Streetwise Professor

March 23, 2009

We Were Awaiting Judgment Day, But Tiny Tim Delivered Groundhog Day

Filed under: Economics,Politics — The Professor @ 4:33 pm

NB: I have slightly augmented this post, with some additional amplification of how the “plan” will provide the least support to the most troubled banks, and generate the least price discovery for the most troubled assets.

The Treasury has released, at long last, additional details of its plan to address toxic assets.   (I refuse to use Treasury’s Orwellian Newspeak “Legacy Assets.”   That sounds like a funeral home advertising slogan.)   I say “additional details” rather than “final plan” quite deliberately.   As I will note below, there are still many parts to-be-colored-in-later.

My overall assessment is very different from the stock market’s initial appraisal.   Mine is negative, the market’s positive.   We’ll see.   I only remark that the market gave its hearty approval to TARP I too, and we know how that worked out.

I’ll divide my analysis into two parts: an evaluation of the big picture, and some comments on the details.

With respect to the big picture, in my view the Treasury approach does not respond to the major problem facing the banks.   It nibbles at the edges, and throws a lot of money at the problem in a very indiscriminate way.   This raises the serious risk that (a) the plan will fail, and (b) when it does, the resources to address the real problem will not be forthcoming for economic and political reasons.

The main problem with the banking system is that many banks, including some of the biggest, are quite likely insolvent.   Maybe, on a consolidated basis, the entire banking system is insolvent.   Addressing this problem requires two basic steps: (1) identify the insolvent institutions, (2) restructure the insolvent institutions, by stripping out bad assets and recapitalizing, both with public funds to cover any deposit insurance obligations, and with private funds.  

The Treasury plan will not do either of these things directly, and are unlikely to accomplish them even in a roundabout, indirect way.   The likely outcome is that some assets will change hands, but that the worst ones, and the ones held by the worst banks won’t.   As a result, considerable uncertainty about what banks are solvent and which are not will remain. Moreover, insolvent and near-insolvent banks will continue to operate, leading to serious incentive problems that can exacerbate the problems down the road.  

In a nutshell, the Treasury plan offers equity and debt financing to private investors who will purchase assets from financial institutions.   An important factor to note is that the current owners of these assets will have full discretion over what assets they sell, and the prices they accept.  

Geithner justifies his plan by saying:  

The Public-Private Investment Program will purchase real-estate related loans from banks and securities from the broader markets. Banks will have the ability to sell pools of loans to dedicated funds, and investors will compete to have the ability to participate in those funds and take advantage of the financing provided by the government.

But banks already have the ability to sell, and private investors already have the ability to buy.   They haven’t done so.   What Treasury adds to the mix is generous funding via equity investments, and more importantly, non-recourse loans.   Its hope is that this funding will lead to more voluntary transactions for toxic assets.

I seriously doubt this will occur to the extent necessary because the Treasury plan seems to overlook entirely the major reason WHY banks with bad assets on their balance sheets have been very reluctant to sell.   Namely, that many of these banks are insolvent, or borderline solvent.   What’s more, they know they are insolvent, or teetering on the edge.   They further know that the absence of active markets for these securities and loans gives them substantial discretion regarding how to value these assets for accounting purposes, and by assigning optimistic valuations they can maintain the illusion of solvency and continue to operate under current management.  

Selling assets at market prices that reflect private investors’ realistic appraisals of value would result in serious writedowns to bank assets, reducing their capital, and raising the likelihood that their insolvency would become readily apparent, leading to government seizure/receivership, and the consequent wiping out of shareholders, some debtholders, and management.  

Bank managers, equity holders, and even some creditors of insolvent institutions realize that there is considerable option value to remaining in operation while insolvent.   Things could turn around, and the bank could get lucky and escape insolvency.   Moreover, its management has an incentive to take additional risk in order to gamble its way out of insolvency.   Management, the shareholders, and even some debtholders realize that the downside of this strategy is small, because the government and some debtholders will take the hit if the gambles turn out bad.   (The government will pay off on deposit insurance, and may be forced to bail out too-big-to-fail firms.)   On the upside, managers have the ability to keep their jobs longer, and if their gambles succeed, may keep them indefinitely.   Similarly, shareholders of insolvent institutions, protected by limited liability, are in a heads I win, tails I don’t lose any more situation.

So, what is likely to happen is that the really bad assets will stay on bank balance sheets. Some of the better assets will be sold.   Zombie banks will continue to exist.   Uncertainty and asymmetric information about the solvency of individual banks will persist, as the banks will still be stuck with large amounts of bad assets.   This will continue to impede interbank lending and the recapitalization of banks.   Moreover, the bad incentive effects of allowing insolvent or borderline solvent banks will continue, leading to substantial dissipation of value.

In other words, this plan is only a slight improvement on the status quo.   It does not strike at the heart of the problem: the facts that (a) there are many banks, including some very large ones, that are insolvent, and (b) that nobody knows exactly which ones are insolvent or by how much.

Additional material begins:

Since the worst-off banks are least likely to participate in the program, they will receive the least amount of cash from the sales of bad assets.  Moreover, since the assets that are currently most misvalued on bank books (which are likely the worst assets) are least likely to be sold under the program, it will contribute least to price discovery for this class of assets.  

Both of these outcomes strike me as perverse.  The least amount of cash flows to the banks that need it most, and the assets that are most imprecisely valued will be the least likely to benefit from improved liquidity and price discovery.  We would like the Treasury (i.e., taxpayer) dollars to go to the banks that need it most, not least.  Especially, as if these banks continue to operate in their zombie state they are likely to wind up on FDIC’s or Treasury’s doorstep somewhere down the line.  Where will the money needed to satisfy government obligations be then?  Well, it might have already flowed to other institutions whose need for it was not as great.  We would like to get better pricing information about the worst of the assets.  We won’t.  This will make it all the more difficult to evaluate the solvency of the banks holding these assets.

In other words, it seems that this plan fights the wrong battle in the wrong war at the wrong time.  Other than that, it’s great.

End additional material.

What is needed here is a kind of Judgment Day for banks.   This is most effectively accomplished through a compulsory stripping of bad assets from banks, either through some variant of the good bank/bad bank approach, or my Humpty Dumpty option.     Once the bad assets are out, it will be easier to identify which banks should live, and which should die.   I favor Humpty Dumpty because the equity claim on the entire pool of bad assets that this approach creates is likely to be more easily valued than the individual bad assets.   It also shares the valuation risks more efficiently among the banking system, and limits taxpayer exposure to valuation errors.  

The Treasury plan defers Judgment Day.    It gives us Groundhog Day instead.  We will continue to repeat, day after day, the experience of living with a banking system of doubtful solvency.

The problem is that every day we wake up to Sonny and Cher, the existing problems of weakened interbank markets and difficulties of banks in attracting capital will fester, and indeed, due to the perverse incentives that zombie bank managements and shareholders face, new problems and risks will appear.  

We’ve seen the effects of delaying Judgment Day before.   The government refused to grasp the nettle when many S&Ls began to run into trouble in the mid-1980s.   It devised many ingenious ways (e.g., regulatory capital, accounting fixes) that allowed insolvent institutions to survive to gamble another day.   (Proposals to permit banks to rely on historical cost accounting today would be similarly stupid.)   Then, due to Garn-St. Germain, Congress gave the S&Ls the ability to take even greater risks, which they did with gusto to gamble their way out of trouble—only to dig their holes deeper, and force the taxpayers to fill them in.   In a few short years a serious but tractable problem metastasized into a hugely expensive one.   (Fortunately, we haven’t seen a repeat of the Garn-St. Germain fiasco this time around, but banks have enough freedom to take on additional risks without any new, “liberating”, “deregulatory” legislation.)

It should also be noted that the Treasury plan in essence gives the worst banks the worst incentives.  The banks with the worst assets, and the banks that are in the worst financial position, have the weakest incentive to take part in the program. Anything that leads to more accurate valuations of their balance sheets increases the odds they have of going from Zombie to Dead.   Managers of zombies figure that that state is preferable to death, and what’s more, that while there is no coming back from death, one can get lucky and escape zombiehood.   Indeed, one can take risks on the government’s dime, which if they pay off, will permit the return to a normal, non-zombie life.    And if they don’t–well, that’s somebody else’s (the taxpayers’) problem.

This scathing assessment obviously raises the question: Why would Treasury do such a thing?   I have no definitive answer to that question, but I would note that banks have no doubt fought Judgment Day tooth and nail.   That is, a political economy perspective suggests that Treasury may well have been captured by the banks. Treasury may also have considerable room to doubt whether Congress would support Judgment Day either, because of a lethal combination of aforementioned bank opposition and likely populist outrage.

