Streetwise Professor

December 27, 2017

Vova the Squeegee Man

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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December 26, 2017

Agency Costs: Washington’s Augean Stables

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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December 21, 2017

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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December 4, 2017

Bitcoin Futures: What? Me Worry?

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

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

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

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

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

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

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

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

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

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

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

Petterfy has expressed worries about weaker FCMs in particular:

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

He has recommended clearing crypto separately from other instruments.

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

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

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

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

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

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

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

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

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

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

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November 23, 2017

Igor Is Not Available. Please Leave Your Name and Number, and He’ll Return Your Call as Soon as Possible.

Filed under: Economics,Energy,Politics,Russia — The Professor @ 10:27 pm

Who knew that Igor Sechin was such a shy and retiring type? He has been summoned thrice to testify at the Ulyukaev bribery trial, and thrice he has failed to appear. One time he apparently dodged the summons by hiding in his office, and having his staff refuse to accept it. The other times he has said his busy travel schedule precludes him from attending. He has been summoned yet again to appear on 27 November, but the judge in the case said that Sechin indicates that his schedule wilt allow him to testify before the end of the year.

What will his next excuse be? “Sorry. I’m washing my hair that day”? Alas, “I’m scheduled to have my mullet trimmed” is no longer credible.

So why is Igor so reticent? After all, it is because of him, and a sting in which he participated, that Ulyukaev is in the dock. I discussed the issue with a Russian who follows the situation closely–perhaps too closely for comfort, in fact–and we pretty much agree on three possible explanations.

First, embarrassment. Transcripts, then audio, and now video of the sting have been released. Sechin does not come off well in these, and his offer of sausages in a hamper has become something of a running joke in Moscow. Relatedly, Sechin’s behavior violates the norms of inter-elite interaction (sort of like violating the mafia code), and this is there for all to see.

Second, there have been inconsistencies in the prosecution story. Sechin may dread cross-examination that will expose the episode as entrapment or fraud.

Third, Sechin may be testing the limits of his power and autonomy, or deliberately flouting the rules to show that he is an untouchable.

Will we ever learn the truth? This being Russia, there is considerable room for doubt. But one thing we can be sure is not the truth is that Sechin is a respectable figure. He is either an arrogant thug who operates outside the law–or wants to do so. Or he is a buffoon who played out a charade–badly–in order to punish someone who tried to thwart him.

Come to think of it, I’m going with “both”.

And it is not that Sechin’s performance as head of Rosneft compensates for his buffoonish thuggery (or is it thuggish buffoonery?). Indeed, the last earnings report was a disaster, and there are still many questions about the whole Rosneft-Glencore-QIA-Intesa-VTB-CEFC-Ivan Doesky* deal, and just how money from that deal made it (or didn’t) to the Russian budget to fulfill Putin’s privatization promise.

Rosneft’s stock price has been lackluster, at best. Yet the company has been on an acquisition binge overseas. (And how is that Venezueula thing working out? Pouring money down a corrupt rathole–sheer genius! What strategic vision!)

Things have gotten so bad–and so impossible to ignore–that even Sberbank released a scathing criticism of the company:

In the 64-page research report, dated October 2017, Sberbank’s division Sberbank CIB called on Rosneft to change its strategy “markedly” after the energy company incurred huge debts following an acquisition spree at home and abroad.

“Rosneft has been touting its top-down efficiency effort, complete with Stalinesque tales about employees being confronted with charges of malfeasance at management meetings and marched straight into police custody,” the initial report said.

. . . .

The report’s authors, in a section titled “Rosneft: We Need to Talk About Igor”, also said Rosneft’s powerful Chief Executive Igor Sechin “almost single-handedly sets the company’s strategy”.

They calculated that since purchasing oil and gas producer TNK-BP for around $55 billion in 2013, Rosneft had spent a net $22 billion on acquisitions, “with no clear focus”.

