Streetwise Professor

May 2, 2008

Speculation Redux

Filed under: Commodities,Derivatives,Economics,Energy — The Professor @ 10:31 am

From Econbrowser, I learned that Paul Krugman (oy) made a point that I was going to blog about, but my procrastination gene kicked in. Specifically, Krugman opined that if speculation were really driving up prices above the equilibrium level, we should also observe an increase in inventories. In energy, and in some other commodity markets, inventories have actually been decreasing. So Krugman concludes–reasonably–that this is inconsistent with the ceaselessly repeated mantra that speculation is causing prices to diverge widely from the equilibrium fundamentals-driven value.

There are historical examples of this phenomenon. The International Tin Council attempted to prop up the price of this metal. The ITC had to buy increasing quantities of tin, as the high price discouraged consumption and encouraged production. Eventually, inventories became so large that the ITC could no longer afford its scheme; tin was dumped on the market; and the price plunged. The accumulation of stocks of grains by governments (including the US government) as the result of price support programs are also good examples.

James Hamilton at Econbrowser is skeptical, noting that in the short run supply and demand for most commodities is so inelastic that prices can diverge substantially from the equilibrium value without leading to a detectable increase in stocks.

If forced to choose, I would go with Krugman on this. The speculation-is-driving-the-market (nuts) mantra has been heard for nigh onto three years, which is more than enough time to see an accumulation of stocks in the hands of speculators (and it would be speculators that hold the stocks as they are the ones allegedly willing to pay the inflated price). Yet this has not happened. Hamilton argues that yes, the last three years have been fundamentals-driven, but the January-February spike may not be. In such a short time frame, he notes, given the inelasticities in supply and demand it may be very difficult to detect any speculative distortion in stocks given their natural volatility. That’s a fair point, but I am reluctant to conclude, based on this absence of evidence that speculators did not cause a distortion, that prices were irrationally high in two months after being fundamentally driven for years during which speculative activity was also intense.

I do have one quibble with Krugman (about this issue–about politics, quibble doesn’t come close to covering it.) Krugman’s analysis is a static, supply-demand one. Any analysis of inventories must incorporate dynamic effects.

Moreover, a dynamic analysis implies that it is possible that stocks and prices can rise simultaneously even if all speculation is rational, i.e., in a rational expectations equilibrium. I sketched the argument in the 2006 post “Care to Dance the Contango?” There I conjectured that increases in uncertainty could cause the simultaneous increase in inventories, prices, and contango in the oil market. I’ve recently completed a stochastic dynamic programming model that formalizes the intuition from that post. (A working paper is in progress, but its completion will have to await my return from Europe in June.)

Commodity storage dynamic programming models posit that equilibrium speculative storage decisions maximize welfare. Given current inventories, the state of the economy, and the stochastic processes governing the evolution of this state, speculative storage decisions maximize the expected present value of net surplus (consumer surplus plus consumer surplus). Equilibrium prices adjust to provide maximizing individual agents the incentive to implement the optimal plan.

One proceeds by conjecturing a function that relates forward prices to the current state of the economy and carry-in. One then solves for the amount of carry out such that the current spot price equals the present value of the forward price; if the spot price with zero carry-out (i.e., complete consumption of inventory) exceeds the forward price, it is optimal to store nothing, and to have a “stock out.” The possibility of stockouts (which will occur with positive probability in equilibrium) leads to backwardations.

Conventional storage models typically restrict attention to a single, mean reverting (i.e., stationary), homoskedastic net demand shock. Other models I have worked on posit two mean reverting homoskedastic shocks, with different speeds of mean reversion.

In this most current work, I have two state variables: a mean reverting net demand shock, and a mean reverting stochastic volatility shock. That is, I don’t assume that net demand is homoskedastic; the second state variable in the economy is the volatility (or variance) of the demand shock.

This framework formalizes the intuition in “Dance the Contango.” And the results of the model are exactly as conjectured in that post. When there is a positive volatility shock, agents respond by increasing storage, and thereby reducing consumption. This leads to a simultaneous increase in inventory and price–a phenomenon that has mystified many commentators on the energy markets in recent years.

I presented the results of the analysis at a conference in Italy in January. Here are the slides, complete with some graphs illustrating the results of the model.

In sum, although a simultaneous increase in stocks and prices could be a consequence of speculative distortion–but this is not necessarily the case. I would surmise that the absence of inventory accumulation is strong evidence against the excess speculation hypothesis, but that the existence of inventory accumulation when prices are rising does not imply that speculation is distorting prices.

I understand that this is not an especially satisfactory conclusion, but it illustrates that it is very difficult to identify implications that definitively distinguish the competing hypotheses. Methinks, however, that it is necessary to go beyond the crude correlation=causation argumentation that dominates the current debate about the impact of speculation: “There is a lot of speculation. Prices are high. Therefore the speculation caused the high prices.” The exact mechanism by which this works is seldom specified. Krugman is on the right track to point out that the excess speculation hypothesis should have implications for quantities as well as prices. His Micro 101 analysis is a good place to start, but when considering storable commodities, it is necessary to model the dynamics. When one does so, one finds that his test may generate false positives. That is, in a world where the amount of fundamental uncertainty is itself random, a simultaneous increase in stocks need not be definitive proof that speculation is distorting prices. It may instead show that speculation is in fact ensuring that resources are being allocated efficiently.

