Streetwise Professor

Thinking more about the Chinese statistical issues that I wrote about on Thursday brought to mind my posts on the “stimulus” package and Keynesian economics.  A major theme of those posts was that massive government spending could raise measured GDP, but that the real value of the output created through such programs could fall far short of the recorded value.  Just because the government spends $100 billion doesn’t mean you’d get anything anyone would be willing to pay $100 billion for.  Keynesian accounting is based on the fallacious notion that there is some homogenous stuff called “output,”  and the loss of $100 of private output can be offset by a $100 of government spending/output.  

This seems to fit China to a “T”. China has undertaken a massive stimulus, drawing down a decent chunk of the nation’s savings to pay for all sorts of infrastructure projects, and other things.  This allows China to record GDP figures that match its forecast of 8 percent growth at the same time that its output of private goods and services (a very large fraction of which were exported) has declined due to the economic problems in the nations to which China exports.  

And the very fact that China has achieved this 8 percent growth target almost exactly, despite plunging exports, is the very thing that raises my skepticism.  The “aha” moment came in a phone call with a friend, who spends one month of every 4 in China.  I asked him about the economy, and he indicated how the government was trumpeting the meeting of the growth target.  I immediately had flashbacks to companies that met earnings targets quarter after quarter, like clockwork, only to have it revealed subsequently that this was achieved through accounting legerdemain.

China’s government can effectively do the same thing.  A yuan of government spending increases measured GDP by a yuan, even if it is spent on a project that generates no economic value.  It may generate political value, however, as a nervous Chinese government is anxious to spend to prevent social unrest.

And that’s a reasonable calculation for the Chinese government to make.  My concern is that many of the forecasts (and hopes) about an economic rebound in the US, Europe, and Japan are based on Chinese growth (and growth in other emerging markets) dragging the rest of the world along with it.  If reported Chinese GDP growth is driven primarily by government expenditure on dubious projects–and many of those in non-tradeables–it is quite difficult to see how these hopes can be realized.  It is unlikely that Chinese consumers are going to dramatically change their spending habits, especially in times of economic uncertainty; it is also unlikely that Chinese consumers are going to increase their demand for non-Chinese consumer goods; and it is further unlikely that recorded growth based on increases in government expenditure is going to lead to increased demand for Western-or-Japanese produced investment goods.   So just how is the Chinese stimulus going to be converted into increased demand for non-Chinese products?  

In brief, it seems to me that a crude Keynesian focus on economic aggregates is preventing people from assessing critically China’s actual ability to spur economic growth not just in China, but in the world at large.  It is highly likely that Chinese growth is largely chimerical, and that such chimerical growth is hardly the basis for a recovery in the world economy, especially given the export-driven nature of China’s recent growth.  

So, apropos my earlier posts, just as I was extremely skeptical that stimulus spending in the US would generate an economic recovery here, it seems to me that reported Chinese growth is a very weak reed on which to base hopes for an economic recovery in the US, Europe, Japan, or elsewhere in the world.

FT’s Energy Source blog kindly links to my piece on oil speculation.  Kate Mackenzie notes my argument on why commercial traders who perceive that they have an information advantage, and who speculate on that information, may support constraints on non-commercial speculators who compete with them.  (Ironically, we have houseguests named “Kate” and “Mackenzie” visiting this weekend.)

There’s another reason why some hedgers may want to crack down on speculation: some hedgers earn a risk premium rather than pay it, and competition from speculators reduces the profit that these hedgers earn.  When there is some segmentation between a particular commodity market (e.g., oil) and the broader financial markets, due for instance to a fixed participation cost like the cost of becoming informed, idiosyncratic risk affects risk premia.  This, in turn, can affect who benefits and loses from greater speculative participation.

The original Keynesian “normal backwardation” story assumes complete segmentation, in which case net hedging pressure–whether short hedging volumes exceed long hedging pressure at an unbiased price–determines the sign of the bias in the futures price (whether the future is above or below the expected spot price at expiration), and the amount of speculative risk bearing capacity determines the magnitude of the bias.  For instance, if short hedging pressure predominates (as Keynes believed) the futures price will be biased downwards (will be less than the expected spot price), meaning that short hedging is costly but long hedgers make a speculative profit; as the downward biased futures prices drift upwards on average to converge with the spot price at expiration, long hedgers profit on their long futures positions.  The bias is a profit for long hedgers, and a cost incurred by short hedgers.  This bias attracts speculators, who bid up the futures price until the expected profit arising from the bias balances the cost of the risk that they incur.  The greater the speculative risk bearing capacity, the lower the bias–and the lower the trading profit of the long hedgers.

This means that entry of speculators helps some hedgers–short hedgers–but HURTS others–long hedgers.  The bidding up of the futures price benefits hedgers who sell futures, and hurts hedgers that buy futures.  Thus, in a Keynesian world, long hedgers oppose speculators.  This means that hedgers will not uniformly support speculation.  Indeed, some market participants should actively support measures to constrain speculation.  

In a world where each commodity futures market is perfectly and frictionlessly integrated with the broader financial market, risk premia are determined solely by the systematic component of the commodity price’s risk.  

In a world between the frictionless world and the Keynesian one, both systematic and idiosyncratic risks affect risk premia, as was shown by Hirshleifer in the late-80s.  In this world, some hedgers will also prefer to crack down on speculation.  For instance, when short hedging predominates, long hedgers prefer to constrain speculation.  That’s because, like in the Keynesian world, they are effectively selling price insurance to the short hedgers, and receive a profit from doing so.  They don’t like the entry of speculators who compete away some of these profits.  

This can also explain why some hedgers would support measures that weaken the linkage between the broader financial market and a particular commodity market.  This weakening allows idiosyncratic risk to affect risk premia, and some hedgers in the market capture this risk premium as a profit even though those on the other side of the market pay it as a cost.  What’s more, the magnitude of this idiosyncratic risk premium depends on the ease of entry by speculators into the futures market.  

This analysis can explain some of the hostility to passive long index investors.  These investors are typically portfolio investors, and their participation in commodity markets helps to strengthen connections between commodity markets and the stock and bond markets.  Moreover, they compete with long hedgers in serving the risk management demands of short hedgers.  In so doing, they compete away some of the profit that long hedgers can earn in a market where short hedging predominates.  

