Streetwise Professor

“How come Obama finds it so easy to apologize for the United States for just about everything, but finds it impossible to apologize for his own words or actions?”

“Calibrate my words.”  Fie.

Pressure is at near record lows in that vortex of stupidity, Washington, DC.  Noted financial wizard Maxine Waters proposes to ban credit default swaps. Financial prude Colin Peterson doesn’t want to go that far–he just wants to ban naked ones.  The Senate holds hearings on puzzling developments in the wheat market, and instead of making inquiries regarding the true mysteries, continues its monomaniacal campaign against the least likely culprit, passive index funds.  Regulators testify in front of Congress, and offer pearls like this:

“Regulators would be able to see (the clearinghouses) and rigorously oversee them,” Gensler said. “I believe over time you might see a consolidation and a concentration in this, but initially the statute would allow for more than one.”

Gary, there you go, making me break out the Ginsu again.*

Yeah, maybe the statute would allow for more than one, but it is well known that there are strong scale and scope economies in clearing.  (I’ve written on this before, and if you don’t believe me, take a look at Darrell Duffie’s paper on the subject.)  It is almost certainly most efficient to have only one clearinghouse that clears pretty much everything.  Having multiple clearinghouses in fact undermines the main benefits of clearing.  Moreover, due to these very same scale and scope economies, natural economic forces are likely to lead to consolidation resulting in the survival of a single big clearinghouse.  Where huge risk will be concentrated.  Too big to fail on steroids.  Worried about the interconnection of big financial players?  Well, this clearinghouse will be a single entity connecting all major financial intermediaries.  So, if you mandate clearing, you are mandating an extreme concentration of risk.

So, it is deeply irresponsible of Gensler to recognize, on the one hand that there might be (understatement alert!) concentration and consolidation, and then blow off the serious systemic risk questions this implies with a lame statement about what statutes would allow–but couldn’t mandate.

The lack of thought over these extremely important and complex issues is endemic.  Here’s Peterson:

“Barney and I are going to have mandatory clearing,” said Peterson. Under that approach, all contracts would go to central counterparties. If a clearinghouse rejected a contract as being specialized, the SEC or CFTC would set the margin and collateral requirements for it.

“I imagine SEC and CFTC will set higher margins” and reserves, said Peterson.

The Agriculture Committee bill passed in February would allow the CFTC to suspend trading of “naked” credit default swaps (CDS). The reform bill would go a step farther, said Peterson — “We’ll probably ban naked credit default swaps.”

“I imagine SEC and CFTC will set higher margins.”  (Cue John Lennon.)  OK, pick a number.  Tell me the methodology for picking the number.  What cosmic wisdom will inform the SEC and the CFTC when they determine what the right margin level is?  Will the agencies just pick a nice round number, like 50 percent, and then keep it there, for I dunno, 35 odd years?  Will this number be the same for all firms, regardless of their creditworthiness?  What information will the agencies have?  Can they possibly have better information than sophisticated market participants?  Will their choice of margin be uncontaminated by political pressure?  (Clearing operators, for example, will lobby the agency to raise OTC margins in order to impede competition from the OTC markets.)  In brief why should we believe for a minute that the CFTC, the SEC, or their future spawn have the knowledge or the incentive to determine the appropriate margin levels more effectively than market participants?

We are talking about trillions of dollars here.   The largest financial markets in the world.  And this is the level of thought that is going into to completely re-engineering them.  One hopes that Bismarck was right, and there is indeed a special Providence for fools, children, drunkards, and the United States of America.  We’ll need it.

*In a recent newsletter, futures industry maven John Lothian made this comment about one of my earlier posts on Gensler: “Gary Gensler gets the ginsu knife treatment (figuratively) from the Streetwise Professor, Craig Pirrong.”

It had been a slow news week or so, Russia wise, but today a bunch of interesting stuff came down the pike, so here it goes.

First on the hit parade.  After his triumphs at  Pikalyovo and Pork Chop Hill, Vladimir Putin strode into the offices of Sberbank, and ordered Russian bankers assembled there to lend more.  And, as a bonus, he dictated the interest rate: 14 percent:

Russian Prime Minister Vladimir Putin on Wednesday ordered banks to dole out more loans at lower rates to get the economy out of recession, but the country’s biggest lender said such cheap credit was unrealistic.

Russia’s government is looking to banks to help restart economic growth with affordable loans. In return, the sector has received billions of dollars of state funds to boost capital as bad loans rise and asset values fall.

“Of course you need to improve the quality of loans, but you cannot close your portfolio either,” Putin said at a meeting of bankers at the headquarters of state-controlled Sberbank. (SBER03.MM) “It’s very easy to just shut the box. It is harder to work with clients and understand which of them are reliable.”

In a bid to encourage banks to offer more affordable loans, the central bank has slashed interest rates by 200 basis points since April, taking the benchmark refi rate to 11 percent.

Putin told bankers that a loan interest rate at 14 percent “is quite acceptable in current conditions”, but Sberbank Chief Executive German Gref told journalists such demands were unrealistic.

Apparently, no pens were thrown.

Consider this part again:

“Of course you need to improve the quality of loans, but you cannot close your portfolio either,” Putin said at a meeting of bankers at the headquarters of state-controlled Sberbank. (SBER03.MM) “It’s very easy to just shut the box. It is harder to work with clients and understand which of them are reliable.”

. . . .

Putin also ordered Sberbank not to close branches.

“A significant part of the (branch) network is not profitable but you cannot abandon it. This is your payment for the state support,” he said.