It is this very difficulty of coming up with empirical tests that cleanly distinguish between the rational speculation hypothesis and its irrational speculation alternative that make it so difficult to resolve this debate. Which is why it has raged for centuries, and will continue to rage into the foreseeable future.

I Have This Friend

Filed under: Derivatives,Economics — The Professor @ 9:08 am

Interdealer broker behemoth ICAP has announced an initiative to create an alternative to LIBOR. The ICAP alternative, dubbed NYFR for New York Financing Rate, will measure the 3 month and 1 month funding rates paid by New York banks. This is deemed desirable due to the apparent divergence between rates in the US and rates in Europe/London.

ICAP will survey 40 banks. Rather than asking what each bank pays, ICAP will ask each bank to assess what a “representative” bank would pay for funds. So, it’s sort of like . . . I have this friend, and he’s paying 3.625 pct for one month deposits.

This is supposedly intended to improve the accuracy of reporting by not putting banks in the potentially embarrassing position of choosing between lying about the rate that they pay, or revealing that they are sufficiently desperate for funds that they are willing to, and have to, pay a high rate.

Well, maybe this is an improvement, but if so, it’s not much of one. It would be much, much better to have a rate based on actual transactions. This is technologically feasible, and indeed, ICAP sees enough of the deal flow to make such a calculation based on real numbers rather than relying on this version of a Banker’s Anonymous meeting in which participants talk about their, ahem, issues, in the third person.

May 1, 2008

Humbug on Parade

Filed under: Military,Politics,Russia — The Professor @ 9:28 am

View this link for numerous pictures of the preparations for Russia’s Victory Day military parade. Each of the numerous photographs has the same caption, which ends with a reference to “Russia’s resurgent military might.” Repetition does not make it so. For as these two articles (and many others) show, behind all the military pyrotechnics, if you pull back the curtain you will find that the Wizard of Rus’ is all humbug. First, the hollow army:

Author: Nikolai Dzis-Voinarovsky
[Transition to contract service: vast sums expended with nothing
to show for it.]

Judging by official reassurances, almost 40% of privates and sergeants in the Russian Armed Forces are contract servicemen. Experts meanwhile unanimously claim that the military reforms have been wrecked. The Russian Armed Forces have lost advantages of service by conscription and never gained benefits of contract service. Funding of the transition to contract service rose to 99 billion rubles over the last three years but all these colossal sums were spent on anything but salaries of the Russians signing contracts with the Defense Ministry.

Colonel General Vasily Smirnov of the Main Directorate of Organization and Mobilization of the General Staff maintains with a straight face that a contract serviceman “is paid much more than 35,000 rubles a carman takes home every month.” Had Smirnov been telling the truth, all carmen would have already been in the Army and Navy. In fact, many others would have been seriously pondering service by contract because the sum Smirnov mentioned is way above the average per capita income in Russia (13,773 rubles).

Most men in Russia actually refuse to even entertain the idea of military service – by conscription or contract. According to Public Opinion Foundation sociologists, 51% of respondents view the situation in the Armed Forces as bad, 29% as so-so, and 6% as good. Specialists of the Transition Period Economy Institute checked Smirnov’s words and ended up with a picture not even
nearly as rosy as the general had painted.

Contract soldier’s basic salary is 8,000 rubles. There are bonuses and so on, of course, but even with all of them accounted for a soldier in Chechnya may only count on 15,000 rubles a month. Engine driver in metro in the meantime is paid between 35,000 and 55,000 rubles.

The Defense Ministry reported federal target program “Transition to contract service in units and formations” for 2004-2007 implemented. The initially drawn plans stood for an increase of contract servicemen in the Armed Forces from 22,100 to 47,758 men by 2008. The figure was eventually reduced to 138,722. Before the spring conscription campaign this year, the same Smirnov was already talking about “100,000 contract servicemen or so”. Funding set aside for the federal target program went up from 79 to 99 billion rubles (in 2003 prices). The additional finances were spent on propaganda and research but “not a ruble was spent on salaries of contract servicemen”, specialists of the Transition Period Economy Institute say. The Auditing Commission discovered misuse of 164.1 million rubles by the Defense Ministry earlier this month.

Specialists view low salaries as the key factor that determines success or failure of the military reforms.

Service by conscription is down to twelve months now. Combat readiness of the Armed Forces is down too. Most deferments have been annulled. Crooks alone benefit from these results of the federal target program. Experts in the employ of the INDEM Foundation say that conscription is the third worst corrupt sphere in the country, after health care and education.

