Streetwise Professor

August 31, 2009

The Sorcerer’s Apprentice, Chinese Edition

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis — The Professor @ 7:25 pm

Trying to figure out what is going on with the Chinese economy is a first-order issue.  Superficially, everything looks great; growth is right on official targets, and is at levels that the world would envy even during boom times.  In spite of that–no, because of that, among other things–there are many reasons for disquiet.

An article in today’s Reuters strikes a very odd note:

A report that Chinese state-owned companies will be allowed to walk away from loss-making commodity derivative trades provoked anger and dismay among investment bankers on Monday as they feared it may set a damaging precedent.

The State-owned Assets Supervision and Administration Commission, the regulator and nominal shareholder for state-owned enterprises (SOEs), told six foreign banks that SOEs reserved the right to default on contracts, Caijing magazine quoted an unnamed industry source as saying in an article published on Saturday.

While the details of the report could not be confirmed, it was Monday’s hot topic in financial circles from Shanghai to Singapore as commodity marketers feared that companies holding underwater price hedges could simply renege on the deals, costing banks millions of dollars in profit.

This could be a very big deal.  A major default on derivatives by huge Chinese SOEs would hurt the banks on the other side of the deal, but more importantly, raise huge questions about the reliability of Chinese SOEs as counterparties not just on derivatives, but on other transactions as well.

But this is all very inscrutable (stereotypically?) as one of the companies allegedly involved denied it sent any letter.  From Bloomberg (no link yet):

China Eastern Airlines Corp., which  had $916 million of unrealized losses last year on wrong-way  bets on fuel prices, denied a Reuters report that it sent a  letter to banks about its futures contracts.

Air China Ltd. and China COSCO Holdings Co. also sent  letters to banks about futures contracts, Reuters reported today,  citing an unidentified Singapore-based banking executive who had  heard of the letters. Companies owned by China’s central  government may terminate derivative contracts with six foreign  banks that provide over-the-counter commodity hedging services,Beijing-based Caijing Magazine reported earlier on Aug. 29.

“No, we didn’t” write letters to banks about futurescontracts, China Eastern Board Secretary Luo Zhuping said byphone today without elaborating. Air China spokeswoman Rao Xinyu  declined to comment. China COSCO spokeswoman Yang Ling didn’t  immediately answer calls to her office today seeking comment.

Now, both stories could be true.  Note that Reuters reports that the threat came from State Assets Supervision and Administration Commission, which oversees companies like China Eastern.  The Reuters story does not claim that the companies wrote the letters on their own behalf: it claims instead that SASAC wrote the letters in its role of regulator of these companies.  So, the Reuters story could be true AND China Eastern’s denial could be true too.

But this raises the question of why would such a course be contemplated, let alone threatened.  One interpretation is that these companies are in financial trouble, and the government doesn’t want to spend its money making western banks whole.  Another interpretation is that the government wants to clamp down on speculation in general, and derivatives speculation in particular, by Chinese companies, and figures that raising doubts about the reliability of Chinese companies as counterparties is a very effective way to do that: It may be very hard to crack down on trading by Chinese companies directly, but if they have nobody to trade with because no banker in his right mind would take the risk of giving away a free default option, the “problem” is “solved.”  Although this may seem to be limited to Chinese SOEs, it will no doubt have the effect of raising doubts about the reliability of all Chinese counterparties, thereby making it costlier for them to trade, and perhaps shutting them out of the market altogether.

There is some hint of this in the Reuters article:

The warning from SASAC follows a series of measures from Beijing this year to crack down on the sale of derivative products by foreign banks to Chinese enterprises, principally big consumers, who bought protection against higher prices last year only to watch the market collapse — leaving them with losses.

There may also be an old school-new school battle going on:

SASAC took over the job of overseeing SOEs’ derivatives trading from the securities regulator in February after several Chinese firms reported huge losses from derivatives.

I would wager that SASAC is dominated by old school industrial types and party types who are not in the least financially sophisticated, and who are probably not all too down with the idea of derivatives anyways, thinking that they smack of speculation, even if they are used for hedging.  (I’ve taught at some Chinese SOEs, and the level of finance knowledge is pretty thin even among higher level execs–or should I say especially among such types.  I imagine that goes exponentially for the SASAC.)

But, if my conjecture that this is an effort to tamp down speculative trading, it would fit in with a good deal of other stories coming out of China that it is struggling mightily with its efforts to stimulate the economy.  These efforts are leading to manifest distortions, and reports suggest that the authorities are operating in a very ad hoc way to try to control the distorting effects of the stimulus.  Like a financial sorcerer’s apprentice, China has unleashed a massively power monetary, fiscal, and credit stimulus, but cannot control it.

The Chinese stimulus is immense, as I’ve written before. The fiscal stimulus is on the order of 15 percent of GDP.  Chinese banks have created huge amounts of credit:

In the first half of 2009, bank credits increased Rmb7,300bn, above the official target for the full year. Credit growth was surprisingly high, and the same was true of the broad money supply, M2, which grew at a record rate relative to GDP. As a result, the inter-bank money market has been inundated with liquidity.

But these efforts have led to the growth of bubbles in real estate and the stock market.  The government is trying to tamp down on the flow of funds into these areas, and it is evidently having some effect: the Shanghai stock index was down 23 percent in August, far and away the worst performer among major world markets.  Moreover, the market is extremely sensitive to signs that the government is tightening credit.

Moreover, there is other evidence that the deluge of spending has led to severe dislocations in the allocation of resources.  Some amazing figures from the same FT article just quoted, by Chinese economist (and former central banker) Yu Yongding:

To maintain decent growth and avoid massive unemployment, the Chinese government was left with no option but to replace flagging external demand by domestic demand. But in the short run it is difficult to stimulate domestic consumption; investment demand became the only alternative. As a result of the stimulus package, the growth rate of fixed asset investment hit 36 per cent year-on-year in the first half of 2009, and China’s investment rate may have surpassed 50 per cent of GDP.

The government knows very well that the economy has been suffering from overcapacity. This is why government-financed investment in the stimulus package is concentrated in infrastructure, rather than new factories. However, there are still problems with an investment-centred expansionary fiscal policy. Due to the hasty and under-supervised implementation, waste in infrastructure construction is ubiquitous, and the prospective returns of this big push into infrastructure are less than promising.

Investing 50 percent of GDP, a nearly 50 percent increase from an already huge 36 percent of GDP, means that it is almost certain that many of the projects are hastily conceived, and ill conceived to boot.  I think that Yongdong is a master of understatement when he opines that “the prospective returns of this big push into infrastructure are less than promising.”  That is the gravamen of the analysis I gave on BNN (Canadian Business Television) earlier in the month.

And indeed, there is evidence that the government is trying to get control of the brooms its fiscal and monetary spells have brought to life.  Not so much in infrastructure, but in other parts of the economy:

China’s cabinet said it’s studying curbs on overcapacity in industries including steel and cement as policy makers seek to rein in investment growth fueled by a record credit expansion this year.

The government will also increase “guidance” over parts of the coal, glass and power industries, the State Council said on its  Web site today. Controls on stock and bond sales by companies in targeted sectors will be strengthened, it said.

China is aiming to prevent excessive investment in the world’s biggest user of steel and cement without imposing restrictions that may endanger an economic recovery. The nation’s  benchmark stock index has dropped 15 percent from its Aug. 4 high on concern banks may tighten credit after extending a record $1.1 trillion of loans in the first six months.

There is a very Austrian lesson in this Chinese story.  The government may be able to manipulate aggregates, but its attempts to do so can aggravate resource misallocations.  In the Austrian story, these misallocations eventually come back to haunt: eventually they result in a contraction that is necessary to force resources out of bloated sectors and into more productive uses.  The Chinese government apparently recognizes this, and is attempt to fall back to its comfort zone–state directed allocations of resources.  But that just raises another problem the Austrians were quite familiar with: the Knowledge Problem.  How can the central planner know where resources should go?  Answer: He can’t.

I don’t think this will turn out well.  There’s no Big Sorcerer to sweep in and undo Apprentice Sorcerer’s mischief.  The Apprentice learned, it’s easy to unleash the magic, but it’s very hard to direct it.  In the Chinese case, it’s easy to go on a spending binge, but it’s hard to ensure that the money is spent well.  It may result (especially given the idiosyncrasies of Chinese income accounting) in high rates of measured growth, but this growth is likely to be chimerical, and even destructive in the long run as resources spent today may prove very unproductive months from now when the world economy begins to turn around and the stimulus-driven investments are ill-suited to serve the resulting demand.

