Streetwise Professor

July 1, 2022

Get Ready: A Baleful Consequence of Inflation You’ve Heard Too Little About

Filed under: Commodities,Derivatives,Economics — cpirrong @ 6:37 pm

Going away the most entertaining–and in some ways educational–experience of my graduate school days was when the great Sherwin Rosen was lecturing to the 0830 Econ 301 Price Theory course at Chicago the last time that inflation was about where it is now. Sherwin was talking about how relative prices are what really matters, and then startled a somewhat dozy class by slamming his fist into his palm and shouting: “And that’s the problem with inflation! It FUCKS UP relative prices.”

Sherwin Rosen

Since we are entering a new inflationary age, you should pay heed to Sherwin’s wisdom.

The argument, in a nutshell, is that due to transactions costs (interpreted broadly) not all goods and services are traded in auction markets or auction-like markets in which prices respond immediately to shocks, including nominal shocks. Prices (including wages/salaries) are set by contracts, including implicit/informal ones. Different contracts have different degrees of flexibility. Prices (and other terms) in some respond quickly, others not so much.

So when there is a substantial nominal shock (e.g., a surge in the money supply) which in a frictionless, classical world would not affect relative prices, some prices adjust more rapidly than others. This leads to changes in relative prices that are artifacts of the nominal shock, and which distort resource allocation.

Cantillon wrote about this issue in the 18th century, and it is also a component of Austrian business cycle theory. (Interestingly, unlike most at Chicago, Sherwin treated Austrian theory sympathetically. I imagine that his emphatic statement in class so many years ago can be traced to Austrian economics in some way.)

Some practical implications.

First, I expect to see a substantial surge in labor disputes as real wages (i.e., the relative price of labor) fall when some more flexible prices rise and nominal wages don’t. We are already seeing some indications of that (keep an eye on potential strikes at US ports and railroads).

Second, arguing along Coasean lines, I expect that since inflation makes it costlier to rely on the price system, there will be a substitution towards non-price methods of resource allocation, including vertical integration (in lieu of long term contracts where misalignment of prices leads to costly disputes between the parties), and the rationing mechanisms that Dennis Carlton (another former thesis committee member of yours truly) wrote about in the JLE in 1991. (There might be some shifts in the other direction too. Goods that are somewhat commoditized but are currently exchanged under formal or informal contracts with relatively inflexible prices might be amenable to being traded on auction- or auction-like platforms with more flexible prices.) (Dennis wrote many interesting things about allocation mechanisms, price rigidity, and so in in the late-80s early-90s.)

Third, contracts will become shorter in duration, and incorporate various indexing clauses (which mitigate, but do not eliminate, relative price distortions).

Fourth, inflation and the associated relative price volatility can be a boon for futures/derivatives markets. It is not a coincidence, comrades, that a major burst of growth in derivatives markets (both in size and scope) occurred at the time of the last major inflationary period.

This list is not exhaustive by any means. It’s just some things that immediately come to mind.

Any adjustment in contracting practices, or increased cost of using contractual practices that work well when relative prices are not subject to inflation-driven variation, is a real cost of inflation. Misallocations of resources that result when nominal shocks distort relative prices are also a real cost of inflation. Inflation will drive more conflict, more battles over rents, more contract disputes, and on and on and on.

As Sherwin forcefully expressed, inflation is anything but economically benign, something that microeconomists (like Sherwin) are sensitive too, but which macroeconomists too often ignore. (Back in the day, macro types thought that the only real cost of inflation was “shoe leather cost” due to people having to walk to the bank more often.)

I tweeted about this some weeks ago. In the interim, I’ve only seen one article discuss it: this one based on an interview with Ross McKitrick. Definitely worth a read, to get you prepared for what’s coming.

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June 25, 2022

Russian Tactical Failures in Ukraine: Where’s the Meat?

Filed under: History,Military,Russia — cpirrong @ 11:02 am

In the very early days of the Russian invasion of Ukraine, after watching many videos of columns of Russian armor or individual tanks getting blown to smithereens, I remarked on Twitter several times that what astounded me is that the tanks were operating without infantry support, which left them vulnerable to being ambushed by a couple of guys with an ATGM fired within spitting distance. FFS, it has been known since the dawn of tanks in WWI, and especially since their widespread employment in WWII, that tanks without infantry are extremely vulnerable to one- or two-man antitank weapons. The bazooka is one example, but the panzerfaust (and subsequently its imitator the RPG-7) is the best illustration.

I had written down the Russian failures to a meatware problem: namely, badly trained or badly led troops, operating under bad doctrine. Well, it appears that it is a meatware problem, but a different one: a lack of meat. To modify the old Wendy’s commercial: where’s the meat?

For it seems that the vaunted Russian Battalion Tactical Groups–BTGs–have been deployed to Ukraine seriously undermanned. Fifty percent undermanned, in fact, a problem only exacerbated by the massive attrition that undermanned units inevitably suffered.

Many of the infantry fighting vehicles like the BMP-2 in its several variants have apparently operated without infantry: only the driver, commander, and gunner man the vehicles. So the reason that Russian armor has no infantry support is that it has no infantry period.

This is nothing short of criminal. Alas, the real criminals here (from Putin on down) will not pay the price. The poor Ivans incinerated when Javelins or Stugnas and other ATGMs demolish their vehicles have–and will.

Recently there have been fewer such images, because the Russians have changed tactics, due no doubt to the carnage of February and March. Now most Russian losses (at least the ones depicted on video) are from indirect fires.

For the war in Ukraine has become one of indirect fires. As predicted here when the original coup de main was smashed, the Russians have reverted to reliance on their God of War–artillery. In particular, after giving the Grozny treatment to Mariupol and winning a pyrrhic victory there, they have done the same at Severodonetsk.

The Ukrainians have wisely decided to withdraw. Perhaps a bit too late, but better late than never. By holding out the Ukrainians did cost the Russians time and materiel and casualties. But the Ukrainians suffered severe casualties as well. Judging when to make a tactical withdrawal is hard.