Of course, this story implies that hedgers will not speak with one voice: based on these factors alone, one group of hedgers (e.g., short hedgers in the Keynesian story) will support speculation, while another group (long hedgers in the Keynesian theory) will oppose it.  (If long hedging predominates, the roles will be reversed.)  But combined with the other factors outlined in my earlier post–and perhaps others as well–this means that commercial traders who use futures markets as hedging tools can take very different views on the benefits of speculation.  

This is an old, old, old story in any analysis of regulation.  Although speculation improves the allocation of risk, and leads to overall improvements in welfare, it also has distributive effects.  Due to its effects on competition over information rents, or raising rivals costs considerations, or competition over risk premia, the entry of speculators can redistribute wealth at the same time that it increases (risk adjusted) wealth overall.  

This means that you should be very, very, very . . . skeptical about the protestations of some commercial firms about the evils of speculation.  They don’t necessarily have the interests of the market at large at heart.  Indeed, they almost certainly place their own interests foremost.  What’s more, it is inevitable that for some significant number of commercial firms these interests are contrary to market efficiency.  In derivatives markets, as in virtually every other, some firms can benefit from restrictions on entry or other impediments to competition.  Derivatives regulation, including regulation of speculation, is like other forms of regulation a rent seeking contest in which interested parties attempt to secure rents through the political process.  Sadly, it’s often those with the best lobbyists who win–not those with the strongest economic case.

One of my new favorite blogs, Zero Hedge, echoes my serious reservations about the reliability of bullish statistics releases from China.  The basic point is that (a) China had a heavily export oriented economy; (b) recent turbocharged Chinese growth was driven by exports; (c) world trade is in the dumper, and every other trade-dominated economy (e.g., Germany, Japan, S. Korea) is doing worse than other, less trade-dominated ones; and (d) it is very difficult to engender a major structural shift in an economy away from one driven by trade to one driven by domestic consumption.  The turnaround is attributed to a near immediate, miraculous reaction to a huge Chinese fiscal stimulus.  Maybe . . . but the evidence on the stimulative effects from other countries would suggest that such an outcome is highly unlikely.

Given that any optimism about world economic prospects is predicated on rosy views of the Chinese economic picture, if this data in fact exaggerates Chinese economic conditions, the implications for the strength and timing of any recovery in the West and Japan are not good.

There are some reasons to doubt Chinese data.  First, China is still an authoritarian state that exerts tremendous control over information.  Second, it quite anxious about domestic unrest–as recent riots make quite clear.  This could make it reluctant to disclose bad economic news.  Third, it does things like cut off releases of electricity data that might give the lie to other statistics.  (Of course, why not just lie about the electricity numbers if they are lying about something else?)

So, maybe the bullish news is true, maybe not.  I think that Zero Hedge’s skepticism is quite warranted however.  For if the data out of Beijing are correct, that would be the real Chinese miracle.

Russia blew a gasket (there’s a shocker) over the Organization for Security and Cooperation in Europe’s resolution laying blame for starting World War II on both Germany and the USSR, and calling for a day of remembrance on 23 August, the date that the Molotov-Ribbentrop Pact was signed:

“This is nothing but an attempt to re-write the  history of World War Two,” Konstantin Kosachyov, who heads the  foreign relations committee  of  Russia‘s lower house of parliament, told  Interfax news agency.

“The reaction of the parliament to this document will be immediate and it will be harsh.”

The resolution called for a day of remembrance for victims of both Stalinism and Nazism to be marked every August 23, the date in 1939 when  Nazi Germany  and the  Soviet Union  signed the  Molotov-Ribbentrop pactdividing  Eastern Europe  between their spheres of influence.

There are two main themes in the Russian response.  One is to say that Molotov-Ribbentrop was Stalin’s doing, not Russia’s.  Relatedly, that it was an action of the USSR, not Russia, and hence it is as much the responsibility of Ukraine and Kazakhstan as Russia.  But what makes that line less than persuasive is Russia’s confusing signals (to put it nicely) on its opinion of Stalin and Stalinism.  Stalin still commands widespread popular admiration in Russia, far more than in other former-Soviet republics, and there is reason to believe that many in officialdom share this view.  Putin’s criticism is limited primarily to the 1937 purges of Party cadres, for instance, and the new history textbooks speak approvingly of Stalin’s “strong leadership” and his role in modernizing the USSR, with little mention of the millions of deaths that resulted directly from this so-called achievement.  

This defense also rings hollow because if Stalin’s USSR and the modern Russian Federation are truly distinct entities, and the latter is not the inheritor of the Soviet legacy, why the outraged, defensive reaction at criticism of the actions of Stalin’s USSR?  Indeed, insofar as Soviet actions facilitated Hitler’s actions, the millions of Russian dead can also be laid at Stalin’s feet; in this interpretation, Russia should support condemnation of actions that contributed to this horrific human toll.  

The second line of defense is to point to the USSR’s immense sacrifices in WWII, and its decisive contribution to the vanquishing of Nazi Germany.  This is true, but it is completely disconnected from the matters raised in the OSCE resolution, and other (primarily Eastern European) criticisms of Soviet actions.  The Eastern European criticisms focus on Soviet actions before the war, especially from August 1939-June 1941: the Molotov-Ribbentrop Pact, Soviet conquest and brutality, or bestiality rather, in Poland, the Baltics, Finland, and Bessarabia, and its actions after the war, including oppression, political murder, and rampant rapine by Soviet soldiery.  

Soviet sacrifices in destroying Hitler deserve proper respect, but they do not excuse the USSR’s culpability in bringing on the war; its material assistance to Germany right up to the time of the invasion (with the last trains of materials destined for Germany rolling west up to the very moment that Barbarossa began); or its behavior in the regions it seized pursuant to the Secret Protocol.  Nor do they excuse its post-war actions.  

Indeed, the Russian refusal to engage this issue, and its furious reaction whenever it is raised, understandably creates great pain–and great fear–in Eastern European countries.  It suggests that Russia still does not view Eastern Europe as truly independent, or equally sovereign as Russia.   Hiding behind the mountain of corpses of Soviet (including Russian) dead in order to avoid a forthright condemnation of actions that arguably contributed to unleashing WWII, and which beyond a shadow of a doubt led to the unleashing of a torrent of blood and torture in the regions occupied by the Soviet Union in 1939-1940, can do nothing but raise serious doubts about Russian attitudes towards Eastern Europe and its people.  