In other words, China may represent history’s biggest free cash flow problem.  (A reference to the finance literature that suggests that companies with free cash flow tend to fritter it away on unproductive investments).

The effects of this will spill over far beyond China, most notably in the commodity sector.  China has been on a commodity import splurge, but apparently that is another thing that is already slowing down, and likely to slow down even further soon.  And that is already having an effect on the canary in the commodity coal mine: shipping rates.  From another Bloomberg story:

Just as global trade starts to recover, the shipping market is crashing for the second time in a year as China reduces raw-material imports and record numbers of new vessels set sail.

The rate for leasing capesize ships, boats three times the size of the  Statue of Liberty, will drop about 50 percent from the current price of $37,865 a day to as low as $18,000 before the end of the year, according to the median in a Bloomberg survey of six analysts and fund managers. Forward freight agreements traded by brokers show the fourth-quarter average price will be 7 percent lower.

Shipping rates, which already fell 59 percent from this year’s high, are retreating as the  Organization for Economic Cooperation and Development predicts a 16 percent drop in world trade for all of 2009. China’s State Council called for curbs on steel and cement production last week.

. . . .

From their low of $2,316 in December, rates rebounded to $93,197 in June as China imported record amounts of everything from coal to  iron ore, used to make steel. Almost two in every five tons of steel are  made in China, according to the Brussels- based World Steel Association. The nation consumes the same proportion of the world’s coal, BP Plc estimates.

Industrial Overcapacity

Rates are poised to keep falling, the survey shows. China’s State Council, the nation’s cabinet, said it’s studying curbs on overcapacity in industries including steel and cement. The government will provide more “guidance” over parts of the coal, glass and power sectors, the group said in a statement.

Imports of refined copper fell 23 percent in July from the previous month. Coal shipments shrank 13 percent, customs data show.  Iron-ore purchases will likely average about 16 percent less in the remainder of the year than in the first seven months, according to  Will Fray, an analyst at Maritime Strategies International Ltd. in London.

“China could very easily turn the taps off,” Fray said. “Rates will keep sliding.”

The commodity import channel is the primary mechanism connecting the Chinese stimulus to the rest of the world.  It’s hard to explain the robustness of commodity prices in recent months (which has redounded to the benefit of Australia–and Russia) on the basis of conditions in OECD countries.  The EU, US, and especially Japan have hardly done well during that period, with the first maybe experiencing an anemic recovery, the second bottoming out at best, and the third still imploding.  The most likely explanation is that this is the direct consequence of the Chinese stimulus, and the related policy of accumulating strategic inventories of everything from aluminum to iron ore to oil to zinc.

But all of the foregoing suggests that this is coming to an end, if it hasn’t come to an end already.  And that’s why very peculiar stories like the one about a threatened default on derivatives trades may just be shadows of larger, looming developments.

August 29, 2009

What Can the Commitment of Traders Report Tell Us?

Filed under: Commodities,Derivatives,Economics,Energy,Politics — The Professor @ 9:12 pm

Short answer: not much.  But here are some fun facts to know and tell that do tend to deflate any grandiose assertions about the effects of speculation on oil prices:

  1. Changes in non-commercial positions did not Granger Cause crude oil returns in the 1986-2009, 2001-2009, or 2006-2009 periods in bivariate Granger Causality analyses.  Not that this is a surprise; if one could predict future oil price changes based on the publicly released COT numbers, one could make money.  But it does belie the Medlock-Jaffe claim that non-commercial positions are a “leading indicator” for oil prices.
  2. In a vector autoregression including crude oil returns, the percentage change in the Baltic Freight Index, the percentage change in the dollar index, and the change in non-commercial positions, the non-commercial positions do not Granger cause the crude oil returns in the 1986-2009, 2001-2009, or 2006-2009 periods.  The percentage change in the BFI does Granger Cause crude oil returns in all three samples.  This might be surprising, at it would seem to suggest that one can make money in oil by making trades based on moves in the BFI.  However, it is more likely that the movements in the BFI forecast time varying expected returns.  The BFI is a proxy for industrial activity, and thus likely reflects systematic risk.
  3. In the entire sample, crude oil returns Granger Cause (i.e., forecast) changes in non-commercial positions.  This is not true in the 2006-2009 period.
  4. In the entire sample, commercial positions Granger Cause non-commercial positions, but the reverse is not true.  In the 2001-2009 and 2006-2009 periods, the causality runs both ways.
  5. In regressions of crude oil returns against percentage changes in the BFI, percentage changes in the dollar index, and changes in non-commercial positions, all three explanatory variables are statistically significant in the entire sample and the two later subsamples.  Changes in commercial positions are associated with changes in crude oil prices of the same sign.
  6. The magnitude of the coefficient on the change in non-commercial positions is relatively small, and has been declining over time.  In the entire sample, a one standard deviation move in the change in the non-commercial position is associated with a 2 percent change in the crude oil price.
  7. However, by 2006-2009, the alleged period of speculative excess, the coefficient on the non-commercial position change is less than half its value in the entire sample.  During 2006-2009, a one standard deviation move in non-commercial positions (corresponding to about 17 mm bbls of crude in a week), is associated with a less than one percent move in the crude oil price.  Given that the standard deviation of returns (this is weekly data) during this period was over 5 percent, this is a relatively modest association.
  8. Moreover, speculative positions rose and fell throughout the period of alleged speculative excess.  Using the estimated coefficient on the change in the non-commercial position from the multivariate regression, and the movements in non-commercial positions from the beginning of 2006 to the height of the oil prices in early-July, 2008, the cumulative effect of speculative trading on the price of oil was . . . wait for it . . . 2.56 percent.  Not 25.6 percent.  2.56 percent.  And this over a period when the price of oil rose from $63 to over $141 dollars.  That means, that speculation might have “caused” the price to move from $63 to not even $65.  Big whoop.
  9. The correlation between changes in non-commercial positions was .36 in 1986-2000, .5 from 2001-2005, but fell to .3 in 2006-2009.
  10. Thus, the data do not support the contention that speculation–at least as measured (or mis-measured) by the COT have played an increasingly important role in affecting oil prices.  Indeed, the association between non-commercial futures trading and oil prices was weakest during the period of time of the purported speculative Bacchanal.
  11. Conversely, the relationship between the crude oil price and the dollar index has strengthened over time.  In the 1986-2000 period, the coefficient on the dollar index in the multiple regression was -.023; during the 2001-2006 period, -.77; and from the 2006-2009 period, -2.03.  During this last period, a one standard deviation move in the dollar index is associated with approximately a 2.5 percent move in the price of crude oil.

This all took about 40 minutes to figure out.

So what does it all mean?  Well, even without grappling with the causation issue, the data provide virtually no support for the hyperventilating assertions that speculation dominates oil prices, and that this domination grew over time, reaching a frenzied peak in 2006-2008.

In contrast the data provide better support for the view that the price of oil became more dollar driven.  Thus monetary policy should deserve more scrutiny, and speculation less, in trying to understand what happened to oil prices.  The attempt by Medlock-Jaffee to attribute the decline in the dollar to oil speculation is implausible.

But even though there is a modest, contemporaneous association between non-commercial positions and oil prices, that provides only the weakest support for the view that speculation distorted prices.  There is the correlation-causation issue.  What caused the changes in non-commercial positions?  Could they have moved in response to oil prices?  Could both have been driven by common factors?  Moreover, even if speculation moves prices, it can move prices towards where they should go.  That is, informed speculation tends to move prices towards their full-information value.

As I’ve written often, looking at prices alone is often inadequate to diagnose speculative distortions.  Prices are important because they provide signals that affect the allocation of resources.  That is, prices affect decisions about quantities.  If prices are distorted, quantities should be distorted too.  For the commodities allegedly affected by speculative excess in the 2006-2008 period, there is no evidence that this was the case.  In fact, for the commodities for which the data are best (industrial metals, where daily inventory data are available), the evidence is quite to the contrary.  The inventory data provide strong evidence of fundamental tightness, rather than speculative excess, as the cause of high prices.  (This will the subject of a chapter in my forthcoming book.)

The COT data are also dubious for a variety of reasons, including their crude categorization of traders, their lumping together of positions in all delivery months, and the fact that they cover only exchange-traded positions, and not the OTC market.

So, bottom line.  The association between speculative trading (as measured by the COT) and oil price movements is weak.  Given this association, and the movements in non-commercial trading during the 2006-2008 period, the cumulative impact of speculation on the price of oil during the spike was miniscule.  Moreover, one cannot conclude that the measured association quantifies a causal relationship, and even if it was causal, you can’t conclude that it caused prices to move away from a level justified by fundamentals.  The non-price (i.e., quantity) evidence for price distortion is lacking.