So, to sum up the SWP take on the big picture: high likelihood of disaster.   By deferring Judgment Day, Treasury is at best perpetuating, and arguably exacerbating the most important problem confronting the banking system.  

Now a few comments on the details, such as they are.  

In brief, this plan, despite months of preparation, is still not ready for (sub)primetime.  

It is not, in other words, a completed plan.   Many holes still exist.   The document released by the Treasury states that the “Legacy [read Toxic] Loans Program will be subject to notice and comment rulemaking.”   In other words, this is not ready to go.   There will be a time consuming, and perhaps contentious, period of public comment.   With respect to the Legacy [Toxic] Securities Program, the Treasury says: “Haricuts will be determined at a later date [!] . . . .Lending rates, minimum loan sizes, and loan durations have not yet been determined. [!!!!]   These and other terms of the program will be informed by [!] discussions with market participants. [What have they been doing for the past weeks/months?]”  

If haircuts (i.e., the amount of leverage), loan size, rates, and maturities have not been determined, pray tell what has?  

At best, the plan warrants a grade of “I” for incomplete.   As a result, it will take months to get off the ground.

Moreover, the program does not touch one of the most important categories of toxic assets: CDOs, CDO squared, etc.   The Legacy [Toxic] Securities Program is limited to residential mortgage backed securities, commercial mortgage backed, and asset backed securities (ABS).   CDOs, etc., are collateralized by ABS, so they would not be eligible.   Thus, a good slug of the bad assets in the system will inevitably stay on bank balance sheets.  

In sum, in my view, based on both the big picture and the details, this plan is a failure on its own very modest terms: “to restart markets for troubled assets, begin the process of repairing balance sheets, and eventually lead to increased lending.”   The worst banks and the worst troubled assets will avoid the program like the plague.  

Sad to say, addressing the fundamental problem of the banking system—insolvency and near insolvency of major banks—will require compulsion of some sort.   This compulsion could come through existing legal processes, notably bankruptcy.   It could come through new forms of government compulsion, such as Humpty Dumpty or the compulsory formation of bad banks.

I am not, as you would know if you read this blog regularly, in favor of government compulsion.   But, in many respects the problems we face are the direct consequence of government policies, notably deposit insurance and the implicit guarantee to large financial institutions through the too-big-to-fail doctrine.   Given these conditions, purely voluntary approaches create serious incentive problems that only exacerbate the perverse effects of these policies.     Given the guarantees (explicit and implicit) baked into the cake, market participants (namely, bank managers, shareholders, and debtholders) will not hold Judgment Day on their own.   It must be forced on them; Groundhog Day works just fine for them, as there is at least a chance that some day they will wake up renewed.   The Treasury plan fails to attack the solvency question, and hence will only defer the inevitable result.   In the interim, unfortunately, things are unlikely to get much better, and may get considerably worse.  


March 22, 2009

Check Your Credibility at Security

Filed under: Economics,Politics — The Professor @ 8:52 pm

Christina Romer’s appearance on Fox News Sunday provided a graphic illustration of how academic economists must sacrifice their credibility, not to say their integrity, when they take high-profile policy positions in a presidential administration.  Romer made several statements that she cannot possibly believe.  She tap-danced on many other issues.  All in all, a very sad performance.

Issue 1–The growth assumptions in the Obama budget.  Romer originally said:  

When you get out five, 10 years, they’re [the Congressional Budget Office] assuming that real GDP is only going to grow about 2.2 or 2.3 percent a year, and that’s just lower than private forecasters. It’s lower than the Federal Reserve. And we think it’s just too pessimistic.

So I think a big part of why they’re getting such different numbers are just some of these technical issues.

When Chris Wallace pointed out that the Blue Chip private forecasts actually had lower 10 year average growth numbers than the CBO, she spun:

Yeah, but they — they actually — something like the Blue Chip has very negative numbers for the next year or two, but then when you get back to normal, when you get back to normal growth, they’re up there at 2.6 or 2.7, whereas the CBO only comes back to, say, 2.2.

This line of questioning arose because the CBO’s growth projections implied that the Obama deficit projections were wildly optimistic, both over the short term and long term.  Thus, Wallace’s comparison is a fair one.  The issue isn’t with the growth rate 10 years out.  It is with growth rates over the next 5-10 years.  

And those “very negative numbers for the next year or two” are not a minor issue, as Romer suggests.  They are very important.  The talk-out-of-both-sides-of-our-mouths Obama administration (a) talks about the worst economy since the Depression when attempting to panic people into supporting stimulus and everything else, but (b) in making deficit projections, assumes that the decline in 2009 GDP will be modest, on the order of -1.2 percent if memory serves.  But if the Blue Chip guys are right, or if CBO is right, and the recession is much more severe in 2009, Obama’s projection of a trillion dollar plus deficit will be laughably low.  And if the average growth rate over the next 10 years is a half-point lower than the administration projects, due to the miracles of compounding, the cumulative deficit will be far larger than the administration predicts.  

In brief, Romer’s defense of the administration numbers was extremely weak, and arguably dishonest.  On the one hand, she compared unfavorably the CBO numbers to private forecasters.  When called on the real numbers, she attempted to obfuscate matters by focusing on the projections 10 years out, when (a) the near term private and CBO projections are far more pessimistic than the administration’s, and (b) the average 10 year projections are also far more pessimistic, both of which imply (c) that the administration’s budget numbers are wildly optimistic.  

I would also note that it is extremely optimistic indeed to believe that large tax increases, the adoption of cap and trade, and other administration initiatives will not seriously retard growth.  Thus, I wouldn’t be surprised if the CBO and Blue Chip numbers are optimistic.

Issue 2–Romer stumbled badly when Wallace pointed out the inconsistency between the positions she is advocating now, and her academic research.  Her academic research casts serious doubts on the efficacy of fiscal policy.  She now argues that it was all just a timing thing, that Congress always implemented fiscal stimulus too late in earlier recessions, but that this time the administration and Congress enacted stimulus at just the right time.  That is a very dubious proposition.

Issue 3–The Fed’s “Shock and Awe.”  This is the biggie, and speaks to Issue 2 as well.  Here’s the exchange:

While everyone was focused on AIG, it went almost unnoticed that the Federal Reserve is pumping another $1 trillion into the financial system.

Do you have any worries as an economist that pumping all of that money into the system is going to drive the value of the dollar down and lead down the line to inflation?

ROMER: No. Actually, I have to say I — I think starting back with Paul Volcker in the early 1980s, the Federal Reserve has shown itself completely capable of keeping inflation under control. And I have every confidence that they will continue to do that.

I think what we’re seeing coming out of the Fed is the same thing we’re seeing coming out of our administration and the Congress, of a sense that we have a big problem and we need to take bold actions to deal with them. We’ve done that on the fiscal side, and the Fed has done that on the monetary side.

What you don’t see in the black-and-white of the transcript is how vigorously and quickly Romer said “No!”  Now, any economist who claims not to have concerns about the potential inflationary impact of the Fed’s printing of money in unprecedented quantities is either clueless, or lying.  Even those who support the Fed’s action will usually express some qualms, and say things along the lines of yes, this can be inflationary, but I worry more about depression now than inflation tomorrow.  

Romer also fails to mention the costs of “keeping inflation under control.”  The costs, that is, of the Volcker policy of the early 1980s.  The cost of that policy was a severe recession.  A recession that the current one has yet to surpass in intensity (though it well might.)  Those costs were incurred, moreover, only after years of inflation had inflicted so much damage on the economy that Volcker (and Reagan, who supported him) believed that the pain of a severe recession was smaller than the pain of continuing, chronic inflation.  

The inflation resulting from the massive injections of cash into the system in recent months could well make the late-70s early-80s inflation look like child’s play.  Consequently, the costs of fighting it could make the 1982-83 recession look similarly benign by comparison.  Moreover, even if the Fed acts prior to inflation heating up to withdraw massive amounts of liquidity from the economy, that could well abort any recovery, and spark another recession.  After all, if the injection of huge reserves is expansionary, would not the withdrawal of such reserves be contractionary?  Is there likely to be some asymmetry between the effects of expanding massively and contracting massively the money supply?  None is immediately obvious.  Perhaps particularly adept navigation by the Fed would allow the economy to sail between the Scylla of massive inflation and the  Charybdis of continued (or renewed) depression. But the probability of a less than wily Odysseus-like performance is very high.  Indeed, the worst of both worlds–stagflation–is a very plausible outcome.  

