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August 28, 2015

Walter Russell Meade Saw Trump Coming, 15 Years Ago

Filed under: Economics,Politics — The Professor @ 9:30 pm

More than 15 years ago, Walter Russell Meade anticipated the emergence of Trump:

It is perversion rather than corruption that most troubles Jacksonians: the possibility that the powers of government will be turned from the natural and proper object of supporting the well-being of the majority toward oppressing the majority in the service of an economic or cultural elite—or, worse still, in the interests of powerful foreigners. Instead of trying, however ineptly, to serve the people, have the politicians turned the government against the people? Are they serving large commercial interests with malicious designs on the common good? Are they either by ineptitude or wickedness serving hostile foreign interests—giving all our industrial markets to the Japanese, or allowing communists to steal our secrets and hand them to the Chinese? Are they fecklessly frittering away huge sums of money on worthless foreign aid programs that transfer billions to corrupt foreign dictators?

Jacksonians tolerate a certain amount of government perversion, but when it becomes unbearable, they look to a popular hero to restore government to its proper functions. It was in this capacity that Andrew Jackson was elected to the presidency, and the role has since been reprised by any number of politicians on both the local and the national stages. Recent decades have seen Ronald Reagan master the role, and George Wallace, Ross Perot, Jesse Ventura and Pat Buchanan auditioning for it. The Jacksonian hero dares to say what the people feel and defies the entrenched elites. “I welcome their hatred”, said the aristocratic Franklin Roosevelt, in his role of tribune of the people. The hero may make mistakes, but he will command the unswerving loyalty of Jacksonian America so long as his heart is perceived to be in the right place. [Emphasis added.]

What is bizarre is that the sin of “giving our industrial markets to the Japanese” was somewhat dated by 1999, but Trump pounds on that theme today, when it is well past its sell date. Decades past. Just yesterday, in  Greenville, SC, he said something to the effect that “the Japanese are up here [holding his hand over his head] and we are down here [holding his hand by his knee].” Fact: Japanese per capita GDP is $36K, and US per capital GDP is exactly 50 percent higher, at $54K. But facts don’t matter. The image of Japanese domination (now accompanied by the image of Chinese domination) resonates intensely among Jacksonians.

But moving beyond that particular point, Meade clearly identified the role Trump is playing, and the audience-Jacksonians-to whom he is appealing.

One of the characteristics of Jacksonians that Meade identifies is their hostility to elites.  Angelo Codevilla makes a similar point, saying that Trump is channeling intense anger at the “Ruling Class.”

And truth be told, there is a lot to be hostile to and angry with. Viewed objectively, the term “elite” can only be used ironically in the America of 2015. There has never been such a sorry lot at the upper echelons of politics and culture in our nation’s history, except perhaps for the 1850s. The Jacksonian instinct to break out the pitchforks and torches and get the bastards is understandable.

But Trump is a fatally flawed vessel for this rebellion, in part because of he echoes so well the flawed beliefs of so many Jacksonians, notably the tribalism that gives rise to protectionism and indiscriminate hostility to all immigration. (And I say this as someone with decided Jacksonian impulses on foreign policy, and as someone descended in part from a quintessential Jacksonian family.)

But also in part-in large part-to Trump’s authoritarianism. Virtually every proposal he makes involves some sort of government intervention, such as the imposition of tariffs, a concerted effort to weaken the dollar, or mass deportation. Indeed, it is difficult to find any serious policy differences between Trump and avowed socialist Bernie Sanders.

What’s more, he promises a highly personalized government, in which he will exercise his personal executive authority to impose his policies. (A style pioneered by Andrew Jackson, notably.) He envisions his presidency as the application of the methods of the corporate CEO (who frequently exercises virtually untrammeled authority) to the governance of a nation that dwarfs even the largest company.

Even beyond the defects of his specific policy proposals, this personalization of process is the last thing we need right now. Obama has already taken us far down this road, and we need to retrace our steps, rather than hurtle even further forward on it. We are careening towards presidentialism, which has proved disastrous to both liberty and wealth wherever it has been implemented. (It is not for nothing that Trump sees a kindred spirit in Putin.)

It is ironic that many Tea Party people are ardent Trump fans, despite the fact that he represents the antithesis of the Constitution-worshipping, small-government rhetoric of the Tea Party. If Trump actually wins, these people will wake up with the biggest morning-after regret ever.

That said, I doubt that Trump can win the presidency, or even the nomination. But I temper my doubts because I never thought that he would make it this far. And even if he does not gain the nomination, he may do so much damage to the (already divided and dysfunctional) Republican Party that its electoral prospects may be doomed, even in a year when the presumptive Democratic Party nominee is a walking disaster who is at some risk of trading her orange pantsuits for orange prison garb, and the alternatives are an aging socialist loon and an aging lifelong pol with a well-earned reputation for buffoonery. (This is another illustration of the degraded condition of our purported elites.)