In one sentence: The COT data that have been used repeatedly to support contentions that speculation distorted oil prices provide no evidence whatsoever that speculation in the 2006-2008 time period materially contributed to the dramatic rise in the price of oil during this period.

August 28, 2009

Have You Heard the One About the Baker Institute and the Oil Speculators?

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Financial crisis,Politics — The Professor @ 8:50 pm

In an apparent attempt to make Michael Masters look good, Rice University’s Baker Institute has released a report on oil speculation, that concludes that increasing volumes of speculation have caused oil prices to be higher than they would otherwise be, and in a novel twist, have caused a higher correlation between the dollar and the price of oil.  It also lays blame on everybody’s favorite whipping boy, the Commodity Futures Modernization Act of 2000.

In a nutshell, this report is bilge.  It relies on no rigorous economic analysis to support its contentions.  Moreover, it is unscientific, eschewing any serious statistical analysis.

The report first sets out its evidence that speculation has increased, and that this increase is due to the CFMA.  It attempts to argue that speculation increased 15-fold, while commercial trading only doubled, by adding non-commercial outright futures, options, and spread positions, as measured by the CFTC Commitment of Traders Reports.  The vast bulk of the increase in speculation is attributable to spread positions.

But it is odd indeed to argue that a massive increase in speculation caused higher oil prices when the bulk of this increase in speculation occurred in spread positions.  Such positions, which involve the purchase and sale of oil for different delivery dates, are speculations on the shape of the oil forward curve, not on the absolute price level.  Indeed, it is very difficult to imagine how such spread positions would cause prices to rise since they involve purchases and sales in equal magnitude.  Certainly the authors of the Baker study provide no rigorous justification for any such connection.  For that matter, they don’t provide any non-rigorous justification either.

Tying the massive increase in speculation as they measure it to CFMA is particularly bizarre.  As they note, the main provisions of the CFMA eased restrictions on trading on the OTC market, and in non-US markets.  As a result, if anything, the CFMA favored these other markets over NYMEX.  But all of the data in the “study” pertain to NYMEX futures markets.  How can you attribute a rise in trading on NYMEX, and a change in the composition of that trading, to regulatory changes that would tend to shift trading to venues not covered by the data?  (You could make an argument that the increase in off-exchange activity lifted NYMEX volumes due to arbitrage, or to the use of futures to hedge OTC positions.  But the Baker boy and girl don’t do that.  And if some non-commercial NYMEX positions are actually hedges of OTC positions, you can’t conclude the futures positions are speculative without knowing about the related OTC positions).

In other words, report authors Ken Medlock and Amy Jaffee play the drunk looking for a wallet under the lamppost.  The COT data is the only data relating to speculation that they can get their hands on, and they use it even though it is peripherally related to what they want to demonstrate, namely, that a set of regulatory changes that mainly benefitted non-NYMEX markets led to a dramatic increase in speculation.

This is the crudest post hoc, propter hoc reasoning.  CFMA happened in 2000.  Speculative futures positions increased, especially post-2003.  Therefore, the former caused the latter.  (Why the big lag?  Don’t bother looking for answers in the report.  You won’t get one.)  This is about as weak as it gets.

When they get to analyzing the effects of speculation on prices, the spreaders are out the window, and Medlock and Jaffee focus on net non-commercial positions.  (This could be viewed as a tacit admission that there is no basis to believe that spreaders could have an effect on price levels.)

Do the study authors utilize statistical techniques, like Granger Causality or the like, to document such a connection?  Surely you jest.

They use a much more sophisticated diagnostic instrument.  Their eyeballs.


They present a graph of net non-commercial positions overlaid on prices, and say:

Generally, movements in price over the last few years have coincided with trends in open interest by noncommercial traders.  We can see that during periods where [sic] speculators have been net short, prices typically declined, even if only slightly.  When speculators are net long, the general shift in the market has been upwards, in some cases to a dramatic extend.  Some exceptions have occurred when speculators were generally in a net long position, but were moving to liquidate positions.  In this case, such as the late spring/early summer 2008, prices responded by moving sharply lower.

Well, when I look at their Figure 5 with my eyeballs, I note numerous instances when the changes in net non-commercial positions were of a similar magnitude to what occurred in spring-summer 2008, and the price movements were nowhere as large as in the late-summer/fall of 2008.  I see other periods (fall, 2008) when net long positions spiked, but prices fell.

I just wonder: think the financial crisis might have had something to do with the collapse in prices?  What financial crisis you might ask, after reading the report: if this was the only information you had, you’d never know there was a financial crisis.

Also, why the asymmetry?  Why do net shorts often result in “slight declines” while net longs can lead to big spikes?  It is not obvious a prior that this should be the case, and Medlock and Jaffee certainly provide no explanation.

There is no way in hell that such a casual, visual analysis of that Figure can provide a basis for their grandiose conclusions.  To say that this is unscientific is far too kind.  It would be too kind to call it junk science.  It’s just junk.

Medlock and Jaffe also interpret the data, uhm, flexibly, in order to make their case.  On the one hand, they claim, prior to 2006 “the open interest of noncommercial players” was a “lagging indicator” of prices.  (If it lags, how can it cause?)  But then, in a “striking” development, it becomes a “leading indicator of price around January 2006.”

Do they present a rigorous test of this assertion?  No.

Do they provide a coherent explanation as to why it would go from a lagger to a leader?  They provide an explanation, but it is not coherent.  It is in effect the story of a perpetual motion machine.  Speculators buy so prices go up so people think prices will go up and so they buy and force up prices more yadda yadda.  This is, at best, ex post rationalization, fitting their story to the data rather than coming up with a rigorous hypothesis without peeking at the data and then testing it.

How do they address the problem that if COT data is really a leader, and leads by months (according to their eyeballs, anyways), why did all of these greedy speculators leave money on the table?  As soon as they recognized that COT data lead oil prices, they would trade on the COT data, and voila!, the relationship would disappear.

Again, the more obvious answer: there is no causal relationship between COT numbers and prices.

A more reasonable explanation is there is no connection between movements in net noncommercial positions and prices.  Sometimes positions lead price, then sometimes the reverse is true, but there is no causal connection, just chance in action.  This makes Jaffee and Medlock look like fools for randomness.

The asserted connection between oil and the dollar resulting from increased speculation is bizarre.  For starters, I contest their statistical results, such as they are.  They report a correlation between the dollar and the price of oil of -.82.  I can reproduce that number by calculating the correlation between the levels of the dollar index and the price of oil.  However, since both time series have unit roots, such high correlations are extremely suspect: highly persistent time series can be highly correlated even if, in fact, there is no economic relation between them.  This is the spurious regression problem.

A more reasonable method is to look at correlations between percentage price changes.  This number is much smaller (in absolute value) for 2001-2009: only -.22.  It is bigger than observed in 1986-2000, but so what?  What’s more, that -.22 isn’t nearly as eye-popping as -.8, is it?

And what theory do these people advance to explain why an increase in speculation would increase the correlation?  They tell a story–and it’s no more than that–about speculation causing high oil prices causing higher trade deficits causing a lower dollar.  There is no evidence supporting any one of these alleged causal connections.  And considering the trade deficit–like, have these two heard of China?  Or any other factor that might have influenced the trade deficit?  This is more post hoc, propter hoc mumbo jumbo, with myriad omitted variables.  A serious study would (a) estimate the relation between the trade deficit and the dollar index, controlling for other factors that could affect the dollar; (b) estimate the effect of the price of oil on the deficit, and combine this with (a) to get an effect of the oil price movements on movements in the dollar, and (c) estimate the effect of speculation on the price of oil, and combine with (a) and (b) to get an estimate of the contribution of speculation to changes in the value of the dollar.  Or include oil speculation as an explanatory variable in a model of the dollar that also includes other relevant explanatory variables.

But that would be, as I say, a serious study.  This one is a joke.

There’s also a serious issue regarding the direction of causality.  Why should it go from oil prices to the dollar?  A decline in the dollar represents a fall in its value relative to other currencies.  The factors that lead to such a fall (e.g., a US monetary policy that is looser than the monetary policies of other nations) also plausibly lead to a decline its value relative to goods, including oil.  A decline in the purchasing power of a dollar means that the prices of goods, including oil, rise in nominal terms.

Here’s a final, telling example of the level of rigor in the report: “While correlation does not imply causation [really?], the trends evident in the open interest data are impossible to ignore.”