This pessimism is particularly warranted when one considers that in the 90s and 2000s the Fed was operating in a relatively benign policy environment, and under political pressures still made very unwise judgments that contributed materially to our current circumstances.  To avoid the possibility of even a mild recession, the Fed fed credit and real estate bubbles, the popping of which devastated the economy.  The likelihood that the Fed will shrink from taking actions that risk a severe recession in the immediate aftermath of a depression is very high.  

In brief, Romer’s “don’t worry, be happy” attitude about the Fed’s unprecedented actions is very disturbing.  It is either deeply dishonest, or reflects a lack of serious thought about the daunting dangers that the economy must avoid in the coming months and years.  

I wish, moreover, that Wallace had asked a follow up question.  (This is not a criticism of Wallace–he did a very good job.)  That is to question her about the inconsistency between the meaning of the Fed’s actions, and her sunny optimism about the effects of fiscal policy, and the economy’s prospects in a year’s time.  The question would be: “If your belief that the stimulus and the Obama budget will be sufficient to make the economy healthy in a year’s time is correct, why did the Fed feel compelled to take historically unprecedented actions to spur the economy?”  The Fed’s action is clearly an expression of hair-on-fire alarm that gives the lie to the administration’s belief in the efficacy of its policies.  This action is a huge vote of no confidence.

To add a somewhat snarky aside, the fact that Romer’s interview was delivered in a tone more befitting Miss Nancy Claster from Romper Room talking about Do Bees was extremely annoying.

One last remark, relating to the difference between Freshwater and Saltwater economists (Romer being one of the latter, both as a PhD student and as a professor).  Very few (I can’t think of any) Chicago economists have taken major policy jobs in any administration, Republican or Democrat.  (Goolsbee is an exception, but he’s not Old School Chicago.  I’m referring mainly to the Giants Who Once Roamed Hyde Park.)  In contrast, there has been a steady stream of Harvard and Berkeley types (and those from other Briny institutions) going to DC.  

Why is that?  One reason, no doubt, is the skepticism most U of C people have (had) about government.  But another is that the Knights and Friedmans and Stiglers and Beckers were far more interested in fierce, uncompromising intellectual inquiry than sitting at the foot of power.  I think too that they understood that for the most part, academic economists in any administration are primarily there for show, and have little real influence.  As a result of these factors, they were unwilling to sacrifice their intellectual independence–or their integrity–and fall for the Siren’s song of political influence.  (Another Odyssey reference!–just stream of consciousness, I swear.)  

One story that I remember vividly brings this to life.  After George Stigler won the Nobel Prize in 1982 (I was taking a class from him that quarter), he was invited to the Reagan White House for a press conference.  The Reagan people probably figured that Stigler was a conservative guy, and he would say nice things about the economy, the administration, etc.  Boy, were they wrong.  When Stigler was asked about whether the economy was in a severe recession, he said something along the lines that no, he thought it was in a depression.  The look of panic on the Reagan people in the room was palpable.  They just about got a hook to pull Stigler off-stage like a bad Vaudeville act.  But that was Stigler.  And that was Chicago.  Take no prisoners, tell it like it is.

Another story.  I did some expert work on the same case as a quintessential Harvard guy, the late Hendrik Houtthaker.  (A very nice man.)  I was having dinner with him one time, and he remarked about how civilized seminars were at Harvard, and how brutal they were at Chicago.  True, that.  You have to jock it up and get ready for combat to give a seminar at Chicago.  In the 80s, the Economics of Legal Organization seminar would have Posner, Becker, Telser, Stigler and Peltzman in the front row.  If the speaker was able to complete two sentences without getting set upon by one, two, or the lot of them, it was a miracle.  I think Lester Telser would say “That’s the dumbest thing I ever heard”–every week’-)  (You know I love you, Les.)  Stigler would ostentatiously read the Wall Street Journal during the seminar when he thought the paper a bad one.  

That’s not DC style, folks.  I think Posner said once, when asked about his prospects for the Supreme Court, something to the effect that his work was not understandable to the Congressional intellect.  That’s true, too.  

This all speaks to the fierce independence and just plain cussedness (and arguably arrogance) of Old School Chicago School that made it and its leaders particularly unsuited to be house economists in DC.  For as Christina Romer demonstrated today, to be an economist with a public profile in any administration, it’s not whether you are saltwater or freshwater that matters.  It’s that you are ready, willing, and able to go onto national television and drink bilgewater, and then tell the world it tastes like fine wine.

March 21, 2009

I Keep Pressin’ This Damn Button, But Nothin’ Happens

Filed under: Military,Politics,Russia — The Professor @ 8:40 pm

Another reset button malfunction (H/T R):

Two Russian planes flew within 500 feet of U.S. Navy ships participating in military drills with  South  Korea, military officials said.

After trying unsuccessfully to contact the pilots, U.S. fighter jets met up with the Russian planes and flew with them until they left the area, CNN reported.

One incident occurred Monday, when Russian Ilyushin IL-38 maritime patrol aircraft flew over the aircraft carrier USS  John C. Stennis  while it was in international waters in the Sea of Japan. The Russian aircraft flew within 500 feet of the carrier, which was lower than other Russian flyovers in the past year, military officials said.

On Tuesday, two Russian long-range bombers overflew the Stennis and the USS Blue Ridge several times at about 2,000 feet, U.S. military officials told CNN.

Military officials said U.S. aircraft tried contacting the Russian planes on  international  air  frequency radio channels on both days but the Russian pilots didn’t respond.

Now, there is nothing illegal per se about the overflights.  However, they are–and were during the Cold War–in your face provocations.  Sort of the military equivalent of trash talking.  They send a signal, and the signal ain’t Kumbaya.  This, and other Russian statements and actions in recent days, indicate that reciprocity to Obama’s earnest efforts is not the order of the day.  The Russian idea of “reset” is to get the US to concede its predominance in the former Soviet space, and to stick it to the US wherever and whenever possible.

But don’t worry!  Surely another earnest gesture to an even more implacable foe, Iran, in the form of a Happy Persian New Year! message is enough to overcome thirty plus years of hostility.  (Thirty years marked by kidnappings, hostage taking, support for terrorism, terrorist acts, nostalgia for the Holocaust and an expressed desire to finish the job, and most recently, direct support for attacks on US troops in Iraq.)

Uhm, no:

 Iran‘s supreme leader, Ayatollah  Ali Khamenei, rebuffed  President Obama‘s latest outreach, saying Tehran was still waiting to see concrete changes in American foreign policy.

Ayatollah Khamenei, who holds the ultimate responsibility for Iranian policy decisions, was responding Saturday to a video message Mr. Obama released Friday in which he reached out to Iran on Nowruz, the Persian New Year, and expressed hopes for an improvement in nearly 30 years of strained relations.

In his most direct public assessment of Mr. Obama and prospects for better ties, Ayatollah Khamenei said there could be no change between the countries unless the Obama administration put an end to hostility toward Iran and brings “real changes” in foreign policy.

“They chant the slogan of change but no change is seen in practice,” Ayatollah Khamenei said in a speech before a crowd of tens of thousands in the northeastern holy city of Mashhad.

Still, he left the door open to better ties with America, saying “should you change, our behavior will change, too.”

Like the Russians’, the Iranians’ idea of reset is all take, no give.  And since Obama and a good chunk of the American foreign policy establishment see rejection of offers as an invitation to offer even more, this is a very wise bargaining position.

In the rougher precincts of the world, the earnest are scorned as easy marks.  This is especially true when it is readily seen that an eagerness to bargain is motivated by a weird combination of a need to be liked, and a self-indulgent tendency to assume the blame for breakdowns in relations.

Even Jimmy Carter eventually wised up (for a while, anyways).  Why does Obama need to re-learn the same lessons?  And perhaps more importantly, will he?

March 20, 2009


Filed under: Economics,Politics — The Professor @ 8:30 pm

Some follow up on yesterday’s post, which was written in haste at the airport (with me pushing the “Publish” button while walking down the jetway).  

The Fed’s plan to increase its balance sheet by a third through the purchase of $300 billion in long term Treasuries and $700 billion in other assets is highly significant, not the least because it betrays a lack of confidence in the political branches’ ability to craft a reasonable policy to address the banking crisis, and associated economic woes.  Go figure.  Where could they possibly get that idea?  

