Streetwise Professor

A reader sent me an email about my post ridiculing Timothy Geithner’s admission that restructuring the OTC derivative markets is really complicated, telling me that (a) I was very mean, and (b) I can be a real smart ass.  (That said, she also thought it was very funny.)  Both (a) and (b) are true–especially the latter, I guess.  My wife is always telling me that sarcasm is the lowest form of wit, but there are some things that are so outrageous that sarcastic ridicule is perfectly appropriate.

And I think that Geithner’s admission that a complete re-engineering of the financial system is extremely difficult is one of those things.  He is playing the Sorcerer’s Apprentice, unleashing forces that he doesn’t comprehend.  Somehow dry, play-it-straight analysis doesn’t seem to be an adequate response to such dangerous arrogance.

Indeed, one of the very pillars of his argument for the need for “reform”, the interconnectedness of the financial system, is precisely the reason why care is especially warranted in this instance.  Highly interconnected, dense networks like the financial markets are complex systems.  Small shocks to such complex systems can lead to discontinuous responses.  And such changes are almost always impossible to predict.

These markets are so complex that one should proceed with great caution before making wholesale changes.  This is especially true when these changes are predicated on a simplistic, not to say incorrect, diagnosis of the nature of the system.  Fools rush in where angels fear to tread.

It would be useful if Geithner–and Obama, for that matter–would read Hayek’s The Pretense of Knowledge or Sowell’s Knowledge and Decisions.  Perhaps such reading would at least temper the presumptuous arrogance that has characterized the administration’s financial regulation initiatives, and its other efforts to remake virtually every other part of the American economy from energy to healthcare.

But I doubt that it will.  And as a result, I would imagine that Mr. Geithner and his colleagues will provide numerous opportunities to exercise my talents in the lowest form of wit.

Frequent commentor, not to say gadfly, S/O, has suggested that American aircraft carriers are obsolete due to the development of new anti-ship weapons, such as hypersonic missiles and conventional ballistic missiles.  Information Dissemination (a Navy geek website) links to a Navy Times article on the US development of a new anti-ship missile that addresses S/O’s arguments head on:

I particularly enjoyed, and agree completely, with the response by Norman Friedman.

U.S. commanders became wary of ship-launched anti-ship missiles in exercises in the 1980s, during which they missed or hit neutral ships about as often as they found their targets, naval weapons expert Norman Friedman said. The weapons suffered from the classic problem of needing good information about their targets.

Friedman said he was skeptical about the prospects for DARPA and ONR’s new missile. Although sensors have gotten better in the age of unmanned aerial vehicles and higher-tech satellites, the classic target-finding problem still remains, he said.

“There are constant efforts to make hypersonic missiles — you see claims about them — but they don’t seem to go anywhere.”

Scouting, Scouting, Scouting. My favorite paragraph in Wayne P. Hughes book  Fleet Tactics and Coastal Combat covers the problem perfectly.

It seems pedestrian to say that scouting has always been an important constant in war. Perhaps the way to put it is this: winners have outscouted the enemy in detection, in tracking, and in targeting. At sea better scouting – more important than maneuver, as much as weapon range, and oftentimes as much as anything else – has determined who would attack not merely effectively, but who would attack decisively first.

While I have no problems with the development of a new anti-ship weapon system, particularly considering this is a weapon system that doesn’t seem to get much attention in the US Navy anymore; I still say the challenge for the US Navy is improving the capabilities in scouting. I could be wrong, but I don’t see any evidence that delivering firepower is a problem for any service branch of the armed forces.

But developing effective maritime domain awareness of the battlefield… I see that as a major issue emerging in the 21st century, particularly with hybrid threats emerging that look and act exactly like the normal maritime traffic seen globally every day.

But if the United States, which has the most advanced, extensive, and capable surveillance resources in the world has difficulties finding maritime targets, any potential challenger will have even more daunting challenges.  This is especially true inasmuch as the US also has the greatest capability to deny any enemy of the ability to use these resources.

This is no reason for complacency by the United States Navy.  It is just to say that some seeming wonder weapons have Achilles Heels that make them far less threatening than their specs would suggest.