And that can only make Eastern Europeans more suspicious of Russia, and more anxious to receive NATO and especially American support, including military support.  This is something else which sends Russia into paroxysms of rage–and for which Russia has itself is primarily to blame.  Jingoistic chest-thumping may feel good, but it is ultimately self-defeating.

Almost exactly a year ago, I testified before the House Ag Committee and wrote an oped for the WSJ on the effect–or lack thereof–of speculation on oil prices.  The issue was high on the political agenda at the time, as oil prices hit $147/bbl, and gas prices were above $4/gal.  The collapse in prices during the financial crisis put the issue on the backburner, but it is back with a vengeance.  To loud Congressional hosannahs, the CFTC has announced its intent to impose a far reaching regime of position limits on energy and other commodities “in finite supply“–pray tell, what traded commodities are in infinite supply?

So, I guess I have to roll that rock up the hill, yet again.  (I have posts on the subject of “excess speculation” and position limits from 2006, 2007, 2008, and 2009.)  

At the risk of becoming even more of a repetitive bore than usual, I’ll restate my objections to the intellectual basis to these policy initiatives, and the policy initiatives themselves.  Before doing so, it is worthwhile to define “excessive speculation,” something those that hurl around the phrase with abandon almost never do.  I define “excessive” speculation as that which drives prices away from the competitive price consistent with available information.  That is, excessive speculation distorts prices.  Now, my objections:

• The mechanism by which speculators allegedly distort prices is almost never specified, and when it is, it makes no sense.  Advocates of the “excessive speculation” hypothesis routinely say that speculators inject artificial demand into the market.  Given that most speculators almost never actually take delivery, and thus offset their positions as they become prompt, they are not influencing either supply or demand for the physical commodity.  This is a point that has been recognized since at least 1902 in a report authored by the US Industrial Commission, which included several Congressmen and Senators.  Which I guess goes to show that Congressional IQ exhibits an inverse Flynn Effect.  
• This is especially the case for commodity index traders, who almost all trade cash settled instruments, and hence can in no way influence supply or demand.
• That is, none of the boatloads of money allegedly flowing into commodity funds actually goes into, you know, actual commodities.  Some of the money in commodity-linked investments is purely notional (e.g., in commodity swaps, or index swaps).  Some goes into T-bills (in the form of margin, or in fully collateralized commodity trades).  
• The evidence of a distorting speculative effect is laughable.  Distortions in prices should lead to distortions in quantities, e.g., in commodity stocks.  No reliable evidence of such an effect exists.  Indeed, I have looked at one commodity–copper–in close detail as part of a chapter of my upcoming book on commodity price modeling.  People were screaming about a speculative bubble in copper last year at the same time as the (louder) screams about a speculative bubble in oil.  But copper stocks (and the stocks of other industrial metals) were drawn down sharply at the same time prices were spiking: this is exactly what one would expect to observe with a positive demand shock.  Indeed, I am working on calibrating a rational expectations theory of storage model to copper data, and this model can explain the twists and turns of prices and stocks during the extreme events of the last several years.  That is, speculative irrationality is not required to explain the movements in copper prices AND inventories over the 1997-2009 period.  (I’ll post more on this when I finish a couple more parts of the analysis next week, hopefully.)
• Some of the “evidence,” logically ungrounded as it is, doesn’t even support the assertion of a speculative effect.  For instance, a common piece of “evidence” is that prices rose right along with measures of long speculative interest in the oil markets.  (This was a Michael Masters favorite).  Set aside the correlation-causation post hoc/propter hoc problems, and the potential for spurious regression problems whenever one examines the relation between two highly autocorrelated series.  Just look at the graph in this WSJ story:

Sure, prices and long non-commercial positions were both trending up in 2005-2008 (not that that means a damn thing).  But look at what happens in late-08 and early-09.  Prices and long spec positions are mirror images: prices were plunging when long interest was rising, and then, just as long spec interest peaked and began to fall, prices ceased their fall and moved strongly upwards.  How can you possibly explain this if the market dances to the speculators’ tune?  The speculative Pied Piper story says that these measures should move up and down together, not in opposite directions.  Now, this Masters style analysis is B.S., but those who used it to rationalize their assertions of a speculative effect are hoist on their own petard: they vouched for the validity of non-commercial long open interest as a measure of the “excess” demand for oil caused by speculation, but the most recent experience is decidedly inconsistent with that story.  Not that that they have even paused for thought, but continue to flog the same story.  

• Not to mention that numerous analyses, relying primarily on Granger causality, have failed to find any reliable connection between changes in speculative positions and price changes.  Or the analysis (by the CFTC!) showing that commercial traders tend to be market leaders and speculators are followers.

The calls for government regulation have gone international, and gone beyond calls for mere position limits.  Gordon Brown and Nicholas Sarkozy penned a WSJ editorial advocating widespread governmental “supervision” (Euphemism alert!) of the energy markets (including cooperation with OPEC):

For two years the price of oil has been dangerously volatile, seemingly defying the accepted rules of economics. First it rose by more than $80 a barrel, then fell rapidly by more than $100 before doubling to its current level of around $70. In that time, however, there has been no serious interruption of supply.

The oil market is complex, but such erratic price movement is cause for alarm. The surge in prices last year gravely damaged the global economy and contributed to the downturn. The risk now is that a new period of instability could undermine confidence just as we are pushing for recovery.

Where does one even begin the ridicule (beyond noting the point that whenever French and British politicians agree, it must be a really bad idea)?  Regarding volatility.  Uhm, the past two years have been among the most volatile in the memory of most living people–you have to go back to the 1930s to find anything remotely similar.  In 2007-FH2008, Chinese (and Asian growth generally) greatly spurred demand for commodities.  Note that in addition to commodity prices, shipping charter prices skyrocketed, even though the price of something perishable like transportation on a ship can hardly be distorted by speculative buying, because it has to be consumed and hence is impossible to hoard.  That was followed by a financial collapse and economic recession of severities unseen since aforementioned 1930s.  Look at every measure of uncertainty, notably such things as the VIX volatility index.  These things have been at dizzying heights since last August (and had begun their rise even earlier, in 2007).  What would be weird is if oil prices (and commodity prices generally) HADN’T been volatile during this period.  