Whatever remained of hopes that Treasury and Congress could craft and implement something workable died with the AIG fiasco.  Not the bonuses themselves, mind you, but the demagogic response to what should be at most a symbolic issue.  Congress’s willingness to take extraordinary measures to punish the parties to contracts it dislikes will make virtually impossible the passage and successful implementation of any restructuring plan, or any plan to deal with toxic assets.  Banks will fight any legislation.  If and when legislation passes, or Treasury implements some plan under existing authority, financial institutions will be extremely reluctant to participate.  (Note that banks are already looking for ways to escape TARP.)  Absent credible commitments to honor contracts, the legal risks facing any participant in a program to buy toxic assets, for example, would be extreme.  Take a risk, make a big profit–expect to be excoriated for greed and taking advantage of the taxpayers, and to face substantial risk of expropriation of these gains.  

Theoretically ironclad legal language would provide little protection, for Congress has shown that it is more than willing to use the power to tax as a policy neutron bomb that leaves the formal contract standing, but which kills the contract’s economic benefits. (Indeed, this neutron bomb can destroy the effects of already enacted legislation while leaving the bill intact, pace the Dodd provision in the “Stimulus” bill.)  And that is only one weapon at their disposal.  With Nancy “nobody can hide behind a contract” Pelosi and her legion of Congressional Orks in control, credible commitments to honor the terms and conditions of any rescue plans, or toxic asset purchase plans, are impossible.  Without credible commitments, few will invest capital in anything involving parallel government contributions.  

This fiasco contributes mightily to the already oppressive atmosphere of fear, uncertainty, and doubt that hangs over the economy.  Consumers are not spending (note savings rates have reached levels not seen in recent years); businesses are not investing; banks and individuals are hoarding cash (money supply is way up, but velocity is way down–meaning that money demand is way up.)  All of these are reasonable behaviors in the face of massive uncertainty.  What military pilots call “the pucker factor” is clearly evident, and quite rational.  

Real options theory shows quite clearly that as uncertainty increases, it is economically rational to delay making irreversible investments and spending decisions.  The current policy chaos and hyper-ambitious plans are creating intense uncertainty.  Unprecedented spending plans with unprecedented deficits unimaginable even months ago.  The prospect for such deficits also raises the possibility of massive tax hikes: income taxes; new “environmental” taxes (e.g., cap & trade plus auctioning of credits); inflation taxes; taxes that haven’t even been thought of yet.  Thus, there is incredible uncertainty about how any income arising from current investments (in physical, financial, or human capital) will be taxed; so why not wait to invest until that uncertainty is resolved?  Radical proposals to revamp the largest single sector of the economy.  Untested environmental policies (cap & trade again) with substantial implementation risks (a subject of a future post) and highly uncertain costs.  The list is unending.  

And the failure to deal in a credible way with the uncertainty in the financial sector only contributes to the problem.  

What’s more, banana republic governance that undermines the security and reliability of contracts adds another entirely unnecessary, self-inflicted source of uncertainty.  To add insult to injury, it undermines the very means by which economic actors attempt to manage uncertainty.  (As would the various proposals to limit sharply the trading of risks through the imposition of more onerous financial market regulations.  Great combination.  Create risk, and simultaneously compromise the effectiveness of the economic tools and markets needed to manage it and share it efficiently.)  

What we need is a more sober, stable, Zen approach to the current situation.  A calm and orderly approach, not a pressured, frenetic one.  (I note too that the pressure to act Now! Now! Now! has been the hallmark of hucksters from time immemorial.)  One lacking in demagoguery, not marinated in it.  One that takes first things first–namely, addressing the financial sector–and leaves other things for later.  

But, suffice it to say, we ain’t gonna get it.  

Hence my pessimism, and my predictions for stagflation.  Uncertainty, plus a massive increase in government spending (almost certainly largely unproductive), necessarily entailing a substantial increase in the tax burden, plus far greater government control over far more extensive reaches of the economy is a recipe for stagnation.  Massive injections of liquidity cannot overcome the severe drag resulting from a crippled and likely insolvent banking sector; government spending on unproductive, unvalued things; rising taxes; and inefficient regulation.  All such injections will achieve is to spark inflation, resulting in a stagflation that is likely to make the 70s an idyll by comparison.  

Have a great weekend!

March 19, 2009

Vlad, Mahmoud & Hugo Heart Ben

Filed under: Economics,Energy,Politics — The Professor @ 7:26 pm

Commodities have rallied strongly on the Fed’s surprise move to quantitative easing (“QE”) on steroids.  Gold and oil in particular have moved up substantially.

This is a big favor to commodity producers, and Russia in particular.  This will materially aid these countries, and help them address their severe economic challenges.

As to whether it’s good news for us in the US, color me skeptical.  Very skeptical.  This, to me, seems to be a recipe for stagflation, if not immediately, then in the near to medium term.

A couple of quick thoughts.

First, to me it suggests that the Fed is deeply concerned about the prospects for the economy, and the banking system.  This action was extreme, and unexpected.  I doubt the Fed would have acted in this fashion if it was confident that the economy was beginning to turn around.

Relatedly, it is very plausible that the Fed’s action reflects its view on the political situation, and in particular the efficacy of fiscal policy and the likelihood of a sane plan to fix the banking system.  In brief, it is a very big thumbs down on both.  That is probably a very astute judgment.  To say that Congress is a clown show is a deep insult to clowns.  The administration, and Treasury in particular, have so buggered the banking issue that it is unlikely that anything constructive will come out of its fire drill.  Indeed, the AIG fallout, and the colossal mishandling of that situation have so politicized the banking policy response that it will be a miracle just short of the Resurrection if anything positive develops on that front.

And Congress has made things infinitely worse.  Nancy Pelosi (please, has there ever been anybody dumber in a position of power?) today remarked that nobody would “be able to hide behind contracts.”  Great.  That’s sure to make anybody thinking of getting involved in TALF or TARP or any successor programs designed to attract private capital into the banking sector or the purchase of toxic assets to think once, twice, thrice–and then say “No thanks.”  These people are traders.  They are not going to enter into a position short a legislative put with Nancy and Obama and other demagogues in charge.

Second, the long term consequence of this are troubling, hence my stagflation forecast.  With a sober, constructive policy response to the banking process, and the normal equilibrating process of the economy, it is likely that later this year or next the economy would make solid improvement.  With a dysfunctional banking system, and huge/immense/gargantuan policy risks, I think that recovery is problematic.  But the injection of huge quantities of money will ultimately prove inflationary.

Moreover, it is extremely difficult to wring inflationary expectations from the economy once they become entrenched.  It basically took the entire decade of the 1980s–and a recession nearly as severe as the present one–to do that.   Moreover, there is considerable room for skepticism that a future Fed will have the political will to do this again.

Therefore, I think that there is a high probability that the coming decade will be one of low growth in output, and high growth in prices.  That’s why I’m buying more TIPS.

March 18, 2009

Bills of Attainder, AIG Edition

Filed under: Derivatives,Economics,Politics — The Professor @ 8:45 pm

In Britain, a Bill of Attainder was a private bill in Parliament which imposed a punishment on a specific person, or group of people, without any trial.  Their abuse was so notorious, that they were specifically proscribed in the US Constitution.

Perhaps there are legal nuances that distinguish the many of the legislative and administrative proposals being bandied about to strip AIG employees of bonuses (some already paid) from Bills of Attainder, but there is plenty of family resemblance.

I say again.  There are legal provisions under which contracts can be modified (e.g., bankruptcy). If they apply here, then by all means proceed.  Unlike the attainder-like proposals ricocheting around Capitol Hill, these mechanisms embed various procedural protections, require rigorous fact-finding, and can draw upon a variety of precedents.  All of these reduce the likelihood of legal error.  If these do not apply, then let’s speak no more about it.

And by all means, every one of the Capitol Hillbillies that has been running his or her mouth on the subject should STFU.  As should pretty much everybody in the administration.  The grandstands are closed.

One sentiment (I won’t dignify it with the words “thought” or “idea”) that I’ve heard is that since the government now owns AIG, it can do whatever the hell it wants.  Uhm, no.  A firm is a nexus of contracts, and if you acquire it, you acquire the entire bundle.  Not just the contracts you feel like living up to.

But the ownership issue does raise a set of questions relating to the bailout, and the “logic” behind it.

The story of the bailout in a nutshell goes: AIG did massive trades without having to post any collateral, due to its sterling credit rating.  (Given the UK’s current condition, that phrase may be obsolete.)  However, the mark-to-market losses on its derivatives and securities lending business became so large that the company’s credit rating was cut to below investment grade, triggering huge collateral calls.  The mark-to-market hole was so deep firm couldn’t make these calls, and fearing a meltdown, the Treasury stepped in.  The bulk of the cash it supplied the firm went to meet collateral calls to various counterparties.

