Streetwise Professor

Illinois Governor Ron Blagojevich has been indicted for attempting to sell off an appointment to replace Obama in the Senate.   This is a late development, as it was widely rumored that Blago was to be indicted for some garden variety pay-to-play scandal.   Yawn.   That’s probably more holiday joy yet to come for good ol’ Ron.

I grew up in Chicago, and am rather jaded by the rampant corruption in the city and the state of Illinois.   After all, with the Blagojevich indictment it is almost certain that 4 out of the state’s last 8 governors have done or will do time in Club Fed.     New state motto: “Illinois–we’re here to make Louisiana look good!”

Blagojevich was a made man in the Chicago machine.   He took over Dan Rostenkowski’s House seat two years after Rosty went to the slammer.   (Anybody see a pattern here?)   Then he was Daley’s pick to become the governor.   The entire Daley administration is under investigation, it seems.

Which raises an interesting question.   Are we really supposed to believe that seemingly alone, out of all of the politicians in Chicago, Barack Obama operated in that sewer for over a dozen years, only to ascend unsullied, uncompromised, Christ-like, as pure as the driven snow, to redeem the nation?

I guess it’s possible.   Unlikely, but possible.

Much news on the Russian economic front.

One of my favorite Russian commentors, Vladimir Milov, said this on Ekho Moskvy:

According to Kiselev’s next guest, Vladimir Milov, president of the Energy Policy Institute, compared with his previous annual question and answer sessions with the nation, this year “the president did not look confident”. Milov continued: “I would put it this way: there was less of the aplomb which we could observe in the previous years and more apologies and attempts to explain the situation.” “It was as if he (Putin) was apologizing for what is happening and, in my view, he was not very successful in this,” he said.

According to Milov, Putin is not suitable for the role of a crisis manager: “Putin is so used to the idea that everything is growing, that mentally it is very difficult for him to adjust.   One can see that he has a very inertial mentality and hence it is very difficult for him, in the conditions of the crisis, to respond to the current major and sweeping changes. He is definitely not suitable for the role of a crisis manager.”

Asked whether he approved of the government’s current strategy of “ensuring economic growth and GDP growth at any cost”, Milov replied: “To be honest with you, I can’t see the government acting in a coordinated manner, not to mention having a clear strategy or aim.” “It is evident that they (the government) have got into a muddle and are not ready to get together as a single team and draw up a coordinated anticrisis plan,” Milov said.

He went back to elaborate on the idea of the “inertia” prevailing in Putin’s and other leaders’ approach: “They are used to the situation of the past few years when everything was improving all the time owing to various external factors which they had nothing to do with, and they are simply not ready, they simply do not know and do not understand what to do in a situation when the economy is functioning in entirely different mode and when very difficult problems have emerged and the essence of which they do not understand either.”

“It is a question of fundamental incompetence and inability to assess the scale of the problems that have appeared very suddenly and are of rather an unexpected nature,” he added.

Asked how he would have dealt with the current crisis, Milov replied: “There are ways, but first of all we still need a competent leadership that would indeed understand the essence of the economic problems we are facing. Judging by what Putin said yesterday (4 December), he is a long way from having even a basic understanding of the nature of these crisis phenomena. He was still blaming America for everything. But soon, incidentally, most people will realize that America is America but jobs are being cut here, in Russia.”

Asked about the possible political consequences of the current economic crisis, Milov said: “It is a very difficult question because there are two opposite theories. According to one, the growing economic difficulties will undoubtedly start affecting a wider circle of people and very quickly push these people towards a realization that something needs to change in the political system and they (these people) will demand this.”

“But there is another theory”, Milov continued, “which says society can be rather adaptable –
people will be getting used to having slightly worse living standards and will start saying, as Putin did yesterday, that in its one-thousand-year history Russia has been through much worse times. At present it is very difficult to say what will happen in society and how this will affect the political system.”

And, in conclusion, he added: “Even if they want to, these authorities, which have only the most primitive tools at their disposal, will not be able to respond because they can’t provide any serious crisis management. Hence, if there is a significant public protest, I think they will simply have to go. There are no other options here.”

It’s easy to look like a genius when the prices of your main products go through the roof.   When oil was $140/bbl, Putin strutted about like the cock who thought his crowing made the sun rise.   Too often, people confuse luck for skill.   Happens with traders all the time.   Now, things are a little bit more difficult, and Vlad is not looking quite so good. Maybe Time should reconsider that Man of the Year thing.

The main issue is the ruble.   Due to concerns about the ruble, S&P has downgraded Russia’s sovereign debt rating, with a negative outlook (meaning that further downgrades are likely.)     Another first! (Russia is the first emerging market to have its rating cut by S&P.) S&P emphasized both macroeconomic and political risks in making its judgment. The political risks are especially important in my view.

In one rather (black) humorous moment, A S&P analyst opined:

“On the other hand, passage of measures to improve the legal and institutional framework for foreign direct investment and enhance competitiveness of the broader economy, as well as implementation of monetary policies to preserve the government’s still substantial liquid assets, could lay the foundations for greater resistance of the balance of payments to external shocks, and lead to a stabilization of the sovereign rating,” S&P’s Frank Gill was quoted as saying.

Good luck with the “passage of measures to improve the legal and institutional framework,” Frank.   That’s a very weak reed upon which to lean. In fact, if that’s the key to creating a firm foundation for future investment and growth–and I believe it is–then going short the ruble is a very good trade.