Is that so?  Just watch me.

August 27, 2009

Trust Me On This

Filed under: Economics,Politics,Russia — The Professor @ 8:34 pm

When the subjects of institutions is discussed, most commonly the conversation/analysis focuses on formal institutions, like laws and the courts that enforce them, or political bodies like legislatures.  But there is another body of research that views beliefs and norms as important institutional features that can decisively affect the costs of transacting, and hence economic progress and prosperity.

In particular, although discussions of “capitalism” or “market economies” frequently focus on competition, the most important institutions in such systems in fact have the effect of facilitating cooperation and coordination.  After all, economic competition is usually competition to cooperate with somebody: different sellers compete to sell to–to cooperate with–a buyer.  Individuals form firms or enter into contracts to facilitate cooperation so as to compete more effectively against other firms or organizations in their ability to cooperate with third parties.  Trade and exchange are all about cooperation between buyer and seller, and strong institutions support such cooperation, oftentimes by imposing penalties on those who opportunistically exploit those who would cooperate with them.

Frequently–and arguably typically–cooperation must take place over time, and the individuals who cooperate often perform on the commitments asynchronously; I may have to make an investment today that provides a benefit for you in exchange for your promise to do something for me in the future.  There has to be some mechanism in place that makes it in your interest to perform on your promise; if there isn’t, I won’t make the investment, and potentially mutually beneficial deals don’t get done.

Reliance on reputation–trust–is one such mechanism.  It is not foolproof, to be sure; reputation is costly (that’s what makes it work), and there are occasions when it is advantageous to incur a reputational hit to secure a more valuable, opportunistic gain.  But in general, trust facilitates cooperation, and more trade takes place in environments where trust levels are high than when they are not.

I’ve written a good deal about Russia’s institutional deficit, and much of that criticism has focused on the weakness of the formal institutions, most notably the appalling court system and the inability of an autocratic executive to commit to eschew expropriation.  But Russia’s “soft”–informal–institutions are weak too.  Paul Goble excerpts and translates portions of a very interesting article that makes that very point very persuasively:

“Rephrasing Hegel,” Pastukhov [obviously a Russphobe] says, “one can say that Russians have exactly the ‘capitalism’ they deserve. That is the kind of capitalism that only can exist in a country where there is no bourgeois consciousness and where the elites are incapable of economic cooperation – not to speak about social partnership and political participation.

To a great extent, the Moscow commentator suggests, “economic relations in most cases remain primitive and archaic.” Russians “do not trust one another,” always assuming that others will cheat them. But trust, confidence that partners to a deal will do what they say will do is the essence of modern capitalism.

Indeed, Pastukhov argues, “capitalism is a system of organized trust. Without trust, this system cannot work under any government.” And because the Russians lack that quality, along with a cultural commitment to honesty, something which “has practically disappeared” from their midst, it is impossible for capitalism to work among them.

Trust and lack of trust can both be self-enforcing equilibria.  If I trust you and you trust me and we both act on those beliefs, you perform and I perform  and we continue to trust one another, and on and on.  If you don’t trust me and I don’t trust you, I’m likely to try to screw you before you screw me–but may find that you’ve beaten me to it.  So being so distrustful, and expecting an opportunistic response to any deal, we probably won’t even try to cooperate in the first place.

Pastukhov’s argument is that Russia is in the no trust equilibrium.  Crucially, he concludes that this is true at every level of society, from the elites on down:

“The inability of the Russian elite to act in a consolidated way,” Pastukhov points out, is legendary. But as a result, “competition Russian-style is a process of unending efforts at surprise, betrayal and cannibalism.”

Pastukhov points out that Russians tend to emphasize the competitive, red-in-tooth-and-claw nature of capitalism, and are oblivious to its cooperative essence:

many Russians and their friends . . .  talk about competition as a basic characteristic of capitalism, but they ignore that “capitalism besides that presupposes social and economic solidarity the external expression of which is a civic position.”

He concludes that:

“a society in which there is no trust, self-control or cooperation, under any government will be incapable of building capitalism. Instead, it is condemned to an archaic kind of economy, based on primitive trade and theft.”

Pastukhov contemplates the possibility that government, through education, could inculcate the “bourgeois values” (or bourgeois virtues, as Deirdre McCloskey would call them) necessary to nurture a less “cannibalistic” economic system.  But, he resignedly concludes this is impossible:

“Who will bring the people back to its senses and return respect to basic moral values? Who? This is the most important and difficult question,” Pastukhov says. Tragically, he continues, the Russian government “is not capable of doing that” because it does not stand “‘above the fight’ but in the very dregs of ‘the events.'”

“In the very dregs of ‘the events.'”  There’s an understatement for you.

But this all raises the question: why is Russia in this bad equilibrium?  This is a complicated question, and I certainly cannot answer it completely.  It is fair to conjecture, however, that rather than being a potential cure, government has been an important cause, and continues to be so.

Autocratic systems, be they Czarist, Soviet, or Putinist, don’t want to encourage cooperation or institutions that facilitate cooperation.  Why not?  Because the autocrats and their henchmen are afraid that others will cooperate against them.  The kind of associative society that de Tocqueville described in Democracy in America is an anathema to an autocrat.  People who can cooperate and associate to start a business or a charity or a church can cooperate and associate to oppose the predations of autocrats.

Autocrats like atomized societies, where people lack trust.  It takes trust to work together against thugs.  A lot of trust.  Atomized individuals, distrustful of one another, pose far less of a threat than people used to cooperation.  For extreme examples, consider the myriad efforts in the Stalinist USSR or Hitler’s Germany to sow distrust: the informers, the spies.

Autocrats like hierarchical relationships (power verticals, if you will) where people look up rather than to their right or left.  Or, to use another metaphor, centralized relationships, with the autocrat at the spoke of the wheel.  (This brings to mind a captured Iraqi document that diagrammed military communications networks in Saddam’s army during the Gulf War.  All communications between units went through a central node–different units could not communicate directly.)

In other words, don’t look to an autocratic government to facilitate trust and cooperation among those it rules.  For the autocrat, a distrustful society is a blessing, not a curse.  The autocrat tries to atomize, to undermine cooperation and social solidarity.

The lack of trust, its difficulties in supporting autonomous cooperation, that Pastukhov describes, is therefore arguably part of Russia’s autocratic inheritance.  The same can be said for other former bits of the Russian Empire and the USSR, notably Ukraine.  It is, alas, one of the prized parts of Putin’s dowry.  Don’t expect him to give it up.

No Money, Big Problem: A Follow Up

Filed under: Commodities,Economics,Energy,Financial crisis,Politics,Russia — The Professor @ 7:44 pm

Blogmeister James at Robert Amerstdam was nice enough to link to нет дениг, нет проблем and say some nice things about it:

Craig Pirrong has a stinging piece [stinging? moi?] over at  Seeking Alpha on all the upcoming nastiness he expects out of the economic crisis in Russia, beginning with the Sayano-Shushenskaya dam explosion to Gazprom’s disappointing first quarter results.   It’s good article (especially the sharp rebuke against bullish analysts predicting a Gazprom rally)

But there’s a but (isn’t there always?):

but I think the eagerness to hold a parade over the collapse of the gas giant will only guarantee its next wave of revanchist corporate foreign policy strategy.   Gazprom has a lot of ways to still make money, and the full bore weight of the Kremlin helping it out.

I agree completely, James.  In fact, that was the thrust of my objections to Biden’s dismissing of Russia due to its economic and demographic weaknesses: namely, that these problems, and the desperation that goes with them, will make Russia more aggressive, not less.

When it comes to gas and Gazprom, that means that anyone touching Russian gas, or in a position to damage Gazprom’s interests better jock it up and get ready for battle.  It means that companies like ExxonMobil that have gas in Russia, and rights to sell it into potentially lucrative markets will face  intense pressure.  It means than even independent Russian companies can expect some smashmouth.  It means that a country like Turkmenistan that sells gas to Gazprom and prices that seemed like a good idea at the time, but no longer, should get ready for economic and even political aggression.  It means that Ukraine–and Europe–should look out come January.

Get ready to rumble, folks.

August 26, 2009

Нет денги, большая проблема

Filed under: Economics,Energy,Politics,Russia — The Professor @ 8:46 pm

I asked a Russian friend how the financial and economic crisis had affected the regional art center in the Urals where she works.  She said that she and her colleagues were coping with typical Russian resignation, and had made “нет дениг, нет проблем” (“No money, no problem”) their motto.