The Defense Ministry is energetically drafting people with higher education into the Army and Navy. They amounted to 1.8% of
the numerical strength of the Army and Navy in 1985, 3.1% in 1999,and amount to 21.7% nowadays. “This withdrawal of specialists from national economy cannot be excused. Instead of drafting former students, the Defense Ministry had better concentrate on educational level of its career officers,” to quote Yevgeny Gontmakher of the Center for Social Studies and Innovations.

The Defense Ministry’s ability to provide tenements for the military is highly questionable too.

As a matter of fact, low salaries of contract servicemen have already resulted in dire consequences. According to Military Prosecutor General Sergei Fridinsky, privates and sergeants serving by contract committed over 3,500 crimes in the first ten months of 2007 (a 25% rise against the figure logged the year before).

Traditionally enough, state officials prefer talking of the cloudless future to doing something to remedy the currently problematic situation. Officials promise to up an average salary in the Russian Armed Forces to $3,375 by 2020. Gontmakher warns that the state cannot deliver what it is promising…

And the hollow navy:

Russia ‘no longer uses’ nuke sub deterrent

WASHINGTON, April 28 (UPI) — Russian nuclear submarines conducted only three patrols last year, indicating Moscow may have effectively abandoned their use as a deterrent, says a new report.

The Federation of American Scientists published its Nuclear Notebook this week, revealing that the number of deterrence patrols conducted by Russia’s 11 nuclear ballistic missiles submarines decreased to only three in 2007 from five in 2006.

In comparison, U.S. nuclear subs conducted 54 patrols in 2007, more than three times as many as all the other nuclear-weapon states combined.

Owing to “changed strategic circumstances” Moscow has apparently concluded “they don’t need this (submarine deterrent capability) for their security,” the federation’s Hans Kristensen told UPI, citing principally the end of the Cold War nuclear standoff.

For such a deterrent to be fully credible, at least one sub has to be on patrol — evading detection in open waters — at any given time, ready to launch unstoppable ballistic retaliation for any nuclear first strike.

But the Russian patrol figures reveal “that Russia no longer maintains a continuous (nuclear ballistic missile submarine, or SSBN) patrol posture like that of the United States, Britain, and France, but instead has shifted to a new posture where it occasionally deploys an SSBN for training purposes,” Kristensen wrote on the federation’s Web site.

He added the shift became apparent “when then Defense Minister Sergei Ivanov declared … that five SSBNs were on patrol at that time.” Later he learned that those five patrols were the only ones conducted that year.

“Combined, the two sources indicated a cluster of patrols at approximately the same time rather than distributed throughout the year.”

Kristensen told UPI that the new posture was likely to damage the strategic capabilities of the SSBN fleet.

“If you talk to U.S. submariners, they will tell you you need to be out on patrol all the time to maintain your readiness. … You can’t just switch back from an occasional deterrent posture to a full-time one.”

Shaun Waterman, UPI Homeland and National Security Editor

This examples could be expanded ad infinitum.

And it is not just the military. Recently Russian government spokesmen have been trumpeting a demographic turnaround. But myriad independent sources–including Russian demographers–cast serious doubt on these claims. Indeed, the consensus independent forecast is that Russia faces a worsening demographic outlook in the first years of the next decade, and that crippling declines in the working population are almost inevitable.

Thanks to the commodity price boom, Russia has a window to make inroads into its myriad health and social problems. This window is likely to be short-lived, because commodity booms often are. The country has already squandered several years, and shows no inclination to do anything different with the next several. Instead, we see bullying of neighbors; continual whining about enemies and the lack of respect paid Russia; Potemkin parades; propaganda masquerading as progress.

Indeed, the Red Square parade is deeply symbolic of Putin’s Russia. Boastful preening and display, mimicking past glories, all to distract attention from an all too often shambolic present and a bleak future–a future that could be a far brighter one, if only the country’s leaders could conceive a future different than an imagined past. But perhaps this is too much to ask, perhaps the habits of rule are too ingrained, for as Richard Pipes has written of governing Russia since the time of Peter the Great:

But once it had been decided that the interests of the country required the existence of a citizenry conscious of its collective identity and of its role in the country’s development, then certain consequences inevitably followed. It was clearly contradictory to appeal to the public sentiments of the Russian people and at the same time to deny them any legal or political safeguards against the omnipotence of the state. A partnership in which one party held all the power and played by its own rules was obviously unworkable. And yet this is exactly how Russia has been governed from Peter the Great to this day. The refusal of those in authority to grasp the obvious consequences of inviting public participation generated in Russia a condition of permanent political tension which successive governments sought to attenuate sometimes by loosening their reins on the realm, sometimes by tightening them, but never by inviting society to share the coachman’s seat.

The parade and the Sochi Olympics and myriad other things are “appeal[s] to the public sentiments of the Russian people.” But the sham of the recent voting, the consolidation of power into one party (United Russia), and the continued absence of a rule of law, which allows those in power to “play by [their] own rules,” all serve “to deny [the people] any legal or political safeguards against the omnipotence of the state.” As Pipes states, this will engender in the populace political tension, when, as is almost inevitable, it becomes clear that the fat years have not been used to address Russia’s chronic and debilitating structural problems in any serious way.

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