Severodonetsk is (or perhaps was) at the nose of a salient. The classic means of assaulting a salient is to strike on the shoulders and pinch it off, trapping the defenders. But the Russians have signally failed in their attempts to do so. So they bashed in the nose of the salient with brute firepower. It is a victory, of sorts, but one that will not have decisive because the Russians have proved that they do not have the ability to exploit such breaches through armored maneuver.

Severodonetsk was just a WWI battle, or a battle akin to the ones in the static phase of the Korean War July 1951-July 1953. A few kilometers are taken, at heavy cost (especially to the attackers) with no decisive strategic effect.

And the prospect is for more such battles, until one side or the other–or both–collapses due to an exhaustion of personnel or emotional/moral collapse.

Morale on both sides involved in the slugging contests is reportedly cracking. This is understandable. Especially on the Ukrainian side, given they are outgunned. There is nothing more terrifying or demoralizing to soldiers than artillery bombardment. The soldier feels utterly helpless, with no way of fighting back, and wondering whether the next whoosh of a shell is the last sound they will ever hear. What we now call PTSD was referred to as “shell shock” in WWI for a reason.

So, again as predicted early on, the war has degenerated into a war of attrition. The deciding factor will be which army, and perhaps which government, collapses first. Existing Russian forces have been hollowed out. Russia has additional manpower to draw on, but that would require Putin to mobilize, something he has been reluctant to do. And even if he does, re-manning depleted BTGs with unmotivated raw recruits will just permit extending the slow grind west, will not result in a decisive advance, and will push the Russian death toll ever closer to 6 figures.

Ukraine has made some marginal gains on the periphery in the north (around Kharkiv) and in the south (around Kherson). But nothing decisive.

Further, the events in Donbas have apparently been a rude awakening and cured the “victory disease” that inflicted Zelensky, the rest of the Ukrainian leadership, and many supporters in the West after the initial Russian thrusts were turned back.

But given that neither side seems willing to stop the fighting except on terms that the other finds completely unacceptable, the bloody, pointless war will drag on for the foreseeable future.

Astoundingly, even though it should have been apparent no later than mid-March that based on events on the ground and betting on form regarding Russian behavior that this is exactly where we would be, US military “intelligence” has supposedly been surprised at how the Russians have responded to their initial setback: “But U.S. intelligence apparently missed another possibility: that Russia would revert to its traditional “way of war” based on mass and attrition.”

How is that possible? I mean really. This should not have been complicated.

After Iraq, Afghanistan, and now Ukraine, U.S. military intelligence–especially the parts responsible for evaluating enemy capabilities and intentions–needs to be ripped down to the foundation and built from scratch. Ukraine is another example of “those who forget the past are condemned to repeat it.” And it doesn’t even require looking at relatively ancient history, like, you know, WWII. It only requires looking back back 20-25 years, to Grozny.

These serial failures of US intelligence scare me far more than anything happening along the Don. An addle-brained president, with moronic advisors, acting on bad information. What could possibly go wrong?

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June 22, 2022

With Friends Like John Cornyn, Who Needs Enemies?

Filed under: Guns,Politics,Punk — cpirrong @ 5:51 pm

Senators have released a draft gun control bill produced as the result of a “bipartisan compromise.” Let me translate: “bipartisan compromise” means a cabal of the uniparty has conspired to screw you. That’s not a conspiracy theory: that’s an empirical regularity.

Some of the bill is unobjectionable. But that conceals its diseased heart: a provision to bribe states to adopt “red flag” laws.

Red flag laws are patently unconstitutional. Fourth Amendment. Fifth Amendment. Second Amendment. Binding on the states by the Fifteenth Amendment. Other than that, great!

It is highly unlikely that these laws can or will prevent lunatics like the Uvalde shooter or the Parkland shooter (whom I will not give any notoriety by writing their names), but they will impose substantial costs on innocent individuals, especially those afflicted with a vengeful spouse or disputatious neighbor.

The “Republican” leader in these negotiations, my own state’s John Cornyn, had the audacity to preen over the bill:

The red flag provision will not reduce the risk of Uvaldes, but it will trounce the Second Amendment. The last sentence is particularly mendacious. “Mental health and school safety bill.” Yeah, right, John. Only nuts will get snared by red flag laws, right? In fact, it’s more likely that nuts will use them against their enemies than it is to disarm murderous nuts.

And “NO NEW RESTRICTIONS”? Please. In fact, I think the all caps are a clear case of thou protest too much. Further, it is an outright lie. Outsourcing unconstitutional and anti-liberty measures to the states (and paying them to take these measures) is cynically dishonest beyond belief. Even for you.

And spare me any of your pompous, pious crap about “due process.” The process is the punishment. It pits the individual against a predatory state. Anyone knows that getting enmeshed in a legal dispute is financially costly and emotionally tortuous: that is especially true in the circumstances that give rise to red flag actions. Even if at the end of the day you “win”–that is, you get your guns back–you lose. And there is no guarantee that you will win. The odds are stacked against you.

If Cornyn were an actual Republican, rather than a member of the uniparty (AKA the government party, the swamp party) he would realize that this is politically idiotic. The Democrats are reeling. They face a disaster in November. Their addled “leader” has, by the last poll, a 32 percent favorable rating. Why give them a victory? Why throw them a line? Just stand there and watch them drown. Or better yet–throw them an anvil.

But no. So by revealed preference Cornyn demonstrates that he is just another uniparty apparatchik.

And indeed, Cornyn has said as much. He was booed at the Texas GOP convention in Houston last week. His stand is highly unpopular among the base. But he said that he doesn’t care what his constituents think.

So also spare me any laments over our dying democracy. It’s people like John Cornyn who are killing it, and who are stoking populism, by betraying those who elected them.

Cornyn is in line to replace Mitch McConnell, and become majority leader in the event of the Republicans regaining control of the Senate. So Tweedledee will replace Tweedledum. Oh Joy! McConnell’s only positive contribution to the Republic is preventing Merrick Garland from ascending to the Supreme Court. Other than that, he’s just another apparatchik for whom Cornyn would be a worthy replacement.