“Assuming he remains in charge, the company will continue to pursue volume growth. In doing so, its heft will push it further out of Russia and perhaps further out of oil. This will only disappoint its shareholders,” the report said.


Actually, Sberbank wasn’t laughing, because Igor and Rosneft took extreme exception to the snarky criticism. Sberbank subsequently withdrew the report and reissued it, minus the offending language.

One can imagine what transpired in order to achieve that result.

Thus the management of the world’s largest publicly traded oil company (by volume, NOT by value, to be sure). Run by–indeed dominated by–a strategic imbecile who attempts to compensate for his managerial incompetence by strong-arming his domestic rivals into giving up their resources, and engaging in clownish masquerades to frame up those who have attempted to thwart him.

There are larger lessons here too. Keep Igor in mind whenever anyone shrieks about Putin’s fearsome juggernaut. If the management of a national champion in the largest and most important industry in Russia is any indication, the colossus has feet of clay–and a head of brick.

* And no, Donald Trump is not one of the Ivan Doeskys, dossier notwithstanding. I am referring to the unknown party or parties who (a) chipped in the difference between what Glencore, QIA, and Intesa cop to have paid, and the amount that Rosneft claim to have received, and (b) indemnified Glencore against loss.

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November 22, 2017

Obama Turned the Net Into a Neut: But It’s Getting Better!

Filed under: Economics,Politics,Regulation — The Professor @ 9:52 pm

Few subjects generate such intense reactions as net neutrality. It has become freighted with much emotional baggage, largely because it has been framed–artfully–as a matter of free choice and free speech vs. censorship and control of information by malign interests.

The Trump FCC’s announcement of its plans to reverse the Obama FFC’s 2015 net neutrality rule has led brought the issue–and the Manichean rhetoric–back to the fore.

One would hope that applying some basic economics might shed some light, and cool some of the rhetorical heat. I will give it a go.

The basic economic issue is straightforward. It is basically a matter of price discrimination, a subject that economists have analyzed and understood for years. The crucial feature of net neutrality is its ban on ISPs charging different prices for different types or categories of service. So for example, your Internet provider cannot charge higher prices for more intense consumers of bandwidth (e.g., streaming services).

Although the term “price discrimination” has bad connotations–which net neutrality supporters emphasize–it can be good, and it is difficult to identify conditions in which it is unambiguously bad compared to the real world alternative.

One reason that charging different prices for different types of customers can enhance efficiency–and why suppressing the ability to do so can be inefficient–is that the costs of providing a service can differ between customers. Some customers are more expensive to serve, or demand a differentiated service that is costlier to deliver. Providing the price signals that give the incentive to consume, produce, and invest in capacity efficiently requires price discrimination: higher cost customers should pay more than lower cost customers.

This is an issue in providing Internet services. Some services and users that consume more bandwidth, and impose greater risk of congestion on the system. A pricing structure that does not charge such users/services a higher price to reflect these higher costs induces overconsumption of these services, and imposes costs (e.g., poorer quality of service) on those who do not put such demands on the system. Furthermore, preventing ISPs from charging prices that reflect higher cost distorts their incentives to invest in more capacity, or in technologies and congestion management techniques that ease burdens on the system.

Prohibiting charging prices that vary by type of service or customer therefore results in cross-subsidization (low cost customers subsidize high cost ones), which both transfers wealth and undermines efficient allocation of resources.

Price discrimination can also occur as a result of market power. There are different “degrees” of price discrimination. To keep things simple, the most common kind is “third degree price discrimination”, in which a firm with market power who can segment customers based on their demand elasticities: less price sensitive customers pay higher prices than more elastic demanders.

It is plausible that demand elasticities for Internet services differ, and that elasticity may vary by the type of content, e.g., that the demand for streaming services is less price elastic than the demand for email or cat videos. In this case, charging a different price for streaming services vs. more mundane uses of the Internet could well be a form of 3d degree price discrimination.