This article by Tom Parfitt in the Guardian on Ramzan Kadyrov and the murder of Natasha Estemirova brings to mind descriptions of Ivan the Terrible and his Oprichnina:

Kadyrov, a 32-year-old former rebel who came over to Russia’s side and took power in 2007, is notorious for controlling thousands of armed devotees known as the “kadyrovtsy”, who are now supposedly absorbed into official force structures. He brooks no dissent in his republic, and the kadyrovtsy have repeatedly been accused of torture, kidnappings and extra-judicial killings. It is true that the kadyrovtsy are fighting armed and ruthless Islamist militants who have committed terrorist attacks, but their efforts have often spilled into persecution of innocent civilians. One person who wrote about their excesses was the campaigning journalist  Anna Politkovskaya (who was assassinated in 2006). Another who investigated abuses was the human rights lawyer, Stanislav Markelov (shot twice in the back of the head in central Moscow in January). A third detractor, who told reporters that Kadyrov personally tortured him, was a former member of the president’s bodyguard, Umar Israilov (shot dead in Vienna in January). A fourth, and Kadyrov’s most vocal critic inside Chechnya, was Estemirova.

Like the oprichniki, the kadyrovsty run amok committing murder, robbery, and mayhem for the benefit of their autocratic, psychopathic boss–and no doubt benefit themselves in the process.

There is a difference, of course.  Ivan was a true autocrat, dependent on no one.  Indeed, the formation of the Oprichnina was part of an effort to eliminate his dependence on the boyars–indeed, to eliminate the boyars period.  Kadyrov, on the other hand, is the creation of Vladimir Putin.  I would say the creature of Putin, but there is some reason to doubt how much control Putin exercises over Kadyrov.

That said, it is certainly the case that with the entire resources of the Russian state–and its security apparatus–at his disposal, Putin could bring Kadyrov to heel–or the grave.  But he chooses not to.  Why?  Because he is willing to let Kadyrov and his neo-oprichniki run amok as long as they keep Chechen rebels under a modicum of control, no matter the human cost.  Vladimir Putin is therefore an accessory to every murder, rape, or other felony committed by Kadyrov and his minions.

Now, the defense is sure to be that the Chechen rebels are a vicious lot who must be destroyed.  They are indeed vicious, and should be destroyed.  But that does not justify any and all means.  The United States has waged a largely successful war against similarly brutal and murderous terrorists and thugs without engaging in anywhere near the kind of tactics that Kadyrov–and Putin–employ on a daily basis.  Rendition is troubling, but employed on a very select group of suspects; Putin and Kadyrov in effect subject every Chechen to the risk of the worst that rendition cold possibly offer.  If Gitmo is a moral stain on the US–and I don’t believe that it is for a moment–there are no words capable of describing how Chechnya degrades Russia.

And responsibility for that rests at the highest level of the Russian government.

Tim Geithner has made a startling discovery: completely reorganizing one of the world’s largest financial markets–OTC derivatives–is an extremely difficult task, worthy of Hercules.  According to Forbes:

The Obama Administration has given itself two months to tell Congress what new legislation is needed to control over-the-counter derivatives, and testimony by Secretary of the Treasury Timothy Geithner late last week indicated how incredibly difficult the job of writing a law is going to be.

Scores of House members turned up to express their special concerns: Will grain elevator operators be required to register as users of derivatives? Can utilities continue to enter into the customized OTC contracts they regard as essential to their business? How, Secretary Geithner, are you going to prevent the derivatives business from migrating to Dubai?

Answering his critics, Geithner said repeatedly the government needed “to find the right balance” between conflicting arguments and conceded that regulation will be “an enormously complex process.” But failure is not an option, he said, because the economic crisis has demonstrated how destructive derivatives can be and how urgent the need is to subject them to new oversight.

Imagine that.  A root-and-branch shakeup of a market involving trillions of dollars of complex transactions, hundreds of firms, some of them quite complex and opaque, in just about every financial and commodity product, is going to be complicated.  Who knew?  

Boilerplate about “find[ing] the right balance” and “failure is not an option” (cliche alert!!!) is woefully inadequate.  There are myriad interconnected decisions that the “reformers” will have to make, each one of them bursting with unintended consequences, and potential for workaround and exploitation and regulatory arbitrage.  In going after the devils it thinks it knows (but really doesn’t), the administration will end up tangling with more heretofore unknown devils that it could possibly imagine.  

It would be comforting if the administration had a coherent diagnosis of just how OTC derivatives contributed to the financial crisis; a better understanding of how structural changes could mitigate these problems; and an appreciation of some of the likely adverse consequences of the proposed reforms.  Instead, we get reruns of the AIG melodrama and airy statements about how clearing and improved transparency will work wonders.  