This title of this song is an apt description of our current age. And John–the chorus is all about you.

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June 16, 2022

Oh Please. Not This BS Again.

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation — cpirrong @ 6:37 pm

I’ve often written that every big move in commodity prices leads to a reprise of Casablanca: “Round up the usual suspects!”

The usual suspects, of course, being speculators.

And here we have a case of the usual suspects calling for a roundup of the usual suspects. People like Michael Greenberger and Tyler Slocum. I would be more than glad to move on. Them apparently not so much.

Now they feel especially energized because they can blame speculators not just for a rise in the price of this or the price of that, but the price of everything. Yes, boys and girls, speculators cause INFLATION!!!!! THEY ARE DRIVING UP THE PRICE OF EVERYTHING!!!!

A handful of congressional Democrats are turning their attention to an arcane loophole that, as TYT previously reported, is driving high prices for gas and food. Rep. Ro Khanna, D-Calif., told TYT that he wants the Biden administration to close the loophole, which lets Wall Street speculators gamble on commodity prices, driving inflation.

I’ll get back to “Ruh Ro” Khanna in a moment.

What Greenberger and others are serving up is the same-old, same-old that was discredited long ago. It’s too tedious to reprise the arguments: go back and look at my posts from 2006-2009 or so. The BS hasn’t changed, so the response to the BS hasn’t changed.

The quickest counterpoint: If–and even Paul Krugman and I agree on this, people, so the apocalypse must be nigh–speculators are driving prices above the competitive level determined by supply and demand fundamentals, (a) inventories increase, and (b) speculators hold the inventories.

Well, inventories are dropping to rock bottom levels in everything from oil, to diesel, to industrial metals. So (a) isn’t happening. And if (a) isn’t happening, (b) can’t happen.


But this would require Greenberger et al to have a modicum of understanding of economics. In fact, I once forced him to admit he has no such understanding.

We were witnesses at a House Ag Committee hearing on speculation and oil prices in July, 2008. Right about the time WTI hit its all time high. (I published a WSJ oped about the same time.). Greenberger and I were on a panel. He tried to make an argument that prices were irrational because they hadn’t gone down when the Saudis announced an increase in output. I pointed out that the real shortage was in low-sulfur crude (like WTI), driven in large part by Europe’s new low sulfur diesel rules. The Saudi oil was high in sulfur and didn’t address this issue at all, so it didn’t impact the prices of WTI and Brent (which are low sulfur).

In reply, Greenberger stuttered: “Well, I’m not an economist . . .” I interrupted: “That’s the first thing you’ve ever said that I agree with.” (Yeah. I know I’m bad. I can never pass up an easy shot.)

That still holds true. He ain’t an economist. He knows no economics. And anybody who listens to him bloviate about economics is wasting time and killing brain cells. (Though looking at his audience–Salon AKA Daily Dipshit readers, congressional Democrats–that latter is pretty much impossible.)

These geniuses think they’ve uncovered some damning new evidence. In footnotes:

But thanks to an obscure CFTC passage — Footnote 563, in regulatory guidance — buyers and sellers of oil and other commodities are outnumbered something like 10 to one by Wall Street traders, none of whom have a genuine buyer’s incentive to keep prices low, because few of them ever actually buy it; they mostly bet on it.

Uhm, that factoid, or a variant thereon, has been tossed around every time this tiresome debate has occurred. It was irrelevant every one of those times. It’s irrelevant now. It means nothing.

But some geniuses in Congress are going to flog this dead horse yet again. FFS.

But this is not the only idiocy that is being resurrected. Ron Wyden D-But you knew that-OR is proposing a revival of the windfall profit tax.

Another ’70s acid flashback. I’m trippin’, man!

Yeah that worked so well under Carter. Hey! Here’s an idea! Let’s reduce the incentive to invest by reducing payoffs when the investments are most valuable! What could go wrong?

Another hardy perennial: Our ranting senile narcissist in chief is demanding refiners cut prices and increase output. Er, look at the EIA capacity utilization numbers, dude. Refineries are operating flat out.

Apparently they did that, because today they mooted restricting exports instead. Another dumb idea.

And then there’s Ruh Ro Khanna:

h/t @CantillonCH

Khanna’s brainstorm is–get this–to have the government “buy the dips” and then sell commodities to consumers at low prices.


Well, because it’s so stupid only a California Democrat could come up with it.

Of the top of my head, Family Feud fashion, the top 4 reasons why this is stupid:

  1. The best traders can’t time the market consistently. Why would anyone possibly believe government GS-13s or whatever could?
  2. The government wouldn’t be a price taker–it would be driving prices.
  3. Every trader in the world would be trying to front run the government. Talk about creating speculative opportunities! Speculate on what the government is going to do!
  4. A California Democrat came up with it.

Bad economic times bring out bad economic ideas. Stupid never goes out of style in politics, and bad ideas never die. And that’s our reality today.

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June 10, 2022

Sic Transit Transitory: Yes. Sic Transit Inflation?: Unfortunately not.

Filed under: Climate Change,Economics,Politics,Regulation — cpirrong @ 6:43 pm

So today inflation as measured by the Consumer Price Index checked in at 8.6 percent annualized. Which is an uptick in the rate rather than the promised easing.

Sic transit transitory.

The Queen of Transitory, Janet Yellen (Jerome Powell being the King) acknowledged as much earlier this week in Congressional testimony, admitting that her prediction had been wrong. Whoopsie!

One wonders about her (and Powell’s and the rest of the herd’s) mental model of inflation, especially under current circumstances. The usual explanation is some version of the Phillips Curve inflation-unemployment tradeoff. Which is stupid because it is just a correlation, and a worthless one at that since it is about as stable as Amber Heard.

But even that idiocy obviously won’t fly here, so Yellen mumbled about COVID and supply chains and Putin and blah blah blah (as well as holding forth on gun control and abortion, which are OBVIOUSLY primary responsibilities of the Treasury Secretary). These explanations are also inadequate.