The “нет дениг” part may fit the country as a whole, but the “нет проблем” part doesn’t, quite.  The    Sayano- Shushenskaya dam disaster is widely considered to be a harbinger of potential problems.  The direct economic consequences are severe, reducing Russian electrical generating capacity by 2 percent; this in fact understates the impact because the dam was an inframarginal (i.e., relatively cheap) source of power.  The costs of repair are very high. Estimates run to $1.25 billion, but being estimates, being early, and being Russia, it is likely that the final bill will be much higher than that.  (Just ask the Indians about how the estimates for the repair bill to the Admiral Gorshkov compared to the actual cost.)  That in itself represents about 3 percent of total Russian infrastructure spending in 2008.

But as bad as the direct cost of repairing this one dam is, the prospect that Russia is just waiting for many additional shoes to drop is even worse.  And all at a time when there is no slack whatsoever in the budget; the state investment funds are being depleted rapidly, the budget deficits are forecast to be at the very upper limit that the country can run without risking grave risks to the currency, and Russia plans to return to the debt markets soon to cover its existing shortfalls.  Nor can the country rely on foreign investors to step into the breach.  The combination of poor economic prospects and a history of mistreatment has exacted its toll.

Even the big cash cows are running dry.  Case in point: Gazprom.

Gazprom’s profits were battered by plunging gas sales to the European Union and Ukraine in the first three months of the year, it has reported in its latest  resultsunder international accounting standards.

A 62 per cent drop in profits to Rbs110bn (about $3.5bn, at today’s exchange rate), reflects steep falls in gas export volumes, which were down 31 per cent to the EU, and 61 per cent to the former Soviet Union countries, including Ukraine. The economic downturn, which has hit demand for gas, particularly from industrial users, in Europe and around the world, was part of the reason; supply disruptions caused by the interruption of flows to Ukraine during the pricing dispute in January were another.

. . . .

The company’s debts are continuing to rise. Borrowings were up 17 per cent by the end of March from the end of 2008 to Rbs1,191bn (about $38bn at today’s exchange rate), mostly because of the fall in the value of the ruble, which pushed up the ruble value of Gazprom’s foreign currency debts. Since then, it has made significant further expenditures, including $4.1bn buying a 20 per cent stake in its oil subsidiary Gazprom Neft from Eni of Italy, and $1.67bn buying 55 per cent of London-listed Sibir Energy.

Amazingly, some, like Sanford Bernstein analyst Oswald Clint are trying to gussy up this corpse:

Capital expenditures have been cut 15% in 2009, the 2008 proposed dividend was cut 86%, and capex hungry projects in the Yamal peninsula have been delayed. Combined, we now expect much improved balance sheet flexibility, and expect the company to generate positive free cashflow this year, which provides plenty of scope to re-grow the dividend. With added tailwinds of favorable government moves to boost domestic pricing tariffs by 15% in 2010, 2011 and 2012, the company is also likely to start generating profit for the first time from  292Bcm of gas sales (50% of total) sold in the domestic market.

So.  Let me get this.  The company is in such deep financial straits that it all but eliminates its dividend, sharply reduces its capital expenditure, and delays its big investments in new production.  And this is good news because this creates “balance sheet flexibility”?  I guess.  But flexibility to do what?

Talk about looking on the bright side.  “Other than that, how was the play, Mrs. Lincoln?”  “Well, there’s now one less mouth to feed.”

Even There’s-a-Pony-in-There-Somewhere Clint recognizes that Gazprom’s production, which fell sharply in 2009, will not reach 2008 levels until “late in the next decade.”  Which means 8-10 years.  And with the sharp drop in capital expenditure, the delays at Yamal, and the accelerating declines in its mature western Siberian giant fields,  that may be very optimistic.  Which means that, even given additional domestic revenue, the company’s prospects for generating the kind of positive cash flow that will not be able to (a) keep certain people living in the style to which they have become accustomed, and (b) more importantly, it will not be able to generate revenues for the Russian state to address its already pressing fiscal problems, let alone provide funds to shore up a collapsing infrastructure.

And in the aftermath of  Sayano- Shushenskaya even the higher domestic revenues may be in doubt.  Putin and Medvedev have already pledged that the state will prevent power prices from rising excessively due to the loss of capacity.  Which means that the on-again, off-again electricity tariff reforms are probably off again for a long time.  Moreover, given that the loss of hydro capacity will increase the demands placed on gas fired power plants, the imperative to keep power prices low will surely induce the power plant operators to pressure the government to keep gas prices low.  Furthermore, it is likely that the government will attempt to palliate consumers who end up paying higher electricity prices with the sop of lower gas prices, and will therefore delay full implementation of the scheduled gas price increases.

In brief, Russia faces a yawning capital gap.  The country has lived, after a fashion, on the Soviet inheritance, from huge hydro stations to massive gas fields.  “Deferred maintenance” became a modus operandi.  The  Sayano-Shushenskaya disaster is just a vivid illustration of the consequences of this.  It makes me wonder what the true rate of Russian growth in recent years would be, if the true depreciation/consumption of capital were taken into account.  The country has consumed much of its seed corn.

The country’s major source of cash–the energy business–has lived off the Soviet inheritance as well, so Russia can’t look to that for succor; indeed, that sector needs a massive infusion of capital too.  Foreign investors won’t step up.  Compared to other countries, Russia invested relative little as fraction of its GDP even during the seven fat years.

So, no money: big problems.

August 25, 2009

Fanning the Jacksonian Flames

Filed under: Politics — The Professor @ 9:29 pm

It is widely conjectured that the Obama administration’s move to investigate, and perhaps prosecute, CIA interrogators and debriefers is intended to shore up a leftist base disenchanted with the prospect of his abandoning the public option on healthcare.

Regardless of motives, this move is a political blunder (as well as being substantively wrong, IMHO) because it will only aggravate the conflict that is derailing his efforts to transform the healthcare system.  Obama’s most vociferous opponents in the firestorm over healthcare are Jacksonians.  As Walter Russell Mead wrote in his famous essay about American political traditions (Hamiltonian, Jeffersonian, Jacksonian, Wilsonian) Jacksonians are fiercely independent, and resentful of encroachments of the powerful on their autonomy.  Jacksonians are especially resentful of powerful, privileged elites.  And the Obama healthcare initiative is nothing if it is not an assault on the autonomy of millions of Americans by a privileged elite.  Hence the ferocious, visceral reaction of millions of Jacksonian Americans.

And as Mead also wrote, Jacksonians are also fiercely patriotic, American exceptionalists who react robustly when the “folk” is threatened, and who are not very squeamish about using violent means to defend it.  Such people will hardly shed any tears over even the worst that the interrogators are alleged to have done.  But they will not take kindly to their prosecution, to say the least.

The administration’s move will only cement the belief among Jacksonians that Obama is an elitist at odds with a folk he views as “bitter clingers”; as someone more interested in the approval of Europeans than in the protection of Americans; and, to be blunt, someone not enthusiastically American.  This will only deepen suspicions among them about anything he proposes, and undermine trust in his motives.  As a result, they will be even less receptive to–no, more militantly resistant to–his healthcare plans.  The vociferous opposition that has burst forth to the astonishment and dismay of the anti-Jacksonian elites will therefore only intensify as a result of this action.

Jacksonians are by no means a majority nationwide, but they are a pivotal bloc in many states, and it is highly unlikely that any major initiative like healthcare can pass over their impassioned opposition.  And by his move on the CIA, Obama has only inflamed that passion.

If Obama is doing this to pacify his base, he is desperate indeed. If he is doing it out of conviction, he is jeopardizing his attainment of cherished goals. Either way, he is not being the uniter of the campaign, but the most divisive political figure in recent memory.  Those on the other side of the divide are usually politically invisible, but woe betides anyone who arouses them.  Obama has done it not once, but repeatedly.  This is not a recipe for political triumph, but for intense political conflict.

August 23, 2009

Not Tall Enough To Regulate

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics — The Professor @ 9:07 pm

Historically, the CFTC has not been an overly intrusive regulator.  It has not attempted to push its jurisdiction to its limits, and in most areas it compares favorably to other federal regulatory agencies.  Under pressure from Congress, and exploiting the opportunities presented by the financial crisis, however, the CFTC is becoming much more aggressive and ambitious.

The most recent cases in point: its actions to clamp down on index funds, and now exchange traded funds (“ETFs”).  Last week, the agency revoked position limit exemptions for two ETFs offered by Deutsche Bank.  Seeing the threat from restrictions on the ability of ETFs to hold positions, several sellers of the funds, such as Barclays and the UNG fund, have announced that they will not issue new shares, even though these shares are selling at a premium.