What great advice!  Make more loans, but make better loans.  What a great banker he would make!  I mean, the guy is just amazing, he knows everything about everything.  I’m sure all the bankers in the room slapped their heads in a collective I-coulda-had-a-V8 moment and said as one: “Why  didn’t I think of that!?!”  And of course Putin knows just what the interest rate should be.  14 percent is Just Right.  Pretty amazing to watch a bald guy do a Goldilocks impersonation.

Actually, reading this and other articles about the performance brought to mind visions of the Red Queen from Through The Looking Glass.  I can just imagine the self-control that the assembled bankers had to exercise, forcing themselves not to roll their eyes–in full knowledge that the eyes of Putin’s creatures were watching for any sign of disrespect for The Great Leader.

At least German Gref had the stones to rain some reality on Putin’s fantasy:

“With today’s price of central bank money, I do not think banks can reach 14 percent (on loans),” Gref said, noting that the central bank offers funding to the sector through collateral free loans at rates of 12 to 13 percent.

“That is the real cost of money. Then you need to add the bank’s margin of at least 3 percent and the result is that minimum (commercial loan rates) are 15 to 16 percent,” he said.

And some fun facts and figures to spoil the fun:

Putin’s comments came minutes before Sberbank published its first-half results to Russian accounting standards, showing its profit tumbled 92 percent year-on-year to 5.3 billion roubles ($170.6 million).

Sberbank’s bad loans rose to 2.8 percent of its portfolio by the end of June from 2.6 percent at the start of the month.

Bankers reckon bad loans for the system as a whole have already reached 10 percent according to international standards, MDM Bank chairman Oleg Vyugin said after the bankers met with Putin [ID:nLM83854].

So, in his desperation to stave off the immediate crisis that is besieging him and his government, Putin is going to crater the banking system.  The end results will be that: (a) he will damage Russia’s longer term prospects, and slow recovery from the current depression, and (b) the state will need to commit more funds to bail out the banking system.

Funds, as it turns out, that  were draining away rapidly as he spoke:

Russia will transfer 1.36 trillion rubles ($43.7 billion) from the  Reserve Fund, one of its two sovereign wealth funds, in the third quarter as the government tries to plug its first budget shortfall in a decade.

The Finance Ministry will use the cash to finance spending during the quarter, according to a decree signed by Prime Minister Vladimir Putin and published on the government’s  Web site late yesterday.

The Reserve Fund, which  contained 2.96 trillion rubles as of July 1, will have 1.6 trillion left by October. The government started tapping the stockpile in March to cover the deficit that’s expected to reach about 8 percent of gross domestic product this year.

Russia will exhaust the 3.6 trillion-ruble Reserve Fund by the end of next year if the deficit is 5 percent, Finance Minister Alexei Kudrin said on May 25. Rising crude oil prices may help the country reduce the use of the fund, Putin said last month.

Russia’s  budget deficit widened in the first half to the equivalent of 4.2 percent ofgross domestic product as the government spent 753.6 billion rubles more than it collected.

In this environment, Kudrin and the rest of the Russian government must be stressed out in the extreme by the substantial volatility in the price of oil over the past six weeks, given the dependence of government finances on oil taxes.  But even if the price of oil strengthens, the dismal situation in the real economy, and the increasingly likely prospect that the banks will require a large injection of state funds, will put the Russian budget under extreme pressure.  And Putin is just intensifying that pressure by forcing these already shaky banks to shovel rubles out the door in a desperate attempt to businesses and consumers afloat.  This is just deferring the day of reckoning, and increasing the price to be paid when that reckoning comes.

The next thing that caught my eye is the story about a group of Russian “entrepreneurs” pleading for the government to ban Skype:

Russia may curb the development of VoIP telephony, notably  Skype, in the country. The Russian Union of Industrialists and Entrepreneurs (RSPP) intends to propose amendments that would regulate internet telephony in Russia and protect the interests of Russian mobile operators. One of the arguments that the RSPP has taken up is that calls through Skype cannot be wiretapped.

Mr Valery Yermakov, first deputy director general of the Russian mobile operator, MegaFon, pointed out that VoIP calls can be made without any control by state authorities whatsoever. In particular, he mentioned software like Skype, which are not connected to Russia’s state wiretapping system (SORM).

RSPP will draft proposals for regulating IP telephony in Russia that would give precedence to Russian telecom operators. Mr Yermakov said local telecoms have two options: either to fight against VoIP services or begin providing those services themselves. While MegaFon has chosen the second option, one can be sure that its VoIP service will meet the RSPP’s requirements…

What a cosmic convergence of sleazebags from government and business.  First, a set of obviously self-interested telecom operators wants to impede competition from VOIP.  Second, it realizes that the best way to achieve this is to appeal to the intense desire of the Russian government to exert control over its citizens.  VOIP is “not connected to Russia’s state wiretapping system.”  We can’t have that, can we? Jeez, what kind of country HAS a state wiretapping system that is specifically directed at its citizens?  That tells you all you need to know about Russia.

Note that the telecom jackals leapt into action immediately following the government’s move to empower the security services (seven of them, in fact, if memory serves) to open everybody’s mail and packages.  There is clearly a trend to clamp down on every means by which Russians can communicate and express themselves.

But that’s relatively benign, as compared to what the Russian state can do to you if it really sets its mind to it.  Consider this horrifying story from the Washington Post:

A Russian police official conducting research under the auspices of Virginia’s George Mason University has been arrested after he reported obtaining evidence incriminating influential figures in Moscow and the far eastern city of Vladivostok, colleagues and local authorities said this week.