Insofar as COVID is concerned, arguably the policy response to it (not COVID itself) shifted back supply curves as stores were closed and people stayed home from work. But those restrictions peaked in early-2021 and have been easing then, so can’t explain by themselves accelerating inflation in the subsequent months.

Yes, COVID has had lingering effects on certain sectors that have constrained supply while demand has rebounded. For example, a lot of truckers that left the industry in 2020-2021 haven’t come back. Interestingly, trucking schools shut down during the pandemic, which has constrained the flow of new labor to the market. In industries such as lumber and oil refining, the largely policy-driven collapse in demand in 2020 led to actual disinvestment and a loss of capacity. We saw the impacts of that in the lumber market a year ago, and are seeing it in the markets for refined products now.

But those factors alone cannot explain the recent spikes: demand has to be part of the equation as well.

Also, supply constraints (and supply chain bottlenecks) cannot explain increases in the general price level, especially as measured by broader measures such as the Producer Price Index and the GDP Deflator. Here’s a straightforward example.

Consider computer chips, inadequate supplies of which hit the auto industry hard, and which are blamed as a major culprit for inflation. Yes, the chip supply constraint limited the production of new automobiles, raising the prices of both new and used cars (which are substitutes for new ones). But, the limitation on the output of automobiles reduced the derived demand for other automobile inputs, such as aluminum, steel, rubber, labor, and capital goods. Ceteris paribus, that should have put downward pressure on the prices of those inputs.

Put differently, bottlenecks increase prices on one side of the bottleneck relative to the prices on the other side. One cannot attribute a rise in the price level (in which the prices of most if not all goods and services are rising, albeit some more than others) to bottlenecks, at least not directly. Bottlenecks can cause prices to fall too. You can’t just look at the impact on the downstream side.

A more indirect story is that by limiting output (and therefore income) bottlenecks cause real income to be lower, thereby reducing the demand for real money balances. Given the nominal supply of money, the only way to equilibrate the now lower demand for real balances with a given nominal supply is to reduce the real value of the money stock by increasing the price level.

Color me skeptical that this can explain the magnitude of the inflation we’ve seen. (The Fed juicing base money by almost 50 percent in 2021 could have added to this impact.)

I therefore am deeply skeptical that supply constraints, attributable to COVID or otherwise, explain the broad rise in prices that has been accelerating over the past year plus.

What about Putin, Biden’s favorite scapegoat? Well, the Ukraine War doesn’t really explain the timing. Consider diesel prices.

There was a spike in the crack spread right at the time of the invasion in late-February, but that subsided quickly. The subsequent runup, especially the ramp-up in mid-April, is harder to ascribe to the war and almost certainly reflects some demand side factors.

Furthermore, it usually takes some time for upstream shocks to translate into higher prices at the consumer level (e.g., a wheat price shock impacting retail food prices). Meaning that a lot of the impact of a disruption first occurring in March is yet to have been fully felt. Good news all around, eh?

No, I think that the stock explanations that the likes of Yellen, Biden and the media fall back on to explain the accelerating inflation are woefully inadequate. Supply chain (and the effects of COVID thereon) in particular.

The most plausible explanation to me is the fiscal theory of the price level, developed formally some years ago by Thomas Sargent and recently studied deeply by John Cochrane. In a nutshell, the theory posits that the price level adjusts to equate the real value of government debt to the discounted real value of government primary surplus. Holding primary surplus constant, an increase in government obligations requires a price level rise to reduce the real value of outstanding debt by the amount of the new debt. Similarly, given the level of government debt, any reduction in expected future surpluses requires a rise in the price level. (The theory is obviously a lot more complicated: that’s a Cliffs’ Notes version of the Cliffs’ Notes of John’s book.)

The massive COVID-driven fiscal stimuluses of both Trump and Biden dramatically increased the nominal value of US government debt. Moreover, the clear preference of this administration and Congress is to expand government spending (and debt) further (e.g., student debt forgiveness, among other things). (It will be interesting to see what happens to inflation if there is a big shift in Congress in 2022.)

I would also suggest that the big regulation plus big “green” agenda pursued by this administration and Congress are also inimical to growth, and expectations about growth. (I put “green” in quotes because as I’ve written before, a monomaniacal focus on CO2 is not a balanced environmental policy, and is indeed inimical to the environment in many ways.)

The green agenda is particularly pernicious. BIden and others (not just in the US) keep yammering away about the wonderful transition to green energy that will occur. What this really means is a transition to more expensive energy and lower incomes. Sic transit transition? I wish.

Less growth means lower future GDP means less future government revenue means smaller primary surpluses.

Meaning that both from the debt side and the growth/surplus side the COVID and post-COVID years are, according to the fiscal theory of the price level, a recipe for large increases in the price level. We’ve seen just such an increase. The timing works out. The fact that the increase in prices is broad works out.

This administration–of which Yellen is unfortunately an accurate avatar–not only does not believe in the fiscal theory, but finds it an anathema because its implications regarding the need to restrain government spending and to jettison onerous regulations and its cherished CO2 agenda require it to become, well, Reaganites. So what is likely the right model of the current inflation will never be their mental model.

Which means we will not be able to say sic transit inflation anytime soon.

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June 8, 2022

Gary “Bourbon” Gensler: He’s Learned Nothing, and Forgotten Nothing

Filed under: Derivatives,Economics,Exchanges,Regulation — cpirrong @ 3:38 pm

Gary Gensler is back, as clueless as ever. Perhaps in a future post I will discuss his malign proposal on corporate climate disclosure, but today I will focus on his latest brainwave: the restructuring of US equity markets.

In a speech, Gensler outlined his incisive critique of market structure:

“Right now, there isn’t a level playing field among different parts of the market: wholesalers, dark pools, and lit exchanges,” Gensler said in remarks delivered virtually for an event hosted by Piper Sandler in New York. “It’s not clear, given the current market segmentation, concentration, and lack of a level playing field, that our current national market system is as fair and competitive as possible for investors,” adding that there was a cost being borne by retail investors.  

