Streetwise Professor

April 27, 2007

WWMD? (What Would Machiavelli Do?)

Filed under: Politics,Russia — The Professor @ 9:54 am

I spent an idyllic 7 days in northern Italy last week. Thought it would be appropriate, and evocative, to read Machiavelli’s The Prince on the flight over. One passage struck me:

From this a general rule is drawn which never or rarely fails: that he who is the cause of another becoming powerful is ruined; because the predominancy has been brought about either by astuteness or else by force, and both are distrusted by him who has been raised to power.

Upon reading this line, Boris Berezovsky immediately came to mind. An astute and forceful man, he was instrumental in bringing Putin to power. In true Machiavellian fashion, Putin wasted little time in ruining him.

Indeed, Putin is clearly (consciously or naturally) a devotee of Machiavelli. Which makes me believe that he recognizes that anyone he might elevate to power to replace him in the Presidency of the RF would distrust him for his astuteness and force. Unlike the old and tired Yeltsin, who posed no real threat to Putin, a young and vigorous Putin would be an omnipresent and existential threat to his successor. No successor is likely to sit comfortably in the President’s chair with Putin in the background–and Putin knows this.

How can he protect himself against the Machiavellian ruin at the hands of his successor like that he dished out to Berezovsky–or worse? (After all, Boris is still exchanging O2 and CO2 in very comfortable circumstances in London, though he must dread every bite he takes.) Are kompromat and a coterie of bodyguards enough? Maybe. But I am sure that Putin recognizes that his position (and his person) would be much more secure as President with the full powers of the state apparatus at his disposal, than as an ex-President relying on blackmail and blackguards for protection.

Which leads me to believe that the consummate Machiavellian Putin will be President 46 weeks from now, and for many years after that. That is, I would lay much better than even odds that Putin will engineer some way to remain in power–de jure, not just de facto.

The most likely way to achieve this outcome? To foment some crisis that will allow the Duma to rationalize changing or circumventing the constitutional term limits on the President. The escalating rhetoric against the US (especially over the laughably trumped up hysteria over the missile defenses in Poland and the Czech Republic), the tatterdemalion opposition, ineffectual NGOs, and spies and malign foreign influences seems calculated to create an environment of paranoia and fear that can be exploited to create a crisis–or an illusion of crisis–that Putin will exploit to retain his grip on power. The rhetoric–and violence real and potential to back it up–are clearly escalating. I expect it to reach a crescendo early in 2008, with a crisis arising soon thereafter–long enough before the election to give the Duma time to act, but not so long as to require maintaining the crisis atmosphere for too long, as this would run the risk of things spinning out of control, or of people figuring out that they were being had.

That’s what Machiavelli would do.

April 26, 2007

Market Definition Follies

Filed under: Derivatives,Exchanges — The Professor @ 9:48 am

Holman Jenkins wrote a blistering article (subscription required) on the all-too-typical inanities of market definition in anti-trust. He didn’t mention CME-CBT, but as I wrote on the day the merger was announced, market definition will be the key issue. I know with near metaphysical certainty which market definition is the wrong one–the one that is most often cited by opponents of the deal, namely “US futures.” One can only hope that Jenkins’s cynical view of the antitrust authorities (namely, that they rig the definition of markets in order to permit them to file cases so as to justify their existence) isn’t confirmed by the Justice Department in the exchange merger case. There is virtually no economic rationale for the US futures definition, but it is the only one under which it is possible to challenge the merger. If Justice uses that definition, it will go a long way to validating Jenkins’s cynicism.

April 25, 2007

Boris Yeltsin

Filed under: Politics,Russia — The Professor @ 7:18 am

One’s appreciation for Boris Yeltsin varies inversely with distance from Moscow. A flawed giant, he should be remembered primarily for one thing: He showed immense moral and physical courage in destroying the Soviet Union. Of course, the greatest beneficiaries of this were the US and Europe (especially eastern Europe), where he is remembered with some fondness. After the Americans, Canadians, and Europeans, the citizens of non-Russian republics have fared best from the dismantling of the USSR. Some have made a hash of it (cf. Belarus) others have done quite well (cf. the Baltic states, and increasingly Georgia). Russia, the heart of the old USSR, suffered severe physical, financial, and perhaps most of all psychological damage as a result of the fall of the USSR, and hence Yeltsin is reviled there–especially in the seat power, Moscow.