Col. Alexander Astafyev, 50, a senior anti-corruption investigator affiliated with a GMU research center in Vladivostok, had been working on an academic paper about “raiding,” or the criminal takeover of businesses with the help of corrupt officials, police or judges, when he was detained last month.

. . . .

Astafyev worked closely with FBI agents investigating organized crime, and he visited Washington last year at the invitation of the State Department, said Louise Shelley, director of the Terrorism, Transnational Crime and Corruption Center at GMU, which operates research and training institutes in Vladivostok and three other Russian cities.

“I think it’s very disturbing,” she said of his arrest. “It’s U.S.-Russia relations without the reset.” [Louise, you are a sucker indeed if you believe this reset thing is a two-way street.]

Shelley said Astafyev had a “long-standing reputation for integrity” and has been affiliated with the Vladivostok center for several years. He was conducting research on the criminal raiding of businesses under a $3,000 grant when he was arrested June 16, she said.

In a draft paper he submitted to the center, Astafyev estimated that 10,000 cases of criminal raiding occur every year but that fewer than 100 are prosecuted and result in convictions. “Law enforcement organs today are either participants or spectators of the takeovers,” he wrote.

In his letters, Astafyev suggested that his research had been a factor in his arrest, noting that he had submitted his paper shortly before he was detained and had included information about the criminal group that he thinks framed him. He also noted that police seized photos of him with American colleagues.

In his paper, Astafyev outlined cases of criminal business raiding in Vladivostok. In the process of seizing a trucking firm, he said, one outfit killed a senior executive of the company and injured several people, including a judge and a prosecutor.

In his letters, Astafyev said that the same group seized a major fishing enterprise and was deeply involved in smuggling. He linked it to officials in the Interior Ministry and the Federal Security Service, the domestic successor to the KGB, as well as to an adviser to the mayor, a former deputy governor of the region and a law enforcement official in Moscow, all of whom he identified.

Just consider the outrages packed into a few brief paragraphs.  10,000 corporate “raids” a year.  10,000 businesses extorted and stolen.  Resist–and die.  Multiple tens-of-thousands of lives ruined. And to think, every other business owner in Russia lives with this specter hanging over his or her head.  All with the active involvement of national and local politicians, law enforcement, and security services.  Not to mention the omnipresent cop, or fire inspector, or building inspector, or tax inspector, all with their grubby mitts extended.  Is it any wonder that small business represents such a small fraction of Russian economic activity, as compared to eastern Europe, not to mention the US.

I was going to say that Russia is like Sicily with snow, but even the Mafia was never that connected.

These last two stories give the lie to all the fine things that Medvedev supposedly advocates.

A knowledge-based, entrepreneurial economy?  Creative endeavors cannot flourish in a society where success is likely to result in extortion by armed thugs–including thugs employed by those ostensibly there to protect you.  Moreover, stifling free communication and expression, and surveilling all means of communication, is hardly conducive to creative, entrepreneurial endeavors–especially when it is well-known that those in the employ of the state routinely use commercial espionage for competitive advantage and to facilitate extortion.

Entrepreneurial?  Make me laugh.  Entrepreneurial, in a country a large organization that supposedly represents entrepreneurs appeals to the state’s basest instincts in order to stifle competition?

The end of legal nihilism, and the establishment of a rule of law?  With tens of thousands of businesses harassed by all levels of law enforcement?  The abolishment of corruption?  Tell it to Colonel  Astafyev.

Dmitri Medvedev is either the world’s biggest fool, or the most mendacious bastard in eleven time zones–which would be saying a lot.

Thus endeth a post bracketed by Russia’s Bobbsey Twins, Putin and Medvedev.  Which is worse?  Is death an option?  Sadly, in Russia, the answer to that question is all too often: Yes.

In the wake of Goldman Sachs’s huge earnings, Morgan Stanley just reported a quarterly loss.  CEO John Mack blamed the loss on the company’s cautious attitude towards risk taking:

A week after  Goldman Sachs Group Inc. proved securities firms still can rake in record profits from taking big risks, Morgan Stanley reported a $159 million second-quarter loss from continuing operations that left Chairman and Chief Executive John Mack conceding that parts of the company got too conservative after surviving its near-death experience last fall.

. . . .

“We are not satisfied with our performance” in “key areas of fixed-income trading and in asset management,” Mr. Mack said in a statement. To turn things around, Morgan Stanley is bringing in new blood in its managerial ranks, expanding its trading with clients and “increasing capital commitments in a disciplined way,” he added.

Translation: Morgan Stanley now plans to rev up its risk taking, which it has been averse to doing since the company came close to perishing or being forced into a government-assisted takeover last fall.

“We were encouraged that they had a more aggressive tone than in past quarters” on trading, said Barclays Capital analyst Roger Freeman. “But the quarter itself doesn’t leave much to be encouraged about. They’ve let opportunity slip by.”

In bond trading, Morgan Stanley’s revenue was barely a third of that reported by Goldman, even after the impact of Morgan Stanley’s own credit spreads were excluded. Stock-trading revenue was less than half what Goldman brought in during the quarter.

Earlier this year, Morgan Stanley executives said they were reluctant to take the sorts of chances that were common before the financial crisis erupted, concluding that the returns wouldn’t be generous enough to justify the possibility of losses.

But hold on!  Felix Salmon reports that Morgan Stanley’s value-at-risk went up by about 25 percent from the fourth quarter of 2008 to the second quarter of 2009.  The WSJ article also reports that the firm increased its leverage from the end of last year.  So much for the “oh-we-lost-money-because-we-were-so-conservative excuse.”  Actually, it should be “we-lost-money-because-we-took-more-risk-and-and-made-bad-calls.”