“Level playing field” is a favorite trope of his, and of regulators generally. But what does it even mean in this context? Seriously–I have no idea. It’s just something that sounds good to the gullible that has no analytical content whatsoever. Yes, there are a variety of different types of market participants in competition and cooperation with one another. How does the existing setup disadvantage or advantage one group of participants in an inefficient way? How do we know that the current distribution of winners and losers does not reflect fundamental economic conditions? Gensler doesn’t say–he doesn’t even define what a level playing field is. He just makes the conclusory statement that the playing field isn’t level.

Furthermore, note the mealy mouthed statement “It’s not clear . . . that our current national market system is as fair and competitive as possible.” Well, then it’s not clear that it isn’t as fair and competitive as possible. And if Gensler isn’t clear about the fairness and competitiveness of the current system, how can he justify a regulator-mandated change in that system?

For God’s sake man, at least make a case that the current system is inefficient or unfair. If your case is bullshit, I’ll let you know. But to call for a massive change in policy just because you aren’t certain the current system is perfect is completely inadequate.

The Nirvana Fallacy looks good by comparison. At least the Nirvana Fallacy is rooted in some argument that the status quo is imperfect.

Foremost in GiGi’s crosshairs is payment for order flow (“PFOF”). This practice exercises a lot of people, but as Matt Levine notes, and as I’ve noted for years, it exists for a reason. Different types of order flow have different costs to service. Retail order flow is cheaper to trade against because retail traders are unlikely to be informed, which reduces adverse selection costs. PFOF is a way of segmenting order flow and charging retail traders lower prices which reflect their lower costs, in the current environment through zero (or very low commissions). This passes some (and arguably all) of the value of retail order flow to the retail traders.

The main concern over PFOF is that retail investors won’t see the benefit. Their brokers will pocket the payments they get from the wholesalers they sell the order flow to, and won’t pass it on to investors. Well, overlooking the fact that’s a distributive and not an efficiency issue, that’s where you rely on competition in the brokerage sector. Competition will drive the prices brokers charge customers down to the cost of serving them net of any payments they receive from wholesalers. In a highly competitive market for brokerage services, retail traders will capture the lion’s share of the value in their order flow.

So if you think retail customers are not reaping 100 pct of the benefits of PFOF (which begs the question of whether that’s the appropriate standard), then the focus should be on documenting some inadequacy of competition (which has NOT been done, and which Gensler does not even discuss); and if (and only if) that analysis does demonstrate that competition is inadequate, devising policies to enhance competition in the brokerage sector.

Only if (a) it is somehow efficient (or “fair”) for retail investors to reap 100 pct (or a large fraction) of PFOF revenues, (b) brokerage competition is inadequate to achieve objective (a), and (c) policies to enhance brokerage competition are inferior to banning or restricting PFOF is such a restriction/ban sufficient.

Does Gensler do any of that? Surely you jest. He says “unlevel playing field blah blah blah crack down on PFOF QED.” It is fundamentally unserious intellectual mush.

Gensler’s approach to equity market structure is disturbingly similar–and disturbingly similarly idiotic–to his approach to swap market structure in the Frankendodd days. As I (tediously after a while) wrote repeatedly while the CFTC was working on Swap Execution Facility regulations, Gensler favored a one-size-fits-all approach that failed to recognize that market structures develop to accommodate the disparate needs and preferences of heterogeneous traders. OTC and exchange markets served different clienteles and trading protocols and market structures were adapted to serving those clienteles efficiently. He did not analyze competition in any serious way at all. He did not address the Chesterton’s Fence question–why are things they way they are–before charging full speed to change them.

History is repeating itself with equity market structure. PFOF is an institution that has evolved in response to the characteristics of a particular class of market participants, (relatively) uninformed retail investors.

Crucially, it is an institution that has evolved in a competitive environment. There is value in retail order flows. There will be competition to capture that value. Considerable competition will ensure that retail investors will capture most of the value.

Gensler has proposed requiring routing all retail order flow through an auction mechanism where wholesalers will compete to offer the best price. The idea is that the auction prices will be inside the NMS spread, giving retail customers a better execution price.

But it’s a leap of faith to assert that this improvement in execution price will exceed the loss of PFOF that is passed back to investors through lower commissions. Will the auction be more competitive than the current market for retail order flow (including both the broker-wholesale and broker-customer segments)? Who knows? Gensler hasn’t even raised the issue–which demonstrates that he really doesn’t understand the real economic issues here. (Big shock, eh?)

And again, this means that the appropriate analysis is a comparative one focusing on competition under alternative institutional arrangements/market structures.

And insofar as competition is concerned, if auctions are such a great idea, why didn’t an exchange or an ECN or some other entity create one? Barriers to entry are low, especially in the modern electronic world.

I further note the following. One potential reason to eliminate or reduce PFOF that would actually be grounded in good economics is that segmentation of order flow exacerbates adverse selection problems on lit markets (exchanges) causing wider spreads there. However, the auction proposal would not mitigate that problem at all. The exacerbation of adverse selection is due to segmentation of order flow. The auction is just another way of segmenting order flow, and executing that order flow outside the lit exchange markets.

And here’s an irony. Assume arguendo that the auction does benefit retail investors–they capture more of the value inherent in their order flow. That would tend to lead to more order flow being directed to the auction market, and less to the lit markets. This would increase adverse selection costs in lit markets, exacerbating the inefficiencies of segmentation.

Nah. GiGi hasn’t thought that through either.

Talleyrand said of the Bourbons: they have learned nothing, and they have forgotten nothing. That’s Gary Gensler in a nutshell. He hasn’t learned any real economics, especially the economics of market structure and competition. But he hasn’t forgotten that he knows best, and he hasn’t forgotten the things that he knew that just aren’t true. That is a poisonous combination that damaged the derivatives markets when he was CFTC chair. But Gensler figures his work isn’t done. He has to damage the equity markets too based on his capricious understanding of how markets work–which is really no understanding at all.