This point is important, and has been too little emphasized in the commentary following Yeltsin’s death. Gorbachev was certainly moving the USSR away from its past, but still desperately wanted to retain the Soviet Union. Even a liberalized USSR, holding its empire underfoot, would have been a continuing problem for the security of the West. Moreover, had the USSR continued to exist, the “near abroad” would have started at the Polish border, rather than the Ukrainian. It is likely that the pressures that the Georgians and Estonians and Ukrainians are currently feeling from Russia would have been directed at the Poles and Czechs and Hungarians had the USSR continued to exist.

Yeltsin insisted on the dismantling of the USSR. Insisted. He dictated this outcome to Gorbachev. Without him, it almost certainly wouldn’t have happened. And thank God for that. The USSR was the most malign force in the post-war world, and even a “kinder, gentler” Soviet Union was an enemy of liberty and a threat to peace. Whatever Yeltsin’s other mistakes and faults, which were arguably legion, he made the world a better place when he forced the dismantling of the USSR. Although the image of Yeltsin on the tank is iconic, and an illustration of the man’s immense courage, his steadfast insistence on destroying the USSR root and branch was his most important service to the world. Thus, when I remember Boris Yeltsin, I will not recall first the image of the man on the tank, but instead I will remember with gratitude the image of the lowering of the hammer and sickle banner of the USSR on that fateful New Years Eve.

Today Russia is a destabilizing force in the near abroad, the Middle East, and elsewhere. Think of how much worse things would be if the current revanchist regime ruled over the territories of the Soviet Union, instead of merely its Russian rump. And when you are done with that mental exercise, say another prayer of thanks for Boris Yeltsin.

Of course his legacy for Russia is much more mixed. Many of the criticisms voiced in the aftermath of Yeltsin’s death, like those of David Satter in The National Review or the Wall Street Journal are quite justified. And the most telling criticism is that Yeltsin created the current regime and the conditions which make many Russians support it. By discrediting capitalism and democracy through clumsy and ill-considered policies, neglect, and nepotism and corruption, Yeltsin provided an ongoing rationalization for Putinism.

That said, when evaluating Yeltsin, one must remember that his task made Hercules’ cleaning of the Augean stables look like light housekeeping by comparison. 70 years of Bolshevism, Stalinism, and its successors had looted the USSR physically, economically, and perhaps most importantly, morally. There was no way–no way at all–that the transition from communism to democracy and the market state was going to be pretty. Whatever Yeltsin’s mistakes, one can only be assured that anybody other than Jesus Christ himself would have made other mistakes as bad or worse. We’ve seen one sample path of history; other sample paths far worse were certainly in the relevant probability space.

Indeed, in my view, given Russia’s history, its intellectual tendencies, and its political inheritance, it improbable in the extreme that any outcome more democratic, more free, and less aggressive than Putin’s Russia would have occurred had anyone other than Yeltsin ruled Russia post-1991.

Yeltsin’s rule demonstrates that a man’s (or woman’s) greatest strength is often his (or her) greatest weakness. Yeltsin’s confidence, courage, and forcefulness were necessary for him to face down the USSR, but ill suited him to be the leader of a normal democratic country. This points out the general problem of revolutionary transition. Those who are best suited to lead revolutions are often least suited to lead normal countries, but it is very difficult to supplant the revolutionary hero who has a moral claim to leadership. Men like George Washington and Vaclev Havel are the exceptions, not the rule.

So, all in all, I mourn the passing of Boris Yeltsin. The world is a far better place than it would have been without him. His legacy is a mixed one, but whose is not? He bequeathed a revanchist Russia to the world, albeit quite unintentionally–but also destroyed the Soviet Union almost singlehanded, and that quite intentionally. Given the realities of his moment in history, the balance of this trade is solidly on the credit side of the ledger.

April 12, 2007

More On Exchange Competition & Merger

Filed under: Derivatives,Exchanges — The Professor @ 11:39 am

The debate over exchange competition and mergers–and the CME/CBT merger in particular–continues to percolate. I’ve commented on several aspects of this debate, but other remarks are in order.

Further my previous musings on elasticities of substitution between CBT and CME products. I’ve opined that they might be negative (due to spreading). I’ve also opined that even things like Treasury futures and Eurodollar futures are unlikely to be close substitutes due to the non-negligible basis risks. But upon further reflection, I believe there is another even more important factor.

Specifically, the demand for an exchange’s services is a derived demand. That is, futures traders demand a bundle of services–liquidity, brokerage, clearing, execution, etc. Of this bundle, liquidity costs (e.g., price impact costs) are probably by far the biggest. Exchange fees represent a relatively small fraction of the total cost of a trade.