Salmon expresses puzzlement at MS’s poor performance as compared to Goldman and J.P. Morgan.  I’m puzzled why he’s puzzled.  Goldman took on more risk, sure, and made money.  But you don’t make more money just because you take on risk.  You make money because you bet, and bet right.  And if you bet big and right, you make a lot of money.  That’s what Goldman did. MS’s performance gap isn’t due  it not betting, it’s due to its betting bigger–and wrong.  No mystery here.

And this represents more bad news, because the lesson the firm has apparently drawn from its experience, and no doubt Goldman’s, is that it needs to take on more risk:

On Wednesday, though, Morgan Stanley Chief Financial Officer Colm Kelleher said he feels more “constructive” about taking trading risks as markets stabilize. He said some traders avoided riskier trades during the second quarter, despite management’s willingness to take more risks. “Some of the trading desks didn’t see the opportunity and weren’t prepared to put capital to work,” he explained in an interview.

. . . .

“We’ve been seeing clear signs of stability,” Mr. Kelleher said, noting renewed activity in the bond and commercial-paper markets. But the firm plans to continue to tread carefully, mainly ramping up risks in well-traveled areas such as government bonds and currencies.

“It takes awhile,” he said. Late last year, “we stared into the abyss,” and some traders may still be “gun-shy.”

Why is this bad news?  To me it suggests that seeing Goldman’s performance, and concluding that it too is too big to fail, Morgan Stanley thinks that loading up on risk is the way to go.  Why be a chump and reduce risk, when Goldman has shown you can swing for the fences and rely on Uncle Sugar if the bets don’t go the right way?  

To me, this line blaming the losses on excess conservatism is just bull, and an excuse to use the losses to justify ramping up the risk taking.  Given that equity holders benefit from the Treasury put of a too big to fail institution, they will be cheering MS on.  Me, on the other hand, being one of the guys who is (involuntarily) short the put, will be groaning.

The Economist recently ran an article describing the soul-searching going on in academic economics, especially macroeconomics. For the most part, I don’t have a dog in this fight, because when in graduate school so many moons ago, like many of the students described in the Economist article, I decided that macro was too abstract and detached from real world institutions for a relatively literal-minded person like me (literal-minded for an academic, anyways). Taking Robert Lucas’s macro sequence was an amazing experience—an intellectual tour de force—but I knew that despite my original intentions to go into macro, it was not for me.

The gravamen of the article is that Lucas-style dynamic stochastic general equilibrium models have failed to predict, or even explain, the current recession. With regards to prediction, that’s a red herring, because such models never aspired to such a goal, and indeed, were the basis for conclusions that such predictions were nigh on to impossible.

What’s galling about the article is the (somewhat implicit) endorsement of the Krugman-DeLong view that we need to atone for the sins of the New Classical synthesis by embracing the Old Time Religion of Keynesianism. Give me a freaking break. Keynesianism fell out of favor the first time around because of ITS abysmal failure to explain economic developments in the 1970s, most notably stagflation. And its applicability to the current situation is incredibly dubious as well. The article criticizes DSGE models for failing to incorporate a financial sector and financial institutions. Like Keynesian models (new or old) do? And, as the article notes, the Keynesian theory goes like this:

In his scheme, investment was governed by the animal spirits of entrepreneurs, facing an imponderable future. The same uncertainty gave savers a reason to hoard their wealth in liquid assets, like money, rather than committing it to new capital projects. This liquidity-preference, as Keynes called it, governed the price of financial securities and hence the rate of interest. If animal spirits flagged or liquidity preference surged, the pace of investment would falter, with no obvious market force to restore it. Demand would fall short of supply, leaving willing workers on the shelf.

This bears no relationship whatsoever to what transpired 2007-present. There was no exogenous surge in liquidity preference; the race for liquidity was a response to another shock—the decline in real estate prices—that called into question the safety of financial institutions invested heavily (directly or indirectly) in real estate. The liquidity panic was an effect, which had knock-on effects: it was not the Prime Mover.

What’s more, the increase in savings that has occurred in the last months undermines one of the rationales for a fiscal stimulus—namely, that there are large numbers of liquidity constrained households that would consume more but for this constraint. But the implication of the constraint is that people will draw savings to zero to consume as much as possible; they would borrow to consume more, but can’t, and government spending can loosen that constraint thereby permitting an increase in consumption. How you can square a liquidity-preference theory of economic slumps in which consumers spontaneously decide to save more and consume less, with a policy recommendation based on the assumption that individuals would like to consume more but cannot due to liquidity constraints escapes me at the moment. Krugman et al blithely blab away without even recognizing the contradiction.

And, for the most part, even modern economists who consider themselves Keynesian adopt much of the Friedman-Lucas-Prescott-et al critique of the Old Time Keynesian Religion that Krugman and DeLong are preaching. Specifically, they discard the silly Keynesian consumption function demolished by Friedman and adopt aspects of the permanent income hypothesis. They assume individuals are forward looking, and make forecasts about policy in a pretty rational way. They assume that individuals are not subject to fiscal illusion, and thereby recognize that government spending increases must be financed by future taxes. They depart from the New Classical approach by assuming wage and price rigidities, but allow a more reasonable, expectations-based adjustment mechanism. The rigidities lead to some broadly Keynesian features, but even in the presence of these rigidities, many aspects of the Friedman et al critique survive.