The increasing consensus is that (a) Russia is making a serious mistake by delaying the adjustment of the ruble to reflect the new bearish fundamentals (most notably the oil price), and (b) political considerations are driving this policy error.   Nouriel Roubini has an excellent analysis:

Given this sudden change in the Russian fortunes there are several key policy issues that the policy authorities need to deal with: of course given the external shocks (terms of trade worsening and sudden stop of capital and credit) it was important to use the buffer of foreign reserves to avoid a bank run by providing liquidity and capital to banks and by providing a fiscal stimulus to a country that is sharply slowing down. But the key unresolved policy issue is what to do with the exchange rate. Until recently Russia was on an effective basket peg (with 55% for the dollar and 45% weight for the euro). But with oil prices now down over 60% from the peak of the summer and with incipient current account deficits and fiscal deficits and a likely recession in 2009 the currency is obviously overvalued. A reasonable estimate of the needed exchange rate depreciation – with oil at about $50 a barrel in 2009 – is 25%. But until recently the authorities resisted the needed depreciation through aggressive forex intervention.

The reasons for resisting such necessary depreciation were varied: the banks and the corporate sector had massive foreign currency liabilities and a sharp movement of the currency would have led to nasty balance sheet effects and severe financial distress; the incipient bank run of retail depositors could accelerate if the currency were to fall sharply (Russian depositors were wiped out already twice in the transition period in the early 1990s and again in 1998 and they tend to be trigger happy); Putin staked part of his reputation and his view of a strong Russia on maintaining a strong rouble.

But the forex intervention that financed the capital flight out of Russia (a flight initially triggered by the increase in political risk given the Georgia conflict and then exacerbated by the global sudden stop of capital given the US financial turmoil in October-November) exacerbated the flight. Indeed, a good part of the forex intervention was sterilized thus preventing a significant stabilizing increase in domestic interest rates that an unsterilized intervention would have triggered. But, as a perfect case study of Triffin’s “inconsistent trinity”, a country cannot maintain a peg, have no capital controls and, at the same time, maintain monetary independence and avoid an increase in domestic interest rates that an expected depreciation triggers. The sterilized intervention thus led to a persistent bleeding of forex reserves that could continue unless such intervention is allowed to be unsterilized and thus force a rise in interest rates that would however be seriously costly in growth terms.

For a while the Russian authorities tried to skirt this inconsistent trinity inconsistency by introducing capital controls on capital outflows (taking the form of reading the riot act to local and foreign banks and financial institutions and telling them not to speculate against the trouble). But even such controls are leaky as many banks – faced with retail depositors converting roubles into dollars – needed to hedge such currency risk to avoid exacerbating their open currency positions mismatch. So the authorities cannot be too heavy handed against banks that are just hedging rather than speculating”. And unless capital controls are imposed in retail depositors their demand for currency hedging drives the financial institutions need to hedge in turn this currency exposure. So the conundrum of the inconsistent trinity still holds as there are limits to regaining monetary independence under fixed rates when such capital controls are effectively leaky and implemented partially.

The more appropriate way to regain a modicum of monetary independence and prevent a sharp increase in domestic interest rates that expectations of a rouble depreciation trigger is to let the currency peg go and flexibilize the exchange rate regime. Only after the currency has moved down enough expectations of further depreciation would quiet down. So, the right policy move would be one of a one-step large depreciation of the currency value that reduces significantly the amount of actual overvaluation of the currency. Instead, for the time being, the authorities have reacted by allowing only a gradual and modest depreciation, in a series of four 1% downward steps in the last month. But such small step depreciations exacerbate the capital flight incentives (and ensuing bleeding of reserves) as they lead to further expected depreciation expectations that triggers further flight. Only a relatively large unexpected step depreciation can stop such expectations and reduce the amount of the capital flight and forex reserve depletion.

But so far authorities had resisted such large step move for three reasons: losing face politically; worrying about a run on banks by depositors; and the large foreign currency exposure of financial institutions and corporate firms. These three reasons to resist a larger currency move are now becoming less important for several reasons. First, a continued bleeding of a large stock of reserves could cause a much bigger problem down the line – a real currency crash that would be politically even more damaging – if continued sterilized intervention leads to a sharp fall in reserves at the time when the current account and the fiscal account are likely to move into a deficit in 2009. Second, the risk of a bank run can be better managed via a controlled devaluation when reserves are still high rather than when reserves have been mostly depleted via a self-defeating defense of an indefensible peg.

Third, and most important, by now a significant part of the foreign currency exposure of the financial and corporate has been reduced by using the forex reserve intervention to effectively allow banks and corporate firms to reduce their exposure to foreign currency liabilities and thus avoid severe balance sheet effects when the currency moves by a larger amount. Effectively Russia has been doing what Brazil did in 1998-99 – i.e. bailing out ex-ante its banks and corporates by allowing them to cover their forex currency exposure via purchase of a large fraction of the reserves of the central bank.   This Brazilian “ex-ante bail-out” prevented the “ex-post bail-out” that would have been necessary if banks and corporates with a massive amount of foreign currency debt had experienced a large currency depreciation before they had the time to hedge such exposure. So now that the forex reserves of Russia have been run down enough to reduce the foreign currency exposure of the private sector the central bank can allow a faster rate of rouble depreciation without worrying about the banks and corporate going bust via the balance sheet effects of a large currency move on the value of their previous large foreign currency exposure.