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May 28, 2022

A Timely Object Lesson on the Dangers of Tight Coupling in Financial Markets, and Hence the Lunacy of Fetishizing Algorithms

FTAlphaville had a fascinating piece this week in which it described a discussion at a CFTC roundtable debating the FTX proposal that is generating so much tumult in DerivativesWorld. In a nutshell, Chris Edmonds of ICE revealed that due to a “technical issue” during the market chaos of March 2020 (which I wrote about in a Journal of Applied Corporate Finance piece) a large market participant was arguably in default to the ICE clearinghouse, but ICE (after consulting with the CEO, i.e., Jeff Sprecher) did not pull the trigger and call a default. Instead, it gave some time for the incipient defaulter to resolve the issue.

This raises an issue that I have written about for going on 15 years–the “tight coupling” of the clearing mechanism, and the acute destabilizing potential thereof. Tightly coupled systems are subject to”normal accidents” (also known as systemic collapses–shitshows): in a tightly coupled system, everything must operate in a tight sequence, and the failure of one piece of the system can cause the collapse of the entire system.

If ICE had acted in a mechanical fashion, and declared a default, the default of a large member could have caused the failure of ICE clearing, which would have had serious consequences for the entire financial system, especially in its COVID-induced febrile state. But ICE had people in the loop, which loosened the coupling and prevented a “normal accident” (i.e., the failure of ICE clearing and perhaps the financial system).

I have a sneaking suspicion that the exact same thing happened with LME during the nickel cluster almost exactly two years after the ICE situation. It is evident that LME uncoupled the entire system–by shutting down trading altogether, apparently suspending some margin calls, and even tearing up trades.

Put differently, it’s a good thing that important elements of the financial system have ways of loosening the coupling when by-the-book (or by-the algorithm) operation would lead to its destruction.

The ICE event was apparently a “technical issue.” Well that’s exactly the point–failures of technology can lead to the collapse of tightly coupled systems. And these failures are ubiquitous: remember the failures of FedWire on 19 October, 1987, which caused huge problems. (Well, you’re probably not old enough to remember. That’s why you need me.)

This issue came up during the FTX roundtable precisely because FTX (and its fanboyz) tout its algorithmic, no-man-in-the-loop operation as its innovation, and its virtue. But that gets it exactly backwards: it is its greatest vulnerability, and its greatest threat to the financial markets more generally. We should be thankful ICE had adults, not algos, in charge.

As I pointed out in my post on FTX in March:

The mechanical means of addressing margin shortfalls on a real time frequency increases the tight coupling on the exchange, and is tailor made to create destabilizing positive feedback loops: prices move a lot leading to margin shortfalls in real time that trigger real time trades that accentuate the price movement. It is like seeding the market with huge numbers of stop orders, which are inherently destabilizing. Further, they can create incentives to manipulate. Anyone who can get some idea of where the stops are can “gun the stops” and trigger big price moves.

It’s particularly remarkable that FTX still is the subject of widespread adulation in light of Terra’s spiraling into the terra firma. As I said in my Luna post, it is lunatic to algorithmize positive feedback (i.e., doom) loops. (You might guess I don’t have a Luna tattoo. Not getting an FTX tattoo either!*)

FTX’s Sam Bankman-Fried is backtracking somewhat:

In the face of the agricultural industry complaints, Bankman-Fried gave ground. While maintaining his position that automated liquidations could prevent bad situations from growing worse, he said the FTX approach was better suited to “digitally settled” contracts — such as those for crypto — than to trades where physical collateral such as wheat or corn is used

Sorry, Sam, but digital settlement vs. physical settlement matters fuck all. (And “physical collateral”? Wut?) And you are deluded if you believe that “automated liquidations” generally prevent bad situations from growing worse. If you think that, you don’t get it, and are a positive threat to the financial markets.

*FTX bought the naming rights for a stadium in Miami. I say only slightly in jest that this is another indication of the dangers posed by FTX and its messianic founder. FFS, you’d think after the 2000 tech meltdown people would recognize that buying naming rights is often a great short selling signal, and a harbinger of future collapse. To say that those who forget the past are condemned to repeat it is too strong, but those who follow in the footsteps of failures that took place before their time betray an an arrogance (or an ignorance) that greatly raises the odds of repeating failure.

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May 26, 2022

Save the World: Nuke Davos

Filed under: Climate Change,Economics,Politics — cpirrong @ 5:55 pm

One of the few compensations of COVID was that the World Economic Federation meeting in Davos was canceled for two years. But all good things come to an end, and Davos is back, more malign than ever.

Of course the opening address was given by Klaus Schwab. (Aside: how come poor Appalachian whites are blamed for the evils of slavery, and the son of a for real hardcore Nazi gets a pass?)

He was touting “trust-based and action-oriented cooperation.” Orwellian doesn’t even come close to doing that justice. And nota bene: “cooperation” can be a synonym for conspiracy.

This is also Orwellian:

And finally. When it comes to business and economic activities, Davos is not a place for narrow self-interest. It is instead a place for the implementation of the notion of stakeholder capitalism, a concept I’m fighting for since 50 years. (Emphasis in original.)

A Forum partner is asked to value the contributions not just of shareholders, but of all those other stakeholders who are essential for business to succeed. As I wrote in my book Stakeholder Capitalism, Davos stands for a global economy that works for prosperity, people, and the planet.

“Stakeholder capitalism” is an oxymoron, and it is a synonym for fascism.

It is an oxymoron, because capitalism means that the owners of capital make the decisions on how it is used. Marxists have never liked the way that capitalists used it, which is why they wanted to expropriate it. At least they were honest, and didn’t say they were advocating “socialized capitalism.” “Stakeholder capitalism” means that those who don’t own something can nonetheless dictate how to use it, because they have some self-asserted “stake” in it. Using the word “capitalism” is a clever trick to seduce non-Marxists into believing that what Schwab et al are advocating is just a kinder, gentler version of a free market economy, when in fact their agenda is profoundly anti-capitalism and anti-freedom.

“Stakeholder capitalism” has no limiting principle. It can be used to claim control over anything anywhere anytime based on some Six Degrees From Kevin Bacon theory of somebody having a “stake” in it.