And Trump also brings out in stark relief the Republicans’ fundamental dilemma. They cannot win without the Jacksonians, but it is seriously questionable whether they can win with them, because they repel a large number of the swing voters who will decide the election. Reagan was able to bridge this gap, but the gap was much narrower 35 years ago. Reagan was arguably the only person that could have done it in the 1980s, but even he would almost certainly find it impossible today.

Trump today is polling at 20 percent or so of a party that may-may-account for 50 percent of the electorate. You can’t win with 10 percent, no matter how intense its support, especially if that very intensity alienates 10 percent (or more) of the voters.

This is particularly true if you look at the electoral map. The swing states that the Republicans need to win to regain the White House are the very ones that are most likely to be neuralgic to Trump and his angry band of Jacksonians.

So what will happen? In such discontented times making forecasts is even more difficult than usual, but I cannot identify plausible, positive scenarios. Trump and the Jacksonian faction he appeals to are a destructive force, even though the object of their anger and disdain largely deserves it.  Destructive because they are likely to perpetuate the misrule of the progressives, and destructive even in the (unlikely) event of victory, because Trump’s policies and presidentialism would just represent a different form of misrule.

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August 26, 2015

Donald Trump Can Only Aspire to Match Obama’s Economic Ignorance

Filed under: Climate Change,Economics,Energy,Politics,Regulation — The Professor @ 8:00 pm

Yesterday I said Trump and O’Reilly were in a cage match to determine the world champion of economic ignorance. There is another contender of course, the current occupant of the office to which Trump aspires. Actually, I would say that Obama is the undefeated reigning world champ, and that the O’Reilly-Trump set-to was merely to see who might contend for the title in the future.

Obama’s gobsmacking ignorance-served up with a heaping side of superciliousness-was on full display at the “Clean Energy Summit” in Las Vegas on Monday. Time is finite, and my energy is only intermittently renewable, so I can’t possibly deconstruct these vaporings in detail. So I will limit myself to a few high-level comments:

  1. Obama’s claims that his policies on renewable energy and carbon will make a meaningful impact on climate is a massive fraud that would land you or me in jail. Obama’s own EPA acknowledges that the policy will reduce global mean temperatures by an imperceptible and irrelevant .02 degrees by 2100. Farenheit? Celsius? Who cares? It matters not. It is rounding error on any scale.
  2. Obama’s mantra is all about the jobs that his renewables policies are creating and will create. Jobs are costs, not benefits.
  3. Further, Obama is clueless about the seen vs. unseen. To the extent that these policies raise the cost of electricity, they will have adverse consequences on wealth and income in consuming sectors, and in sectors that could produce electricity more efficiently, but for the subsidized competition from renewables.
  4. And yes, these policies will increase costs. Renewables are intermittent and diffuse and therefore require backup resources to ensure reliability; there is often a long distance between renewable sources and demand, meaning that new investments in icky transmission are required; and there is often a negative correlation between renewable production and electricity demand (e.g., the wind usually stops blowing when it’s really hot). Just look to Germany, with its Energiewende fiasco if you have any doubts. There is a strong correlation between electricity costs and fraction of electricity from renewables, and although this could be due in part to an endogeneity issue (those with more costly electricity sources utilize more renewables), this does not explain the entire effect.
  5. Obama and other boosters of renewables boast about falling costs of solar. Wind is conspicuously absent from this discussion, even though it represents the bulk of renewables generation. Further. Fine! When these inexorable efficiency gains make solar economical as a large-scale source of electricity, it will be able to compete without subsidy. This is no reason to subsidize now. This technical progress in solar argument is a non sequitur of the first magnitude.
  6. Obama and other boosters rave about capacity additions attributable to renewables. Well, due to the intermittence issue, capacity utilization is very low. It takes a lot more than 1MW of renewable capacity to replace 1MW of thermal or nuclear capacity. Indeed, if the wind ain’t blowing, all the windmills in the world can’t replace one conventional plant.
  7. Obama’s ignorance is on full display when he claims that conventional electricity generation was not characterized by “a lot of innovation.” This is just a crock. Compare heat rates of plants 20 years ago to those of today: in California, for instance, thermal efficiency has improved by 17 percent over the last 13 years. Heard of combined cycle, Barry? There has been considerable innovation in electricity generation. Well, not at the light switch plate, which is probably the extent of Barry’s familiarity with the electricity value chain.
  8. Obama mistakes opposing subsidies with being anti-free market. Welcome to bizarro world. And, as is his wont, he did so in an Alinskyite fashion, demonizing his opponents (the always handy Koch Brothers) in a very personal way.

I could go on, but that would be an S&M exhibition, and this is (usually!) a SFW site.

Suffice it to say that in Las Vegas Obama gave a demonstration that proves that when it comes to economic illiteracy, Trump can only aspire to fill Obama’s shows.

And yeah. Take a moment to absorb just what that means.

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