This is exactly what gives exchanges pricing power. If the exchange’s fees represent say 5 percent of the total cost of executing a transaction, if an exchange doubles its fee, the cost of trading goes up by 5 percent. Thus, the demand for an exchange’s services is very own price inelastic. Hence the ability of exchanges to earn such nice margins–this inelasticity gives them considerable pricing power.

This also has important implications for cross price elasticities. For instance, if the CBT halved its trading fee on Treasuries in an attempt to attract business from the CME, the cost of trading Treasuries would fall by about 2.5 percent (again assuming that fees represent about 5 percent of the cost of a trade.) Thus, in this example, the cross price elasticity for CBT/CME services is about 2.5 percent of the cross price elasticity (taking ALL costs into account) between Treasuries and Eurodollars. Thus, if I am correct that the “gross” cross price elasticity (taking all costs into account) is small to begin with due to basis risks and spread trading, the cross price elasticity relevant for evaluating the competitive effects of a CME-CBT merger is far smaller. Even if the gross price elasticity is somewhat larger than I conjecture (and positive), the effect of the fact that exchange fees represent a relatively small fraction of total trading costs tends to make the relevant cross price elasticity small nonetheless. Small cross price elasticities drastically attenuates the “static” competitive effects of the merger of exchanges trading non-overlapping product sets.

There is one case where exchange fee cutting did appear to be decisive–Eurex vs. LIFFE in 1998. A couple of points. First, this involved competition in identical products–no basis risk or spreading considerations. This is not relevant in evaluating the CME-CBT merger. Second, LIFFE made key strategic errors that are unlikely to be repeated in the future. In particular, it did not respond to the Eurex price cuts, whereas such inaction is unlikely in the future. Anticipating a quick response to price cuts, an exchange is unlikely to initiate a round of price cutting. Third, due to the rough parity in other trading costs, the Eurex price cut was sufficient to induce tipping, meaning that the effect of the price cut was exaggerated. This is not likely to happen in competition between different products. For instance, a CBT price cut is not going to cause all volume to leave Eurodollars.

Thus, in my view, cross price elasticities between CBT and CME products are likely to be quite small, meaning that the “static” competitive implications of the merger are likely to be quite benign.

Now consider the impact of the merger on innovation. John Lothian opines that the merger would reduce competition to innovate. This is a complicated issue, but I respectfully disagree that innovation will suffer, or that if efforts to innovate do in fact decline, that this is necessarily inefficient.

I should note that there is little agreement among economists about the effect of market structure on innovation. Profitability is what provides the incentive to innovate. Reduction of competition through merger does not attenuate this incentive, and may strengthen it.

I don’t believe that a CME that absorbs the CBT will rest on its laurels, and feel no need to innovate. Indeed, the high CME stock price clearly capitalizes the stock market’s expectation of high cash flow growth. This growth is unlikely to result from volume growth in existing products alone, as healthy as this growth has been. Pleasing the god of the street will require growth from other sources–new products. The CME is like a pharmaceutical company that needs to keep its pipeline full. The stock market will punish the CME if it fails to do so. This will tend to concentrate management’s minds and keep them on the hunt for new products.

Moreover, even if one believes that more competitive market structures are more conducive to innovation, in the modern electronic trading era, in which foreign exchanges (absent regulatory barriers) can offer products in US markets (and vice versa), and in which global financial firms trade on exchanges around the world, the relevant market is the world market. Looking at the US market share of a combined CME-CBT entity is inappropriate in this regard. From a world-wide perspective, the increase in market share (or the Herfindahl index) resulting from the merger would not typically present anti-trust concerns.

It must also be remembered that the winner-take-all nature of exchange competition can mean that competition to create new products can be inefficient. The winner of the competition earns a rent. As in patent races or land rushes, competition to earn the rent can dissipate it, creating a social cost of approximately the same magnitude as the rent. Thus, competing firms can spend too much on innovation. (More innovation, or more expenses spent on innovation, are not always better. There can be too much innovation, or too much spent on trying to develop new products.) Perhaps counterintuitively (to most folks) softening competition can actually improve welfare.

Against this is a good point that Lothian raises. Specifically, nobody knows exactly what the right design for any futures product should be. Everybody agrees that credit derivatives are the Next Big Thing for exchanges. But nobody agrees on what the “right” credit derivative product design should be. Having more exchanges experimenting with different designs increases the likelihood that one of them will be close to optimal. Losing a “laboratory” through merger may reduce the odds of finding the Goldilocks design. Note, however, that exchanges can revise their contracts if they don’t appear well-suited to market needs. Also, at the risk of being repetitive, due to the rent at the end of the rainbow for the winning exchange, exchanges may spend excessively to find the product that is Just Right.