Regarding “serious interruption of supply.”  Uhm, Gordo, Nicky–there’s this concept called “demand.”  Believe it or not, it’s one of the “accepted rules of economics.”  Don’t take my word for it.  It’s in all the textbooks.  Price evolution in the recent period is clearly demand driven, not supply driven.  Prices spiked when demand spiked.  Prices plummeted when demand cratered.  

And there have been supply shocks.  Nigeria is an ongoing source of supply shocks, and during the price spike last summer losses of sweet Nigerian crudes in the face of very high demand for distillates (driven in part by European regulations regarding clean diesel) led to big spreads between benchmark sweet crudes like WTI and Brent and sourer crudes.  What’s more, OPEC output cuts (especially by Saudi Arabia) played a key role in the firming of prices following the price collapse in October-January.

I should also note that recent research by Lutz Kilian (nicely summarized in his JEL piece) shows that movements in oil prices hew more closely to movements in proxies for demand than measures of supply.  James Hamilton disputes Kilian’s contention that supply shocks are unimportant, but Kilian does demonstrate that demand is clearly an important price driver.  (I also have some reservations about some of Kilian’s analysis, most importantly his conclusion that changes in demand for precautionary inventories is also an important driver of prices.  I don’t disagree with the logic, having written several posts and an academic paper–which will also be another chapter in the book–showing rigorously how that can work in practice.  My problem is that Kilian does not measure factors that could affect precautionary inventories directly, but instead attributes oil price movements not explained by supply or demand measures to an “oil market specific” factor which he asserts is related to the precautionary inventory effect.  I am currently working on developing some more direct measures that would influence precautionary inventory holdings.  I have a good handle on measuring demand side risks that could influence such holdings, but measuring supply side risks is far more difficult.)

In recent months, the oil market and world equity markets have exhibited unprecedented positive correlation (something I called attention to in October-November).  Oil and equities swooned together; they rallied together March-June; and have been selling off together in the last couple of weeks.  This reflects the dominant role of demand in commodity prices at present.  Both equities and commodities are responding to rapidly evolving views in a highly uncertain situation about the likelihood and strength of economic recovery.  They are also responding to government policies, notably aggressive quantitative easing strategies that raise the specter of inflation.  

Now, you could argue that this is speculative.  And indeed it is.  Both equity market and commodity market participants are speculating on the future course of the world economy.  But is it destablizing speculation?  

What’s more, to the extent that energy prices (and commodity prices) are reflecting information/perceptions/sentiment about the future course of economic recovery, and are reflecting the same information/perceptions/sentiment as equity markets and bond markets, why would anyone think that position limits on commodity derivatives would break this linkage?  Once embedded in equity prices, information/perceptions/sentiment about future economic growth become public information that will be embedded in prices even if speculators are forced to trade less.  

The arguments against position limits as a policy are well known.  Speculators absorb risk from hedgers, and supply liquidity.  They therefore impair ability of the markets to serve their essential risk shifting function.  They therefore increase the costs of managing risk, and impose harm on hedgers.

This makes a mockery of the distinction that politicians and regulators draw between the “good hedgers” with price exposures inherent in their businesses that need to be managed, and “bad speculators” who have no underlying exposure to manage, but are taking on risk like gamblers in a casino.  But there is a symbiotic relationship between hedging and speculation.  To whom do hedgers transfer the risk if not to speculators?  And if there are no speculators, how is it possible to hedge risks?; after all, hedging doesn’t make risk magically disappear, it just transfers it to somebody willing to hold it–a speculator.  Thus, politicians and regulators who invariably say that they just want to protect “legitimate” commercial participants from the predations of evil speculators are more full of it than usual.

That said, there is an apparent puzzle: many of the most ardent critics of speculation are physical market participants.  But it’s not necessarily a puzzle, for the same reason that nobody should be amazed that Walmart supports Obama’s health care plan: many firms benefit from regulations that make markets less efficient.

In the commodities case, here are a couple of examples.

It is well known that some commercial market participants are informed traders who make money on the basis of their information.  A Cargill, for instance, has an extensive information network that allows it to trade profitably.  (I sat at the trading desk of Continental Grain some years back, and observed that the traders had access to information around the world about weather conditions and grain flows due to their physical presence in numerous markets.  This gave them an information edge.)  Such firms don’t hedge mechanically.  They trade futures and other derivatives strategically to optimize a risk-return trade-off.  Their information advantage allows them to time the placement and unwinding of their hedges so as to make money.  

Competition from informed speculators tends to erode the competitive/information advantage that informed commercial firms have.  Hamstringing such competition could provide a greater benefit to such firms than would result from the loss of liquidity from speculators.  

As another example, a reduction in market liquidity resulting from speculative position limits almost certainly has disparate impacts on commercial firms.  Some firms, due to capital structure, operational leverage, real options, or other reasons, get more benefit out of hedging than other firms in the same industry.  A regulation that reduces market liquidity raises everybody’s costs, but the first type of firm’s costs go up more than the second type of firm’s.  Thus, the second type of firm may actually support regulations that make hedging costlier or less effective because it raises their rivals costs more than its own costs go up.  

So, the support of some commercial firms for restrictions on speculation is not necessarily a puzzle.  In my view, it more likely reflects an opportunistic use of the regulatory process to distort competition in a way that profits some firms.  This is a ubiquitous phenomenon, observed in many industries and many regulations: why should derivatives trading be any different?  

Well, that’s all I have to say for now, though I doubt this will be last word on the subject, hardy perennial that it is.  Like Sisyphus, I am resigned to the unending task of rolling the rock of enlightened reason up the slope of benighted ignorance, only to see it slip back down again:)

Obama’s trip to Moscow has brought more than the usual attention on Russia.  One story that received considerable attention was the President’s drawing a distinction between Medvedev and Putin, and accusing the latter of having a Cold War attitude.  I think that, as usual, Obama’s grasp of history leaves something to be desired.  Putinism is more of a throwback to imperial, or patrimonial Russia, rather than Soviet communism; any similarities between Putin’s Russia and the Cold War USSR are attributable to the latter’s tsarist inheritance.  Moreover, if this is Obama’s idea of a clever turn-the-tables-and-divide-and-conquer-the-master-divider-and-conquerer gambit, fuggitaboudit.  I am sure they are having a good belly laugh in Moscow about it as we speak.  There is a clear verticality in the relationship between Putin and Medvedev (verticality being a theme I return to below), with Putin clearly in the dominant position.  Attempting to play this game betrays a serious misunderstanding of the situation, and a by now familiar overconfidence from Obama.  