It has long been known that the welfare effects of 3d degree discrimination are ambiguous: as compared to a single price for all services/customers charged by a firm facing a downward sloping demand curve, welfare (consumer plus producer surplus) or consumer surplus can be higher of lower with price discrimination. Furthermore, if a firm faces substantial economies of scale, the efficient way of covering fixed costs typically involves 3d degree price discrimination (“Ramsey Pricing”).

So one cannot say a priori that even if price discrimination by ISPs reflects market power, suppressing price discrimination improves welfare: the market power remains, and the ISP might exercise it in a way that causes welfare to be lower than if it exercises it by price discriminating.

Moreover, there is reason to doubt that a predicate for inefficient price discrimination–ISP market power–exists, or is more acute in this market than it is in many other markets where price discrimination is common (and believe me, that is pretty much every market). The days of the “last mile” monopoly are over. A very large fraction of Internet users in the US have access to multiple ISPs. Furthermore, wireless service (4G, and perhaps soon 5G services) competes with traditional cable and DSL service. Between wireless and cable, off the top of my head I can think of 8 providers that I can access. Yes, there is some overlap (e.g., ATT provides both types of service), but the number of choices most Americans have for Internet access is greater than they have for many other goods and services. Meaning that it is unlikely that market power problems are so acute in this market as to justify regulations unheard of in other markets where price discrimination is widely practiced.

I should also note that some kinds of price discrimination can unambiguously improve welfare relative to simple monopoly pricing. First degree (rare in practice) or second degree (e.g., quantity discounts, two part pricing) is superior to simple monopoly pricing. I would wager that some ISPs will adopt such efficiency enhancing price policies if freed from net neutrality restrictions.

Thus, if your concern is that ISPs exercise market power by price discrimination, suppressing price discrimination is not the best way to tackle the problem: attack the market power directly by reducing entry barriers or antitrust actions against ISPs. Furthermore, it is not at all clear that price discrimination in this market is driven primarily by market power, given the competitive conditions in the market. Lastly, and perhaps most importantly, attempting to squelch (at best ambiguously inefficient) market power driven price discrimination also precludes efficiency enhancing price discrimination based on differences in service/customer cost. Doing so imposes substantial costs.

For all these reasons, I conclude that net neutrality is (a) a solution to a non-existent problem, and (b) can do positive harm by preventing the development of efficient pricing systems that give appropriate incentives to consume and invest in system capacity, and to optimize its use.

Another aspect of the net neutrality rule is to prevent ISPs from favoring its content (which it either produces, or buys from others) over that supplied by independent parties.  Again, a necessary condition (but definitely not a sufficient one) for this to be a problem is ISP market power, which as noted above is unlikely to be a particularly serious issue. Furthermore, it is typically not in the interest of a downstream firm with market power to restrict its customers’ access to upstream product. Offering suboptimal product variety reduces the demand for the putative monopolist’s services, which reduces its profit. It is typically more profitable for the monopolist to offer the optimal product variety, and profit by charging a higher monopoly price.

There are some rather contrived models in which vertical restrictions (e.g., tying or exclusive dealing) can be used to lever market power from one good to another: the practical applicability of these models is dubious at best, as some of the modelers themselves acknowledge. But there is also an extensive literature (much of it originating in Chicago in the 1960s, including seminal contributions by my thesis advisor Lester Telser) showing that such vertical restrictions are usually efficiency-enhancing responses to some incompleteness in property rights or information problem. Indeed, in US antitrust law, horizontal restrictions (e.g., cartels) receive far more scrutiny that vertical ones, precisely because academic research on the potential efficiency enhancing effects of vertical restrictions, and the difficulty of using them to increase monopoly power, has informed antitrust policy–under administrations of both parties I might add. (As an aside, this makes the Trump DOJ challenge of the Time Warner-ATT deal somewhat strange, and intellectually at odds with the FCC’s move against net neutrality.)