Now, if these counterparties viewed the government-owned AIG as being backed by the full faith and credit of the US government, there would be no need to post collateral.  The fact that government cash went out the door to meet AIG’s collateral requirements means either (a) counterparties don’t view AIG’s credit as good as the Federal government’s, or (b) the AIG bailout is really a disguised lending program for the counterparties, or (c) the government is clueless.

Now, insofar as (a) is concerned, there is good reason to believe that even in government hands that AIG’s credit is bad, and it poses a substantial risk of default.  After all, the government has a limited liability equity stake.  It can still walk away.  Given that fact, perhaps the counterparties are operating under the motto “In God We Trust.  All Others (including Uncle Sam) must pay cash.”  Presumably, the howling over the bonuses only encourages those now holding AIG collateral to think that keeping their hands on that cash is a far better alternative than to rely on the hope that the government will come through when the contracts at issue actually must payoff.  (Whether it should is another issue.)

This illustrates one of the absurdities in keeping AIG in its current Living Dead state.  If the government really intends to guarantee that AIG’s obligations will be paid off (in order to avoid a systemic crisis) then it can do so without having any cash go out the door as collateral to ease the fears of jittery counterparties.  The government could provide an explicit guarantee of the contracts in question.  It could novate the trades, and substitute itself for AIG as the counterparty.  (Or perhaps the Fed could do this.)

Now, from a mark-to-market perspective, either would be a wash.  The liability is worth what it is worth.  But they would not require the government to pony up tens of billions in cash to provide to counterparties.  Just like AIG’s counterparties effectively extended credit to the firm by allowing it to hold underwater positions without collateral, the government should be able to do the same thing.

Indeed, if Treasury and the Fed really believe what they’ve been saying since the crisis broke in the late summer, the mark-to-market loss on the position is far greater than the present value of the loss that the AIG portfolio is expected to suffer.  After all, Bernanke and others have argued that the market prices of these positions are artificially depressed as a result of the lack of liquidity, and the potential for fire sale liquidations of troubled assets.  So, according to this logic, if Treasury (or the Fed) took these positions onto its books, the eventual cost to the taxpayers would be expected to be smaller than the current mark-to-market loss–and hence smaller than the amount of government cash paid to counterparties as collateral.  (Of course, if this is right, then eventually some of that collateral will be paid back as liquidity improves and market prices rebound as a result.  But, since the government doesn’t own 100 percent of AIG, it will only capture a fraction–80 percent, if memory serves–of that rebound.   But note that this means that the government could potentially face the risk that the counterparties would not pay back the collateral.   Which raises another question: is this truly collateral, held in a particular account, not commingled with the counterparty’s funds?)

This all raises questions in my mind as to why the government is persisting with this indirect way of absorbing the risk on the AIG positions.  If the powers that be consider it essential that the government absorb this risk because (a) AIG cannot, and (b) doing so is necessary to maintain the stability of the financial system, then why do it in a way that (c) requires a lot of cash, and (d) incurs the agency costs and other frictions that arise when working through a firm with incentives that are not necessarily well-aligned with those of the taxpayers.

Thus, I hold open the possibility that there is an ulterior motive for the convoluted structure of this intervention.  The difference between the intervention as it is, and the alternatives I’ve sketched above, is that the existing structure puts a lot of cash in the hands of large financial institutions, whereas the alternatives would not.  It effectively monetizes the mark-to-market values of the positions these institutions had with AIG.  This suggests that the reason for doing it this way is that it effectively extends credit to these institutions.

But, this just kicks the can down the road.  If these institutions need injections of government credit, why not do it in a more straightforward, transparent manner?  Or is this indirection part of the plan, an effort to conceal the liquidity needs of these institutions?

I dunno for sure.  What I am pretty sure of is that the “collateral” narrative does not make a lot of sense.


Filed under: Uncategorized — The Professor @ 10:09 am

Diminishing resources, and the prospect that the country’s serious economic straits will linger for far longer than originally thought are forcing Russia into making hard choices over how to spend its reserve funds.  The choices are quite interesting.  

First, what is getting whacked.  At the top of the list:  infrastructure:

[T]he finance ministry released a list of cutbacks for this year’s regional budgets.

The list called for spending on road repairs, building maintenance and other basics to be slashed 50-100 percent in 21 regions, including Moscow and several oil-producing areas such as Tyumen.

. . . .

Badly needed repairs to Russia’s transport systems are meanwhile being shelved indefinitely, transport officials said at an industry conference.

‘The economic situation that has unfolded has forced us to correct many of our development plans,’ Nedosekov said.

Russia’s rail network is more than 50 percent depreciated and most of its fleet of trains and wagons have already passed their theoretical maximum age, according to a recent report by investment bank Renaissance Capital.

Before the crisis, 2.5 trillion roubles ($71.78 billion) per year was slated for transport infrastructure development over the next 20 years, Nedosekov said.

‘Now we are spending 10 times less than that,’ he said.

Rail freight shipments fell 26 percent to 27 percent in the first half of March compared with the same period of 2008 and will fall by a fifth for the year, Nedosekov said.

This trend is cutting deeply into the revenues of transport companies such as state monopoly Russian Railways, which was supposed to fund much of its own development.

The government does not have enough money to compensate for the contraction because its spending on anti-crisis measures is already pushing it toward a budget deficit of around 8 percent.

Private investors, who who were expected to pay for about half of Russia’s infrastructural renewal over the next decade, have fled the sector, leaving only two public-private partnerships in effect out of dozens that had been planned.

This includes the construction of a 43-kilometre stretch of highway between Moscow and  St. Petersburg, the two biggest cities, which have no high-speed road between them.

‘But that doesn’t come to much. There are not 43 kilometres there, but 700. What about the rest of it?’ said Sergei Shishkaryov, head of the transport committee of the lower house of parliament, the State Duma.

Government worker wages are also getting cut:

Workers paid out of the budgets of eight regions face wage cuts of 10 percent to 30 percent, the document posted on the ministry’s website said.

What is getting money?  There is $43 billion going to support social services and “anti-crisis measures.”  That’s a lot of money, and represents on the order of 20 percent of Russia’s rainy day fund.  

But of more interest is the fact that the  military will get a big chunk of money:

Russia said it would re-arm its military and boost its nuclear forces in response to the expansion of Nato to its western frontiers and the increased threat of international terrorism.

Dmitry Medvedev, Russian president, said on Tuesday: “The main task is to qualitatively improve the combat readiness of our forces, above all our strategic nuclear forces.”

Bloomberg has more:

A “large-scale rearming” of the army and navy will begin in 2011, Medvedev said today in  comments  broadcast on state television. “Significant funds are earmarked for the development and purchase” of weapons and spending won’t be curtailed as Russia enters its first recession in a decade, he said.

Defense Minister  Anatoly Serdyukov  said at a meeting of ministry officials that “the likelihood of armed conflicts and their potential danger for our state is growing.” He didn’t elaborate.

Medvedev said last month that the government will maintain spending on armaments procurement and housing for military personnel as it trims spending in the 2009 budget. He has called for a sweeping overhaul of the military since a five-day war with Georgia in August, including an upgrade of the country’s nuclear deterrent and the renewed production of aircraft carriers, as Russia seeks to restore its military power.

Medvedev and Serdyukov also raised the NATO bogeyman to justify the military expenditures in the face of a severe economic contraction.  

These choices are quite interesting, and reveal a great deal.  The focus on military expenditure, justified by risible alarms at security threats to Russia, is of particular interest.  

The decision to cut infrastructure spending, and to splurge on the military brings to mind Gogol’s observation “In  Russia  there are two big problems:  bad roads  and a lot of fools,” or Custine’s excoriation of the country’s byways.  Russia’s long term prospects depend, in part, on improving its wretched, largely Soviet-era infrastructure, both road and rail.  It was inevitable that the crisis would force the country to curtail its ambitious (not to say unrealistic) plans in this area, but the decision to essentially zero out this expenditure points out the increasing recognition that the crisis is likely to be long and deep.  When you face starvation, eating the seed corn is a hard, but necessary choice.  But this points out that the economic crisis will have very long-lasting effects on Russia, and postpone indefinitely its ambitions to develop a modern economy.  The already ramshackle will only degrade further.

But why choose a ramshackle military over ramshackle roads?  Ah, that is the interesting question.  Part of this is the intense desire to restore great power status.  But that’s not all of it.  The concentration on social expenditures betrays a concern about popular unrest; the preservation of military spending betrays an even deeper concern about military unrest.  And it is the latter that truly troubles Putin and his minions.  