All these factors suggests that the Russian authorities are now ready to let the currency fall at a faster rate than it the past. They have already moved in that direction by surprising markets with their weekly 1% moves. But since a much larger depreciation is needed and since further expected 1% moves will trigger even greater amounts of capital flight and reserve depletion a broader and large one-step move is now necessary and viable. The rouble may need to fall by about 25% before reaching a new equilibrium value. It is thus better to make a good chunk of that adjustment faster and in an unexpected way rather than keep on bleeding a large stock of forex reserves if small step movements trigger expectations of further depreciation. Now that banks and corporate firms are more hedged than before and the war chest of reserves has not yet fallen to alarming levels it is time to let the currency level take a larger burden of the necessary adjustment that the country needs to cope with lower oil prices, the sudden stop of capital, the increase in investors’ risk aversion and a global economic outlook that signals a sharp recession in advanced economies and a very likely recession in Russia too.

Roubini does endorse one argument that DR has made–namely, that defending the ruble has effectively bailed out those banks and corporations who have borrowed in foreign currencies. But Roubini argues that the time for that is over. The other deleterious effects of maintaining the peg which I have focused on are becoming too big to ignore. But Russia seems to be ignoring them, and primarily for political reasons, or, as Roubini puts it, “losing political face.” Putin’s ego is a very expensive proposition, indeed.

Roubini’s best point is that by burning through its reserves to prop up the ruble at levels completely inconsistent with the currently low price of oil, Russia is depriving itself of the means to manage the currency at a more realistic level when the real fiscal crunch begins to kick in sometime in 2009.

The incoherence of the Russian policy is becoming more widely acknowledged. One thing I had noted (in a reply to DR in the comments, I think) is that there was a certain dog-chasing-its-tail aspect to Russian policy, with the central bank printing rubles to try to provide liquidity to the domestic economy, and then sopping them up by buying them with dollars and euros. The ruble printing tends to drive the ruble down, so the bank has to sell more dollars to keep up the exchange rate. This can work, after a fashion, if, as Roubini notes, three are effective capital controls that effectively segment the domestic and FX markets, but these controls are not in place. As one Russian economist noted:

Yevgeny Gavrilenkov, economist at Troika Dialog, argues this has accelerated the exodus from the rouble.

“The expectation there will be a devaluation is present and . . delaying this is only making it worse,” he says. “The [central bank] is printing roubles to support liquidity and half of that . . is going to the dollar market. This is a bit absurd.”

Hence, Russia is blowing through its reserves in a thoughtless way that is impeding its adjustment to the new reality of a $40 oil price and depriving itself of the policy flexibility it will need down the road if world economic conditions–and hence the price of oil–continue to be weak well into next year.

All of which just goes to demonstrate the justice of Milov’s rather damning judgment on Russian economic policy and Putin’s crisis management acumen.

Well, the chess thing was something of a flop, but Russia is atop the bribery world!:

Companies from emerging economies such as Russia and China are more likely to pay bribes when doing business in other countries, a survey claims.

Anti-corruption body Transparency International interviewed 2,742 senior business executives to see which firms would pay bribes in foreign countries.

Russia, China, Mexico, India, Brazil and Italy were the worst of the 22 major economies ranked in the survey.

And there’s the cancer death rate too:

A new report from the International Agency for Research on Cancer (IARC) explores the global burden of cancer, which is poised to become the leading cause of death worldwide by 2010.

The report predicts that:

• By 2030, 27 million new cancer cases and 17 million cancer deaths will occur each year worldwide. That compares to 12 million new cancers and slightly less than 8 million cancer deaths in 2007.
• Based on current trends, the rate at which new cancers are diagnosed is expected to grow by 1% annually, as are deaths from the disease.
• China, Russia, and India are projected to have the biggest increases in cancers and cancer deaths.

What a tragedy.   Yet we are to believe that Russia is a future colossus.   Perhaps a little less hubris, a little less imperial ambition, and a little more attention to demographic and public health disasters would be warranted.   Just sayin’.

This is getting confusing.   First, there were reports that Russia would delay its implementation of electricity tariff reform (specifically, increasing rates to reflect economic realities).   This caused considerable anxiety among investors who had committed capital to build badly needed generation in anticipation of the tariff reform.   Second, a few days later, Putin and the government denied that the reform would be delayed.   Third, today’s Bloomberg reports that Putin’s assurances may no longer be operative:

OAO Gazprom, the world’s biggest natural-gas producer, declined the most in a week in London on concern that possible cutbacks in the Russia’s planned electricity price increases will be extended to gas prices.

Russia may scale back electricity price increases to 5 percent next year from an earlier proposed 19 percent increase, Interfax reported late yesterday.

Cuts in gas prices will probably follow so that thermal power generators, which rely on natural gas, won’t lose money in the first half of the year, according to Matvey Taits, utilities analyst at UralSib Financial Corp. in Moscow.

“If they review the tariffs for the generators, then I suppose they also have to revise them for Gazprom, because gas is the primary fuel for electricity generation in Russia,” Taits said by telephone. Concerns over gas prices are “one of the reasons” the shares are under pressure, he said.