In sum, I favor jettisoning net neutrality. No, I do not believe that the ISP market is perfectly competitive, but that is a red herring. Even acknowledging the possibility of imperfect competition in that market (although I do believe fear thereof is overblown), net neutrality is not the right way to address it, and indeed, might actually mean that market power is exercised in a way that reduces efficiency. In other words, the Obama FCC wanted to fight ISP market power in the worst way–and it did!

So if net neutrality is an inefficient policy, why did it prevail in the US, at least for a while? That is, what is the political economy of net neutrality?

Well, Chicago has a lot to say about this as well. Indeed, the work of another of my former advisors–Sam Peltzman–is directly on point. Sam’s amazing 1976 JLE article “Towards a More General Theory of Regulation” has an important, but widely overlooked prediction: regulation is likely to occur in industries where there are substantial differences in costs of serving different customers, and that regulated price structures suppress these cost differences. That is, regulated price structures cross-subsidize high cost customers. As Sam put it: “cross—subsidization follows a systematic pattern in which high cost customer groups are subsidized by low cost customers.” And: “The important contribution of politics is to suppress economically important distinctions and substitute for these a common element in all prices.”

That is net neutrality in a nutshell. Put simply, the Obama FCC bought political support Google, Facebook, Amazon, Microsoft, Netflix, et al by implementing a policy that cross subsidized their services. They used the political system to push regulation that suppresses economically important distinctions.

This result is less surprising from a political economy/public choice perspective than the Trump administration’s reversal of net neutrality. My first stab at an explanation is that this reflects the fact that a Trump administration can never expect to obtain political support from these companies, and can doesn’t really have to fear additional opposition: they already hate him with the heat of 1000 suns. So why  not stiff them?

Karma is a bitch, eh?

Now for some laughs!

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October 17, 2017

Financial Regulators Are Finally Grasping the Titanic’s Captain’s Mistake. That’s Something, Anyways

Filed under: Clearing,Commodities,Derivatives,Economics,Financial crisis,Regulation — The Professor @ 7:11 pm

A couple of big clearing stories this week.

First, Gary Cohn, Director of the National Economic Council (and ex-Goldmanite–if there is such a thing as “ex”, sorta like the Cheka), proclaimed that CCPs pose a systemic risk, and the move to clearing post-crisis has been overdone: “Like every great modern invention, it has its limits, and I think we have expanded the limits of clearing probably farther beyond their useful existence.” Now, Cohn’s remarks are somewhat Trump-like in their clarity (or lack thereof), but they seem to focus on one type of liquidity issue: “we get less transparency, we get less liquid assets in the clearinghouse, it does start to resonate to me to be a new systemic problem in the system,” and “It’s the things we can’t liquidate that scare me.”

So one interpretation of Cohn’s statement is that he is worried that as CCPs expand, perforce they end up expanding what they accept as collateral. During a crisis in particular, these dodgier assets become very difficult to sell to cover the obligations of a defaulter, putting the CCP at risk of failure.

Another interpretation of “less liquid assets” and “things we can’t liquidate” is that these expressions refer to the instruments being cleared. A default that leaves a CCP with an unmatched book of illiquid derivatives in a stressed market will have a difficult task in restoring that book, and is at greater risk of failure.

These are both serious issues, and I’m glad to see them being aired (finally!) at the upper echelons of policymakers. Of course, these do not exhaust the sources of systemic risk in CCPs. We are nearing the 30th anniversary of the 1987 Crash, which revealed to me in a very vivid, experiential way the havoc that frequent variation margining can wreak when prices move a lot. This is the most important liquidity risk inherent in central clearing–and in the mandatory variation margining of uncleared derivatives.

So although Cohn did not address all the systemic risk issues raised by mandatory clearing, it’s past time that somebody important raised the subject in a very public and dramatic way.