Articles in the Washington Post and LA Times identify a key driver in Russian attitudes towards the US that will make any serious rapprochement unlikely: that being a deep Russian sense of insecurity and grievance.  David Ignatius in the WaPo:

The Russia that Obama will encounter is proud and prickly. The country’s leaders aren’t sure what they want from America, other than to be respected and taken seriously. U.S. analysts talk about a new strategic partnership, but Russian officials are mistrustful of large American designs. They think the United States took advantage of them during their years of weakness, and they’re still licking their wounds. Their empire collapsed partly because of a misconceived war in Afghanistan, and they think America’s should, too.

. . . .

“We want equality. We want our interests recognized — to have them considered as significant,” said one Russian panelist. But when Americans attending the meeting asked for specifics, another Russian who is a prominent politician suggested: “The real problem is that we don’t understand what we want.”

 Megan Stack in LAT:

The Cold War is a faded relic in American memory. Now there are Iran and North Korea to worry about; a few years ago, there was Saddam Hussein. And so it is perhaps easy to forget that, in Russia, the Cold War remains a poignant and powerful idea.  

Talk of current events often conveys the distinct sense that Russia is clinging to the idea of an American threat. If there is no hostility with the United States, the thinking runs, it can only mean that Russia is no longer important enough to merit it. And that’s unpalatable to Russia’s political elite.

. . . .  

In this atmosphere of heightened anxiety, a documentary called “Velvet.ru” appeared on state television to warn Russians of the threat at hand. This was the gist:

The U.S. State Department and the CIA, jealous of Russia’s vast oil, gas, timber and diamond riches, were backing anti-Kremlin activists in a bid to overthrow the government and dismantle the country.  

“They’re already here on our threshold, agents and professional provocateurs, preparing for a coup in Moscow,” the narrator warned. “In American perception, this state should disappear. Russia should break into pieces.”

I hypothesize that these delusions about American obsessions with Russia are psyche-salving cover for a reality that many Russians probably suspect but just cannot abide: bluntly put, that the vast majority of Americans spend more time deciding between Original Recipe and Extra Crispy than they spend thinking about Russia.  For Russians, Machiavelli’s choice between being loved and feared is easily answered, but the worst thing by far is to be ignored.

This kind of thinking reminds me of an observation sent to me by a SWP reader: the Russian obsession with status, position, hierarchy–verticality, if you will.  Putin, with his obsession with the “power vertical” epitomizes this, but it is arguably a fairly widespread phenomenon (which perhaps help explain his popularity, as he embodies a widespread mindset).  More generally, it pertains to the subject of the peculiar, and to a classical liberal repellent, relationship between ordinary Russians and those in authority.  Obama’s diss of Putin betrays a complete misapprehension about that relationship, and is hence almost certain to backfire, and not just with Putin, but with a large majority of Russians.  

Which, in turn, leads me to a book I’ve been skimming, Daniel Rancour-Laferrier’s “The Slave Soul of Russia: Moral Masochism and the Cult of Suffering.”  Now, Rancour-Laferrier is a psychoanalyst, and the term “moral masochism” is a term of art in psychoanalysis: after being force-fed Freud as an undergrad at Chicago, few things generate a quicker eye-roll reflex than psychoanalysis.  Although I don’t really buy the psychobabble, Rancour-Laferrier does raise a key question: who is ultimately responsible for Russian authoritarianism, and Russian suffering?  

I can anticipate the head-exploding reactions in some quarters, so I’ll just lay out some of what Rancour-Laferrier has to say:

What are the causes of the great suffering that goes on in Russia?  Whence the Russian “need to suffer” (“potrebnost’ stradaniia”)–as Dostoevsky put it?  Who is to blame?–to ask the perennial Russian question.

Russia is customarily characterized as an “authoritarian” or “patriarchal” culture.  This is no doubt true, but the very terms tend to attact blame toward those exercising “authority,” and draw analytic attention away from those who do the suffering and who might possibly be complicitous in the “authoritarianism.”

. . . .

Little effort has been made to understand just how the Russians manage to consistently get themselves into situations where there appear to have no choice but to submit and to suffer.  How did Russians come to acquire their well-deserved epithet of “long-suffering people (“terpelivyi narod”)?  

The centrality of Russian suffering as a reality, and as a centerpiece of Russian self-identity I think is beyond question.  The issue is why?  

An important issue with respect to suffering is the old Leninist matter of “who-whom.”  The conventional wisdom is that authority is the “who” that inflicts the harm, and the Russian populace is that upon whom the suffering is inflicted.  But Rancour-Laferriere suggests that it is not so simple: that perhaps ordinary Russians are complicit.  He pays special attention to the submissiveness of Russians towards authority.  Discussing Russian folklore proverbs collected by Vladimir Dahl, he says:

These utterances attempt to teach the peasant a sense of absolute submissiveness before authority . . . Note also the “vertical” orientation of many of the sayings, the submissive party being well “below” the dominant party in the spatial configuration.  Perhaps this is what [poet Viacheslav] Ivanov had in the back of his mind when he spoke of a Russian “law of descent.”  

This whole subject of suffering, vertical relationships to power, and status is quite complex.  It is a minefield to which I don’t claim to possess the map.  But the important thing is that Obama doesn’t either, and his extremely clumsy foray into such dangerous terrain is quite frightening as a result.  Fools rush in where angels fear to tread. The mistranslated, written in Latin (rather than Cyrillic) characters “Reset Button” looks like a canny move by comparison.

What would be a better approach?  Well, certainly not the kiss up to thugs approach a la the outreach to the Mullahs.  There’s no need to lie or flatter–it won’t make any difference anyways.  I would suggest just playing it straight.  Representing American interests and views, and avoiding ham-handed attempts to play politics in Russia.  Such games are likely to backfire with a nation hypersensitive about status and characterized by a symbiotic relationship between the rulers and the ruled.  

One more comment about Rancour-Laferriere.  His concluding lines are quite intriguing:

In his book on Dostoevsky Berdiaev says: “There is a hunger for self-desruction in the Russian soul, there is a danger of intoxication with ruin.”  I confess that I have sometimes found it exhilarating to observe this danger–from afar.