Such policy uncertainty is hardly the way to create (I wouldn’t dare say “restore”) confidence among investors about the security of their investments.   It is particularly dangerous for Prime Ministers to weigh in on such issues, provide assurances, and then have these assurances given the lie within days.

I quote from the Book of Duh:

Top executives from four major financial exchanges told federal lawmakers Monday they believe the clearing of certain kinds of credit derivatives should be mandated by law.

. . . .”Clearing should be mandated for most [credit-default swap] instruments,” said Johnathan Short, vice president and general counsel for Atlanta-based ICE.

Terry Duffy of the CME chimed in (this is from Bloomberg–no link yet): “We do believe there should be a mandate for clearing of credit-default swaps.”

Eurex also joined the party, although they were a little more restrained in their remarks, with the exchange’s Thomas Book (whom I participated with in a panel at the SFOA in September) asking only for:

As a consequence, Congress should take into account whether the regulatory enhancements that it is considering will reinforce and be supportive of the migration of (credit-default swap) transactions from the current bilateral structure to regulated and transparent (central counterparties)

Well of course the exchanges want Congress to force clearing onto exchanges because, as Thomas so mellifluously put it:

It should be noted that although the benefits of clearing are significant for the integrity of financial markets, it cannot be assumed that centralized clearing will be automatically and broadly accepted by current (over-the- counter) market participants.

That is, the banks are unlikely to do it voluntarily, so it’s necessary to force them to clear. And if they’re forced to clear, guess who’s just licking their chops to do that business?: ICE, CME, Eurex.   Surely a coincidence.

Which begs the question, often asked here: If it such a great idea, why don’t the banks do it on their own initiative?

[Crickets chirping.]

I’ve beaten this horse so many times that I’m sure PETA is already filing a complaint with local law enforcement, so I’ll try to keep it brief and make my getaway.

One should pay considerable deference to the survivorship principle.   Although path dependence can complicate matters, the survival of a particular institutional arrangement in the face of viable alternatives suggests that it offers efficiency advantages over these alternatives. I have laid out a case as to the likely sources of such an efficiency advantage of bilateral arrangements over central clearing: lower costs associated with asymmetric information.

Only if one can identify some sort of market failure (e.g., a coordination problem) or externality is a mandated change in default risk sharing arrangements justified.   Although there has been a lot of serious talk about “systemic risk” and “financial stability,” there has been no real identification of a concrete externality, or a demonstration that mandated clearing would fix it.     Apropos yesterday’s analysis of the Allen-Gale book, the discussion of clearing has been carried out without reference to any credible theoretical or logical framework.

So, my challenge to the advocates of clearing: What externality that justifies the impostion of clearing?   If the individual firms who would belong to a clearinghouse don’t internalize the externality, why would a clearinghouse?   Why, despite the fact that the concept of clearing is very well known and tested, have wide swaths of the OTC market deliberately eschewed it?   What are the likely equilibrium responses to the imposition of clearing?   How exactly will clearing reduce systemic risk?

The political economy of this is very interesting.   The congressional committee (House Ag) with jurisdiction over the futures markets and the exchanges is pushing legislation to mandate clearing.   (Chairman Peterson has indicated that he hopes to have a bill in January.)   This suggests that this is being driven by politics and the concentrated economic interests of the exchanges, rather than a serious deliberation over the pros and cons.   (Well, “Duh” again.)

I will close with an entertaining quote from a Chicago trader and CME clearinghouse member who understands very well the risks (notably the balance sheet risks) that CDS clearing could pose:

Howard Simons, one of the Chicago traders who always loathed the New York CDS dealers, speaks for many of his comrades in rejecting the trading of CDS on the futures exchanges. “The clearing members of the CME [Chicago Mercantile Exchange] think trading this stuff is the stupidest idea in the world. I didn’t work my whole life so some investment bank can take all our capital. Do I look like Hank Paulson?”

One of the most succinct descriptions of balance sheet risk ever uttered.   Couldn’t have put it better myself.

It is almost axiomatic that financial crises in general, and this financial crisis in particular, represent market failures that require government regulation to correct.   But this conclusion is logically defective for two reasons.   First, as hard as it might be to believe, financial crises can occur in a first-best, or constrained first best equilibrium.   Second, because there is no guarantee that governments that are subject to the same information constraints that likely make financial crises possible, and which suffer other defects in addition, will make things better rather than worse.

These points are made quite well in a book providentially published in 2007, Understanding Financial Crises, by Franklin Allen and Douglas Gale.   (I don’t know Douglas Gale, but I can say that Franklin Allen is not only a great economist, he is one of the true gentlemen of the profession–a truly nice man.)   I imagine the book would be rough sledding for non-economists (but, not as hard as the even more technical papers upon which it is based), but it does lay out in a systematic and persuasive way some relatively straightforward models of financial crises and contagion.