Commenter Highgamma asked me whether this was from my lips to Cohn’s ear. Well, since I’ve been sounding the alarm for over nine years (with my first post-crisis post on the subject appearing 3 days after Lehman), all I can say is that sound travels very slowly in DC–or common sense does, anyways.

The other big clearing story is that the CFTC gave all three major clearinghouses passing grades on their just-completed liquidity stress tests: “All of the clearing houses demonstrated the ability to generate sufficient liquidity to fulfill settlement obligations on time.” This relates to the first interpretation of Cohn’s remarks, namely, that in the event that a CCP had to liquidate defaulters’ (plural) collateral in order to pay out daily settlements to this with gains, it would be able to do so.

I admit to being something of a stress test skeptic, especially when it comes to liquidity. Liquidity is a non-linear thing. There are a lot of dependencies that are hard to model. In a stress test, you look at some extreme scenarios, but those scenarios represent a small number of draws from a radically uncertain set of possibilities (some of which you probably can’t even imagine). The things that actually happen are usually way different than what you game out. And given the non-linearities and dependencies, I am skeptical that you can be confident in how liquidity will play out in the scenarios you choose.

Further, as I noted above, this problem is only one of the liquidity concerns raised by clearing, and not necessarily the the biggest one. But the fact that the CFTC is taking at least some liquidity issues seriously is a good thing.

The Gensler-era CFTC, and most of the US and European post-crisis financial regulators, imagined that the good ship CCP was unsinkable, and accordingly steered a reckless course heedless to any warning. You know, sort of like the captain of the Titanic did–and that is a recipe for disaster. Fortunately, now there is a growing recognition in policy-making circles that there are indeed financial icebergs out there that could sink clearinghouses–and take much of the financial system down with them. That is definitely an advance. There is still a long way to go, and methinks that policymakers are still to sanguine about CCPs, and still too blasé about the risks that lurk beneath the surface. But it’s something.

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October 12, 2017

Trump Treasury Channels SWP

SWP doesn’t work for the Trump Treasury Department, and is in fact neuralgic to the idea of working for any government agency. Yet the Treasury’s recent report on financial regulatory reform is very congenial to my thinking, on derivatives related issues anyways. (I haven’t delved into the other portions.)

A few of the greatest hits.

Position limits. The Report expresses skepticism about the existence of “excessive speculation.” Therefore, it recommends limiting the role of position limits to reducing manipulation during the delivery period. Along those lines, it recommends spot month on limits, because that is “where the risk of manipulation is greatest.” It also says that limits should be designed so as to not burden unduly hedgers. I made both of these points in my 2011 comment letter on position limits, and in the paper submitted in conjunction with ISDA’s comment letter in 2014. They are also reflected in the report on the deliberations of the Energy and Environmental Markets Advisory Committee that I penned (to accurately represent the consensus of the Committee) in 2016–much to Lizzie Warren’s chagrin.

The one problematic recommendation is that spot month position limits be based on “holistic” definitions of deliverable supply–e.g., the world gold market. This could have extremely mischievous effects in manipulation litigation: such expansive and economically illogical notions of deliverable supplies in CFTC decisions like Cox & Frey make it difficult to prosecute corners and squeezes.

CFTC-SEC Merger. I have ridiculed this idea for literally decades–starting when I was yet but a babe in arms 😉 It is a hardy perennial in DC, which I have called a solution in search of a problem. (I think I used the same language in regards to position limits–this is apparently a common thing in DC.) The Treasury thinks little of the idea either, and recommends against it.

SEFs. I called the SEF mandate “the worst of Frankendodd” immediately upon the passage of the law in July, 2010. The Treasury Report identifies many of the flaws I did, and recommends a much less restrictive requirement than GiGi imposed in the CFTC SEF rules. I also called out the Made Available For Trade rule the dumbest part of the worst of Frankendodd, and Treasury recommends eliminating these flaws as well. Finally, four years ago I blogged about the insanity of the dueling footnotes, and Treasury recommends “clarifying or eliminating” footnote 88, which threatened to greatly expand the scope of the SEF mandate.