Just what is the theoretical or empirical basis for these restrictions on commodity ETFs?  Beats me.  It is possible that these funds affect prices when they roll from an expiring contract into the next one, but there is a self-correcting mechanism that would mitigate these effects: the funds demand for liquidity is known, both in its approximate magnitude and certainly its timing.  This permits the flow of additional capital into the market during roll periods to mitigate the price impacts.   Moreover, to the extent that ETFs affect prices during the roll, they tend to move prices against them.  That is, their price impact raises their cost and reduces their performance.  Since the funds have to compete with other investment vehicles for funds, if these costs become too large and thus impair performance sufficiently, the flow of money to the funds will decline.

But I don’t think it’s the roll issue that exercises certain CFTC commissioners.  I think that they really believe that these ETFs distort prices.  The basis for that belief escapes me.  The Commission surely has produced no reliable evidence of such an effect, nor have I seen any reputable academic studies documenting such an effect.  Moreover, although many of these funds are “long only,” leading some to claim that they inflate prices, there are also funds that profit when prices go down, meaning that there is no necessary structural bias towards purchases.

Before interfering with the ability of investors to allocate capital across alternative vehicles, a government regulator should have a very strong logical and empirical basis to conclude that free choices are inefficient, and are distorting prices.  It should identify a market failure, and provide empirical evidence that this market failure is resulting in a material distortion in prices and resource allocations.  Moreover, it should analyze rigorously the effect of its actions: How will investors respond to the regulation?  If the flow of funds is distorting market X, will limiting the flow into X just divert monies into markets A, B, and C, distorting those prices?  Or, will investors respond to constraints on the size of a given fund by splitting investments across multiple funds, thereby sacrificing management scale economies and inflating costs?

The CFTC has done none of these things.  None.  It just justifies them with vacuities such as:

Cutting out individual investors isn’t the goal, said Bart Chilton, a CFTC commissioner, in an email. “The Commission has never said ‘You aren’t tall enough to ride,’  ” Mr. Chilton said. “I don’t want to limit liquidity, but above all else, I want to ensure that prices for consumers are fair and that there is no manipulation — intentional or otherwise.”

The CFTC seems hell-bent on segmenting commodity and financial markets, apparently viewing the commodity markets as some kind of ghetto, or insufficiently responsive to normal economic forces to be largely self-regulating.  This is bad finance.  The goal of public policy should be to encourage the integration of financial markets to ensure the efficient allocation of risk across investors and market participants, and the consistent pricing of risk across these markets.

Chilton’s statement is shocking for another reason.  Consider the last sentence: “I want to ensure that . . .  there is no manipulation — intentional or otherwise.”  Now, note that as a CFTC commissioner, Chilton may have to rule on manipulation cases.  Therefore, although it would be nice if he knew economics, it is imperative that he at least know the law.  But Bart Chilton apparently does not, or is in the habit of speaking so carelessly as to give the impression that he does not.  In fact, under existing case law, including CFTC decisions, to find someone guilty of manipulation under the Commodity Exchange Act, four conditions must be met.  One of these conditions is that the accused have a specific intent to cause an artificial price.  (See especially the Commission’s decision in the in re Indiana Farm Bureau case.)

In other words, “unintentional manipulation” is a legal oxymoron, at least so far as the CEA is concerned.

So, here we have one of the commissioners with responsibility for enforcing Federal anti-manipulation laws who apparently does not know the law.

Rather than speaking carefully, and expressing views that are consistent with the laws and precedents that he is charged to enforce, Chilton appears to be the poster child for the arch comment of a Texas cotton trader testifying before the Senate in 1928:  The word ‘manipulation’ . . . in its use is so broad as to include any operation of the cotton market that does not suit the gentleman who is speaking at the moment.”

ETFs apparently do not suit Bart Chilton.  God knows why.  But to justify his dislike of them, he throws around the very, very heavily freighted word “manipulation” in a way that is inconsistent with its meaning under the laws that he is responsible for enforcing.  That is very disturbing.  Very.  If you use that word, you better have a high degree of confidence that you have the law, the economics, and the facts on your side.  On that score, Chilton strikes out.  Ignorance of the economics is, alas, pretty common.  Ignorance of the law is inexcusable.

Yesterday I wrote about the German financial regulator Bafin seeing no evil in what the data strongly suggest was one of the largest manipulations in history.  Today I write about a US regulator who sees manipulations where there is no evidence that they exist.

Keep this in mind when anybody–a Congressman, a regulator, or a talking head–tries to convince you that more regulation is the key to reducing the prevalence of misconduct in financial markets, and ensuring that these markets work more efficiently.  Regulators can make both Type I and Type II errors: false positives (Chilton) and false negatives (Bafin).  I would suggest that the rates for both type of error is extremely high, especially when policies are predicated on as little logic and evidence as the crackdown on commodity ETFs.  I would further suggest that the costs of these errors are very high, and importantly, those that make the errors do not incur the costs–which would tend to explain why they make so many of them.

The CFTC is getting vast new powers, and asking for even more (cf. Chairman Gensler’s letter to the Congressional Agriculture committees regarding the Administration’s draft OTC regulation bill).  It does not inspire confidence that at least one of the commissioners who will exercise these powers does not even know one of the very fundamental tenets of the law governing the powers he already has.

Seventy Years of Shame–or Is It A Model to Be Emulated?

Filed under: Military,Politics,Russia — The Professor @ 9:16 am

Today marks the 70th anniversary of the Nazi-Soviet (Molotov-Ribbentrop) Pact, the secret protocols of which divided eastern Europe between the two totalitarian powers.*

Rather than being a matter of shame to modern Russians (as it is to modern Germans), it is something to be defended, and by some, even celebrated as the template for a reordering of the geopolitical order.  The Russian counter-narrative is that prior to the British and French appeasement at Munich, Stalin was committed to collective security to contain German aggression.  After witnessing Western capitulation, however, Stalin concluded that collective security was a dead end, and that the USSR had to make its own deal with Germany in order to buy time and protect itself from Hitler.

There are myriad problems with this interpretation of events.  First, although the USSR was formally a part of a collective security arrangement with Britain, France, and others, to support the sovereignty of Czechoslovakia and other European states, its commitment was thoroughly hedged, and gave Stalin many options to escape having to perform on this commitment or to utilize the arrangement as a ways of realizing his own territorial ambitions at the expense of some of the very states the USSR was allegedly committed to defending.  Furthermore, even though in the days leading up to Munich the USSR did make some military preparations consistent with an intent to intervene on behalf of the Czechs, these preparations were ambiguous at best.  As Richard Overy states in his Russia’s War:

[t]he new evidence [from Soviet archives on Russian thinking at this time] is open to a  number of interpretations.  The Soviet Union might well have used the crisis to intimidate Poland, a state loathed by the Soviet leadership [la plus ca change].  On the same day that Soviet forces were put on alert an ultimatum was sent to Warsaw warning the Poles that any move against the Czechs on their part would be regarded as an unprovoked aggression.  No ultimatum was ever sent to Germany.  German intelligence was unimpressed by Soviet military movements and did not interpret the Soviet position as a threat of war.  War with Germany would have meant more serious of large-scale mobilization.  It is not improbable, given that military preparations were being kept secret from the Germans, that they were for domestic consumption–an elaborate military exercise or another war scare like 1927, designed to keep the system on its toes.  The most likely answer is that Stalin was keeping his options open.  The option he did not want was to be left fighting Germany alone.  Soviet intervention, if it came, was always dependent on the willingness of the ‘imperialist states’ to fight first.

In brief, the USSR may have been made commitments to collective security, but these commitments were never tested.    The credibility of these commitments therefore lay completely in the realm of conjecture.  Given Stalin’s well-known opportunism, there is considerable room to doubt that if Britain and France had indeed stood behind Czechoslovakia, that the USSR would have indeed joined the effort with any objective in mind other than exploiting the crisis to achieve its own ambitions.

This is particularly plausible when one avoids the error of interpreting the strategic situation in Europe in 1938-1939 in light of what happened subsequently.  In retrospect, it is clear that Germany was the greatest threat to European peace–and to the USSR.  In light of the campaign of 1940, it is also evident that France and Britain were no military match for Germany.

But that’s not the way it looked in 1938-1939, least of all to Stalin.  Stalin, and the Soviet hierarchy more generally, saw not just Germany, but Britain and France too as threats to the Revolution and the USSR.  From the Soviet perspective, informed by Marxist and Bolshevist ideology, these nations were just different manifestations of capitalism, and all deadly enemies of, and mortal threats to, the USSR.  Germany and France/Britain competed in Stalin’s mind for the status of Greatest Threat to the Revolution.