Hence, failure is quite definitely an option.  Sadly, failure is most likely to result if Geither and the administration “succeed” at implementing their “reform” plan.  A plan that presumes one of the largest market failures in history, but which does not state coherently just what that market failure is and how it will be addressed, is a disaster waiting to happen. With no coherent overarching understanding of the source of market failure, there is no way to implement all necessary details of any plan intended to address it.  Moreover, lacking any such overarching understanding, it will be very difficult to distinguish the legitimate arguments of affected market participants from special interest self-pleading.  With so many decisions to be made, and so many affected interests, this will degenerate into a political bazaar like Waxman-Markey, and which health care “reform” promises to be.  And, just like Waxman-Markey, what is likely to emerge is a Frankenstein monster of regulation that is more likely to be the cause of the next crisis, than our deliverance from one.

According to Matt Leising and Justin Blum at Bloomberg, the Justice Department investigation of the CDS markets includes clearing:

A U.S. antitrust probe of the credit-default swaps market includes efforts to guarantee contracts through clearinghouses, according to a Justice Department spokeswoman.

“The Antitrust Division is investigating the possibility of anticompetitive practices in the credit derivatives clearing, trading and information services industries,”  Laura Sweeney, a Justice Department spokeswoman in Washington, said today in an e-mail.

Just what would the anticompetitive practices in CDS clearing be?  Here are some theories the DOJ might be considering and investigating:

• If a subset of big dealers form a clearinghouse, and exclude other market participants from membership, they could reduce competition.  That is, as I’ve shown in my academic work, a cooperative organization that is subject to strong scale and/or scope economies can serve to cartelize an industry.  A smaller than optimal set of members creates a CCP.  It is just big enough such that no other organization can achieve the scale or scope to compete with it, but smaller than optimal, thereby ensuring that its members can charge supercompetitive prices.  What’s more, through the pricing of its services, and the rules for sharing revenue, the members can coordinate pricing, and in some cases, achieve a monopoly pricing outcome.
• The DOJ may actually be more interested in the resistance of the CDS dealers to clearing.  Here the idea would be that the CDS market currently behaves like an oligopoly that is very profitable.  The dealers don’t have to worry that much about competitive entry, because there are few other firms that have the scale to compete effectively.  Clearing would make it easier for other firms to enter in competition with the big dealers, as these competitors would essentially be able to take advantage of the clearinghouse’s scale.  This would undermine a competitive advantage of the big dealers–so if they kneecap or slow walk clearing, they could protect their oligopoly.  Similar arguments would apply to anticompetitive practices in trading.
• The big banks are impeding competition by refusing to deal with potential competitor clearinghouses, such as the CME’s or the just euthanized NYSE-EuronextLIFFE venture.

I don’t know which, if any, of these theories is in DOJ’s mind.  But the antitrust scrutiny of the entire gamut of OTC trading practices is quite interesting, and bears close watching going forward.

This article from the Guardian resonates with me, given some of the discussions zinging back and forth in the comment section:

A group of British academics including the historian Orlando Figes and the poet and translator Robert Chandler have spoken out after authorities in  Russia  closed down a website dealing with the country’s controversial Soviet past.

. . . .

Much of Soviet history is now taboo. Particularly sensitive for the Kremlin is the 1939 Molotov-Ribbentrop pact, under which Hitler and Stalin agreed to carve up Europe, with Moscow annexing the Baltics and two-thirds of  Poland. The Kremlin also refuses to acknowledge Ukrainian claims that the Stalin-engineered famine of 1932-33 amounted to a genocide.

This month Russia’s delegation walked out of the Organisation for the Security and Co-operation in Europe (OSCE) after it passed a resolution likening Stalinism with Nazism. The resolution called for 23 August, the day of the Molotov-Ribbentrop pact, to be a day of remembrance for victims of both Stalin and Hitler.

Russia accused the OSCE of trying to “distort history with political goals”. [Talk about the pot calling the kettle black!]

This quote brought a wry smile to my face:

Today Figes said in an email the Kremlin had become “very active on the  internet” on history, claiming that it even hired bloggers to pose as members of the public, their task being to disseminate a Kremlin-approved version of the past and to “rubbish historians like myself”.

Anybody have anything to tell me?  LOL.

Many commentors were giddy with the news of Goldman’s large profits.  Not me.  By a long shot.  