For me, masochism is part of the very attractiveness and beauty of Russian culture.  Where would Tatiana Larina or Dmitrii Karamazov or Anna Karenina be without their masochism?  To “cure” them of their masochism would be to detract them from their aesthetic appeal.  

It has often struck me that Russia is essentially a Romantic culture, and that it appeals primarily to non-Russians of a Romantic persuasion.  The sufferer has always attracted the Romantic, and since Russia is the archetype of the suffering nation, what could be more, well, romantic?  But if you are not a Romantic–and I am definitely not–you are more likely to be repelled than attracted.

Seeking Alpha has picked up SWP as one of its regular contributors, for which I am appreciative.  I join a select group of 400;-) including (ironically) Bill Gross.  It will be interesting to see how it affects traffic, which set a (very modest) record in June: maybe I should leave the country more often.

A trader at British oil brokerage PVM Oil Associates has been identified as a rogue trader who entered buy orders for 9mm barrels of Brent crude futures on ICE Futures in London during the illiquid early morning hours, causing a spike in the price of oil–and costing PVM $10 million.  To me, the most interesting aspect of this is the potential for can’t-change-their-mind-won’t-change-the-subject fanaticism of American legislators railing against the “London loophole”:

Unauthorised trading in oil futures in London and the corridors of power in the US Congress may not seem to have much in common.

But London’s markets have become easy targets for US lawmakers eager to show that loose practices on foreign energy markets are hurting US consumers.

Traders, so the theory goes, are carrying out nearly half the world’s global crude oil futures trades on ICE Futures Europe under the eyes of the Financial Services Authority.

The  PVM case  could re-ignite such concerns, just as US politicians are again railing against “excessive speculation” in energy and commodity markets.

This week Bart Chilton, a commissioner at the US futures watchdog, the Commodity Futures Trading Commission, said it was looking for signs of excessive speculation in commodity markets, with specific attention on oil prices.

Last month senator Carl Levin, a Michigan Democrat who has long campaigned for  tighter regulation of energy markets, said the US futures markets regulator needed to enforce strict position limits to curb speculation that last year caused record  wheat prices  that could not be explained by the dynamics of supply and demand.

A year ago, Mr Levin became convinced that improper trading of oil futures was taking place in the UK’s financial centre without sufficiently tight supervision by regulators.

A version of the West Texas Intermediate crude oil contract is traded in London on ICE Futures Europe, and regulated by the FSA. It is similar to the WTI contract traded on the New York Mercantile Exchange, regulated by the US futures watchdog, the CFTC.

Dubbing this the “London Loophole”, Mr Levin forced the CFTC to forge closer ties with the FSA, including a system by which the FSA would report irregular market activity much more quickly to the US.

Yet it does not seem to have worked as intended in the PVM case. CFTC officials claimed they were kept in the dark for several hours in spite of last year’s agreement for closer co-operation.

The FSA said on Friday: “We work very closely with the CFTC to ensure fair and orderly markets. The way we oversee the commodity markets is adequate for the UK regime.”

If there was any delay, regulatory experts say that could easily have been due to the time it took for FSA officials to get a clear picture of what had taken place at PVM, not a break-down in communications with the CFTC.

“The last thing they want to do is start rumours if they don’t know all the facts,” said one.

For the record: rogue trading is an international problem. A few choice examples: Singapore’s China Aviation Oil (2004, $550 million); France/Germany, SocGen’s Jerome Kervial, (2007-2008, $6.5 billion) (yes, with a “b”); Japan/Singapore, MItsui Oil Asia (2006, $81 million).  

Oh, and the United States.  We don’t know whether the 22 September, 2008 spike in the oil price–which dwarfed the recent spike apparently caused by the PVM trader–was due to a rogue trader, but it is highly suspect nonetheless.

And who can forget the MF Global trader in Memphis who lost $141.5 million in a day on Minneapolis wheat?  

I could go on.  

Where does rogue trading occur?  Well, where trading occurs.  There is a lot of trading in London, so it is inevitable that some rogue trading will occur there.  When assessing the adequacy, or not, of regulatory oversight in a market, it would be worthwhile to control for the magnitude of trading activity.  On that score, Singapore looks like a more dodgy place (with the infamous Nick Leeson/Barings episode in addition to the two cases listed above).  So, actions relating to the London Loophole (a vastly overrated financial bogey man in any event) are unlikely to have any effect on the frequency of rogue trading.  

It is primarily a problem of internal controls, but there is no system of controls that is capable of eliminating rogue trading altogether.  (Moreover, as with anything, there is a trade off, and it would be inefficient to invest in controls sufficient to eliminate such trading.)   And the US is hardly immune to the problem.  So although regulatory jingoism may feel good, it can happen here.  And it does.

The Senate Permanent Subcommittee on Investigations released a report on “Excessive Speculation in the Wheat Market.”  The report blames index funds in particular for driving up wheat prices, and particularly for driving a wedge between wheat futures prices and the price of cash wheat, both prior to and at contract expiration.  

The methodology of the report should be tiresomely familiar by now.  It notes concurrent events–(a) increased volume of trading by long-only index investors, and (b) higher prices and lack of convergence–and asserts (a) caused (b).  To be fair, the report does make comparisons between Chicago wheat and Kansas City wheat, which have experienced different degrees of index participation (measured by fraction of open interest) and convergence problems, but this analysis is weak because it does not attempt to determine whether other differences between the contracts might also be responsible for the differences in behavior.  (A bit more on this below.)    

However, the report largely ignores the rigorous empirical evidence that has examined the relations between index fund trading and price changes, and found no reliable evidence of such a connection.  Moreover, there are numerous commodities embedded in the indices, and the following the logic of the hypothesis, increasing index activity should affect price levels and cash-futures relations in all of these markets.  The report does not undertake a rigorous cross-sectional or time series of the cross-section analysis of the relation between index participation and the basis or convergence.

There are also serious logical problems with the analysis.  The main issue relates to the convergence of deliverable cash and futures prices as a contract moves to expiration.  It is very difficult indeed to see how index funds could possibly be implicated for this phenomenon.  Index funds roll from the expiring contract to the first-deferred contract before expiration. They therefore cannot have a direct impact on the expiring futures price at expiration.  Indeed, during the roll, long-only funds are selling the expiring futures, which per the crude story embedded in the report should cause that futures price to decline relative to the cash price.  In brief, I cannot think of any reasonable argument explaining how index funds can prevent convergence when they are out of the market altogether when the absence of convergence has occurred.  