CCPs. Although it does not address the main concern I have about the clearing mandate, Treasury does note that many issues regarding systemic risks relating to CCPs remain unresolved. I’ve been on about this since before DFA was passed, warning that the supposed solution to systemic risk originating in derivatives markets created its own risks.

Uncleared swap margin. I’ve written that uncleared swap margin rules were too rigid and posed risks. I have specifically written about the 10-day margining period rule as being too crude and poorly calibrated to risk: Treasury agrees. Similarly, it argues for easing affiliate margin rules, reducing the rigidity of the timing of margin payments (which will ease liquidity burdens), and overbroad application of the rule to include entities that do not impose systemic risks.

De minimis threshold for swap dealers. I’m on the record for saying using a notional amount to determine the de minimis threshold to determine who must register as a swap dealer made no sense, given the wide variation in riskiness of different swaps of the same notional value. I also am on the record that the $8 billion threshold sweeps in firms that do not pose systemic risks, and that a reduced threshold of $3 billion would be even more ridiculously over inclusive. Treasury largely agrees.

The impact of capital rules on clearing. One concern I’ve raised is that various capital rules, in particular those that include initial margin amounts in determining liquidity ratios for banks, and hence their capital requirements, make no economic sense, and and unnecessarily drive up the costs banks/FCMs incur to clear for clients. This is contrary to the purpose of clearing mandates, and moreover, has contributed to increased concentration among FCMs, which is in itself a systemic risk. Treasury recommends “the deduction of initial margin for centrally cleared derivatives from the SLR denominator.” Hear, hear.

I could go into more detail, but these are the biggies. All of these recommendations are very sensible, and with the one exception noted above, in the Title VII-related section I see no non-sensical recommendations. This is actually a very thoughtful piece of work that if followed, will  undo some of the most gratuitously burdensome parts of Frankendodd, and the Gensler CFTC’s embodiment (or attempts to embody) those parts in rules.

But, of course, on the Lizzie Warren left and in the chin pulling mainstream media, the report is viewed as a call to gut essential regulations. Gutting stupid is actually a good idea, and that’s what this report proposes. Alas, Lizzie et al are incapable of even conceiving that regulations could possibly be stupid.

Hamstrung by inane Russia investigations and a recalcitrant (and largely gutless and incompetent) Republican House and Senate, the Trump administration has accomplished basically zero on the legislative front. It’s only real achievement so far is to start–and just to start–the rationalization and in some cases termination (with extreme prejudice) of Obama-era regulation. If implemented, the recommendations in the Treasury Report (at least insofar as Title VII of DFA is concerned), would represent a real achievement. (As would rollbacks or elimination of the Clean Power Plan, Net Neutrality, and other 2009-2016 inanity.)

But of course this will require painstaking efforts by regulatory agencies, and will have to be accomplished in the face of an unrelentingly hostile media and the lawfare efforts of the regulatory class. But at least the administration has laid out a cogent plan of action, and is getting people in place who are dedicated to put that plan into action (e.g., Chris Giancarlo at CFTC). So let’s get on with it.




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October 9, 2017

The Thaler Nobel: A Nudge to Progressivism in a Populist Age

Filed under: Economics,Politics — The Professor @ 9:02 pm

Richard Thaler won the 2017 economics Nobel. Another win for Chicago. Ironic, in a way, given that in many ways Thaler is the anti-Chicago. The fact that the prime critic of homo economicus is on the faculty of the school most associated with neoclassical economics that utilizes homo economicus as its primary analytic engine is an indication of Chicago’s self-confidence, and reflects a belief that intellectual tension is a spur to scholarly innovation. Also, it may well indicate a canny instinct about future trends in economic science.

