Streetwise Professor

I’ve blogged a few times on Russia’s demographic implosion. A few interesting things along that line came to my attention in recent weeks.

Most recently, via Window on Eurasia a reasoned critique of the Russian government’s recent crowing over the 142,000 live births in June of this year. In essence, this is a consequence of the current relatively large cohort of 18-29 year old women. As these women age, the succeeding cohorts of women of peak child bearing age will decline, and absent increases in the fertility rate among these women, births will inexorably decline in succeeding years. Very interestingly, the demographers quoted in WindowOnEurasia state that the fertility rate has actually begun to decline again after its post-98 crisis rebound.

This suggests that the economic recovery has not boosted fertility rates. Indeed, Western European experience suggests that economic growth no longer leads to increased fertility rates, but quite the opposite. Spain is of particular interest in this regard. The Spanish economy has grown dramatically in the post-Franco years, but birth rates have plunged. As I’ll discuss more in a bit, this trend to one-and-done is likely to be even more pronounced in Russia. Put differently, Russia cannot count on renewed economic growth to increase its fertility rate, and given the impending decline in the number of women of childbearing age, the absolute number of births is almost certain to decline sharply in years to come.

Which brings me to the second article, an extensive interview with Nicholas Eberstadt. Eberstadt emphasizes the important point that what distinguishes Russia’s demographic crisis from demographic trends in other countries is not its birth rate, but its astronomical death rate. I think what is underemphasized is the link between the death rate, and likely future trends in fertility; specifically, the high death rate is likely to depress fertility.

I have touched on this point in earlier posts, but it deserves emphasis. The unprecedented high mortality (in what should be a developed country) among young and middle aged men raises women’s cost of having children. There are several causal connections at work here. Two are of particular importance. The first is that reductions in the supply of healthy men in what should be the peak of their productive years raises the wages of women, increasing the opportunity cost of having children. Rising productivity and work opportunities for women is one factor depressing fertility rates in Europe and the US, but the exceptional death rates among men in their working years should tend to strengthen this tendency in Russia. The second is that women who have children face a greater risk of widowhood while their children are still at home. This prospect also discourages having children.

At the risk of being repetitious, given these depressing facts, the actions of the Putin government seem detached from reality. Great Gamesmanship, military posturing, grandiose plans to spend trillions on new infrastructure and fantastical developments in Siberia are lunatic priorities for a nation facing demographic collapse. Perhaps Putin and his ilk are at a loss as to how to address Russia’s real problem, and find it more appealing to pursue chimera of glory. Or, alternatively, maybe they aren’t so lunatic after all. To echo another theme of SWP, perhaps the dismal demography is at the root of the short time horizons/heavy discounting of the future that is implicit in much of Russian politics. The future is so bleak that Putin et al feel compelled to grab as much as possible today.

Suffice it to say that given Russia’s daunting demographic prospects, it is the height of chutzpah for Russia’s ambassador to Georgia, Vyacheslav Kovalenko, to warn the Caucasian nation about its impending demographic “death.” People in glass houses . . .

My recent post on the Russian military mentioned that I was looking for an article I had seen regarding how little rumble Russia was getting for the ruble spent on the military. Via La Russaphobe, I came across this article by Pavel Felgenhauer that made the point:

Under Putin, the defense budget has multiplied as petrodollars poured into the country. In 2000, it was 146 billion rubles ($5.8 billion); this year, it is 870 billion rubles ($34 billion). But it is unclear where all this money is going. Contract soldiers today get on average only 8,000 rubles ($315) a month; officers get 12,000 ($470) to 15,000 ($590). Moreover, service conditions in the military continue to be appalling and the ranks are full of discontent. This year’s procurement budget for new weapons is some 300 billion rubles ($11.8 billion), but the only procurement to speak of consists of 30 new tanks, several helicopters, missiles and other small items.

This inspired me to Google “Felgenhauer Russia Military Corruption” and I found an article by Felgenhauer that spells out in much detail the abject failure to make any progress towards a viable conscript army in Russia. Felgenhauer also argues that the Russian military establishment is mired in the past, looking backwards to WWII rather than responding to current military realities. It still envisions relying on mass conscript armies rather than modern professional cadres.

A few more clicks led me to this Felgenhauer article from 2004 which says:

In 2003, the Defense Ministry officially spent 118 billion rubles ($3.84 billion) on procurement. This year, more than $4 billion has been allocated for Defense Ministry procurement. If one takes into account that the U.S. dollar’s relative purchasing power in Russia is twice that in the United States, it is indeed a large sum of money, as Putin says.

If the military procurement funds of other Russian armed forces are added to the Defense Ministry’s budget, the total amount is roughly equivalent to Russia’s net proceeds from weapons exports.