In several of the models, financial crises–such as widespread bank failures–occur even with optimal contracts.   A couple of extended quotes are worth reading:

[W]e want to challenge the conventional wisdom that financial crises are always and everywhere a ‘bad thing.’   It may well be true that financial crises impose substantial costs on the economy . . . . At the same time any regulation of the financial system involves costs.   The most important of these costs are the distortions imposed on the financial system by a regulatory regime that restricts what financial institutions may and may not do.   To measure the costs and benefits of any policy, we need to have a clear understanding of the conditions for efficiency in the financial system, including the conditions for efficient financial crises. (p. 153)

As long as we have complete markets for hedging aggregate risk and intermediaries can use complete contingent risk-sharing contracts, the equilibrium in a laisser-faire economy will be incentive efficient.   If intermediaries are forced by transaction costs to use incomplete contracts, the equilibrium will be constrained efficient.   In either case, it is wrong to suggest that financial crises constitute a source of a market failure.   A central planner subject to the same information constraints or the same transaction costs could not do better than the market. . . . Incomplete contracts . . . distort the choices that an intermediary would otherwise make; relaxing these constraints by defaulting in some states of nature allows the intermediary to provide the depositor with superior risk sharing and/or higher returns.   (pp. 188-189)

To provide a justification for regulation of the financial system, we first need to identify a source of market failure (constrained inefficiency).   Then we need to identify a practical policy that can remedy or at least ameliorate that failure. . . . Our view is that it is not enough merely to show that there exists a welfare-improving policy.   We also need to characterize the policy and show that it can be implemented.   A badly designed intervention could make things worse.     If the welfare-improving policy is too complicated or depends on information that is unlikely to be available to the policymaker, such mistakes are likely.   (p. 191)

[T]he optimal allocation [of resources] can involve financial crises.   So it is not the case that eliminating systemic risk is always optimal.   A careful analysis of the costs and benefits of crises is necessary to understand when intervention is necessary.   This analysis is typically missing from proposals for capital adequacy regulations such as the Basel Accords.   Incomplete financial markets provide one plausible source of market failure and a possible justification for capital regulation. (p. 214)

These quotes just give a flavor of the conclusions, without shedding light on the careful analysis that underlies them.   But the analysis is there.   The models are very bare-bones, and I imagine that some will conclude as a result that the analysis is therefore unrealistic.   But I derive a very different conclusion.   Things are very devilishly complicated in even the simple models, and even in the simple models seemingly “obvious” policies like increased capital requirements or regulations on bank balance sheets can have beneficial or baleful effects depending on the values of parameters that are impossible to measure in practice (e.g., the coefficient of relative risk aversion).   Thus, the models show that in even simple economies “obvious” solutions can have perverse, unintended consequences.   The potential for such policy failures is even greater in the more complex real world.

The chapter on financial regulation (Chapter 7) is particularly provocative and insightful.   Allen and Gale present a model in which markets are incomplete and there are random liquidity shocks.   In such an environment, bank capital can improve risk bearing; bank equity investors can help insure depositors against liquidity shocks.   But bank capital is costly.   Evaluation of the optimal amount of bank capital requires a comparison of the benefits of the cost of equity capital with the benefits of insurance.   This is not a trivial task even in the simple model.   Moreover, the answer is not always that forcing banks to hold more capital than they would under choose to hold absent any regulation improves welfare.   In some cases, forcing banks to hold less capital can increase welfare (p. 200).   The authors’ warning is well warranted:

It is not known how robust these results are when the model specification is altered or generalized, but even if the results turn out to be special they reinforce the lesson that, when general-equilibrium effects are involved, it is very difficult to predict the macroeconomic effect of changes in capital structure across the financial system.   Until we have a general theory to guide us, caution in policy making seems to be advisable.

In the current environment, this discussion of the response to the Great Depression is particularly worth chewing over:

Looking back, there is no sign of formal theory guiding these [Great Depression-era policy] changes.   Everyone seems to have agreed the experienceo f the great Depression was terrible; so terrible that it mut never be allowed to happen again.   According to this mind set, the financial system is fragile, adn the purpose of prudential regulation is to prevent financial crisis at all costs.   Why does the mindset of the 1930’s continue to influence thinking about policy? [Why] does policy making continue to be an empirical exercise, with little attention   to the role of theory?   This empirical procedure is unusual.   Indeed, the area of financial regulation is somewhat unique n the extent to which the empirical developments have so far outstripped theory.   In most areas of economics, when regulation becomes an issue, economists have tried to identify some market failure that justifies the proposed intervention.   Sometimes they have gone further and derived the optimal form of regulation.   This has not been the usual procedure with financial regulation, however.

Re that last comment: if that was true in last year, it is infinitely more true today   There are more proposals to “reform” the banking and financial systems than you can shake a stick at.   Most of these are based on casual empirical observations of “what went wrong” that are, at best, journalistic and impressionistic.   The proposals do not reliably identify what the market failures are, or how proposed regulatory changes would remedy those market failures.   They don’t trace through the likely responses of market participants to the proposed regulations, or the costs and benefits associated with these responses.

I’m not trying to be Panglossian here, suggesting that we are in the best of all (financial) worlds.   But I am suggesting that there is a major outbreak of the nirvana fallacy going on–i.e., there is a naive belief that the market has failed and that government regulation can only make it better.   Both of these beliefs are of a religious variety, and only weakly grounded on rigorous logic or empirical evidence–if they are grounded at all.

Allen and Gale don’t have all the answers–and they admit as much–but they do pose some very provocative questions and challenges.   These questions and challenges are especially apposite today.   Anyone giving the book a fair read should come away with a healthy skepticism of any proposed regulatory fix to prevent the occurrence of the next crisis.     Especially if that fix seems intuitive or obvious.