For one thing, it is in large part a commentary on the weakness of the banking system, and the consequent erosion of the competition Goldman faces from other big dealers.  (JP Morgan-Chase is in a similar position.)  

More ominously, Goldman had this record quarter by dramatically increasing its risk exposure:

 Goldman Sachs Group Inc.  ratcheted up risk-taking to an all-time high in the second quarter, increasing equity bets 58 percent to amass record trading revenue and quarterly earnings.

Value-at-risk, a measure of how much money the firm could lose in a day’s trading, rose to $245 million from $240 million in the first quarter, the New York-based firm said yesterday. The figure stood at $184 million last May (see table, below). Most of the increase during the second quarter stemmed from equity-trading risk, which surged to an average of $60 million per day from $38 million in the previous three months.

Goldman Sachs’s  move to become a bank holding company in September to win the financial backing of the Federal Reserve didn’t curb the firm’s appetite for wagering its capital on trading, a formula that fueled Wall Street profit and compensation records in 2007. Second-quarter earnings and revenue also benefited from reduced competition, following the collapse of Bear Stearns Cos. and  Lehman Brothers Holdings Inc.

Goldman knows it is too big to fail.  How does it know this?  Well, the government bailed out AIG not so much for AIG’s sake, but for the sake of big AIG counterparties–most notably Goldman.  Moreover, given the conventional wisdom that the government’s primary error in the financial crisis was its failure to bail out Lehman–a piker compared to Goldman–it doesn’t take a rocket scientist to figure out that it won’t repeat that mistake in the future, and let Goldman go down.  So Goldman knows it can get bigger, and take more risk.  It is the classic heads Goldman wins, tails the sucker taxpayer eats the loss gambit.  If nobody steps in to rein in the firm, it will continue to add risk, thereby enhancing the value of the Treasury put hiding in the equity entry on its balance sheet.  

Somebody should be stepping in–but nobody is. Why not?  Partly, no doubt, it is Goldman’s political heft.  It is likely too that important policy makers don’t want to crack down on a major source of risk capital to the markets in the fear that this would impede a recovery.  Even though in reality, that risk capital is your money and mine, with the exception that we have no chance of capturing the upside, and are left with a good chunk of the downside.  This is a piece with the hair-of-the-dog strategy being pursued by Treasury and the Fed.

Too big to fail is extremely pernicious.  It is the biggest systemic risk, bar none.  The big Goldman profit, and the big Goldman risk, should raise serious concerns that TBTF is alive and well, and rather than roping it in, regulators are feeding it in the short-sighted belief that it is essential to a financial and economic recovery.  This is just laying the groundwork for bigger risks in the future.

Administration officials, most notably Geithner and Gensler, Congressional leaders, and European regulators have touted central counterparties/clearinghouses as a way of dramatically reducing systemic risk.  They have portrayed the CCP as nearly free of the risk of default.  

Apparently the Federal Reserve takes a different view.  (H/T Matt Leising, who made me aware of the issue and reports on it in today’s Bloomberg.)  Evidently responding to the glowing praises of clearinghouses emanating from Geithner et al, on behalf of the members of ICE Trust the law firm of Cleary, Gottlieb, Steen and Hamilton wrote the Fed a letter requesting that

a zero percent risk weight  under the risk-based measure of the Board’s Capital Adequacy Guidelines for state  member banks and bank holding companies (“Risk-Based Capital Rules”) be  assigned to (1) the counterparty credit risk charge on credit default swap (“CDS”)  transactions with ICE Trust, and (2) funds placed with ICE Trust as part of ICE  Trust’s guarantee fund (“GF Contributions”) or as additional margin (“Margin”).” That is, the Cleary lawyer asked the Fed to consider the ICE Trust clearinghouse to be effectively free of default risk, thereby eliminating the necessity of any bank or securities firm with an exposure to the clearinghouse to hold any capital against that exposure.

The Fed demurred, however:

Based on all the facts of record, including the information provided in your  request and other supervisory information, the Board believes that it would be  appropriate to allow current participants in ICE Trust (and their top-tier bank  holding companies) to apply a 20 percent risk weight under the Risk-Based Capital  Rules to claims on ICE Trust, including counterparty credit risk of the CDS  exposures cleared through ICE Trust and claims in the form of Margin and  GF Contributions, for the first-quarter reporting period of 2009 and for subsequent  reporting periods. A 20 percent risk weight for such claims on ICE Trust is  appropriate because the risks ICE Trust poses to counterparties are not materially  different than those posed by other U.S. depository institutions, as well as by banks  in countries that are members of the Organisation for Economic Co-operation and  Development (“OECD banks”). Claims on OECD banks are also risk weighted at  20 percent.