This is illustrated very well in a paper by Cogan, Cwik, Talyor and Weiland, which uses a New Keynesian model to estimate the effects of the 2009 “stimulus” package. A crude Keynesian model predicts very strong multiplier effects; as Cogan et al note, moreover, this conclusion also depends on the insane assumption that the central bank can keep the nominal interest rate at zero forever without sparking a massive inflation. As if.

A New Keynesian model that incorporates wealth effects from taxation, forward looking households, nominal rigidities with a more realistic adjustment mechanism, and a monetary policy that does not result in a hyperinflation (fingers crossed on that one) generates very small multipliers. Indeed, more realistic characterizations of the nature of the fiscal stimulus (including characterizations based explicitly on the 2009 stimulus package) generate NEGATIVE multipliers fairly soon in the future—and can generate negative multipliers immediately. This means that the “stimulus” can actually reduce output. Great.

Moreover, the increase in GDP in the analysis comes entirely from the increase in government expenditure. Indeed, the increase in government expenditure causes consumption and investment to fall because this expenditure crowds out private consumption and investment due to the wealth effects; consumers anticipate the higher tax burden, and cut back their expenditures accordingly, and business anticipate the lower consumption and cut back investment. Great again.

And as Cogan et al note, this result, as awful as it is, is based on some assumptions very favorable to the stimulus. Most notably, it assumes that $1 of government expenditure provides $1 worth of goods. Not likely, given the nature of the spending. I’d rather have $1 in private consumption than $2 in government spending, giving the stupid stuff the government actually buys with my money. But the Cogan et al analysis assumes that the $1 of government stuff is worth $1 to you and me.

Moreover, and perhaps more importantly, the Cogan experiment assumes that the taxes used to finance the higher spending are not distorting. We know taxes distort and thereby reduce output. Thus, the already paltry positive effects of the stimulus implied by the model are likely to be smaller in practice.

All in all, even a Keynesian-influenced model makes predictions very similar to what I argued in my jeremiads against the stimulus. Wasteful government consumption crowds out beneficial private consumption, and when you take into account the effect of distorting taxes, the effect of the stimulus is likely to be baleful indeed.

The Bacchanal of future spending contemplated by Congress and the administration will, in my view, be even more disastrous. I would surmise (based on the above) that New Keynesian models would come to similar conclusions.

So, I stand by my conclusion that the “saltwater” economists like Krugman and DeLong are all wet. And remember, if you drink saltwater, you go crazy.

Does that leave the New Classical folks blameless? No. But I think the diagnosis of The Economist and the saltwater types misses the problem.

I remember distinctly Lucas’s lectures on business cycles. He started out his discussion by referring to the seminal empirical work on cycles done by Wesley Mitchell for the NBER. Lucas argued that virtually every cycle that Mitchell documented exhibited a very similar pattern. From this, he (and others) concluded that there must be a common cause to these cycles. This motivated a search for the cause. The Friedman and Schwartz work suggested that monetary fluctuations were a prime suspect. Real business cycle theory went in another direction. But, both were predicated on this view that the “business cycle” is a unitary thing, with a single, primary cause.

In retrospect in particular, this reasoning is suspect. Perhaps it is the case that most fluctuations in output are traceable to a single cause, but it is possible that there can be unique circumstances that also lead to large output changes. To me, it seems that the recent experience with a housing price runup and subsequent collapse triggering a financial crisis in large part because of the heavy investment of financial institutions in assets strongly tied to housing prices is a pretty unique event.

In other words, economists of all stripes—New Classical types and Keynesians New and Old—arguably vastly overstated the temporal homogeneity and regularity of the economy. They constructed models that were conceivably Theories of a Lot, but which weren’t Theories of Everything. Unfortunately, the decent empirical success of these models in characterizing the historical record, especially the post-War experience, provided undue confidence in the universality of the models. But with models, as with investments, the old caution that Past Performance is No Guarantee of Future Performance holds. Successful backcasting, and even somewhat successful forecasting, does not imply that unprecedented outside-the-model events will not occur in the future.

This represents a challenge to economics as a science, and one that is likely to be insurmountable. The evolution of vast, complex, unplanned, interconnected systems of (mostly) maximizing agents operating in conditions of sharply limited knowledge will inevitably produce unique historic contingencies. Sure, there are regularities. Sure, some features may repeat over time (e.g., technology shocks that induce business cycles, or monetary policy changes), and these will lead to many fluctuations that exhibit some similarities over time. But from time to time, something completely unique will happen; some unique confluence of contingencies will lead to economic changes that confound the models. The primary regularity is that irregularities periodically occur, and some of these irregularities can be quite extreme.

This does not mean that the entire modeling exercise was a waste. All it means is that we should have relatively humble expectations about economic models in general, and macro models in particular. Stuff happens, and no model will ever be capable of capturing all the stuff that could happen.

Methodologically, this means that although I am sympathetic to the logical rigor that formalization brings, a diversified portfolio of approaches is needed. Less formal approaches, and militantly anti-formal ones, like Austrian Economics, can produce important insights. In particular, Austrian-influenced approaches that emphasize the implications of radically constrained knowledge and innovation in complicated systems can provide a useful framework for coming to grips with the unexpected, and the unmodelable (to coin a word). And history—and the study thereof, and narrative history in particular—matters too. Not because the past provides all that reliable a guide to the future, but because studying it makes one more aware of the role of contingency, and the confluence of unique circumstances resulting in unique effects in systems where purposeful action by billions of people leads to outcomes intended by no one.