All in all, I am skeptical that the CME-CBT merger will appreciably reduce innovation. Moreover, given the nature of liquidity (and the consequent winner-take-all nature of exchange vs. exchange battles for market share in a given product type), dissipative (“excessive”) rent seeking competition between exchanges is a real concern. Given these circumstances, I do not believe that concerns about the impact of the merger on innovation can provide a firm basis for blocking it.

April 7, 2007

The Ghost of Admiral Byng

Filed under: Military,Politics — The Professor @ 12:10 pm

Accountability is one of the three pillars of leadership (authority and responsibility being the others.) The British Navy set an extreme example for holding leaders accountable for failure in battle with the execution by firing squad of Admiral John Byng in March, 1757. Byng was found guilty under the Articles of War for his lack of aggressiveness in engaging the French in an abortive attempt to relieve the siege of Fort Mahon in Minorca during the Seven Years War.

It is widely recognized that Byng’s conduct, though hardly up to the standards of a Rodney or a Nelson, did not warrant such extreme punishment, and that the Admiralty went too far in its zeal to hold him accountable for failure. Fast forwarding 250 years since Byng’s demise, I get the sinking feeling that the modern Admiralty is in the process of making the exact opposite error. In the sorry episode of the 15 UK sailors and marines held hostage by Iran, it seems evident that there were serious failures of judgment up and down the chain of command, yet it seems that little will be done to hold those responsible accountable.

Anyone paying attention to the news from the Middle East over the past weeks and months should have been aware that the Iranians were in a fury over the capture and/or defection of numerous intelligence operatives, and that there is a war in the shadows between Iran and coalition forces in Iraq. Moreover, any sentient being in military and political circles should understand the Iranian predeliction for hostage taking to achieve political ends (cf. 1979, and Iranian supported hostage taking in Lebanon in the 1980s and last summer.) Add to this the tensions over the Iranian nuclear program, and it takes little imagination to understand that some sort of incident was almost inevitable.

Yet British commanders sent lightly armed detachments into areas swarming with Iranian speedboats without adequate cover or support under rules of engagement that rendered them virtually defenseless against a sudden attack. Despite this chain of failures, there appears to be no movement to relieve, cashier or otherwise discipline those responsible. Nor has anyone taken responsibility and resigned, as would be respectable and honorable.

This is disgraceful, and a serious blot on British Naval prestige. Not to say that the Byng treatment is in order, but numerous careers–from the commander of the HMS Cornwall to officials at Whitehall–should terminate posthaste.

And what about the 15 hostages just released? They have been subjected to withering criticism from numerous quarters, and with justification. I would not have wanted to be in their shoes, and I am sure that their experience in Iranian hands was unpleasant in the extreme. But countless servicemen (and women) have been in situations as bad–and much worse–and conducted themselves much more responsibly and honorably than they did. As an example, in the Vietnam War POWs such as Jeremiah Denton and John McCain held out for far longer under far more brutal torture and treatment than that visited on the 15 Brits before they submitted to their captors’ demand for statements condemning their country. And when they did so, despite the fact that they had cracked only under infinite duress, they felt guilty and ashamed–emotions that are not conspicuous among the 15.

Why did they cooperate so readily? In large part, it is attributable to training. After all, numerous American captives cooperated with the North Koreans in the early stages of the Korean War; the Code of Conduct adopted by the American military (which requires a POW to resist their captors in all ways possible and forbids cooperation beyond stating name, rank, and serial number) was a direct response to this problem. I had to memorize this code as a Midshipman during Plebe Summer at the Naval Academy, and it is drilled into every American serviceman and woman. I believe that the natural instinct of POWs is to cooperate, and it can only be overcome through intense training and repetition. As a result of this training, American captives in Vietnam and the first Gulf War did not provide their captors with cheap propaganda victories.

Or consider the example of the crew of the USS Pueblo. Despite horrific treatment, the crew resisted their captors at every turn. For instance, when the North Koreans attempted to take propaganda photos of them, the crew gave the finger. Commander Bucher wrote a “confession” only after brutal torture and a mock execution, and even then wrote it in a way that mocked North Korea’s “Dear Leader.” (Nonetheless, a Navy Court of Inquiry recommended Bucher’s court martial. Only the intervention of the SecNav prevented this.)