Though I would not recommend claiming that you have a stake in a fancy dinner at Davos. The WEF police (yes, they exist) will arrest you for sure.

It is a synonym for fascism because it is a variant on corporatism, which is the essence of the fascist economic model (as I’ve written before). Note the “cooperation” in the title of Herr Schwab’s speech: cooperation among stakeholders (namely, the state, corporations, and labor unions) was touted as the main virtue of fascist economics and governance. The stakeholders may be a little different (labor, for example, is barely even an afterthought at Davos), but the idea is functionally identical.

Now, Fascism 2.0 does have some differences with Fascism 1.0. The latter was avowedly nationalist, something which the former detests: it is avowedly anti-nationalist, and indeed globalist. “WEF” is more accurately an acronym for “World-Extensive Fascism.” It is the bastard child of world government types and economic fascists.

The WEF is also fascist in its utter antipathy for individual liberty and freedom. The most anti-freedom threat on the horizon–central bank digital currencies–was praised to the skies. And free speech? Well, you know, that needs to be “recalibrated.” (Inman is basically a less crazy-eyed version of Nina Jankowicz.) And you all just need to change the way you eat, got it?

I could go on.

The main moving force behind the WEF agenda is “climate change.” It is the existential threat that “stakeholders” need to “cooperate” on to fight. It is the primary reason why “stakeholder capitalism” has no limiting principle, because everything–I mean everything–supposedly affects climate, so everybody has a stake in it, so our enlightened WEF leaders acting benevolently on our behalf can reorder everything because climate change.

All of the nostrums that are being pushed will make energy and food more expensive. A lot more expensive.

Not that this lot cares. After all, energy and food expenditures represent a trivial fraction of their incomes. So they won’t feel a thing!

You, not so much. And the poorer you are, the more you will feel it.

Of course, these . . . people . . . claim to be acting on behalf of the poor. Because, of course, climate change hurts the poor most we’re told. Except that all of these assertions are highly speculative (at best), and the purported evidence supporting them is based on junk science.

Just like WEF-endorsed COVID policies (e.g., lockdowns), the cost of WEF-endorsed climate change policies will exceed the cost of climate change itself. And the cost difference will be greater, the poorer you are.

These people are your enemies. And the less well off you are, the bigger enemy they are.

You might think that the title of this post is hyperbole. You might want to think again.

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May 20, 2022

Meade at Gettysburg: A Gap in the (Story) Line

Filed under: Civil War,History,Military — cpirrong @ 6:26 pm

This C-SPAN video of Kent Masterson Brown talking about his Meade at Gettysburg was sufficiently intriguing that I bought the book, and I’m glad I did. it is a thorough analysis of Meade’s generalship. I am in agreement with most of Brown’s full-throated defense of “that damned old goggle eyed snapping turtle” and his actions at Gettysburg. Laboring under tremendous disadvantages, having been thrown into command unexpectedly, operating with little information about his enemy, and knowing that a baying mob in Washington would crucify him if he failed, Meade responded smartly and professionally, and came away with a great victory.

Hell of a lot of good that did him, though. His post-battle actions were the subject of brutal criticism, by Lincoln no less. As Brown explains in detail, this criticism was incredibly unjust. His battle actions were also second guessed, most notably by the notorious Daniel Sickles and his coterie of political, military, and journalistic backstabbers. Those criticisms were also unfair, as Brown shows. Meade’s shade must be smiling to know he finally has an able defender.

What convinced me to buy the book was the video’s retelling and interpretation of Meade’s actions leading up to the battle, and in particular the “Pipe Creek Circular” (which was also the subject of much post-battle and indeed post-war discussion). In Brown’s telling, thrust into command, Meade was going by the book. The books, actually, namely those of Jomini, Clauswitz, and his old West Point instructor Dennis Hart Mahan.

The textbook approach was (a) to establish a strong position, (b) send out a force (a reconnaissance in force) to cause the enemy to concentrate, (c) have that force withdraw, fighting, drawing the now concentrated enemy back onto the prepared position. According to Brown, this is what Meade intended left wing commander John Reynolds to do with the I and XI corp when he dispatched Reynolds north. Knowing Lee was generally oriented along the Chambersburg Pike that ran through Gettysburg, and receiving word from John Buford that many Confederates were near the town, Meade dispatched Reynolds as his reconnaissance force with the intent of using it to lure Lee onto Meade’s extremely strong Pipe Creek Line some miles to the south.

But Reynolds lost his head, and instead of fencing with Lee and drawing him back onto Pipe Creek, the Pennsylvanian advanced to support Buford, even leading the brigade in the van–the storied Iron Brigade–personally into the fight. For his troubles, Reynolds got a bullet in the back of the head. His successor, Abner Doubleday (whom, ironically, far more people have heard of for exactly the wrong reasons than have ever heard of Reynolds or Meade for that matter), did not know what Reynolds’ or Meade’s intentions were. He concluded that Reynolds must have wanted to fight west and north of Gettysburg, and therefore he would too.

Although the I Corps and some elements of the XI Corps fought valiantly, they were eventually overwhelmed. And here Reynolds’ precipitate decision to fight with the town on his line of retreat turned defeat into disaster. Retreating through the town led to a breakdown in units and mass confusion, and the loss of thousands of prisoners. The panting, panicking remnants, much thinned, rallied–just–on Cemetery Hill to the east of town.

So far, Brown’s story hangs together. Meade sent out a reconnaissance in force, but its commander either misunderstood its purpose or forgot it in the excitement, and brought on a battle in the wrong place at the wrong time.

It’s the next act in the drama that raises questions about Brown’s interpretation. Hearing of the situation in Gettysburg, Meade sent his trusted chief engineer, Gouverneur K. Warren to reconnoiter and report back. But crucially, he also sent his junior corps commander, Winfield S. Hancock to Gettysburg with the following instruction: “If you think the ground and position there a better one to fight a battle under the existing circumstances, so advise [me] and [I] will order all the troops up.”