China, India and other countries spent about $2 billion per year in the 1990s, rising to about $4 billion per year from 2000, to buy Russian weapons. Over 400 jet fighters and bombers, over 20 new submarines and warships and many other weapons were procured, while the Russian military got nothing.

Last year procurement money was spent, but next to nothing was actually acquired — several new tanks, four helicopters. And that’s it. The official line is that most of the money went to develop new weapons that the Russian military will get in years to come.

But Russian defense analysts report that they can clearly see the returns from Chinese and Indian procurement spending in the accounts of Russian defense industry companies, while they can find almost no trace of the $3.84 billion the Defense Ministry has spent on procurement and R&D. This money has apparently been misappropriated or disappeared down rat hole.

Still haven’t found the exact article I was looking for, but these are consistent with what I remember. They also suggest that the Russian procurement budget is intended primarily to procure boodle for those with the juice, rather than things that go boom. Which ain’t all bad.

This WSJ article (subscription required) warns about Russia’s creation of an oil exchange that will “shift energy business away from existing global financial centers.” St. Petersburg’s historic Greek Revival Bourse building is being restored to house it. Author Judy Shelton says that this is just one effort among many by Putin to challenge America’s (and to a lesser degree Europe’s) global financial primacy.

My fearless prediction: within months of its opening, you will hear crickets chirping on the trading floor. I base my prediction on two factors, one common to all attempts to start new exchanges, one specific to Russia and other nations that do not respect property rights and which are dominated by lawless governments.

The universal problem is liquidity. It is notoriously difficult to start a new market, or to launch a new contract, especially in competition with existing markets. This is due to the difficulty of attracting liquidity. As a result of the Catch-22 nature of liquidity, nobody wants to enter a market where no one else is trading. Potential traders are like Alphonse and Gaston, each waiting for the other to go first.

There is an excellent example of this right now in the very oil market that Russia hopes to enter. The world’s oil supply is increasingly sour and heavy, but both major pricing benchmarks—Brent and WTI—are sweet and light. Thus, oil traders, producers, consumers, and marketers have been seeking a viable sour/heavy price benchmark and hedging vehicle. Both ICE and the Dubai Commodity Exchange (“DCE”) launched Middle East crude contracts (tied to Omani crude) that would meet these needs. After the typical initial flurry of activity, volume in both contracts has declined dramatically, and ICE has pulled its contract. These problems follow the pattern of earlier failed attempts to launch a heavy/sour contract (NYMEX tried back in the 1990s.)

Both ICE and DCE are excellent exchanges operating under secure legal and contractual regimes. Both have spent a lot of money designing, developing, and marketing their contracts. Despite these efforts, both contracts have withered, and I have little faith that this trend will be reversed.

The specifically Russian problem? That should be problems, plural. Futures and commodity markets are markets for promises. If there is even a modicum of doubt that contractual promises will be honored, a futures market cannot develop. Russia’s lack of a rule of law, and its recent flouting of laws and contracts, creates a something well beyond a modicum of doubt regarding the sanctity of contractual commitments.

One can easily imagine scenarios in which contracts are abrogated or undermined. Let’s say that a politically connected individual or firm (a member of the siloviki, for instance, or Rosneft or Gazprom) takes a big position that loses a lot of money. The loser raises a hue and cry that the market has been manipulated, and a sympathetic government (which may include people with a direct financial interest in the losing company, or who can be “persuaded” with a well-placed gratuity) brings its investigative and police powers to bear. It finds manipulation, and either explicitly abrogates the contracts, or exerts pressure that leads to a “negotiated” settlement that makes the loser whole—and maybe even more than whole. This outcome is particularly likely if the party on the right side of the market happens to be a foreigner.

If you think this is far-fetched, you obviously haven’t been paying attention to the way that Putinworld works, cf. Yukos, Rusoil, Ukrainian gas, Sakhalin II, BP/TNK, maybe Sakhalin I, etc.

And speaking of manipulation, let’s turn the example on its head. A playah—a Rosneft or a Gazprom—has incredible leverage through its control of physical assets to manipulate prices. Consider this very real possibility: Remember that pipeline that is the source of deliveries against the futures contract? Well, it just sprung a leak, and darn it, we really don’t know how long it will take to fix. So deliverable supply has just gone to zero. And wouldn’t you know it, we just happen to be long. Sorry about that, suckers . . . we mean shorts. Better luck next time. Or a connected a firm can just run the tried-and-true squeeze play.

In either instance, is there any reason to believe—any at all—that the Russian authorities would intervene, or impose penalties on the connected malefactor?

As a quick example, I read some months ago how Gazprom was using its market power to hammer the Russian electricity behemoth EES. (I also read another article that specifically discussed a gas auction which resulted in EES paying much higher prices. There were allegations that Gazprom withheld output from the auction. It’s in my clip files–I’ll try to dig it out.) Were there consequences? Surely you jest.