An important harbinger of the problem occurred recently:

After last week’s demonstration by members of the much-decorated 67th Spetsnaz Brigade in Berdsk against the Russian defense ministry’s plans to disband that unit, the chief of the Russian general staff said over the weekend that Moscow in fact had no such intention and that the 67th’s officers would be given posts in the Siberian Military District.

Army General Nikolay Makarov’s declaration was clearly intended to mollify the officers of the unit. He said that they represent “the elite of our forces, the gold fund as it were, and that no one has any plans to do away with their priceless military experience, which was acquired in the most extreme circumstances” (

But because it appears that his words apply only to the officers and not to the professional soldiers in these units and because Makarov said that the officers will serve in a single new unit consisting of officers and men from the second spetsnaz brigade which now exists there, it is possible that this announcement may not have the effect the general was hoping for.

On the one hand, his comment may not reassure at least some officers and many of the men in the 67th – as well as their families and those living in Berdsk who rely on both – that they have a collective future and can rely on this latest version of what Moscow and its officials say they intend.  
And on the other, Makarov’s decision to make this statement is certain to encourage some within the 67th and quite possibly other officers and men affected by military downsizing plans to protest as well. After all, by going into the streets, the 67th and its supporters have won what may be a reprieve if not a victory.

The possibility that there will be more such protests within the military is further increased by the rising number of protests in the civilian population. Over the course of the last week, there were marches in Moscow and a number of other cities. And yesterday, there were especially large protest meetings in Vladivostok and St. Petersburg.

This is a big deal. Spetsnaz are the Russian special forces. (They are not exactly equivalent to the Green Berets, or the Seals. They are more like the Army Rangers.) They are controlled by Military Intelligence (GRU). Spetsnaz are the kind of troops the government would rely on to deal with very messy situations. If they are unreliable, or are dissatisfied with the government, they would pose a very serious threat. Very serious. This is not a group of grumbling conscripts with nondescript leadership, bad morale, bad training, and bad transport. These are the elite. The government cannot afford to have outfits like these disgruntled.

It is particularly interesting that the government has limited its concessions to the officers.  These are the most educated and politically aware.  They also share many interconnections throughout the country, and are a self-identified elite.  Therefore, they incur lower costs to coordinate action among themselves.  The officers present the greatest danger, and by focusing concessions on them alone the government economizes on the cost of buying off the malcontents.

Interestingly,  the demonstration cost the head of the GRU his job:

The head of the GRU, Russia’s military intelligence service, was reported to have resigned yesterday after special forces soldiers under his command took part in an anti-government demonstration earlier this month.

General Valentin Korabelnikov was absent from a meeting of top defence officials yesterday when Dmitry Medvedev, president, spoke about military reforms.

The unrest in the military runs deep.  The proposed reforms are extremely unpopular with the uniformed military–many of whom will be on the streets if the reforms are actually implemented.  The FT has more:

The head of Russia’s military intelligence service, the GRU, was reported in the Russian press to have resigned on Tuesday after special forces soldiers under his command took part in an anti-government demonstration earlier this month.

General Valentin Korabelnikov was absent from a meeting of top defence officials on Tuesday when Dmitry Medvedev, Russian president, spoke about military reforms. The reforms, announced last year, would slash the officer corps by half in a bid to create a more agile force.

“The main task is to qualitatively improve the combat readiness of our forces, above all our strategic nuclear forces,” Mr Medvedev said, adding that Nato was continuing to expand closer to Russia’s borders.

A ministry representative told Interfax news agency that Gen Korabelnikov was “on vacation” and declined to comment on reports that he had resigned.

On March 9, covert operation specialists from one of the GRU brigades due to be demobilised as part of the reforms took part in a demonstration in Novosibirsk demanding the resignation of Anatoly Serdiukov, defence minister.

“They didn’t participate as soldiers, but some of them were there as individuals” said Alexei Rusakov, a deputy in the Berdsk city council, who helped organise the demonstration.

The GRU protest and Gen Korabelnikov’s absence on Tuesday underline the depth of resentment over the reforms. Opposition to the cuts is adding to a climate of instability in Russia, which is reeling from the economic crisis.

Russia’s military has been historically cautious about getting involved in politics.

Public anti-government protests, while still small, are becoming more common as unemployment and wage arrears rise.

On Monday a message posted on the defence ministry website assured members of the 67th GRU brigade that they would be given different jobs in the armed forces. “The officers of the 67th brigade are the elite of our military, our ‘golden foundation’ and no one has the intention of rejecting their priceless military service,” it said.

The reforms were first broached in October, following Russia’s victorious war against Georgia, which nonetheless exposed the lack of modern equipment and a top-heavy military bureaucracy.

The war also caused tension between the army and the Kremlin, according to retired officers, who said the generals were unhappy with the political decision to end the conflict before Georgia was completely defeated.

Lev Ponomarev, a human rights organiser in Moscow and opposition figure, said the government was committing a grave error by proceeding with the military reforms in a climate of unrest. “The reform of the army was planned before the crisis, and maybe it was a rational thing to do then. But now, in this environment, to dissolve two brigades of GRU, who are specialists in secret warfare, I can’t think of anything stupider.”

I can’t think of anything stupider, either, Lev.  That’s the kind of thing that will get your insurer to yank your whole life policy.  

So, how to tamp down the unrest?  Well, first, stop doing stoopid stuff.  Second, shower shiny new toys (or the promises thereof) and some apartments on the military.

Moreover, even though the government is reducing support to oligarchs, it is continuing its support forailing defense manufacturing firms  (H/T Penny):

The fortunes of the Russian defense industrial sector at present make AIG and Bank of America look like the financial picture of health. The Russian industrial conglomerate umbrella company, Rostekhnologia (ROT) that has monopoly control over the entirety of the nation’s defense industry is headed by Sergei Chemezov. He is also a life-long–and perhaps the number one–FOV (Friend of Vladimir Putin) in the Russian government, the two having first befriended one another when they served together in the former East German Democratic Republic (GDR) as KGB officers during the waning days of the Cold War.

Chemzov recently announced that 30 percent of Russia’s defense industry is on the verge of bankruptcy and that of the 70 per cent remaining only half of those may be categorised as “stable.” Those that are in danger of becoming insolvent include more than half of the enterprises in Russia that produce ammunition and explosives.

When ROT was officially formed last year–taking control of a total of 426 firms in one fell swoop–Chemezov looked like the all-time world champion of corporate raiders. Moreover, 118 of these firms had no connection to the defense sector, but were merely large, moneymaking enterprises that were ripe for the picking. “T. Boone Pickens, eat your heart out,” seemed to be the theme of the day for Russia’s number one FOV.

However, some seven months later, accumulating all of these industries into one basket does not seem like the smartest move any more. The 340 out of the 426 ROT-controlled firms that are defense suppliers currently owe 25 billion roubles (US $17.5 billion) of debt. In the aftermath of the global economic downturn, not only have Russian banks closed their doors to lending to these defense enterprises, but those banks that have remained open to lending have raised interest rates to 12 to 13 percent. These interest levels have caused ROT to open negotiations with western banks, although no one from the Russian arms export monopoly has been willing to reveal which banks they are actually in contact with.

“Credit is the most painful topic,” said Chemezov. “With such high [Russian banking] interest rates, we are simply unable to develop industry.” The current policies of western banks, however, are not encouraging due to their recently declared unwillingness to make additional loans to the east–even to those former Warsaw Pact nations that are now members of the EU.

. . . .

Back home in Moscow and one day after Chemezov’s announcement of the impending financial meltdown in the defense sector, the Russian government announced loans of $56 billion to provide some relief to these defense firms. Additionally, and following the example of the U.S. government’s bailout scheme, it was announced that the Kremlin would increase its control in RSK-MiG and other major arms producers by buying more shares in these enterprises. Whether these bridge loans will be enough to sustain these firms during the current economic crisis remains a large question, given that there are no solid prospects for major export or domestic orders in the near future.

Despite these handouts from the Russian state, there are still plenty of reasons to believe the Cypriot deputy defense minister was spot on in his assessment. First of all, explained a Moscow colleague, “the record to date of money being loaned by the state central budget to defense industry is not a happy one. Examples of some of all of this money being diverted into peoples’ pockets are well-known, so it is questionable if even half of this $56 billion will end up where it is supposed to.”

“Additionally, it is impossible to deny that some parts of Russian industry are no longer capable of producing a full-up weapon system and never will be able to again. Sooner or later Russia will end up importing weapons–instead of making them as they have done for decades. It is already easier all the time to import foreign components that are incorporated into Russian weapon platforms for the simple reason that there are no longer any Russian analogues to these components in production. Moving from this situation to importing whole, final-production weapon systems to Russia is not such a small step anymore.