My original reaction was that the Dianafication of British society, the mesmeric attraction of being on television, and the “vocationalization” of European militaries (although far less severe in British than continental services) had contributed to the too ready cooperation of the 15 captives. Some cable commentary (e.g., Colonel Jacobs on MSNBC) draws unfavorable comparisons between this generation of Brits and their WWII forebears. I am less certain that these conjectures/comparisons are apt after seeing a Military Channel documentary which played German propaganda films showing British soldiers captured at Narvik, Norway in 1940 praising their captors’ kindness, and even singing a chorus of “It’s a Long Way to Tipperary” for the German cameras. So this is not a new phenomenon. I think that soldiers, sailors and marines have to be trained to hold out against the duress of captivity, and that absent intense training of this type, captives are all to likely to succumb to pressure to cooperate. The apparent absence of this training is something else for which somebody or somebodies in the Royal Navy should be held accountable.

At Trafalgar, Nelson famously signaled “England Expects That Every Man Will Do His Duty.” Some of his men were insulted that he felt it necessary to remind them of their obligations to King and Country. If the behavior of the 15 and those who commanded them is considered consistent with the duties of British seamen and marines, the standards of the Royal Navy have indeed fallen below the Nelsonian level–and below the standards of the ordinary tars who felt no one need remind them of their obligations as sailors and warriors. Every day that passes without holding those responsible for the fiasco in the Shat al Arab accountable for what transpired there and in Iran in the days that followed only strengthens my conviction that this is, sadly, indeed the case.

April 5, 2007

I Swear I Read This Someplace Before

Filed under: Commodities,Derivatives,Exchanges — The Professor @ 8:22 am

Today from Reuters:

IntercontinentalExchange Inc.’s (ICE.N: Quote, Profile, Research) bid for the Chicago Board of Trade may have been fomented by a broker backlash against the potential power of a combined CBOT Holdings Inc. (BOT.N: Quote, Profile, Research) and original suitor Chicago Mercantile Exchange Holdings Inc. (CME.N: Quote, Profile, Research).

Atlanta-based ICE, virtually unknown in the futures business just a few years ago, stunned the industry in March with an unsolicited bid that would give CBOT shareholders a majority stake in the combined company.

Banks that are among the largest futures players have signed on to advise ICE, whose innovative proposal for CBOT has at the least created a roadblock to the consummation of a marriage between the two largest U.S. futures markets, each of which has called Chicago home for decades.

“ICE may be getting support from some some of the brokers who were critical of the CME-CBOT deal,” said Keefe, Bruyette & Woods analyst Richard Herr. “The development of ICE’s bid for CBOT speaks to a further intensification of the brokers versus exchanges.”

Last week ICE said that UBS AG (UBSN.VX: Quote, Profile, Research) and Societe Generale (SOGN.PA: Quote, Profile, Research), parent of brokerage Fimat Group, had joined Morgan Stanley (MS.N: Quote, Profile, Research) as co-advisers in its offer for CBOT, which is the parent of the No. 2 U.S. futures exchange.

Oh now I remember. I advanced this hypothesis the day the ICE deal was announced.

Although the Reuters story focuses on “brokers”–implying FCMs–it is also important to emphasize the point (raised somewhat parenthetically in the story, he said parenthetically) that these FCMs are arms of big banks that dominate the OTC derivatives market. Methinks that the OTC desks of the big banks is where the real source of the opposition lies.

The story quotes a FIMAT exec providing a rationale for the FCM/bank opposition to the merger:

“Separately, both the CBOT and CME already have virtual monopolies for most derivatives contracts they offer to the public,” wrote Fimat general counsel Gary DeWaal in a November editorial in the Financial Times.

“Naturally the new entity would have significant pricing power and … unparalleled power effectively to inhibit real competition.”

I agree completely with the first statement. The second one is highly arguable, and depends on implicit assumptions that are highly dubious. Merging two monopolies would increase pricing power only to the extent that the monopoly products are substitutes (in which case the businesses aren’t really monopolies–hence something of a contradiction in Mr. DeWaal’s reasoning). I have seen no explicit estimates of cross-elasticities of demand for CME and CBT products, but doubt they are large, and suspect they might not even be positive. That is, as I have pointed out before, it may well be the case that the products traded on the two exchanges are complements, rather than substitutes. (This would imply negative cross-elasticities). This is because the exchanges’ products are traded in spreads (e.g., Treasuries vs. Eurodollars, corn vs. live hogs). In this case, the exchanges will engage in double marginalization/markup because neither takes into account the impact of its pricing on the sales of the complementary product. Merger would actually improve the efficiency of pricing in this case. Add in the effect of cost savings, and the welfare improvement resulting from the merger could be large indeed.

In any event, its good to see that the press is finally catching onto the possibility that support for the ICE effort is not all Mom and Apple Pie, but likely reflects the very intense commercial interests of large financial players looking to protect their own turf.