In other words, when casting back for great economists whose work years ago can better help us understand the present and future, I look not to Keynes, but to his rival, Hayek.

SWP in Pravda.  Yes, Pravda.  Well, I guess for once there’s something true in Pravda:)

Ironically, when I looked at the link (sent to my by a SWP reader), next to my deathless prose were a series of chest-thumping articles on the Bulava missile and Russian nuclear missile forces more generally.

Even though I am tattoo free, I am a big punk rock fan; my musical tastes are a case of arrested development.  Indeed, the name of this blog was inspired by a punk song.

Last night I was able to do something I’ve wanted to do in a long time–see East Bay punk legends Rancid live.  I dragged my daughters and a friend of my youngest daughter to the Verizon Wireless Theater in Houston to see the show.  #1 daughter said (on Facebook) “I must have gone temporarily insane to agree to this.”  The kids were particularly dismayed to see that there were no seats on the main floor where our tickets were for–just a throng of people.

I wasn’t the oldest guy there, but I was definitely one of an elite few.  I’ve never seen so much black in my life.  It’s kind of what you’d expect to see if people went to funerals in T-shirts.

The show was all I’d expected, just too short.  Rancid was the opening act for Rise Against, so their set was only 50 minutes long.  But it was a great 50 minutes.  The girls sort of hovered on the fringe of the crowd in front of the stage but I went in pretty close.  Not mosh pit close (I’m not that hard core), but pretty close.  It was a blast.  Really got a kick out of new drummer Branden Steineckert–now that’s a workout, nearly an hour of non-stop arm exercises.

The projected visuals were interesting.  A lot of black-and-white excerpts from movies (hard to describe–basically scenes from old films modified to look like moving line drawings).  The two that caught my eye were the car chase scene from Bullitt (Rancid being a Bay area band) and some scenes from the Who’s Quadrophenia.

My only disappointment (other than the length, or lack thereof, of the set) was that they didn’t play anything from Rancid 2000.  But that’s a minor quibble.  All and all, a memorable experience.

And speaking of arrested development, now the Russian authorities would have another reason to place me under surveillance if I were to go back:

The  St. Petersburg Prosecutor’s Office has admitted that local music fans are under police surveillance — officially as a measure to counteract “extremist activities.”

The city’s Primorsky District police “have organized the exposure of members of informal entities, whose activities may have an extremist nature, on a permanent basis,” the web site of the Prosecutor’s Office reported on July 2.

According to the report, the district’s criminal police have identified and included on a register “88 people who attribute themselves to informal entities such as ‘Skinheads,’ ‘Aggressive Football Fans,’ ‘Punks,’ ‘Emos,’ ‘Black Metallers,’ ‘Fans of [the band] Kino,’ ‘Alternative Rock Fans,’ ‘Anarchists’ and others.”

Once exposed and registered, the music fans and members of the other “informal entities” are the subject of “preventive work” conducted by the district’s police officers, the district’s administration officials and educational institution staff to “prevent crimes, including those of an extremist nature.” [“Preventive work.”  That sounds ominous.]

. . . .

On what grounds have the police and prosecutors decided that fans of music groups and people united on common philosophical grounds such as anarchists could be involved in extremist activities, Maxim Ivantsov, coordinator of the Youth Human Rights Group asked in a letter to the district’s prosecutor and police chief.

He also wondered what “informal entities” are meant by the word “others.” Finally, Ivantsov inquired whether such activities by the Primorsky District’s criminal police are lawful.

Earlier this year, an unidentified police detachment stopped a concert at the local club Arctica and detained some 400 fans for hours, fingerprinting and taking photos of them, which can only be done with a person’s consent under Russian law.

The St. Petersburg Times article notes that Britney Spears is playing in the city this weekend.  Now if that’s not a legitimate excuse for extremism, I don’t know what is.

Having spent last evening amidst such dangerous types, I can say with near absolute confidence that this is just another manifestation of the foolishness and depravity of official Russia.  Yeah, I can’t say that I saw too many kids that I would peg as high achievers.  There were a few idiots there–like in any crowd.  But for the most part, it was just a bunch of awkward kids looking for a place to fit in and a good time.  (Which raises questions about what the hell I was doing there, no?;-)

But a social threat?  What a laugh.  I would think that the St. Petersburg police would have more important things to worry about.  (And are punkers, etc., likely to be particularly profitable bribe targets?  I wouldn’t think so.)  The use of the coercive power of the state to harass the unconventional in order to impose conformity to officially condoned standards of behavior is disturbing–and pitiful.  The metastasizing scope of the phrase “extremism” and the legal powers it justifies says a great deal about Russia’s regression from anything remotely resembling a free society.  Not that it ever got that close in the first place.

Isolated and inbred populations lack genetic and immunological diversity, making them more susceptible to genetic illness and more vulnerable to epidemics caused by new bacteria or viruses.  That is, this limited diversity increases systemic risk; the population is systemically more vulnerable to shocks.  Europeans died from smallpox, but due to the effects of accumulated exposure had enough immunological diversity to limit its impact: in contrast, it virtually wiped out Amerind populations.

This came to mind when reading Jeffrey Friedman’s excellent “A Crisis of Politics, Not Economics: Complexity, Ignorance, and Policy Failure,” an introduction to a Critical Review special issue on the financial crisis.  In this essay, Friedman notes that proscriptive laws and regulations impose constraints that increase the homogeneity of behavior.  That is, systems with fewer such laws and regulations exhibit a greater diversity of behavior.  Moreover, the laws and regulations are predicated on a worldview, and if that worldview is seriously flawed, the resulting homogeneity can be particularly vulnerable to shocks, unintended consequences, or just the perverse results arising from the inherent contradictions in the worldview.  But homogeneity increases systemic risk even abstracting from the possibility for cognitive error.