Insofar as the Nobel is a measure of impact, this one is warranted: there is no doubt that behavioral economics, of which Thaler is the recognized leader, has had an impact on the profession. That said, this area was recently recognized with Kahneman’s Nobel a few years back, and it would have been preferable IMO to have awarded Thaler along with Kahneman.

Insofar as the substance of behavioral economics is concerned, I largely agree with Mario Rizzo’s opinions on the Thaler award. Along with Rizzo, I find it useful to divide things into positive and normative economics.

With respect to positive economics, as Rizzo notes the primary use of the rational actor assumption is to derive predictions about aggregate/market behavior. It is not at all evident how the irrational actor assumption leads to more empirically robust models.  I vividly recall Gary Becker’s discussion of irrationality in an Econ 301 class at Chicago, in which he showed that rationality (in the form of utility maximization) is not necessary to derive the law of demand (though it is sufficient). Random choices on the budget line lead to a downward sloping demand curve, meaning that the location of the opportunity set, rather than how agents choose a point on that budget set, is the more important factor in causing the demand curve to slope down.

Indeed, there is a danger of falling prey to the fallacy of composition: even if certain behaviors are observed at the level of the individual does not imply that they will characterize behavior at larger elements of aggregation. Allowing for individual irrationality certainly adds modeling degrees of freedom, but that’s more of a bug than a feature, especially given the now vast number of alleged behavioral biases. There is always the risk of cherry picking this bias or that to explain a particular phenomenon, and then cherry picking another (which could be completely at odds with the first one) to explain another. This creates the risk that behavioral economics is empirically vacuous.

Further, there are already plenty of degrees of freedom even within the standard economics maximizing agent framework. Information environment–note that the most die-hard advocate of neoclassical economics and the exemplar of the Chicago School, introduced costly information in the form of search costs to explain price dispersion, which is inexplicable in the Marshallian costless information, perfect competition framework. Preferences–which raises a question: is habit persistence rational or irrational? Strategic interaction–one of the problems with game theory is that virtually any outcome is possible with rational actors depending on the details of the game, the information environment, beliefs, etc. Many phenomenon that seemed anomalous in one type of model with rational actors have been explained by tweaking one of these features all the while retaining the rational actor assumption.

So I’ve yet to see how deviating from the maximizing agent framework (and maximization is really what rationality means) improves the ability of economics to improve the empirical performance of its predictions regarding aggregate/market behavior. Meaning that the contributions of behavioral economics to positive economics are dubious, in the sense that they are unnecessary, and often subject to abuse.

But what really distinguishes behavioral economics is its avowedly normative thrust. People are irrational, and would be better off in objectively measurable ways if these behavioral biases were corrected. Furthermore, many behavioral economists, and Thaler specifically, are quite confident in their ability to identify and correct these biases–and make people better off–through “nudges”.

I have two major objections to this. The first is the fallacy of composition problem mentioned earlier. Nudged agents interact in markets, organizations, and institutions. Individual behavioral changes will lead to changes in prices and market outcomes. It does not follow that “better” individual behavior will result in “better” market outcomes–that’s the fallacy of composition in action. Economies are emergent orders, and small changes in individual behavior can lead to very different emergent outcomes. The law of unintended consequences is ruthless in its operation in emergent settings.

My second objection is more straightforward. Behavioral economics of the nudge variety is relentlessly progressive, in the political sense. There are the elite nudgers, and the irrational hoi polloi who can be improved by the beneficent interventions of the nudgers. Moreover, the elite are apparently not just benevolent, but also devoid of their own behavioral biases.

To which I reply: one of the major biases identified by behavioral economists is the overconfidence bias. Mightn’t the nudgers be particularly prone to that bias? The likely commission of the fallacy of composition suggests that they are. As does the dreary experience of social and behavioral engineering efforts large and small, where technocratic elites in their overweening confidence wreaked great havoc around the world.