We’ll See

Filed under: Military,Politics — The Professor @ 8:04 am

No sooner had I posted my sourly pessimistic remarks regarding the Iran-UK hostage standoff than Iran announced its intention to free the 15 British sailors and marines. Does this change my view? Too early to tell.

I see three possible explanations of the apparent Iranian volte face.

First, Ahmadinejad decided he was in the wrong, and unilaterally decided to make amends.

Yeah, me neither. Moving right along . . .

Second, Ahmadinejad and the Mullahs had a come-to-Jesus moment (as it were;-) spurred by visions of JDAMs dancing in their heads–literally. Maybe two CVNs and a few choice words (perhaps reinforced by some spec ops mischief) convinced them that this was the best way to save face–and their heads. If this were indeed the case I will gladly eat my words and put on a happier face.

Third, Blair and Ahmadinejad cut a deal which in some way expressed or implied an equivalence between the capture of the British naval personnel and the Iranian agents captured in Iraq while hatching plots to sow further misery in that prostrate nation and to kill Americans in the bargain. The Iranians are spinning it this way, but again they would. The Americans, who hold five Iranian agents deny any swap, or that the Iranian government will be allowed to visit the five. But again, they would too. The near simultaneous return of an Iranian diplomat by the Iraqi government could reflect a trade. The inestimable Wretchard at Belmont Club suggests that a deal may well have been made.

If this third alternative turns out to be the truth, my dyspeptic pessimism will only intensify. There is no equivalence–moral, legal, or otherwise–between Iranian covert operatives plotting murder in a foreign country and British sailors undertaking a UN-sanctioned operation in Iraqi waters. It is through these types of deals that thugs achieve a respectability and apparent moral parity with the law abiding. This gives them the camouflage they need to engage in yet further outrages. The British may feel they cut a good deal if they get 15 live bodies back in exchange for 1 and the promise of visitation rights to the 5 imprisoned Iranians, but the real price that the British–and the US–will have to pay will only be realized in the future. I suspect that it would be more than optimistic to hope that only 15 Americans will die directly or indirectly as a result of this deal–if it was a deal. The difference is that the names and faces of the 15 Britons are semi-celebrities known with certainty, and the 15–or 150–Americans blown to bits by Iranian supplied weapons will just be additional figures in the casualty report, and the culpability for their deaths never assigned to where it belongs. Thus the politically easy way out is to deal now, avoid the known problem today, and blame the future consequences on the unpredictable fortunes of war.

This would be more than a crime. It would be a blunder of the first order, but it is the kind of choice politicians make all the time–because others pay the price.

April 4, 2007

European AutoDeguello

Filed under: Politics,Russia — The Professor @ 10:34 am

The word “Deguello” means “throat slashing” in Spanish. It is the name of a battle tune dating from the Reconquista in Spain. Playing of the song signified no quarter: Santa Anna’s army played the Deguello before the final assault on the Alamo.

Nowadays, Europe seems bent on slitting its own throat. One can almost hear the strains of the Deguello playing as the soundtrack to Europe’s most recent We Have Met the Enemy and He is Us moments.

Example One. European energy policy, especially vis-a-vis Russia. Echoing an earlier SWP theme, Keith Smith provides depressing detail on the short sighted insistence of numerous European nations on making bilateral energy deals with Russia, and this at a time when a unified approach is essential. It is particularly galling (not to say Gaul-ing) to hear the constant prattle about the New Europe and then to watch how they behave in very Old European ways.

Example Two. The UK-Iran hostage standoff. This is incredibly depressing. Indeed, the craven, cringing, pusillanimity of the British response in this case is beyond depressing. Britain’s fetal position-don’t-hit-me-again posture will only spur the Iranians to more outrageous actions. And the response of the UN (under whose “aegis” the British sailors were operating), the EU (of which the UK is a member), and NATO (ditto) are beyond disgusting. (I put “aegis” in quotes because the word means “shield” and the UN has done nothing whatsoever to shield its minions.)

Two things in particular stick in my craw. First, the Europeans have been so tiresome in their hectoring lecturing of the US about the Geneva Conventions, yet here Iran has committed one flagrant violation of the GC (the display of POWs on TV) and threatened another (the trial for espionage of military personnel captured in uniform) and nary a peep is heard from Our Moral Bettors. Just further proof that the Europeans feel safe in criticizing us knowing we’ll shrug it off, but they wet themselves at the prospect of standing up to somebody who will fight. (Perhaps a realistic attitude from a continent that has been free riding on the US military for decades and has let its military capabilities atrophy to such a degree that they could not, as Patton so eloquently put it, “fight their way out of a piss-soaked paper bag.”)