From Stalin’s perspective, the best of all worlds would be for the Germans, French, and British to fall on one another and tear one another to pieces, gravely weakening all three major threats to the USSR, and potentially leaving the Soviets in a position to dominate Europe.  Given the experience of the First World War–which dominated the thinking of most military and political figures in Europe of the time–bloody stalemate looked to be the most likely outcome of a war between Hitler and the Western Powers.  And bloody stalemate was just what Stalin craved.

Given these beliefs, a wise strategy for Stalin during the Czechoslovakian crisis would have been to make moves that would have convinced the British and French of a Soviet commitment to intervene on behalf of the Czechs in the expectation (or hope) that this would lead to combat between the Germans and the Western Powers.  In this scenario, Stalin would have had the strategic freedom to realize his own strategic ambitions, and in the best of all worlds (from his perspective) put the USSR in power not just in the entirety of eastern Europe and the Balkans, but in Germany as well.  Appeasement prevented this outcome in September, 1938, but another opportunity soon presented itself.

This conjecture cannot be proven, but it is as consistent with the historical record as the view that Stalin was firmly committed to collective security.  Methinks, however, that this cynical conjecture is more in conformity to Stalin’s ruthless, paranoid, and opportunistic persona than the more idealistic alternative.

Indeed, the events of 1939 bolster this argument.  If (a) Stalin’s motivation for dealing with Hitler in August, 1939 was his disillusionment with British and French commitment to collective security, and (b) Stalin’s overriding fear was Hitler and Germany, then (c) British and French actions in the spring of 1939 should have led to Stalin away from a deal with Germany, and towards a closer relationship with Britain and France.  At the end of March, 1939, Britain made a guarantee to Poland.  France soon followed.  If Stalin had indeed been desperate for an alliance to fend off Hitler, the Franco-British guarantee would have been a signal to reinvigorate collective security efforts.

But Stalin did no such thing.  In early-May, about a month after the British guarantee, he replaced the Foreign Minister that had been the architect of collective security (Litvinov), and in typically brutal fashion tortured virtually the Foreign Ministry personnel associated with the policy.  He did engage in talks with the French and British, and by July had agreed on a draft treaty that largely conceded his (mercenary) terms–but with this in his pocket, he reached out to Hitler.  In other words, he tested the British and French commitment to oppose Germany, and when he was sufficiently confident of this commitment, openly moved to deal with the Devil.

From his perspective, this was a triumph.  With Britain and France committed to fight Germany, it was in Stalin’s interest to promote war.  This would entangle his three–three, not one–mortal capitalist enemies in a war that would give him the greatest opportunity to emerge the dominant power in Europe.

Note that if stopping Germany had been the sine qua non of Stalin’s policy, his interest in cooperation with France and Britain should have increased as those countries abandoned their appeasement policies, and took a more belligerent and aggressive posture towards Germany.  In fact, it is almost universally recognized that the reverse is true.  As France and Britain abandoned appeasement, and as Britain in particular engaged in a crash re-armament drive, Stalin became more favorably disposed towards a deal with Hitler.  The more the British and French prepared to fight Hitler, the more open Stalin became to the latter’s blandishments.

Stalin’s openness to Hitler after the Western Powers became more set in their opposition to Germany makes perfect sense if you accept that Stalin’s true motivations were to embroil all of his enemies in a war, and to realize territorial ambitions in eastern Europe.

Knowing common human tendency to project one’s own views, Stalin’s fear that Britain and France were really trying to maneuver the USSR and Germany into war is very telling.  Russian historian Edvard Radzinsky’s anecdote is quite illuminating:

The Boss personally thought up an explanation of the alliance for the Soviet people.  In army units, a comic drawing was displayed.  It showed two triangles.  The caption over one of them read: “What did Chamberlain want?”  At the apex of the triangle was the word “London” and at the lower two corners “Moscow” and “Berlin.”  MEaning that Chamberlain wanted to bring the USSR and Germany into conflict.  The caption over the other triangle was “What did Comrade Stalin do?”  Now the word at the apex was “Moscow.”  Stalin had brought Berlin and London into conflict, leaving the USSR on top.

It should also be emphasized that if Stalin’s true objective were to stymie Hitler, firm support of British and French guarantees of Polish security would have been the best way to do it.  As a reader of Mein Kampf, Stalin would have been aware of Hitler’s morbid fear of repeating the mistake of waging a two-front war as Germany had done in WWI.  (A fear that dissipated as a result of the heady triumph in France in 1940–but that was in the future.)  Confronting Hitler with this prospect would have made war far less likely.  Instead, just when Britain and France took measures that increased their commitment to fighting Germany, rather than taking parallel measures that would have greatly increased Hitler’s risks if the two front war he feared, Stalin did the exact opposite.  As Norman Davies states in No Simple Victory:

[E]veryone saw that the key to further developments lay with Poland’s eastern neighbour, the USSR.  If Moscow were openly to side with the Western Powers, a unilateral German attack on Poland would be too risky to contemplate.  If Moscow were to adopt an ambiguous position, the world would be kept guessing.  And if Moscow were to throw its weight behind Berlin, Hitler would be given the green light.

And we know that Stalin indeed gave Hitler the green light.

This cannot be rationalized as a Stop Germany by Whatever Means Necessary policy.  Such a policy would have induced Stalin to act very differently than he did.  Instead, it is best explained as an opportunistic way of dealing with all of his enemies, and realizing his fondest territorial and political ambitions in the bargain.  Rather than treating Germany as an existential threat, he considered it just one enemy among many, and cannily maneuvered to pit his enemies against one another, and to swoop in to grab considerable spoils for himself.

Indeed, Stalin was brutally frank in his explanation of his motives.  In a speech to the Politburo on 19 August, 1939 (but which was not made public until 1994–go figure), Stalin said:

We must accept the proposals of Germany and diplomatically discard the British and French delegation.  The destruction of Poland and the annexation of Ukrainian Galicia will be our first gain.  Nonetheless, we must foresee the consequences of both Germany’s defeat and Germany’s victory.  In the event of a defeat the formation of a Communist government in Germany will be essential . . . . Above all, our task is to ensure that Germany be engaged in war for as long as possible and that Britain and France be so exhausted that they could not suppress a German Communist government.

Does it get any clearer than that?

In sum, the counter-narrative of Molotov-Ribbentrop, that it was needed for an isolated USSR to ensure its security after the Western Powers had capitulated at Munich, is contrary to: the actual course of events in 1939, an understanding of Stalin’s worldview and personality, and his very words.  Although in retrospect it seems obvious that Hitler was an existential threat to the USSR, and that Stalin must have been acting with a singleminded purpose to counter that threat, that retrospective perspective is misleading in the extreme.  The contemporary evidence tells a very different story.

To put it more bluntly: Stalin bears great responsibility for the outbreak of the Second World War.  He wanted war–between Germany, Britain, and France–and he got it.  Indeed, until May, 1940, from his perspective the war was a great boon.  It pitted his enemies against one another, rather than against him.  What’s more, he gained substantial territories in the bargain, and destroyed what had long been a Soviet bugbear–an independent Poland.

The Second World War would not have broken out when it did and where it did had not Stalin, as part of a coldly calculating policy to advance Soviet interests, dealt with Hitler.  We cannot say that it might not have broken out later or at some other time.  But WWII as it happened was a war of Stalin’s choosing.  He just thought he was choosing a war between his enemies.  His was a strategy of “let’s you and him fight.”  In retrospect, it was a catastrophic error.  But at the time, Stalin believed he had executed an incredible coup.  Indeed, he was so enamored with it that he was reluctant to admit its ultimate failure even after German tanks rolled east on 22 June, 1941.

And, regardless of the motivations for the Pact, the unspeakable brutality of the USSR’s implementation of its terms should never be ignored.  I encourage you to read Overy’s account of what the Soviets did in Poland and the Baltics in the aftermath of the Pact–if you have the stomach for it.  Russians who sputter and whine and posture about the hostility of modern Poles or Lithuanians or Estonians or Latvians, and who threaten retribution against those who “slander” the good name of the USSR, should instead be deeply ashamed of Soviet behavior, and understanding of these attitudes.  Indeed, as Russians (and everybody else) are wont to point out, the Nazis were monsters.  If so, then why do myriad eastern Europeans find it so hard to differentiate between Nazis and Soviets?  The most obvious answer: The Soviets were monsters too.