Ironically, I would assert that behavioral economics actually feeds the overconfidence bias among its practitioners. A seemingly powerful intellectual tool has the tendency to do that. In economics, I would proffer Keynesianism as an example.

Shall we consider other biases as well? Given that there are many of them, we could be here for a while. Suffice it to say that once you admit the nudgers are themselves imperfect decision makers, the case for nudging becomes very weak indeed. When you add the fact that even Spock-like nudgers operate with seriously limited information (about outcomes of emergent social processes in particular), the case becomes weaker still.

Behavioral economics therefore is just what a would-be technocratic elite ordered. It provides a justification for their existence, and also for an existence that should be independent of check by popular institutions. For it would be irrational, wouldn’t it, to subject rational, bias-free technocrats to the whims of irrational individuals crippled by various behavioral biases? Decision making elites unconstrained by popular forces is the essence of progressivism (and in its extreme form, totalitarianism).

Behavioral economics is particularly precious to the elite in this populist age when technocratic elites are under attack from the hoi polloi. The Nobel committees are notoriously political, and often make political statements through their choices. I would not be surprised if the Thaler award has a strong political undercurrent, given the palpable elite panic at resurgent populism, and the decidedly elitist, progressive thrust of behavioral economics generally, and its Thaler-inspired nudge variety in particular.

Behavioral economics is very congenial to top-down approaches to social problems. It is viewed by deep skepticism with people like me who believe that the knowledge problem; emergence and the law of unintended consequences; and the deforming effects and perverse incentives of power (to name just three things) make top down solutions disastrous in most cases.

So the Thaler Nobel is accurately reflective of the influence of behavioral economics on the profession, and on the profession’s contribution to policy debates. And that is a disturbing reality.

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September 19, 2017

Motivated Seller

Filed under: Economics,Energy,Politics,Russia — The Professor @ 8:18 pm

I conjectured that Qatar’s sale of half of its Rosneft stake reflected at least in part the dramatic change in the emirate’s circumstances between December (when it initially bought in) and September (when it sold off), specifically the cold war with Saudi Arabia, the UAE, and the rest of the Gulf Cooperation Council (oxymoron alert!) that broke out over the summer. This conflict has put substantial financial strains on Qatar, which would suggest it bailed on Rosneft (at what price???) to raise cash and reduce risk.

This story from Bloomberg is consistent with that: private depositors have been fleeing Qatar’s banks, and the state is stepping in, putting about $11 billion into these banks. Liquidating investments like the Rosneft stake is one way of raising that cash, and reducing debt. (This raises the possibility that if the crisis drags on, Qatar may sell the rest of its 4.7 percent share of Rosneft.) That is, Qatar could have been a very motivated seller–war clouds can do that to a country. And if it was a motivated seller, CEFC probably obtained its position at a good price, perhaps even a fire sale price. That’s not evident from the reported terms of the transaction, which means that there are side deals.

One other thing about the Qatar-GCC standoff. There are reports that Trump kept the cold war from going hot:

Saudi Arabia and the United Arab Emirates considered military action in the early stages of their ongoing dispute with Qatar before Donald Trump called leaders of both countries and warned them to back off, according to two people familiar with the U.S. president’s discussions.

The Saudis and U.A.E. were looking at ways to remove the Qatari regime, which they accused of sponsoring terrorism and cozying up to Iran, according to the people, who asked not to be identified because the discussions were confidential. Trump told Saudi and U.A.E. leaders that any military action would trigger a crisis across the Middle East that would only benefit the Iranians, one of the people said.

Donald Trump, peacemaker. Not that he’ll get credit. Note that early on, Trump’s pro-Saudi message clashed with Tillerson’s more neutral approach. This story suggests that Trump’s private and public positions may have been different, and that he was really on board with Tillerson all along. Alternatively, Trump initially tweeted his gut reaction, but Tillerson and others quickly persuaded him to moderate his course. Either way, the outcome conflicts with the prevailing narrative about Trump.


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