I’ll let Friedman speak for himself:

By its very nature as a law, a regulation is imposed on every market participant.  This means that even if the regulation takes the form of an inducement rather than a prohibition, it has a homogenizing systemic effect.  The whole point of regulation is to get market participants, on the whole, to behave differently than they otherwise would.  But this means that every regulation imposes one opinion–the regulator’s–on all market participants, even if only by advantaging those who go along with it.

. . . .

The process of competition, like the process of biological evolution, need not have some master note-taker standing above the process and learning its lessons if the process is to work.  This is crucial because such a synoptic perceptor, being human (hence fallible), could not be relied on to learn the right lessons. . . . [T]he regulator is required to be a synoptic perceptor, codifying what he thinks leads to market failure.  If he errs in this analysis, the mistake is imposed on everyone else.

. . . .

But where there are many power centers, as in a capitalist economy, there is more chance of heterogeneity than when there is a single regulator of all the participants.  At worst, in the limit case of complete market homogeneity, unregulated capitalism would be no worse than regulated capitalism, since a theory that is homogeneously accepted by all market participants at that time and place is likely to be accepted by the regulators of that time and place, too.

Just so.  And here’s my favorite:

Geithner may be right or he may be wrong.  He, too, is human, as he demonstrated in his years at the New York Fed when he did nothing to prevent the crisis.  But as much as he may recognize his fallibility, his role as regulator compels him to act as if he were omniscient.

This is all so pertinent in the current setting.  Geithner et al believe–or act as if they believe–that they KNOW the causes of the crisis, and they KNOW how to address them.  Their preferred solution is to impose a set of regulations that will sharply constrain market participants’ behaviors, and induce and/or compel them to utilize a very sharply constrained set of institutions to consummate financial transactions.  They want to compel standardization of financial contracts; compel the use of standardized clearing mechanisms; compel the use of standardized trading mechanisms.  They want to greatly homogenize–“simplify”–the markets for trading financial risks.

But, as Friedman notes, and the inbreeding analogy suggests, such simplicity can create systemic risks of its own.  The resulting lack of diversity means that shocks to which these institutions are acutely vulnerable will lead to a systemic crisis.  And remember that every institution is unduly vulnerable to some shocks, and it is highly unlikely that a particular set of institutions is more robust to all shocks than any other set.  Even if Geithner et al are right that their favored institutions are more resilient to most shocks than the incumbent institutions–a contention that I dispute–the lack of diversity means that when the kind of shock to which these institutions are acutely vulnerable arises, the effects will be systemic and devastating.  And if–as I believe the case–Geithner et al’s analysis is incredibly wrong, we have the worst of both worlds.  We will have created a monoculture in which risks are systemic due to excessive homogeneity, and one that is fundamentally defective because it is predicated on a serious cognitive and analytical error, increasing the likelihood of a system-threatening shock.

Friedman also reprises a theme that I have echoed often on SWP: “The greatest lesson of the Great Depression is that we learned the wrong lessons from the Great Depression.”  Citing the work of Gary Gorton, and the chapter by Bhide in the Critical Review special issue, Friedman notes that how a US-centric view of banking panics led to a failure to understand the role of US laws and regulations in causing them to occur disproportionately in America.  And this misdiagnosis begat deposit insurance.  And deposit insurance begat reserve requirements . . .

And reserve requirements (in large part) begat the financial crisis.  Here Friedman provides a convincing case for something that I’ve believed to be a major cause of the financial crisis: the Basel bank capital rules.  A key factor that distinguishes this financial crisis from other collapses in securities prices (e.g., the Dot-com implosion) is that banks had invested heavily in mortgage backed securities, and asset backed and CDO securities derived from those.  The housing price collapse caused the prices of these instruments to fall, precipitating the crisis because banks and other financial intermediaries had loaded up on them.

But why had they loaded up?  The Basel rules–combined with the institutionalization of credit ratings, another factor Friedman emphasizes–gave preferential capital treatment to these instruments.  And since all banks were subject to the same capital requirements, with a few exceptions (e.g., J.P. Morgan), they nearly uniformly took exposure to the same risk.  Thus, whereas the dot-com burst was not systemic, the housing and subprime burst was.

This is particularly worrisome, because the conventional wisdom (not surprisingly the mantra of Geithner et al) is that tightened capital requirements will be a pillar of regulatory changes.  Indeed, they are seen as an all-purpose tool: Geithner’s “reform” plan proposes to use higher capital charges on OTC derivatives in order to channel more trading onto clearing and exchange platforms–i.e., the proposed financial monoculture.

“TIghter capital requirements” seems like a no-brainer, but the foregoing makes it very, very clear that the details are incredibly important.  They can induce excessive homogeneity in behavior that increases systemic risk.

In sum, “simplified” and “standardized” are not synonymous with “systemically robust.”  Indeed, the exact opposite is likely to be the case.  I believe that there is a strong argument to be made that the diversity of institutions in derivatives markets, e.g., the co-existence of exchanges, cleared OTC, and non-cleared OTC, is a discriminating match between trading mechanisms, instruments, and market participants.  Maybe I’m wrong.  But I am highly, highly confident that this more diversified set of institutions is more systemically robust than the kind of monoculture that the administration and leading legislators are hell-bent on creating, even were I not to believe that their diagnosis of the current crisis and its causes were incorrect.  For even if against the astronomical odds they were right about this, they cannot assume that all crises are alike, akin to Tolstoy’s happy families.  Indeed, they are instead like Tolstoy’s unhappy families–unhappy in their own way.  By creating an institutional monoculture they are merely legislating a particular systemic vulnerability that will be the root of the next 21st century financial crisis.