Relatedly, the report repeatedly states that the index funds are creating demand for wheat (and other commodities).  Uhm, no, actually.  They don’t take delivery, and don’t consume the physical wheat or hold it off the market.  For every contract they buy, they also sell, so they don’t create any demand.  Moreover, although unexpected flows of buy orders can cause price reactions even if the orders are submitted by the uninformed (because other market participants don’t know exactly who is submitting the orders and there is a positive probability that the buy is from an informed trader), index activity is pretty well understood, and unlikely to result in the market being systematically surprised as would be required to support the report’s conclusion.  

The analysis also begs the question of why smart money hasn’t piled in to offset the purported effect of the dumb index money.  After all, in the scheme of things, the Chicago wheat futures market isn’t that large.  If the investment of the index funds was sufficient to drive up prices, not that much investment would be required to have an offsetting effect.  During the time that the basis and convergence anomalies were most pronounced, the world was awash in liquidity and capital desperate for returns.  Not only was money piling into indices, it was also going into hedge funds and managed futures funds whose whole business is to identify mispricings and jump on them.  That is, if this was an era of “excessive speculation” as the report laments, why didn’t other evil speculators trade ruthlessly against the dumb money?  

All this said, the absence of convergence during the period studied (most pronounced in wheat, but also present in corn and soybeans) is a puzzle.  It would seem to present a fabulous opportunity for operators of delivery facilities (e.g., Cargill, ADM and The Andersons) to make huge money buying cash, selling expiring futures, and delivering, and continuing to do that until convergence was achieved.

In a competitive market, the spread between expiring futures and cash prices should equal the marginal cost of making delivery.  This should be true, regardless of whether index funds are inflating the entire price structure or not.  What could explain such an extremely high shadow cost of delivery?  

One difference between Chicago and Kansas City is that the former’s contracts use a shipping receipt delivery mechanism which is effectively a call option on delivery elevator capacity, whereas the latter’s is a traditional in-store warehouse receipt delivery mechanism.   The report doesn’t mention this difference, which in theory could have an effect on futures-cash spreads (as I outlined in posts last summer).  However, it is difficult to believe that this option-based story is sufficient to explain the very large futures-cash spreads at expiration.  

Where convergence is concerned, the first focus of inquiry should be the behavior of delivery elevators and their operators.  It needs to be asked: “Why don’t you deliver more when the expiring future is so far above the cash?”  It is an extremely serious failing of the report that it does not ask this question.  Interestingly, the names “ADM,” “Cargill,” and “The Andersons” appear only once in the report–and then only to state factually that they operate delivery facilities.  It is beyond belief that any serious study of the convergence issue would not attempt to dig into this real mystery of why operators of delivery facilities do not pick up the money that appears to be there in large amounts for the taking.  This is not an accusation of any wrongdoing–perhaps there is an explanation, and the apparent large sums of money to be had are chimerical because there is some cost that the delivery facility operators incur that is not obvious to me and other observers of this phenomenon.  But it should be the primary focus of any examination of convergence.  In the Senate report, this issue doesn’t even rise to the level of afterthought: it isn’t thought about at all.

The flagrant failure to engage the primary puzzle suggests that this was not a serious endeavor to understand an admittedly anomalous regularity in the wheat market.  Instead, it suggests that the Subcommittee and its chairman, Levin, had predetermined agenda: Speculation bad!  Index speculation bad!  The report goes nowhere close to proving that point.  Indeed, its watery-thin empirics, shaky logic, and failure to ask the most basic question prove only that one shouldn’t look to legislative reports for a serious discussion of serious issues.  They are polemics, not science.

The European Commission has just released a Commission Staff Working Paper  on “Ensuring efficient, safe, and sound derivatives markets.”  Not surprisingly, it comes out in favor of extending central clearing, especially to credit default swaps.  It must be said that the EC’s paper is far superior to the product of the US Treasury Department (a low bar, to be sure).  That said, I believe that many of the arguments and conclusions are fundamentally wrong.  The paper does the best job I have seen in making the case for extending clearing, but in so doing has unintentionally pointed out the flaws in that case.  Indeed, the basis for many of the paper’s conclusions actually supports the exact opposite of what the paper recommends.

At a high level, the failings of the paper are: (1) it identifies alleged benefits of central clearing, virtually all of which are private benefits, but completely begs the question “if these (private) benefits are as large as the EC says, why haven’t private parties adopted central counterparties (CCPs) more widely?”; (2) relatedly, it does not provide any explanation of why the market share of products purportedly traded on inefficient market structures has increased in recent years; (3) it fails to take into account the endogeneity of market structure, or explain how these structures arose and why–or why not–they are inefficient; and (4) although it clearly identifies the unique risks associated with CDS, it draws the exact wrong conclusion about how default risks from CDS should be borne–bilaterally or through a CCP.

The paper’s main case for CCP clearing (set out in section 2.4.2 and 2.4.2.2) focuses on netting, and the benefits associated therewith including “more efficient use of collateral” and “operational efficiencies.”  But these are benefits captured by the members of a CCP, and provide no rationale for mandating the adoption of clearing.  There’s no externality related to these issues that needs internalizing.  Relatedly, the paper asserts that a CCP is “considered a zero risk counterparty” and hence frees regulatory capital.  Really?  Clearinghouses can fail.  Cf. Hong Kong, 1987, and the near failures in Chicago at the same time, and the near failure on COMEX on “Silver Tuesday” 1981.  If regulators really treat it this way, a CCP would be a source of regulatory arbitrage, again meaning that market participants would have a strong–too strong, in fact–incentive to adopt it.  

With respect to risk sharing and collateral, the paper mistakenly claims that all collateral can be used to cover the costs of a default.  This is obviously wrong–as the box on SwapClear default management process in section 3.2.5.1 shows.  

The paper fails to mention that netting is not necessarily a social benefit, and can facilitate redistribution from one group of firms to another.  This redistribution can also give excessive incentive to form a clearinghouse.  

The paper also fails to recognize that more rigid collateral mechanisms can reduce the utility of a market as a hedging mechanism, and forcing adoption of these mechanisms can actually increase risks some firms face by precluding otherwise mutually beneficial hedging trades.