This is not the action of a man with a plan, particularly a plan to draw Lee onto a strong, prepared position. Meade delegated a crucial decision to a man, capable though he was, who had no full understanding of the current disposition of the Army of Potomac or its lines at Pipe Creek or its logistical situation–all relevant considerations for determining the best course of action. Further, if Meade had been so set on his plan (a) he would have explained that to Hancock, so the II Corps commander could have used that information to determine whether it was “better” to fight at Gettysburg or follow Meade’s original plan to fall back to Pipe Creek drawing Lee along with him, and (b) asked Hancock whether a fighting withdrawal from Gettysburg was possible.

Punting such a major decision to an uninformed subordinate does not bespeak commitment to a plan. But Brown is silent on this, which is the weakest point of the book, and something that undercuts his up-until-then plausible argument.

In the event, Hancock concluded that Gettysburg was “the strongest position by nature on which to fight a battle I ever saw,” and recommended to Meade to bring up the army.

Except it wasn’t–as Brown discusses in detail. Hancock only saw a part of what became the battlefield, which happened to be the strongest position. The rest of it, as Meade found out when he arrived and performed a detailed reconnaissance, had severe disadvantages. These almost cost the Army of the Potomac the battle on 2 July.

Moreover, by moving forward to Gettysburg instead of withdrawing the battered survivors of the 1 July battle back to Pipe Creek, Meade greatly exacerbated the already serious logistical handicaps under which he was operating. One of the best parts of Brown’s book is his detailing of these handicaps–including his extended description about how the march away from established supply lines to Gettysburg stretched the Army’s logistics to the breaking point.

Furthermore, advancing to Gettysburg required his already fagged soldiers to undertake forced marches of dozens of miles in heat, humidity, and dust, with too little food and water. It put tremendous strain on horseflesh–another under-appreciated consideration that elsewhere Brown gives due weight. In essence, Meade gave Lee the gift that Meade was hoping to get from Lee: advancing and concentrating on an enemy already in position.

Perhaps there is an explanation for Meade’s actions. Maybe he, like Reynolds, got his blood up and this clouded his judgment. Perhaps he believed that a retreat would be considered treason by the febrile politicians in Washington. Perhaps something else.

But Meade’s decision and decision making (especially delegating such an epochal decision to a subordinate with an extremely narrow perspective) is problematic, at best. I think that it is worse than that, especially given that it cut against every consideration that Brown raises to explain Meade’s actions from the time he took command until news arrived of Reynolds’ death. So an explanation is required, but Brown does not give it. According to Brown, Meade was going by the book. Then he threw the book out the window. Why? We’re not told. There is a serious gap in Brown’s line.

Many mysteries and conundrums surround the battle of Gettysburg–which is why 159 years after the fact it is the subject of book after book, few as good as Brown’s. This is another mystery, and I wish Kent Masterson Brown had attempted to unravel it–not least because he poses it implicitly. Alas, he doesn’t even acknowledge it as a mystery. Which, I guess, creates an opportunity for yet another author to write another book about Gettysburg.

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May 19, 2022

Z Is For Zugzwang

Filed under: Military,Politics,Russia,Ukraine — cpirrong @ 4:05 pm

Ten days ago Vladimir Putin gave his much anticipated “Victory Day” speech, and said . . . well, not much at all.

There was much anticipation and speculation in advance. He would declare war and full mobilization. He would declare victory, or announce some criteria for victory that even his shambolic military could achieve.

Instead, he basically affirmed the status quo. Russia would keep grinding away. It would not escalate. Nor would it de-escalate.

In other words, Putin tacitly admitted what I had asserted weeks ago: Putin/Russia are in Zugzwang: any move makes things worse, so Putin has basically chosen to do nothing, or at least to change nothing.

There has been much conjecture what the Z on Russian equipment means. Now you know. It means “Zugzwang.”

Things have gotten even worse for Russia since 9 May. Ukraine has mounted a modest counteroffensive (a real counteroffensive, not a local counterattack) north of Kharkiv, and pushed the Russian army back across its border in places. The Russian offensive in Donetsk and Luhansk is essentially stalled. Indeed, the Russians suffered a humiliating reverse in an attempt to mount a river crossing: an entire battalion tactical group and its equipment were destroyed, as was the bridging equipment.

Overall, Russian losses continue to mount, with nothing to show for it. The only simulacrum of an achievement is the surrender of the besieged and battered defenders of the Azovstal plant after weeks of relentless Russian assault and bombardment. But on net Ukraine gained far more from that battle by delaying and attriting Russian forces than Russia has by its ultimate capture of the facility.

And now the Russians appear to view their “triumph” as an excuse to commit a massive war crime by trying the captives as war criminals and threatening to execute the surrendered Ukrainians.

But of course they have to do that to justify their war propaganda that they are fighting Nazis. You know, act like Nazis to pretend they are fighting Nazis. But the Russian military and state are already so far down the war crimes road they won’t stop now, especially if this one provides something that they can use to sell this fiasco to the Russian public.

Now the battle resembles World War I far more than World War II. It is an artillery war being fought on a relatively static front. Even if Russia gains some local objectives, “the big push” and “breakthrough” are clearly beyond their capabilities.

Ukraine is clearly encouraged that it can win, with victory defined as pushing out Russians from all of Ukrainian territory. I think this is too optimistic, and even if it is realistic, the cost to Ukraine, let alone the world, is not worth it.

I understand the risk of leaving Putin/Russia with a rump of Ukrainian territory from which they can spin up a future justification for resuming hostilities once they’ve licked their wounds and convinced themselves that they have really fixed their military this time. But the pretext will exist, and in fact be even stronger, if Ukraine retakes the Donbas. For no doubt the Russians will claim that Ukraine is Nazifiing the recaptured Donbas if it retakes control, and this will be a future casus belli. Retaking it would alter the tactical situation somewhat in Ukraine’s favor for the next time, but not enough to change materially the probability of another Russian attempt. The war exists because Ukraine exists. Redrawing the lines of effective control in Ukraine won’t remove the Russian rationale for war. It is not worth it.

So the war will grind on, because Zugzwang Putin can’t admit he’s lost, and Ukraine believes it can win. Nothing good will come of that.

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