Second, the EU’s utter silence in the face of this outrageous provocation is largely driven by the commercial interests of large European corporations who engage in substantial trade with Iran–trade that arguably is the difference between the survival of the mullahs and the economic collapse that would spell their doom. Again, from people/governments who never tire of criticizing the hypercapitalist, materialist US.

Spare me.

And of course the US is to blame. Isn’t it always? You see, we “botched” an attempt to strike at Iranian agents actively engaged in efforts to destabilize Iraq and kill Americans, so of course the Iranians are perfectly justified in taking Britons prisoners.


Like the old adage says, be careful what you wish for–you might get it. Many Europeans are itching for the US to withdraw from the world and bow to European “leadership.” (I know, I know–but it’s not polite to laugh at the delusional.) If that happens, the Deguello will sound for Europe long before it echoes in the US. Unfortunately, whereas there was a Churchill to sound warnings in Europe in the 1930s, there is no such clarion voice today. When the clash comes–and it will–who will step into the breach? Tragically, the most realistic answer is: No One.

The New Patrimonial Russia

Filed under: Energy,Politics,Russia — The Professor @ 10:01 am

Back in January I was reading North, Wallis and Weingast’s “The Natural State: The Political Economy of Non-Development” and came across a passage that captured modern Russia to a T:

A natural state is a specific way of structuring political and economic systems so that the economic rents created by limited entry are available to secure credible commitments among politically powerful groups. Potential rivals in a natural state stop fighting (or fight less when the economic rents they enjoy depend on continued existence of the sate and of social order. Natural states limit economic entry to create rents and then use those rents to credibly commit powerful groups to support the state. In other words, natural states use the economic system as a tool to solidify the stability of the ruling coalition.

Natural states create property rights to the exclusive use of land, labor and other valuable resources, as well as rights to perform valuable economic functions, such as trade. These rights are only available to members of the dominant coalition. Limiting access to rights increases economic rents . . . . The rents bind particular constituent groups to the ruler because they have something to lose if the ruler is replaced. Creating a wide range of rents allows the ruler to create a support constituency potentially capable of both maintaining power and supporting the wealth associated with specialization and exchange. . . .

The natural state is natural because it is based on personal exchange: privileges are granted to specific gbroups and differ across groups. These exchanges are enforced by the same type of mechanisms used in the primitive order, namely, face to face repeat play mechanisms. Moreover, economic exchange is also based on personal exchange mechanisms: the natural state cannot sustain impersonal exchange associated with open access orders. . . .

[T]he state is self-limiting in that it cannot honor rights to individuals outside of the narrow set of constituents. . . .

[T]he natural state is self-limiting with respect to the economy. . . . The natrual state’s systematic “market intervention:” is not the result of mis-guided policymaking, but fundamental to how [it creates] political order and stability. Natural states therefore cannot support competitive markets based on open entry. This logic also implies that natural states view markets as instruments of political control, not sources of citizen welfare.

North, Wallis and Weingast do not discuss post-Soviet Russia in particular, but their natural state is an apt characterization of it. A recent article by Celeste Wallander in the Spring 2007 Washington Quarterly does not mention North et al, but presents an analysis of post-Soviet Russia that mirrors their argument almost exactly:

Patrimonial authoritarianism is a political system based on holding power in order to create, access, and distribute rents. It is well known that Russia is deeply corrupt, but corruption in the Russian system of patrimonial authoritarianism is not merely a feature of the system; it is essential to the very functioning of political power. The political system is based on the political control of economic resources in order to enrich those within patron-client clans. The patron remains in power by rewarding clients, and the clients are rewarded by supporting their patron. The patron requires support from his clients, and he must access and distribute rents for that support. Without the creation and control of rents, political power disappears. At the top of the political system, Putin manages relations among competing patron-client clans headed by top government and business figures, such as Development and Trade Minister German Gref, Deputy Prime Minister and Gazprom chairman Dmitry Medvedev, Gazprom president Alexei Miller, and Igor Sechin, deputy head of the presidential administration and chairman of Rosneft. Each of these individuals in turn has his own set of clients, who are in turn patrons of their own clans, and so on, creating a complex web of relationships that sustain political power and distribute patronage rents.

Obviously, patrimonial authoritarianism is wholly inconsistent with transparency, rule of law, and political competition. The true purpose of the political system is not to mediate among citizens, businesses, or interest groups but to manage and control them so that they do not impinge on the ability of the patron-client clans to use their political power to generate, access, and distribute rents. Patrimonial authoritarianism requires a nontransparent, nonaccountable, nonpermeable, vertical, and centralized political system.