When Chemezov created ROT and acquired control of almost every Russian industrial enterprise worth owning he looked as though his corporate behemoth had also acquired that “too big to fail” label that we are hearing so much about in the United States during the current world financial meltdown. But, just wishing does not make it so. No one can undo the almost 20 years of neglect and zero investment that Russian industry has suffered. No matter how much is done now failure in the defense sector seems about the only option and drinking the night away in Abu Dhabi instead of tending to business is only going to accelerate that decline.

The comment about the potential ulterior motive for this support–to keep the goodies flowing to the connected–is particularly apposite in this instance.

So, the bottom line: damn the future, save the regime today.  The primary threats to the regime are popular unrest and the military, and especially, as Goble notes, a synergistic combination of the two.  So, axe capital expenditures on everything but the military, pay off the  babushkas, keep the military happy, and keep disgruntled oligarchs in line by proceeding full speed ahead with the Khodorkovsky/Lebedev prosecution despite its lack of merits.  (Indeed, the lack of merits may be a very deliberate feature intended to emphasize the awesome and arbitrary powers of the state to destroy anyone it chooses.)  

In brief, the government is going into survival mode, and using a combination of sticks and a diminishing supply of carrots to pacify the most direct threats.  Thus, Priority One is self-preservation.  

Will it be enough?  Maybe.  Maybe not.  Shrinking financial resources sharply constrain Putin’s options.  A coalition of peeved oligarchs and military types could pose a serious threat.  Throw in regional governors sensing distraction and weakness at the center and problems could become acute.

As I’ve noted before, the main advantage of a central government is the difficulty potential opponents face in trying to coordinate their actions.  Playing divide and conquer through threats and bribes impedes coordination as well.  But, the fuel for a conflagration is there.  A spark–which could come from anywhere–is all that is needed to set it off.  A major confrontation or failure somewhere could be sufficient to overcome the coordination problems for a critical mass of individuals and lead to a serious challenge to the regime.  And if that happens, there can be a rapid shift of equilibria from uncoordinated passivity to unified opposition.  

That’s what Putin fears most.  His spending priorities demonstrate that quite clearly.  

March 16, 2009

Selective Intervention

Filed under: Derivatives,Economics,Politics — The Professor @ 11:28 pm

Oliver Williamson, the premier transactions cost economist, coined many neologisms and succinct phrases.  One of them is “selective intervention.”  This concept means that managers cannot credibly commit to utilize discretion to intervene only when this is economically efficient.  The inability to commit to use discretion efficiently is, in Williamson’s view, one of the factors that limits the size of firms.  It is also why imposing ex ante constraints on decision makers can enhance efficiency even though these constraints are costly ex post.  It is, in brief, why rules are frequently superior to discretion.  

The outrage over the AIG bonuses provides a particularly acute illustration of the dilemmas that arise with selective intervention.  (The UK has screened a similar soap opera in recent weeks, involving the pension of RBS’s Sir Fred Goodwin.)  Assume arguendo (a common Williamsonian trope) that revoking the AIG bonuses is an efficient use of government discretion.  Can any financial institution, or any business for that matter, be assured that if it accepts government assistance, that the government will use its discretion to intervene to change contracts or alter management decisions only when efficient?  Or, would it be more reasonable for said institution or said business to conclude that policymakers acting according to political, rather than economic, calculus, will frequently abuse their discretion, and implement politically popular but inefficient decisions?  

Given the sums at stake in the ongoing financial crisis, the selective abrogation of contracts, no matter how outrageous they appear ex post, is likely to result in costs that dwarf the hundreds of millions in bonuses due to the employees of AIG Financial Group.  In particular, it would likely lead to a dramatic increase in the difficulty of negotiating workouts or recapitalization or restructuring of other troubled financial institutions.  Delays in such measures could have immense real costs.  Costs, by the way, that would fall on everyone, as taxpayers but also just as economic agents (due to the adverse effects on the overall economy).  Moreover, the uncertainty associated with the use of discretion can impair private decision making and investment.  (Why make an irreversible investment when a subsequent exercise of government discretion could lead to its effective expropriation?)  This again imposes substantial costs across the entire economy.  

Under these circumstances, there is a strong case to be made for relying on rule-based, rather than discretionary, responses to the distress of large financial institutions.  If the government, as the residual claimaint of AIG, has a legitimate legal justification for eliminating or reducing the AIG bonus payouts, there are established legal rules and procedures for achieving that outcome.  And no, this doesn’t mean Spitzer-like granstanding and armtwisting by Andy Cuomo.  It means a methodical pursuit of redress through real courts, not through the court of public opinion.  

It also means that there should be a strong preference for existing, rule-based mechanisms, such as FDIC receivership and bankruptcy procedures.  

This episode provides a very illuminating illustration of the costs associated with the ad hoc (read, discretionary)  way in which the government has addressed the financial crisis.  At its very outset, there was some justification for this, as there was room for serious doubt that existing rule-based institutions were capable of dealing with unprecedented crises in real time.  But 6 months have passed since Lehman and AIG, 9 or so since Fannie and Freddie, 12 since Bear.  The new administration has been in place for 3, and its senior financial policy team since the election.  Given these experiences, and the time that has lapsed, we should be far further along in creating a legal and regulatory structure for addressing large, troubled financial institutions.  Instead, we seem to be pretty much where we were a year ago.  

To the extent possible, this should cleave to existing precedents in bankruptcy law, and in FDIC procedures and regulations.  These things are messy, no doubt.  (Having been involved in several bankruptcy cases as an expert, I have first hand experience with this.)  But they are messy in a somewhat predictable way, and in a way that limits the potential for abuse of discretion.

At cynical moments (and I have many, if you haven’t noticed;-) I wonder if this is a feature, not a bug, at least from the perspective of those in government.  To them, discretion is a good, not a bad.   Sovereigns always bridle at the restrictions of law, precedent, and procedure, even though these often lead to substantial increases in wealth and efficiency.    

The bonus fiasco also shows the problematic rationale for the entire AIG bailout.  It is clear that the Treasury and Fed felt compelled to support AIG, rather than let it implode, in order to protect its counterparties, who happened to be large, systemically important financial institutions (e.g., Goldman).  But supporting these institutions indirectly, by funneling money through AIG, rather than in a more direct way, has created a huge agency problem.  AIG has become, in effect, the government’s agent in maintaining the solvency of other large financial institutions.  But AIG and its managers have their own agendas, and their interests and incentives are not well aligned with those of the other large financial institutions, or with the taxpayers who are ultimately on the hook in this arrangement.  Using AIG as a conduit for taxpayer financial support to other institutions has added substantial friction to the process.

It would be far more efficient to take AIG out of the middle of this process of channeling billions from taxpayers to financial institutions.  This would require novating AIG’s trades.  Maybe the government should become the counterparty.  Or, it could novate the deals to other institutions and provide credit support.  Or it could negotiate closeouts, perhaps requiring the in-the-money counterparties to take a haircut.  All of these alternatives pose challenges, but it is almost certain that these challenges entail lower costs than the agency costs incurred using AIG as a conduit to keep its counteparties whole.  In other words, cut out the middleman.

A constant theme of my Russian commentary is that the absence of a rule of law; the insecurity of contractual and property rights; and the abuse of discretion by a state only weakly bound by procedural checks and balances; have all contributed to that nation’s economic dysfunction.  No doubt one can make an argument that this or that Russian state intervention was efficient, but there is no doubt that the vast scope of state discretion has been detrimental to Russian economic development.  Similarly, a strong argument can be made that the AIG bonuses are unconscionable, and inefficient in light of current information.  But as in Russia, the cost of weakening the rule of law in general, and contract rights in particular, will far exceed the benefits of a legally dubious discretionary intervention.  

As in many situations, we face a choice of evils.  Given the essential role of the rule of law in binding Leviathan, in my mind the far greater evil is an erosion of the security of property and contract rights.  We don’t want a nation where government officials can threaten to send corporate executive to the doctor for having the temerity to do something that offends the Sovereign.  Several hundred million dollars is a lot of money.  But it pales in comparison to the amount that would be lost by undermining contracts and the rule of law.

Reset This!

Filed under: Military,Politics,Russia — The Professor @ 7:07 pm

The Russian military has expressed its interest in basing strategic bombers in Cuba and Venezuela.  

A top Russian military official has confirmed that the Kremlin is thinking of parking some of its strategic bombers in Cuba or Venezuela, within easy range of the continental United States.

That’s just one of several options currently under discussion in Moscow that, if carried out, would see Russia’s armed forces take up positions around the world on a scale unseen since the cold war ended almost two decades ago.