That is, from the Fed’s perspective, ICE Trust is just another bank. Note the key sentence: “the risks ICE Trust poses to counterparties are not materially different than those posed by other U.S. depository institutions.” Thus, an OTC counterparty must hold as much capital against a CDS position cleared through ICE as a CDS deal done with Goldman Sachs–or even BofA or Citi. So much for the magical powers of a clearinghouse to make counterparty risk disappear.

Interestingly, the Fed letter notes that the capital weight required for derivatives traded on exchanges like the the CME that adjust margins daily is zero.  

This decision is very difficult to square with the official boosterism of clearing emanating from the administration, the Hill, and the EC.  It has always seemed to me that the Fed was much more diffident about the efficacy of clearing than Treasury, and this letter makes that difference in enthusiasm quite plain.

There is another interesting angle to this.  In his recent testimony Geithner made it plain that he intended to impose more onerous capital requirements on OTC deals that were not cleared than cleared deals.  The Fed letter essentially puts cleared and non-cleared deals on a level playing field.  So does this mean that other changes are in store, such as raising the capital requirement to above 20 percent on bank-to-bank OTC derivative exposures?  If so, will other inter-bank exposure capital weights be changed, or will there be a differential between OTC derivative risk weights and other inter-bank exposure weights?  Or will the Fed decision be modified subsequently?   Whatever changes are to come, this appears to represent a major disconnect between the Fed–which announced its decision on 5 June–and Treasury, which as recently as last week stated its intention to treat cleared and non-cleared exposures differently.  

Moreover, the Fed’s action gives the lie to Treasury and Congressional and EC boosterism of clearing.  It is a salutary reminder that clearing does not make counterparty risk go away.  Perhaps the Fed’s equation of the risk of ICE Trust and Citi, for instance, is wrong.  But by making it quite plain that the counterparty risk of ICE Trust is north of zero, its decision will hopefully lead to a more productive and informative discussion of the real risks of clearing vs. bilateral dealing.   It’s about time.

In his testimony in a joint hearing of the House Financial Services and Agriculture Committees last week, Treasury Secretary Timothy Geithner stated:

We also will require that regulators carefully police any attempts by market participants to use spurious customization to avoid central clearing and exchanges.

Just how is this “careful policing” supposed to work?  Will those who want to enter into customized transactions have to get pre-approval?  This seems inherently unworkable, due to fact that transactions are frequently time sensitive.  Alternatively, will parties have the ability to enter into transactions without prior restraint, but face the risk that a regulator will subsequently challenge, and disallow the transaction?

Under either alternative, what are the criteria that will be used to separate the unspurious sheep from the spurious goats?  Given the myriad possible reasons for entering into a particular transaction, and designing it in a particular way, it seems nigh on to impossible to identify ex ante a set of criteria that can be employed.  Hence regulators will have incredible discretionary powers.  Presumably there will be legal challenges to regulator decisions, meaning that there will be more than a few court cases arising out of these “policing” efforts.  

The closest analogy that comes to mind is the IRS, which rules on the permissibility and legality of various financial transactions that have tax implications.  We all know the byzantine and costly process associated with such powers.  In essence, the CFTC and/or SEC would have to be empowered to make similar judgments of the commercial rationale for particular transactions, and evaluate the trade-offs that market participants make.  For instance, is a particular transactions structure designed to reduce basis risk, or to escape the clearing requirement?  What will be the standard applied to such evaluations?  Who will have the burden of proof?  

Given the myriad arcane and complex commercial rationales that may exist for entering into derivatives transactions, especially customized ones, it stretches credulity to the breaking point to believe that the SEC or the CFTC have the expertise, not to say the incentive, to make the right call.  There will be many false positives and false negatives.  What’s more, the transactions costs of such a system are likely to be large, just as is the case with the tax code.  Much money will be spent in court trying to reverse the false positives and false negatives.  

Am I done?  Hardly.  Let’s consider the regime in which done deals are subsequent to regulatory challenge ex post.  What happens if a particular transaction is found to be “spurious”?  The deal will be in the money to one party or the other.  How is it to be unwound?  Is it just terminated, costing the in the money party the value of the contract, and allowing the loser to skate?  Is there some termination process whereby the contract is valued?  But if the deal is customized, who does the valuation?  Another source of litigation.  Just what we need.  