Wallander calls this system Patrimonialism, and asserts that it is “Transimperial,” in contrast to “neoimperial” and “postimperial” alternatives. Interestingly, Wallander does not cite Pipes’s analysis of Patrimonial Russia, although there are some strong similarities between the historical Russian patrimonial state Pipes analyzes in his Russia Under the Old Regime and Property and Freedom and the new patrimonial state that Wallender describes.

One source of concern: natural/patrimonial states are extremely brittle. They rely on a balance between contenting forces in a rent seeking battle. When a shock upsets the balance of forces, or when one faction deems that it has a preponderance of power and therefore should get a greater share of the rents, a battle can break out–and it can become very brutal. Indeed, since natural/patrimonial states have underdeveloped institutional means for settling and mitigating conflict, breakdowns in cooperation can lead to open warfare. The threat of violence in the event of a breakdown in the system is what sustains the cooperation. It is a political system sustained by MAD. But (analogous to mutually destructive price wars in a cartel) cooperation can break down, and when it does–look out.

If you need a mental model of what can happen in this kind of system, think of Chicago, Capone, Moran, and the St. Valentine’s Massacre. One shudders at the prospect of that happening in Russia, but it is not an idle fear. This fear is the driving force behind attempts to find a way to keep Putin in command, de facto if not de jure. But this course holds its own perils. There are no doubt those who think that it should be their turn post-2008, and may resort to resistance (carried out mafia style, no doubt) if the Putin regime is extended by hook or by crook.

The current uncertainty over the post-Putin transition will put incredible strain on the Russian natural/patrimonial state. This uncertainty will only increase in the coming weeks. And with it comes the prospect for an explosion. Not that it will happen, but it is a serious possibility.

April 1, 2007

The Singlemost Important Thing

Filed under: Energy,Russia — The Professor @ 2:52 am

The singlemost important thing the west can do to liberate itself from its increasing dependence on Russian energy is to support the development of alternative transportation routes that circumvent the current Russian stranglehold on the shipment of gas from Central Asia to Europe. The singlemost important component of that strategy is a Transcaspian gas pipeline. This will free gas from Turkmenistan, Kazakhstan, and Uzbekistan to flow to Europe without transiting Russia.

This will provide direct competition for Gazprom. Recall that Gazprom essentially uses Turkmenistan as its gas piggy bank. It pays the Turkmens peanuts and sells the gas to the western Europeans at far higher prices. Gazprom (and the Russian state) pocket the difference. Moreover, access to Central Asian gas makes it easier for Gazprom to meet its contractual commitments without making additional investments in new reserves in Russia. It is now widely recognized that Russia’s domestic production is stagnating, and with growing domestic demand it would have difficulty meeting its commitments unless it could exploit Central Asian reserves at bargain prices–bargain prices because Gazprom provides the only way for this gas to reach the market. Create an alternative route, and the cheap gas would disappear. Without its piggybank, Gazprom is in a world of hurt.

Fortunately, it seems that the US, some states in the Caucasus, and some Europeans recognize this and are looking for ways to achieve this objective. Unfortunately, this article also argues that some Europeans–round up the usual suspects, that is, the French and the Germans–want to deal bilaterally with Russia and don’t support these multilateral efforts. Talk about selling the rope, sheesh. This is the one strategy that poses a serious threat to Russian hopes to retain massive energy market power. Get with the program boys and girls. You can grasp the nettle now, or suffer much greater pain later.

The very fact that this strategy strikes at their vitals will ensure that the Russians will do everything to thwart it. Their pressure on Georgia is part of these efforts. The sweet-talking of the Hungarians and Bulgarians to create a pipeline that would undercut the Nabucco pipeline (a key link in the chain from Central Asia to the Caucasus to Europe) is another. One can expect that the intensity–and dirtiness–of Russian efforts will only increase if these efforts to circumvent them appear to have a prospect for success.

However, Russian squealing and dirty play should only spur the Turkmens, the Azeris, the Georgians, the Europeans, and the Americans to even greater efforts, because squealing and retaliation would indicate that the circumvention strategy is having the desired effect. I am skeptical, however, that the Europeans have the stones to do what is necessary. (One need only to observe its pusillanimous response to Iran’s hostage taking provocation to understand that Old Europe is very old, tired, impotent and cowardly indeed.) Hence, perhaps again the US–this time in conjunction with former Soviet Republics–will have to save the Europeans from themselves. Not that we can expect any thanks (and indeed expect the opposite), but hey, we’re used to that by now.

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