A couple of stories provide further illustrations of the challenges of being a foreign investor in Russia.

First, the governor of Kemerovo has threatened to seize two coal mines owned by ArcelorMittal unless it keeps the mines open:

Russia’s Kemerovo region has threatened to seize two of  ArcelorMittal‘s Siberian coal mines if it does not boost output as government fears grow over production instability during a steep recession in the country.

ArcelorMittal said this year it could temporarily close its Anzherskaya coal mine at the end of July and its Pervomayskaya coking coal mine at the end of November as demand for coal plummeted.

“If your team is not able to stabilise production at these facilities, then we propose that you hand them over without compensation,” said Aman Tuleyev, the governor of Kemerovo, referring to the two mines.

In a telegram to Lakshmi Mittal, ArcelorMittal’s chief executive, later published on the local government’s website, Mr Tuleyev added: “I, as governor, am stating in a responsible manner that I will not allow the closure of our mines.”

“Our mines.”  “Without compensation.”  An all too typical Russian government view of property.  And, if the government seizes the mines and keeps them over, how will it pay to operate them?  ArcelorMittal would not close them unless revenues from the sale of coal were sufficient to cover operating costs.  So, if the government seizes them, it will have to cover this difference.  Where is the money to come from?

The other story is courtesy of commentor Michael V.  It’s in Russian, but Google Translator makes quick work of that.  In a nutshell, in the early-90s, to attract McDonald’s to Moscow, the city leased two locations in the city for one ruble per square meter per year for 49 years.  Obviously, that was a great deal then, and it’s an exceptional deal now, given that Moscow is one of the most expensive cities in the world.  Now the city’s property department wants to claw them back.  (Why don’t they get  Elena Baturina to buy them outright.  I think she can afford them.)

Sure, McDonald’s made out great, but a deal’s a deal.  Evidently the city felt it needed McDonald’s badly enough when it made the deal to make an attractive offer.  Now things have changed, but a that’s life.

The Kemerovo-ArcelorMittal conflict is a sign desperation in difficult economic times.  But the short run expedient of seizing property is the kind of thing that will continue to undermine Russia’s long term economic prospects.  The McDonald’s case has no such mitigating circumstances.  It is just opportunism pure and simple, and is another cautionary tale for investors: what’s theirs is theirs, and what’s yours is yourstheirs–if they want it.  Given Russia’s dependence on foreign capital flows, this is a counterproductive attitude that will impede Russian progress for years to come.

The Russian military and government were looking towards the most recent test of its troubled Bulava sub launched ballistic missile (a modification of the Topol ICBM) with great anticipation.  Today, they met with yet more disappointment:

News agencies says Russia’s latest test of the advanced ballistic missile Bulava has failed, with the missile self-destructing.

It’s the sixth failure in 10 test launches for the Bulava — a major setback for Russia’s efforts to upgrade its aging missile arsenal.

RIA-Novosti and Interfax cite Defense Ministry officials as saying the missile was fired Wednesday from the submarine Dmitry Donskoi and that the first stage malfunctioned and the missile self-destructed.

A Defense Ministry duty officer said Thursday he could not immediately comment on the report.

Despite the failures, Russian leaders have boasted of the Bulava’s capability to penetrate missile defenses and described it as a key part of the military’s future nuclear arsenal.

Uhm, you can’t penetrate anything if the first stage blows up less than 30 seconds into flight.

And speaking of missile defense, it is interesting to compare the results of the Bulava tests (60 percent failure rate) to those for tests of the Aegis Ballistic Missile Defense system, which has failed in only 2 out of 13 tests.  Considering that (a) SLBM technology is 50+ years old, (b) the Bulava is the modification of an existing system, and (c) BMD is a far more difficult task with many more moving parts (e.g., multiple sensors, missile), the differential performance is pretty staggering.

Since technology is unlikely to be the issue, Bulava’s problems are more likely attributable to manufacturing problems, and provide further testimony of the erosion of Russia’s military production capabilities.  (The fiasco over the reconstruction of the Gorshkov is another example.)

The main effect of the test failure is likely to be an increase in the Russian leadership’s angst.  Russia places great emphasis on its military strength.  It realizes that its conventional forces are decrepit, and that the just-beginning reform process will take a long time to succeed, if it does, and that there is a high probability of failure.  It therefore places heavy emphasis on its nuclear forces.  A huge fraction of its defense spending is directed to these forces, and they take first priority.  Russia knows that without nukes, it is pathetic, a dying country with gas and a UN Security Council Veto and not much else to exert the influence on the world that its leadership (and a good fraction of its population) believes is its due.

Anything that impedes the rejuvenation of its nuclear forces will lead to increased anxiety, not to say paranoia about missile defenses, including missile defenses in Poland and the Czech Republic, even though those pose no threat to Russian ICBMs.  Indeed, the weaker the SLBM leg of the Russian nuclear forces, the more paranoid it gets about any threat real or imagined to its land based systems.  Thus, expect more histrionics and pressure regarding the BMD systems in Europe.  The Bulava failure may also make the more aggressive in strategic weapons negotiations with the United States.  Consequently, this test failure may contribute to increased tension with the US.