Relatedly, there is the possibility that the underwater party to a contract can opportunistically utilize the requirement that a deal not be “spuriously” customized to attempt to escape the onerous obligation to perform.  In the old days, transactors who entered into futures contracts tried to argue that (a) they entered into the futures as a speculative wager, and (b) wagers are uneforceable in court, to escape losing trades.  I foresee such attempts as inevitable if “spurious” customization is banned.  Thus, such a ban will undermine the reliability of contracts and create legal risks.  This is hardly a desirable public policy outcome.

All in all, attempts to distinguish spurious from non-spurious customized transactions, and the Talmudic inquiries necessary to do so, will be extremely onerous.  Moreover, the existence of such a distinction creates substantial legal risk, and the prospect for protracted and expensive litigation.  But perhaps for Geithner et al, these are features, not bugs: regulatory burdens that will serve the larger purpose of suffocating the OTC market.  

And all this begs the question:  Why would anyone want to create a “spuriously” customized contract?  One can understand why one would want to structure a deal solely to reduce tax payments, hence the arms race between the IRS and financial engineers.  It is far harder to understand why someone would want to customize something to escape the obligation of having it cleared, or traded on an exchange.  It is easy to understand why someone would want to customize a deal to achieve specific risk management objectives that cannot be attained using standardized and cleared contracts.  But what’s so bad about clearing that people would want to go to the lengths of designing a customized, illiquid instrument solely to avoid it?  And if the private “bad” of clearing is so big, where’s the public “good” that offsets it?  

This puzzle as to why consenting adults would choose to customize to avoid clearing and exchange or exchange-like clearing is just part of a larger puzzle: if the OTC market is so terrible, why do informed parties utilize it, and why has it grown relative to the exchange traded sector to such an extent that OTC volume and open interest now dwarf exchange volume and open interest?  The entire thrust of the Geithner-Obama policy implicitly assumes the existence of what would have to be the greatest market failure in the history of man, a market failure that has led to trillions and trillions of dollars of transactions that are suboptimal in the way that they are designed, traded, cleared, or settled, or all of the above.   So just what is the market failure?  So far, the administration and its cheerleaders in the media have failed miserably to identify it, let alone to show that its cost is sufficiently massive to justify a vast re-engineering of the financial markets.  Repeating “AIG AIG AIG” over and over again like financial Hare Krishnas doesn’t cut it.

Several posts discussing ongoing controversies about the Soviet role in World War II have resulted in extended discussions in the comment section about the Molotov-Ribbentrop Pact, also known as the Nazi-Soviet Non-Aggression Pact.  One line of thought, expressed most cogently by Cutie Pie, is that Stalin entered into this agreement with Hitler because the French and the British had left the USSR hanging by conceding Czechoslovakia to Germany; that the USSR was willing to go to war to defend the Czechs, but that France and Britain had undermined such an effort at collective security.  Given this evidence of Western pusillanimity, the argument goes, Stalin had no choice but to treat with Hitler to protect Soviet security.

I’ve responded that this doesn’t fully account for a good deal of Stalin’s motivation for entering the Pact; excuse Soviet behavior in the aftermath of the Pact; or recognize that the Pact actually turned out to be quite detrimental to Soviet interests because it freed Hitler to attack Poland, and then turn west to dispose of France and drive Britain to the brink, thereby leaving the USSR to fight Hitler almost alone.

Here’s a few things that speak to this debate.  The Encyclopedia of the Second World War gives a fairly balanced overview:

Aware of Russia’s enormous weaknesses . . . Stalin watched Hitler’s moves to rearm German and the success of his armed diplomacy in the Rhineland (1936), Austria (1938), and the Sudetenland (1939) with increasing nervousness.

Nonetheless, Stalin’s suspicion of all the imperialist powers, combined with marked Anglo-French reluctance to accommodate Soviet political and strategic interests in eastern Europe or to commit themselves to multilateral treaties with the Soviet Union, lent increasing weight to the idea of some rapprochement with Germany.

The crude Anglo-French assumption that Russia’s ideological incompatibility with Nazi Germany guaranteed Stalin’s de facto partnership with the West without a formal alliance was not shared by Stalin, who noted the widespread conservative sympathy for German expansionism in Britain and France . . . . Employing his own style of appeasement with some skill, Stalin . . . signaled his preparedness to treat with Hitler by replacing Litvinov with Molotov in May 1939. . . .