The nomination of Eric Shinseki to be Secretary of Veteran Affairs has touched off an avalanche of false memories about the retired General’s (supposed) victimization at the hands of Donald Rumsfeld for his temerity in asserting that hundreds of thousands of troops would be required to maintain peace in Iraq post-invasion.   Bush’s and Rumsfeld’s failures to pay heed to Shinseki’s allegedly Cassandra-like (that is, allegedly true, prescient–and ignored) warnings were repeatedly lamented during America’s travails in Iraq in 2005-2006.

Except it ain’t true.   First, Jamie McIntyre of CNN(!):

It’s an appealing narrative, but the facts as we know them are not nearly so complimentary to the retired Army chief.

You see, Shinseki never made any recommendation for more troops for Iraq. In fact, as Army chief of staff, it wasn’t really part of his job to take part in direct war planning.

But as a member of the Joint Chiefs of Staff, he did owe the president his best military advice. And if he felt strongly enough that the advice was not being taken, he could have resigned.

According to senior military officers who were in the pre-war meetings, Shinseki never objected to the war plans, and he didn’t press for any changes.

When the joint chiefs were asked point-blank by then-Chairman Gen. Richard Meyers if they had any concerns about the plans before they went to the president, Shinseki kept silent.

He kept his counsel

But Shinseki was a very private leader who did media briefings only when ordered to and rarely gave interviews. If he had concerns about the Iraq war plans, he kept them to himself.

He admitted as much in a rare e-mail exchange with Newsweek magazine in 2006.

Asked to respond to the criticism that he failed to push to stop Rumsfeld from going into Iraq with too few troops, he told the magazine, “Probably that’s fair. Not my style.”

Knowing his opinions were not particularly welcome, Shinseki kept his mouth shut. In that sense, he was “marginalized,” as some say.

And it’s true that in retrospect, many U.S. commanders believe there should have been more troops sent to Iraq, even though it’s far from clear that would have prevented the insurgency and sectarian violence that the Pentagon failed to anticipate.

But the idea that Shinseki was a strong advocate for a bigger force and that no one listened vastly overstates his role.

It’s one of those Washington myths that are almost impossible to dispel — like the popular misconception that Shinseki was fired for standing up to Rumsfeld.

That myth is so pervasive, the authoritative Associated Press repeated it again Saturday night, saying “Shinseki was removed from [his] post after challenging the Bush administration.”

He did not stand up to Rumsfeld, nor was he fired.

There’s no question that Shinseki was on the outs with his civilian bosses, especially Rumsfeld.

Shinseki ordered that all soldiers wear black berets, a move that infuriated the special forces community, for whom the berets were a badge signifying their elite status. Rumsfeld, according to aides, was particularly miffed that Shinseki spent so much effort changing the Army’s head gear, when the nation was at war.

He retired after serving a full four years as chief at a ceremony in 2003 that neither Rumsfeld nor Wolfowitz attended.

Next, Mack Owens of the Navy War College:

In fact, Shinseki’s February 2003 statement before Congress suggesting that “several hundred thousand” troops might be necessary in postwar Iraq was far from the example of prescience that Bush’s critics have claimed. As my Naval War College colleague John Garofano wrote in an article for the spring 2008 issue of Orbis, “no extensive analysis has surfaced as supporting Shinseki’s figures, which were dragged out of him by Senator Carl Levin only after repeated questioning.”

Shinseki’s claim was based on a “straight-line extrapolation from very different environments” — an analysis by the Army’s Center for Military History that based its figure of 470,000 troops for Iraq on the service’s experience in Bosnia and Kosovo. But as Tom Ricks pointed out in an article for the Washington Post, this effort was criticized as naïve, unrealistic, and “like a war college exercise” rather than serious planning.

The best that can be claimed on Shinseki’s behalf is that he was right for the wrong reasons. His claim that more troops would be needed in Iraq was based on his incorrect assumption that humanitarian operations rather than counterinsurgency would be the main driver of U.S. force requirements.

But misleading claims about Shinseki do not stop there. On Sunday’s Meet the Press, Tom Brokaw identified Shinseki as “the man who lost his job in the Bush administration because he said we [would] need more troops in Iraq than Secretary of Defense Don Rumsfeld thought . . . at that time.” But this oft-made charge is simply false. Service chiefs are appointed for a maximum of two two-year terms. It is true that Rumsfeld named Shinseki’s successor a year before the end of his second term, but Shinseki finished that term before leaving — he served for the entire time permitted by law. Shinseki was never “forced into early retirement.”

The fact that most politicians have accepted the need for a larger Army and Marine Corps seems to vindicate Shinseki’s broader — and correct — warning about the danger of trying to implement a “12 division strategy” with a “10 division army.” But numbers aside, the Army’s experience in Iraq indicate a more serious failing of that service’s leadership — including Gen. Shinseki: a failure of vision.

In a blistering critique of U.S. Army leadership in the April 2007 issue of Armed Forces Journal, Army Lt. Col. Paul Yingling wrote:

For the second time in a generation, the United States faces the prospect of defeat at the hands of an insurgency. In April 1975, the U.S. fled the Republic of Vietnam, abandoning our allies to their fate at the hands of North Vietnamese communists. In 2007, Iraq’s grave and deteriorating condition offers diminishing hope for an American victory and portends risk of an even wider and more destructive regional war.