Moreover, although the Russian government is no doubt happy now that oil markets are establishing high prices, but will it be so happy if (and I should actually say “when”) the worm turns, and prices move lower? The government’s temptation to interfere with the market, or to shut it down, will be very great. Shooting the messenger is not unknown in Russia (and unfortunately, the shooting is arguably not just metaphorical.) The government may like the market’s message now, but will not like it nearly so much in the event of a price decline, and in my view it is highly likely to act aggressively in that event. This is another major political risk that will impede the development of an open oil trading market in Russia.

Vertical integration is another obstacle to a successful Russian energy futures market. Vertical integration impedes the development of a viable futures market. There are fewer arms-length transactions that need to be priced and hedged in a highly integrated chain, as opposed to a dis-integrated one. Energy trading is all about identifying and pricing transformations in space, time, and product. These transformations are internalized in an integrated structure, and hence there are fewer trading opportunities.

The Russian energy infrastructure is already highly integrated, and becoming even more so as the result of conscious political decisions, rather than economic forces. The “power vertical” in the energy industry means that vertical integration is the dominant form of organization in Russian energy. Indeed, Russia is trying to integrate extensively into marketing, distribution, transportation, and refining outside of Russia. This integration will impede the development of a Russian energy exchange.

Information asymmetry is another impediment to the development of a liquid market. The notorious lack of transparency in Russia aggravates information asymmetries. And there is incredible opacity obscuring the kinds of information that are particularly important in Russia—such as political information and operational information relating to the Russian energy infrastructure. Energy has been identified as a primary pillar of Russian state security, and the aggressive use of state secrecy and espionage laws that has characterized Russia in recent years strongly suggests that these laws could readily be directed against those attempting to ferret out price-relevant information in the energy market. Indeed, since information advantages would tend to redound to the politically connected in Russia, there is a direct economic incentive to use the state’s powers to preserve those information advantages.

In sum, launching a new exchange is hard enough in a country subject to the rule of law, with independent enforcers and a tort system available to crack down on manipulators, a culture of transparency, and a relatively unintegrated market structure. The fundamental defects of Russia’s political, regulatory, and economic structure make the prospects for an energy exchange dim indeed. Inside a cave at midnight dim. And this is true in spades for Iran, another country that has made noises about starting an oil bourse to undermine American economic hegemony.

So, it’s nice and all that a historic building with ties to Russia’s financial past is being refurbished. It is a nice symbol of the demise of communism, and of the fact that Russia is at least paying lip service to markets. But don’t expect much of consequence beyond the architectural preservation/revitalization. A la the military posing I analyzed in an earlier post, this seems just another Potemkin moment. Viable markets need the appropriate institutional and legal infrastructure, and those are woefully underdeveloped in modern Russia–when, indeed, they are not actively undermined by the actions of the state and politically connected companies.

Soon after finishing this post on the economics of military organization do I read this letter to the Marine Corps Times discussing the debate between the Air Force and Army over the control of attack helos in the 1970s, and the current debate over the control of UAVs. Not surprisingly, since the writer is a retired Zoomie, the letter comes down foursquare in favor of the proposition that the USAF have control over UAVs that can carry out attack and interdiction missions. Why? ‘Cuz Congress sez so, that’s why; you see, Congress specifically gives the Air Force control over ground support and interdiction. QED.

Sorry to disagree, but what Congress decided at the time the Air Force was created in the late-1940s is hardly dispositive on the issue of whether the Army should have control over some UAV assets today–and tomorrow. The decision was, no doubt, partially based on military realities of the time, and partially based on politics. Military realities have changed in the 60 odd years since the law was written, and the politics no doubt distorted the decision.

The relevant question is whether it is appropriate to perpetuate the legacy of the P-51 era, or to craft an organizational solution that reflects the current and foreseeable technological and battlefield realities. The question seems to answer itself.

My last post focused on the implications of transactions cost considerations for military organization. Upon further reflection, I also conjecture that real options theory might shed some light on the issue. Military assets have optionality (e.g., an F-15 can be used in air superiority, strategic, or tactical support roles). Moreover, there is considerable uncertainty on the battlefield. Thus, there is a non-trivial decision on how to exercise the options inherent in military assets. The question is: who is best positioned to determine the exercise decision? Who has the best information? Hard questions . . . but thinking about the issue in this way may shed some light on the subject.

The military is one of the oldest and most important formal organizations, far older and more universal than the limited liability corporation, for instance, yet it has drawn little analytical attention from organizational economists. This is unfortunate, as the military presents some fascinating issues and problems, many of which seem quite amenable to analysis using transactions cost economics and property rights economics.