The paper touts that a CCP “an institution whose sole focus is risk  reduction.” But the world involves trade-offs, and an organization with a “sole focus” is not able to make such trade-offs. If the CCP prices risk appropriately, and therefore charges the right amount of collateral, then other market participants will make the appropriate decisions. But as I’ve argued extensively here, in my Regulation Magazine piece, and in working papers and presentations, for many transactions the clearinghouse is at an informational disadvantage relative to dealers in appraising risk–in which case it is less likely to price risk appropriately.

Moreover, the paper does not consider the incentives that the CCP faces. Yes, it has one job, but how strong are its incentives to do that job? A CCP is typically subject to low-powered incentives (e.g., non-profit form), which is understandable since it is an agent, and an agent of multiple principals; whereas a dealer bears many of the costs of poor counterparty risk management, as an agent the CCP does not. Moreover, although the CCP is touted as a solution to systemic risk, if systemic risk gives rise to externalities that affect those beyond its membership, this benefit is overstated: the CCP does not internalize all relevant externalities and therefore takes too few measures to address systemic risk.

The clear logical implication of the EC paper is: “If clearing is so great, somebody should have done it by now.”  Like virtually all advocates of the idea, the EC paper does not raise, let alone answer, that objection.  To do so, the EC must identify the market failure, and show how its proposed solution would ameliorate it. It has not done so.  It has not even recognized the necessity of doing so.  

The paper also asserts that clearing can “solve[] disruptive information problems” by improving information on positions.  But this can be achieved without the mutualization of risk that clearing entails.  

The paper sets out in great detail the dramatic growth in OTC trading, and the limited penetration of clearing, even in relatively standardized sectors.  Again, given the asserted benefits of clearing and other changes to OTC market structure, this calls for an explanation that is completely absent from the paper.  There must be something else going on here sufficient to overcome the supposed advantages of a CCP.

The paper does provide a very nice description of the variations in structure across different OTC products.  Note that these structures arise endogenously.  This raises the questions: (1) why do different products (e.g., interest rate swaps and CDS) have different structures? and (2) are these structures inefficient?  The endogenous variation suggests that there are fundamental differences across products and participants, and that different structures have evolved to accommodate these differences.  The paper sets out no serious argument or evidence that these variations are accidental, or inefficient.  As a result, it provides no basis for recommendations on how to change market structure via regulation.  

This failure to grapple with endogeneity–the causes of variations in market structure across products–leads to silly inferences, such as: “CCPs have proven to be resilient even under stressed market conditions . . . and showed their ability to ensure normal market function in the case of failure of a major market player” (2.4.2.1).  Yes . . . but this does not imply that similar results would obtain if all products were cleared.  The products that are cleared, and which worked successfully, have attributes that differ from the attributes of products that are not cleared–a point that the paper makes very forcefully.  Therefore one cannot conclude that requiring clearing of other products would work as well.  It could also be stated that other non-cleared products, e.g., CDS, also worked successfully in the face of the failure of a major dealer.

This issue of the differences across products is essential, and one that the paper raises repeatedly before drawing the wrong conclusion.  For instance, in the Executive Summary, and elsewhere, the paper says that CDS are different because of their “binary and discontinuous pay-out structure, concentrated dealer market structure, difficulty in valuing the rights and obligations contained in the contract, especially for the less liquid single name part of the market, lack of solid risk management measures and disproportionate dimension of the derivatives market with respect to the underlying market.”  I agree, completely.  

But I disagree with the conclusion drawn from these differences: “CDS have particular risks . . . all of which are difficult to mitigate . . . . For all these reasons, CCP clearing is desirable.”  But all of these features pose major informational challenges to clearing, and in my view, make it sensible to share risks bilaterally; the conclusion therefore does not follow from the stated premise.   Similarly, the paper points out the valuation difficulties involved in setting collateral from some products, due to the difficulties of valuation.  Again, agreed.  But the relevant question is who can do this better, bilateral parties or a CCP.  For some products, a CCP can do just fine, but for other products, it is quite likely that dealers can do a better job.  

These very considerations are why many operators of clearinghouses–who at first blush would seem to have an interest in a clearing mandate–have come out almost universally against such a requirement.  Note, this is not allegedly self-interested dealers talking: it is the clearing operators.  They recognize the unique risks of clearing some products, notably CDS, and believe that these risks make some products inappropriate for clearing.  That’s been the gravamen of my argument all along, but the paper completely overlooks this point–even though the clearing operators expressed their reservations very publicly weeks before the paper was released.  

Relatedly, in section 2.4.1.4 the paper identifies as a “Potential weakness of bilateral clearing” to be the fact that it relies on “each party’s internal ‘risk engine’ . . . . These risk engines are essential parts of a bank’s comparative advantage and while the broad contours may be similar each bank has a slightly different approach to risk assessment.  Overall, the crisis has highlighted the difficulty of designing models that adequately measure market risk.”  True, again.  But the relevant–unasked–question is: in this imperfect world, who can design the better model?  (Not perfect, but better.)  Due to the very “comparative advantage” aspect the paper identifies, dealers and other big traders have stronger incentives and better information to build better models than a CCP.  (A point I first made back in the 1990s.)  Moreover, an argument can be made that diversification in models is beneficial as a way of reducing the market’s exposure to model risk, whereas a clearinghouse chooses one model, and exposes the market in a big way to its (inevitable) limitations.  

In sum, in my view the paper presents a very thorough and accurate overview of the various OTC markets and products, and the unique characteristics of these products.  It then either ignores the implications of these differences altogether when making its recommendations, or makes recommendations that do not follow from its factual analysis.  Indeed, its recommendations are often the opposite of what a thorough consideration of the implications of these differences would imply.  

That is, the paper is very effective at pointing out the wide variation in the informational and risk characteristics of the various products traded in the OTC market.  It also effectively characterizes the wide variation in trading structures.  But it fails altogether at connecting these two inherently interconnected things.  Moreover, it focuses on the private benefits of its favored “solution” (clearing), even though this cannot be the appropriate basis for its policy recommendation.  There must be some sort of externality or other market failure that results in the adoption of inefficient institutional arrangements, but the paper fails altogether to identify what this externality or other market failure.

In brief, whereas the Treasury Department earns an F+ (and I am a generous grader), the EC merits a gentleman’s C.  It at least provides a factual basis for a considered analysis of the trade-offs entailed with different market structures.  I disagree with the conclusions it draws from its facts, but it’s a start, and a big improvement over Treasury’s arguendo ad AIG.