These debacles are not attributable to individual failures, but rather to a crisis in an entire institution: America’s general officer corps. America’s generals have repeated the mistakes of Vietnam in Iraq. First, throughout the 1990s our generals failed to envision the conditions of future combat and prepare their forces accordingly. Second, America’s generals failed to estimate correctly both the means and the ways necessary to achieve the aims of policy prior to beginning the war in Iraq. Finally, America’s generals did not provide Congress and the public with an accurate assessment of the conflict in Iraq.

The fact is that Gen. Shinseki failed to prepare his service for the kind of war that emerged in Iraq in 2003: an insurgency. The “surge” implemented in 2007 by Gen. David Petraeus was successful not only because of an increase troop strength. It was successful because of the application of a new counterinsurgency doctrine that Gen. Shinseki and most other Army generals had rejected. As Garofano observes, the situation in Iraq “comes down, as it did in Vietnam, to analysis, getting it right, and providing clear alternatives that address or confront policy goals.” In the final instance, this Shinseki failed to do.

In brief: (a) Shinseki’s statement about troop strength was based on an ad hoc, facile analysis; (b) this analysis was based on an assumption that the main challenge facing the US military in the post-kinetic phase of Iraqi freedom would be humanitarian relief, not a vicious insurgency; and (c) Shinseki was, like too many high-ranking officers, unimaginative and unable or unwilling to adapt to the circumstances on the ground.   He was not prescient.   He was not a casualty of Pentagon retribution for speaking truth to power.

Rumsfeld also made mistakes, just different ones.

In the end, the debate over numbers was almost completely a distraction.   As Owens’s article states, the issue was not how many troops were in Iraq, but how they were used.   The   crucial failure of the Army’s leadership (under George W. Casey, now, unbelievably, the Army Chief of Staff) and Rumsfeld was their blindness to the seriousness of the insurgency, and their unwillingness to respond to it aggressively using well-known doctrine and tactics.   Out of fear that a visible American presence would outrage Iraqi sensibilities, Casey and Rumsfeld advocated hunkering down in bases, effectively leaving vast swaths of Iraq in control of the Sunni insurgents.

Using far fewer troops than Shinseki suggested might be needed to pacify Iraq, General Petraeus aggressively and systematically wrested the initiative from Al Qaeda, using local allies to augment the combat power of American and Iraqi regular forces.   In the end, it wasn’t the numbers that were decisive; it was using the number of troops available in an intelligent and aggressive way, rather than ceding the initiative to the enemy.   It is all very, very basic.

The great tragedy is that the country’s civilian and military leadership–Shinseki among them–didn’t recognize the basics, and apply them in a timely way.     This cost us years and thousands of lives, and undermined America’s position and prestige in the region and the world.   It effectvely gutted the Bush administration.   And it cost tens of thousands of Iraqi lives.

Churchill once said that America always does the right thing, after trying everything else first.   Iraq, sadly, is a perfect illustration of Churchill’s mordant remark.   And, although Eric Shinseki has served his country loyally throughout a long career, he should not be lionized for his role in the Iraq war.   He was just one of many who advocated some of the wrong things that were tried before we finally, almost out of desperation, settled on the right thing.

No, not Old Soldiers, but those who soldier in the pits–the futures trading pits.   In a couple of weeks, the Minneapolis Grain Exchange will close its floor.

Less than 15 years ago, electronic trading had made its first inroads into the futures business, but the conventional wisdom was that floor trading was inherently more efficient and would dominate well into the future, with computers being a mere ancillary.   I know that argument well, because I heard it a lot–usually expressed in a very dismissive, go-back-to-academia-you-egghead sort of way.

I heard such derisive remarks because in 1994 I completed a study for the Deutsche Terminborse (now Eurex) that challenged this conventional wisdom.   I documented that electronic markets could be as liquid and deep, and perhaps more liquid and deep, than floor markets.   The responsein the industry, and especially in the US, where the floor trading community was deeply entrenched in the exchange hierarchy, was basically: “Data.   We don’ need no stinkin’ data–we KNOW the floor is more efficient and will live forever.”

Well, in one case, forever lasted about 4 years.   For the industry as a whole, it lasted about 10.

My study compared the electronic DTB and the floor-based LIFFE markets.   The DTB had commissioned the study, and had originally intended to keep it private, for use in their strategic planning.   The exchange was contemplating adding a class of members analogous to locals on floor exchanges in response to the constant refrain that locals were the main source of liquidity in the market.   The results of the study were surprising to the exchange (and admittedly, to me, given my previous exposure to the conventional wisdom), so they decided to release it.

The study received some play in the press, with articles appearing in Risk and the Financial Times.   The FT article quoted LIFFE head David Hodson snorting at my study, saying (in essence) that everybody knows the floor is best so one should just ignore Yank academic scribblings.

In 1998, less than 4 years later, DTB wrested the Bund futures contract from LIFFE, and the British exchange was teetering on the edge of oblivion.   (The DTB used my study as a part of the marketing blitz that resulted in its victory.)   David Hodson was ousted as LIFFE CEO.   (I resisted the temptation to send him a copy of the FT article. )

Soon, the move to electronic trading turned into a flood.   The CME, and especially the CBT, tried to resist, but eventually competitive pressures and customer demand compelled them to adopt computerized trading.   The CBT’s members’ attempts to resist, delay, stymie, and sabotage electronic trading, and their half-hearted moves to create electronic markets, undermined the exchange’s competitive position, and ultimately doomed the exchange to become the acquired, rather than the acquirer.