In August, with the German attack on Poland set for 1 September, it became imperative for Hitler to have an assurance of non-interference from Russia. . . . Ribbentrop’s overtures to Molotov on 15 August stressed the urgency of negotiations but were at first stalled by Moscow.  Requesting a  trade and credit agreement as a preliminary to the signing of the pact, Molotov also referred to the need for a special ‘protocol’ with respect to mutual interests in the Baltic states.  Impatient with the progress of negotiations, Hitler intervened on 20 August with a personal telegram to Stalin.  The resulting meeting in Moscow on 23 August produced an agreement in 24 hours. . . .

Despite the undoubted triumph of diplomacy for Russia, the signing of the pact contributed directly to the exercise of Nazi aggression, to which the Soviet Union would in its turn would fall victim in June 1941.

Contrary to the narrative outlined above, in which a desperate USSR, abandoned by France and Britain, attempted to secure its own safety by treating with Hitler, this account makes it clear that a nervous and impatient Hitler initiated the agreement, after receiving signals of Moscow’s willingness to bargain.

Henry Kissinger’s  Diplomacy  discusses the Pact in considerable detail.  It is far to long to quote extensively, but the name of the chapter that sets out the analysis–“Stalin’s Bazaar”–captures well Kissinger’s verdict.  He is scathing in his assessment of the British and French, condemning their dreamy unrealism.  He clearly admires Stalin’s diplomatic skills.  But his ultimate judgment does not support the Cutie Pie Hypothesis.

The entire chapter is obviously too long to quote in its entirety, but here are some salient parts:

“Only extremely wishful thinking on the part of the democracies’ leaders could have led to the widespread belief that Stalin–the original Bolshevik and a staunch believer in so called objective, material factors–could have converted to the juridical and moral doctrine of collective security.  For Stalin and his colleagues had reasons other than ideology to be unenthusiastic about the established international order.  After all, the Soviet frontiers with Poland had been imposed by force and Romania had seized Bessarabia, which the Soviets considered their own.  

Nor did the potential German victims in Eastern Europe desire Soviet help.  The combination of the Versailles settlement [which created many small states] and the Russian Revolution had created an insoluble problem for any system of collective security in Eastern Europe: without the Soviet Union, it could not work militarily;  with it, it could not work politically.”

This is particularly germane to the discussion of the realism of conjectures that the USSR would have defended Czechoslovakia militarily if the British and French hadn’t have folded at Munich:

One can only speculate what Stalin might have intended at the time of Munich.  Yet his least likely course at the moment when he was convulsing his country with purge after purge  would have been automatic and suicidal implementation of a mutual assistance treaty.  Since the treaty with Czechoslovakia committed the Soviet Union only after France was at war, it left Stalin with a number of options.  For instance, he could demand passage through Romania and Poland and use the nearly certain refusal of  those countries as an alibi to await the outcome of battles in Central and Western Europe.  Or else, depending on his assessment of the consequences, he could recapture the Russian territories lost to Poland and Romania in the aftermath of the Russian Revolution, much as he did a year later.    The most unlikely outcome was one in which the Soviet Union would mount the barricades as the last defender of the Versailles territorial settlement in the name of collective security.  

No doubt, Munich confirmed Stalin’s suspicions about the democracies.  Yet nothing could fundamentally deflect him from seeking to fulfill, at nearly any cost, what he considered his Bolshevik duty–pitting the capitalists against each other and keeping the Soviet Union from becoming a victim of their wars.  The effect of Munich, therefore, was primarily to alter Stalin’s tactics.  For he now opened up a bazaar for bids–one which the democracies had no hope of winning if Hitler was prepared to make a serious offer.

On the distrust of the British, and the difficulties of Britain and France in dealing with the USSR on Stalin’s terms:

[I]f Great Britain concentrated on a Soviet pact, Stalin was sure to demand his pound of flesh for helping the Poles by pushing the Soviet border westward, toward the Curzon line.

Spurred on by public outrage and convinced that retreat would further weaken Great Britain’s position, the British Cabinet refused to sacrifice any more countries, whatever the dictates of geopolitics . . . . Above all, the British leaders distrusted the Soviet Union: “I must confess,” Chamberlain wrote, “to the very most profound distrust of Russia.  I have no belief whatever in her ability to maintain an effective offensive, even if she wanted to.  And I distrust her motives, which seem to me to have little connection with our ideas of liberty, and to be concerned only with getting everyone else by the ears.”