Venezuelan President Hugo “Chavez has proposed to us a whole island with an airfield that we can use for temporary basing of strategic bombers,” Maj. Gen. Anatoly Zhikharev, chief of Russia’s strategic aviation forces, told journalists on Saturday.

“There are four or five airfields in Cuba with 4,000-meter-long runways, which absolutely suit us,” he added. “If the two chiefs of state display such a political will, we are ready to fly there.”

For his part, wacky Hugo Chavez at first embraced the Russian presence, but is now claiming that he offered no bases to the Russians, just the temporary use of them if the Russians have a “strategic need”:

 President Hugo Chavez said Sunday that Russian bombers would be welcome in Venezuela, but the socialist leader denied that his country would offer Moscow its territory for a military base.

Chavez — a fierce critic of Washington with close ties to Russia and Cuba — said his government did not raise the possibility, as Russian media had reported.

“It’s not like that,” the president said, responding to a report by Interfax news agency quoting the chief of staff of Russia’s long range aviation, Maj. Gen. Anatoly Zhikharev, as saying some strategic bombers could be based on an island offered by Venezuela.

Zhikharev reportedly said Saturday that Chavez had offered “a whole island with an airdrome, which we can use as a temporary base for strategic bombers.”

Speaking during his weekly television and radio program, Chavez said he told Russian President Dmitry Medvedev that his nation’s bombers would be allowed to land in Venezuela if necessary, but no such plans have been made.

Venezuela hosted two Russian Tu-160 bombers in September for training flights and joined Russian warships two months later for naval exercises in the Caribbean.

“I told President Medvedev that any time Russia’s strategic aviation needs to make a stop in Venezuela as part of its strategic plans, Venezuela is available,” he said.

Interfax also reported that Zhikharev said Russian bombers could be based in communist-led Cuba, but a Kremlin official said Zhikharev had been speaking hypothetically.

To me, this sounds like typical Russian posing: the military equivalent of vaporware.  It is intended to send a message: “Here’s what we could do if you force us to.”  A bargaining chip to be used in negotiations over NATO expansion, missile defense in Poland and the Czech Republic, and strategic arms talks.  

Two comments.

First, the Obama administration would be well advised to forego trading anything in exchange for promises regarding a Russian strategic air presence in the Caribbean.  Whereas missile bases, and strategic weapons (warheads, delivery systems, etc.) require long lead times and the expenditure of considerable political capital, bombers are eminently redeployable on rapid notice.  This means that a decision to give up a missile defense base, or warheads or delivery systems, is only reversible at very high cost, whereas a promise not to utilize Venezuelan or Cuban bases for Russian strategic bombers is reversible almost immediately and at effectively zero cost.  That is, there is a tremendous asymmetry between terminating a missile base, or a delivery system, and promising to end the deployment of bombers to the Caribbean.  Given this asymmetry, only a fool would trade the former for the latter.

Second, on matters of tone, this threat, delivered so close in time to Biden’s reset button speech, Hillary’s embarrassing follow up on that, and NATO’s decision to re-engage, indicates that Russia is perfectly willing to reset–on its terms.  Like Medvedev’s Iskander threat speech on the day of Obama’s inauguration, this suggests that Russia is in no mood to engage in mutual gestures of accommodation.  It will gladly take whatever Obama or NATO or Merkel proffer, and then push for more, and use threats to get it.  

How many cheeks does Obama have to turn?  You can be assured that every gesture will be met by escalating demands.  

So Obama, Hillary, and Joe: don’t bother.  It takes two to bargain in good faith.  All of your earnest desires to reach an accommodation with Putin and Russia will fail.  Such efforts will fail because (a) Russian ambitions to regain great power status require continuing proofs of its dominance, which come primarily through confrontations with the US, and US concessions, and (b) in the present economic crisis, tension with the US is very useful in Russian domestic politics.

Lucy Sechin

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 5:03 pm

OPEC had another meeting over the weekend, and Igor Sechin reprised his role as Lucy with the football.  Sechin repeated his fulsome praise of OPEC, and his expressions of Russia’s undying support for the cartel’s actions.  As long as, you know, like, Russia doesn’t actually have to cut output or anything:

Hounded by a pack of journalists on his arrival, Russian deputy prime minister Igor Sechin led a parade of government officials to OPEC’s latest shindig in Vienna. He proposed a slew of things for Russia and OPEC ministers to work on together, such as coordinating (i.e., raising) taxes on foreign oil firms’ crude production and refining operations.

But Sechin, at his third OPEC meeting in six months, again signally failed to promise any big commitments to keep barrels out of the global crude market even as OPEC members said they’d push on with shoring up compliance with their own output cuts.

That’s obviously good news for consumers as Russia, the world’s top oil producer, and OPEC pump almost half the crude used daily globally. Any formal and disciplined coordination between the two could easily spell higher oil prices.

Mr. Sechin claimed Russia cut production and exports in recent months but most OPEC officials weren’t buying it. Exasperated, they say independent data show Russia boosted exports by almost 700,000 barrels a day the past six months, even as OPEC members shaved their own production.

But Russia is still flirting with OPEC and may yet consummate a more formal relationship with the group. For its part, OPEC is still open to the courtship. Mr. Sechin said Sunday that Russia wants, among other things, a “permanent representative” stationed at the OPEC secretariat.

Mr. Sechin said that doesn’t mean Russian OPEC membership but a deeper and wider exchange of data, information, and ideas.

“Flirting.”  Interesting choice of words.  “Exchange of data, information, and ideas.”  In other words, you let us in on your information flow, and we’ll use that to optimize our decisions.  

Sechin claims that Russia will stimulate domestic consumption, as part of a strategy to curb exports:

Russia will cut oil exports and increase domestic oil consumption in a bid to stabilize world oil prices amid the ongoing financial crisis, Deputy Prime Minister Igor Sechin said on Sunday.

“We will be cutting oil exports through the expansion of domestic consumption. In particular, we plan to transfer 2 million tons of fuel to agricultural producers and also increase oil refining inside the country,” Sechin said.

And pray tell how will the government expand domestic consumption in an economy that is continuing to hemorrhage, especially in its energy intensive manufacturing and transport sectors?  And, the best way to divert oil from export to the domestic market would be, as I’ve said numerous times before, to raise substantially export duties.  But those have just been cut again.  And insofar as domestic oil refining is concerned, it has long been a Russian policy objective to encourage Russian refining of domestically produced oil.  Indeed, the duty structure was designed in part to encourage the export of value added refined products in place of crude.  And note that Russia also just cut its duty on refined products too.  Exporting refined products puts as much downward pressure on international prices as exports of crude.

In other words, pay no attention to Sechin as long as his lips are moving.  And never take your eyes off of his hands.    

OPEC seems to be catching on, at long last:

OPEC officials have said privately that Russia — which sees itself as a leader on the world stage — is unlikely to give up its energy independence by joining OPEC. In an apparent allusion to Russia, el Badri on Monday urged “the larger producers” outside OPEC not “to take advantage” while his organization tries to manage crude supply and demand.

Russia “take advantage” of OPEC?  Go on!  Or should that be “что Ñ‚Ñ‹!”?  

Sechin did make one revealing comment.  He suggested greater use of long term contracts in the oil market.  These contracts could be effective in facilitating a division of the market.  They also play into the traditional divide-and-rule strategy.

Sechin framed his proposal as a means of taming those eeeevvvviiiiilllll oil speculators:

The price that the producers would charge under these long-term contracts would take into account the rising costs of lifting and delivering crude, ensuring future investment, he said.  

A system of such contracts would not allow financial institutions to “unreasonably rock the boat,” Sechin said.  

It is clear, however, that as always, Russia sees benefits in reducing transparency and flexibility as means of exerting market power.  In other words, Sechin (and Russia) would like to remake the oil market into something similar to the gas market.  

This is something to be avoided if at all possible.  The nat gas market–especially the LNG sector–is evolving to support more spot trade.  The “gas OPEC” Russia has proposed can be seen as a method to throttle spot trading in gas, and to keep the market relying on opaque, long term contracting relationships that subject the buyers especially to holdup, and reduced competition at times of contract renegotiation (because supplies from other sources are locked in via long term contracts, leaving the original buyer and original seller in a small-numbers bargaining situation.)  Russia’s ability to exploit a fragmented buyers side of the market in such circumstances is well known.  The last thing we need is the oil market to adopt the same dysfunctional structure.  I hope that policy makers in consuming nations are alive to this possibility, and will fight it tooth and nail.  Experience (especially in the European gas market) suggests, however, that my hopes may be in vain.

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