Why the intellectual resistance?   Well, part of it was self-serving: the floor crowd understood that their time and space advantage would disappear in an electronic environment.   But part of it was rooted in a genuine belief that floor trading WAS better.   This belief, in turn, reflected an all-too-human response to new technology.   The strengths of an incumbent technology are well known.   The existing technology has had time to develop and achieve its potential.   The new technology is often buggy and imperfectly realized; its failings and weaknesses are usually obvious.   Moreover, pragmatic, practically-minded people born and bred in the industry tend to view a new technology through the lens of their own experience.

Viewed through this lens, it was obvious that computerized markets didn’t have many of the valuable attributes of the floor.   They did have other attributes that the floor lacked, but these were all but invisible to most of those who had spent their lives in the business.   In the end, however, these invisible attributes of the new trumped the well-known virtues of the old.

When thinking about this history, it brings to mind parallels, like the dismissive reaction of cavalarymen to the introduction of the tank.   New ideas often appear ludicrous and doomed to failure when evaluated using the old paradigm–but often, they render the old paradigm completely obsolete.   In retrospect, it is easy to see when that has occurred.   The difficult thing is to identify prospectively which innovations will overturn the old ways altogether, rather than just facilitate their evolution–if they don’t flop altogether.   Many revolutions are trumpeted, few actually succeed.   Electronic trading has revolutionized the financial markets, and stories like the above from Minneapolis are reminders of how much things have changed.

Although I was an early advocate of electronic trading, I must confess to some nostalgic regret at the passing of the floor.   There is something romantic, something intensely human, about it.   The floor is fascinating historically, economically, sociologically, and even anthropologically.   But like many romantic, historical things (e.g., dashing cavaliers), it has become obsolete in the face of advancing technology, and will soon be of merely antiquarian interest.

Russia Weakens Ruble Defense After Record Drop in Crude to $39.

Dec. 5 (Bloomberg) — Russia weakened its defense of the ruble for a fourth time in a month, pushing the currency near a three-year low against the dollar, as the price of the nation’s crude oil fell by a record this week to less than $40 a barrel.

The currency slid as much as 1.2 percent to 28.1344 per dollar and dropped 1 percent to 31.5971 against the central bank’s target basket of euros and dollars. “The corridor has been widened,” a Bank Rossii official who declined to be identified said in a phone interview from Moscow today.

As for those of you (ahem) who took solace in the $5 billion rise in reserves last week, this was largely a technical seasonal development driven by tax payment considerations.   The article continues:

“Given oil is already below $40 a barrel we can’t rule out more depreciation,” said Evgeny Gavrilenkov, chief economist at Troika Dialog in Moscow, Russia’s oldest investment bank. “Any further devaluation depends on oil.”

Russia is facing its worst financial crisis since the government defaulted on $40 billion of debt a decade ago, prompting a 71 percent ruble devaluation against the dollar that eroded bank deposits.

Concern about the currency’s decline spurred Russians in October to withdraw 355 billion rubles ($13 billion) from their deposits, the most in two years, according to central bank data. Foreign-currency deposits rose 11 percent.

Putin’s Pledge

“The gradual approach feeds expectations of further devaluation and prompts the population and companies to convert all extra rubles into foreign exchange,” said Tatiana Orlova, an economist in Moscow for ING Groep NV. “This policy will likely lead to further depletion of foreign exchange and gold reserves.”

Those quoted in the article predict a ruble decline of between 15 and 30 percent.

The ruble has actually declined less against the dollar than other commodity currencies, even though Russia’s main export has declined in price more than, say, Brazilian soybeans.   This suggests that a big decline is coming.   And the consensus is increasingly that Russia is throwing good money after bad by attempting to slow this process:

Russia is wasting its cash reserves by propping up the ruble as lower oil prices drive away investors from commodity-led economies, according to Brown Brothers Harriman & Co.

“The pressure on the ruble will remain and Russia shouldn’t try to resist it by depleting its reserves,” said Win Thin, a currency strategist at Brown Brothers Harriman in New York. “Oil producers are really struggling in terms of trade shock.”

The CHART OF THE DAY shows that the 16 percent slide in the ruble is yet to match the decline in the currencies of commodity exporters including Australia and Mexico, which have fallen 33 percent and 24 percent versus the dollar since July.

Urals crude, Russia’s main export blend of oil, has slumped 68 percent since July to $43 a barrel, below the $70 average needed to balance the country’s budget next year. Russia has spent $148 billion or a quarter of its international reserves since August to defend the ruble.

Of the other “commodity currencies”, the Brazilian real slid 33 percent against the dollar, the New Zealand dollar dropped 30 percent, the Chilean peso 21 percent and the South African rand fell 23 percent.

Deferring the day of reckoning will only make the ultimate consequences all the worse.

A few posts ago I suggested that the Bruce Springsteen song “Glory Days” was quite apropos to Russia.   Today, another Springsteen song seems appropriate: “I’m Goin’ Down.”     What’s goin’ down, again, is the price of oil.

As I write, Brent on ICE is down $3.30–or 7.8 percent.   Cash settled WTI on ICE is down $3.33, or 7.6 percent.

A couple of weeks back, Michel asked when the price of Urals Med would fall below $40/bbl.   Since it was selling at $41.75 yesterday, I imagine that today is the day.

So . . . any guesses as to when we hit $30?