On the calculating nature of Stalin’s diplomacy post-Munich:

The Soviets’  interest in preserving the status quo in Eastern Europe ended with the Eighteenth Party Congress . . . . Crucially, Stalin did in fact have the option of turning to Hitler and, after the British guarantee of Poland, could play his Nazi card with considerable safety. . . . his strategy . . . . was to make certain that the Soviet Union was the last major power to commit itself, thereby achieving the freedom of action for a bazaar in which either Soviet cooperation or Soviet neutrality would be offered to the highest bidder.  

More on the virtual impossibility of Britain (and France) dealing with the USSR on Stalin’s terms:

Yet it was not Great Britain’s clumsy diplomatic conduct that led to the Nazi-Soviet pact.  The real problem was that Great Britain could not meet Stalin’s terms without abandoning every principle it had stood for since the end of the First World War.  There was no point in drawing a line against the rape of small countries by Germany if that implied having to grant the same privilege to the Soviet Union.  A more cynical British leadership might have drawn the line at the Soviet border instead of Poland’s, thereby greatly improving Great Britain’s bargaining position with the Soviet Union and giving Stalin a serious incentive to negotiate about protecting Poland.  To their moral credit, the democracies could not bring themselves to consecrate another set of aggressions, not even on behalf of their own security. . . . Stalin had a strategy but no principles; the democracies defended principle without ever developing a strategy.

This last point emphasizes the importance of avoiding, to the extent possible, the error of interpreting decisions in light of what transpired afterwards.  From the British and French perspective, in 1939, it was not a trivial task to determine who was the greatest enemy to peace, Hitler or Stalin’s USSR.  The USSR was a committed enemy to capitalism and democracy, that had a longstanding policy of aiming to overthrow the western democracies.  It had a demonstrated record of mass murder and atrocity–more in fact, in 1939, than Hitler.  It had obvious designs on Eastern Europe–as did Hitler.  It could be expected to act brutally if it did move in to that region.  It is understandable that the British and French declined to deal with Stalin.
In the light of events, it is very plausible to assert that Hitler was in fact the greater threat, due Hitler’s unique psychology, in combination with Germany’s military and geographic characteristics.  From this perspective, it is possible to argue that the Allies misjudged.  

But Stalin clearly misjudged too.  He calculated that Germany would become bogged down in a war with France and Britain, and that this would give him the time he needed to prepare the USSR to defend against a German onslaught.  He calculated incorrectly.  The rapid German victory in the west, made possible by the Nazi-Soviet pact and the consequent securing of Hitler’s rear, left the USSR to face Hitler alone.

Here’s Kissinger’s final judgment:

Russia played a decisive role in the outbreak of both [World Wars].  In 1914, Russia had contributed to the start of the war by rigidly adhering to its alliance with Serbia and to an inflexible mobilization schedule; in 1939, when Stalin relieved Hitler of the fear of a two-front war, he must have known that he was making a general war inevitable.  In 1914, Russia had gone to war to preserve its honor; in 1939, it encouraged war to share in the spoils of Hitler’s conquests.

This seems to be a balanced judgment.  In this assessment, although Munich affected Stalin’s calculations, the Nazi-Soviet pact cannot be seen as primarily a response to it.  Instead, Stalin had territorial ambitions in Eastern Europe, and dealt with Hitler because that was the most effective way, in his view, to advance those ambitions.  Deflecting Hitler westwards also, in Stalin’s view, created the possibility of a vast Capitalist War that would destroy the USSR’s main rivals, Britain, France, and Germany, leaving the USSR dominant not only in Eastern Europe, but Europe more generally.  

In other words, the Nazi-Soviet Pact was the result of a bloody-minded calculation–or, in the event miscalculation.  Although French and British diplomacy in 1936-1939 was a disaster, to blame it for the Nazi-Soviet Pact is mistake.  The responsibility for this Pact lies squarely with its principals, Hitler and Stalin.  The consequences of the Pact–a World War that commenced in Poland on 1 September, 1939, and also, tens of millions of Soviet losses– therefore lie squarely with its principals as well.  The OSCE resolution that lays blame for the war on both Hitler and Stalin is therefore well grounded.