Many military organization issues are those of integration and the allocation of control rights–the bread and butter of TCE and property rights economics. For instance, the US Army and the US Air Force are currently duking it out over control of Unmanned Aerial Vehicles (UAVs). The USAF wants total control over them; the Army is loath to concede control over many of its birds. The Army ceded all its fixed wing aviation to the Air Force in the 1950s, and there has been conflict about over the adequacy of tactical air support ever since. (The development of helicopters was in large part a response to this.) In contrast, the Marine Corps has always maintained an organic fixed wing ground support capability.

These issues are not new. From time immemorial militaries have changed organizational structures. How much artillery should be assigned to brigades and divisions, and how much should be assigned to the control of higher headquarters (e.g., corps and army)? Should armor be concentrated in specialized divisions and corps, or distributed among infantry divisions? The examples go on and on.

An examination of the problems that military organizations must address suggests that transactions cost economics may shed light on these issues. Asset specificity is likely to be important.

In particular, temporal specificity (identified in some of my early research as an important factor in explaining contracting practices in shipping markets) is of major importance. Time and speed are of the essence on the battlefield, and in the absence of markets, ensuring the timely allocation and reallocation of scarce military assets can be the difference between victory and defeat. [As an aside, my previous remark raises the question: could one design markets for allocating some military resources among commanders? TCE could well provide interesting answers to this question.]

The flexibility of military assets is also relevant. One of the reasons for the ongoing conflict over the control of air assets is that they can be used for both strategic and tactical purposes.

Moreover, information is incomplete and imperfect in combat; the fog of war is cliche, but cliches are so because they are true. The distribution of information among commanders at different levels (platoon, company, regiment, brigade, division, corps, army, army group) should influence who controls what assets.

Organization can also affect negotiation costs between those in control of complementary assets. Consider the earlier example of tactical air assets. If an Army commander wants tac air support, he often needs to negotiate with the Air Force to get it. (There is an ongoing dispute over whether tactical air controllers assigned to Army units–who have authority to direct air assets to hit specific targets–should be Army or AF personnel. In contrast, a Marine division commander can call on his own air assets.) If an Army commander is upset with the tac air support he gets from the AF, he does not have the authority to make the appropriate head roll; he must take up his beef with his AF counterpart, who may do something, or may stick up for his peeps and tell the Army guy to pound sand. If by contrast the Marine commander is upset with the performance of his air wing, he can shake things up, and good.

Rent seeking is also important in the military, though the rents are likely to be largely non-pecuniary in nature. Empire building, for instance, is a common problem in military organizations. (The story of J.C.H.–“Jesus Christ Himself”–Lee’s supply organization in the European Theater of Operations in WWII is a classic example of this. Ditto the battle between MacArthur and King/Nimitz in the Pacific during that war.)

A TCE approach may shed light on military organizational issues. For instance, it seems capable of making predictions regarding how a shock to technology–such as an improvement in command, control, and communication (“3C”) technology, or the development of a new capability such as UAVs–should affect military organization. Similarly, the type of warfare should matter.

The thoughts are, as they say, preliminary and incomplete. But it seems that the economics of military organization is fertile ground for a rigorous TCE analysis, and I hope some young scholar takes up the challenge.

I read with regret that Dr. Roger Pielke is ending his excellent Climate Science blog. I have learned a great deal reading it over the past couple of years. Dr. Pielke’s last post provides an excellent summary of his main conclusions, which are quite reasonable and persuasive. Most notably, Dr. Pielke argues very cogently that a monomaniacal focus on CO2 as the only important anthropogenic climate forcing is counterproductive. Moreover, Dr. Pielke’s criticism of average global temperature as a climate metric is tremendously important and deserves more attention. Temperature is not a conserved quantity, and temperature measurement is rife with errors arising from poorly sited instruments; Dr. Pielke has shown very convincingly that daily minimum temperatures are a particularly flawed measure of climate trends.

Dr. Pielke is also very measured and reasoned in his approach, and is the quintessential scientist. His sober and scientific tone couldn’t be more different from the hysterical millenarianism of GISS’s James “Jeremiah” Hansen. Hansen has been over the top for literally decades, but his stridency and evangelical fervor have reached new extremes in recent months. Rather than honestly acknowledging errors in his data, Dr. Hansen viciously attacks those with the temerity to point them out, and accuses those who disagree with his True Belief with callous indifference to the fate of the planet. [As an aside, Hansen’s dismissal of the irrelevance in the correction of his US data is incredibly lame. If there is such a thing as “global temperature,” temperature one large region (e.g., the US) should be a good proxy for the global temp, so a lowering of temperature in recent years in the US is a bigger deal than Hansen is willing to admit–if Hansen is right about global mean temperature as the best metric of climate change.]

The blogosphere will certainly miss Dr. Pielke’s reasoned voice. He will certainly continue making his prolific contributions to the scientific literature, but more popular media need to hear his views too. We know that Jeremiah Hansen will continue to use the popular media megaphone. Who will make the more reasoned scientific view more accessible to the public? Dr. Pielke, you will be missed.