Read Overy, or other honest accounts of the events of that time, and tell me otherwise.

But modern Russians, and most notably state organs, are not ashamed at the Nazi-Soviet Pact.  Indeed, many celebrate it.  No.  This is not a sick joke.

Indeed, the efforts of the state to defend Molotov-Ribbentrop go to extremes that would be considered comical, were the subject not so horrific.  A case in point is a report issued by the Russian foreign intelligence service, the SVR.  As Pavel Felgenhauer writes:

According to Sotskov [the author of the SVR report, and a former KGB official], before signing the Molotov-Ribbentrop Pact in August 1939, Russia was trying to create a system of collective security in Europe with Britain, France, Poland, Lithuania, Latvia, Estonia, and other nations to stop Nazi Germany. Moscow’s main condition in 1939 was that its armed forces must be allowed to massively deploy in the Baltic territories and in Poland. But the Poles and the Baltic nations refused, while Paris and London hesitated to press them to accept Russian troops on their territory. If the Russian demand had been met, “our troops would have entered the Baltic territories much earlier,” according to Sotskov, “but the Poles, the West and the Baltic countries wanted to collaborate with Nazi Germany instead.” After the West refused to cooperate, the Kremlin accepted a German offer that gave Russia what it wanted: half of Poland, the Baltic countries, Finland and the part of Romania that is now Moldova – as a sphere of influence to occupy. After the Nazis attacked Russia in June 1941, Western democracies soon formed an “effective collective security system with Russia,” which according to Sotskov is one of the main positive results of the Molotov-Ribbentrop Pact. The Pact also allowed Russia to rearm and to “move the border with Germany to the West” (

What a tissue of lies.  As just one example, the statement “after the West refused to cooperate” is flatly contradicted by Stalin’s own statement, quoted above, that “[w]e must accept the proposals of Germany and diplomatically discard the British and French delegation.”  Stalin made the choice. (Not to deny that the Franco-British diplomatic efforts were late, bumbling, and ineffectual.  But the point is that Stalin let everybody come to him; if he had been so anxious to secure an alliance against Hitler, he would have taken the initiative, and been less mercenary in his dealings with the West.  It should also be noted that the Western Powers’ reluctance to deal with Stalin was due, in large part, to their understanding that his motives and methods were as malign as Hitler’s.  As was shown in the event.  The British and French–much more the former than the latter, not surprisingly–were extremely reluctant to deal with the USSR to prevent Hitler’s devouring of eastern Europe if the price was to let Stalin do it instead, with their active complicity.)

This “reasoning” is also self-contradictory.  On the one hand, the USSR wanted to deploy massive forces in Poland and the Baltics as part of a plan to stop Hitler.  But on the other, it is acknowledged that the USSR just wanted these territories for itself, and dealt with Hitler because he would give them what Stalin wanted.

This organ of the government oh-so-concerned about defending the integrity of the historical record heaves up stuff like this:

According to Sotskov, “it is a lie; the Baltic States were never occupied by Russia.” The KGB intelligence reports that were sent to the Kremlin in 1940, say the Baltic people volunteered to join the Soviet Union. According to the KGB, communist rule was established through democratic elections, though elections were undemocratic, since many Russian-speakers did not vote. The denunciation of the Molotov-Ribbentrop Pact and the secret protocol that divided Europe by the People’s Congress in Moscow in 1989 under President Mikhail Gorbachev was a grave mistake, according to Sotskov, who is apparently fully supported by the SVR (

Ah, yes, the myth of the fraternal peoples united under wise Soviet leadership.  And they wonder why the Balts in particular distrust them, not to say hate them?

But Falgenhauer puts his finger on it:

Today Russian official support of the Molotov-Ribbentrop accord that divided Europe into spheres of influence is not just a difference over historical interpretation. Last year, during a visit to Germany, Medvedev announced that Moscow wants to call an all-European conference to create a new collective security system (RIA Novosti, June 5, 2008). After the invasion of Georgia in August 2008, Medvedev announced that Russia has a “sphere of privileged interests.” Medvedev insisted that the war with Georgia had confirmed the need to form a new collective security system in Europe, since the existing ones (NATO, OSCE) did not manage to prevent the conflict (, August 30, 2008).

Alexander Golts concurs that this isn’t about the past, but about the present:

There is really nothing surprising in the fact that the government has so passionately taken up the defense of Stalin’s foreign policy. Vladimir Putin’s understanding of realpolitik is the same as Stalin’s; everything is decided by military might and if there is a chance to bite off a chunk of someone else’s territory, you should go for it.

In other words, from the ruthlessly 19th-century realpolitik perspective of Putin et al, and large swathes of Russians more generally, Molotov-Ribbentrop, and Yalta as well, represent the way the world should work.  Great powers should divide the map between them.  Russia had then, as it has today, a legitimate interest in dominating eastern Europe.  Molotov-Ribbentrop secured that interest–at least Stalin thought it did, wrongly in the event.  The Pact, and ultimately Yalta, gave Russia what belonged to it by right.  The British and French are to blame in large part because they would not recognize these interests; Russia dealt with someone who did, someone with no scruples about the human consequences.  To criticize the Pact is to deny Russia recognition of its legitimate right to dominate “its” space.  Molotov-Ribbentrop divided eastern Europe in 1939.  Russia wants to divide eastern Europe in 2009.  To condemn the former is to delegitimize the latter.

So, you can expect even more robust defenses of M-R, and more hysterical attacks against those who criticize it, on this anniversary and in the days to come.  For to criticize Stalin and the revisionist USSR is, by extension, to criticize Putin and the revisionist Russia.  Their means may differ, but their worldview, and their strategic objectives, are largely the same.

* Hitler agreed to the Secret Protocol on 23 August at 10 PM.  The Pact was dated 23 August, but signed at around 2 AM on 24 August.

August 22, 2009

Adding Insult to Mortal Injury

Filed under: Economics,Energy,Politics,Russia — The Professor @ 9:28 pm

The tragedy at the  Sayano-Shushenskaya power plant has caused Vladimir Putin to leap into action:

Prime Minister Vladimir Putin called for a sweeping probe of Russia’s creaking Soviet-era infrastructure on Thursday after a disaster at its largest hydroelectric power station.

. . . .

“The tragic events at the Sayano-Shushenskaya power station showed with full clarity how much we need to do to improve the reliability of our engineering structures in general,” Putin told a meeting of the government.

“A serious review of all strategic and vital infrastructure is required,” said Putin, who was to travel to the site of the disaster on Friday.

Few of Russia’s roads, bridges or railways have been upgraded since Soviet times; the turbines at the plant were designed to last no more than 25-30 years, but were still in place 31 years after the colossal dam opened.

Analysts say Moscow has fallen behind its emerging market rivals in infrastructure investment — Russia’s roads alone claimed 30,000 lives last year.

“What happens on our roads is like a report from a war zone — and the same is true of work at sophisticated technical facilities,” Putin told the cabinet.

Excuse me? This is news?  The decrepitude of Soviet, sorry, Russian infrastructure has been well known for a very long time.  From the roads to the rails to air transport to gas pipelines to whatever, Russian infrastructure has been a safety and maintenance nightmare.

And remind me, how long has Putin been president or prime minister?   Ten years, almost to the day, right?  And he’s just figured out all of a sudden that this is a major problem?  Only now is he seeing problems with “full clarity”?  Only now he understands that a full review is needed?

Just what has he done to address these matters during this period during which he has exercised almost absolute power?  How has he encouraged the development of institutions and financial markets that would facilitate the direction of capital to the rehabilitation of “engineering structures”?

He has done very little, in fact. He has spent inordinate amounts of time on playing CEO of Gazprom, and blowing inordinate sums on “prestige” projects like the Sochi Olympics ($6 billion and climbing) and the billion dollar bridge to an island of a few thousand people to show off for a few days for the 2012 APEC Summit.  These paragraphs from an NYT article on the bridge to Russki Island (AKA the Bridge to Nowhereski) speak volumes:

The spending looms large because the government has sharply cut the rest of the infrastructure budget in response to the financial crisis. As a result, the work  in Vladivostok and Sochi is drawing criticism that the Kremlin is focusing on trophy projects that might burnish national pride, but will not yield long-term economic benefits.

. . . .

Before the financial crisis, Prime Minister  Vladimir V. Putin proposed a $1 trillion program to modernize infrastructure, but those plans have been largely shelved, officials said, in favor of spending on social and employment programs, which are aimed at helping to soothe tensions in distressed parts of the country.

Financial analysts estimated that Russia spent roughly $42 billion for infrastructure in 2008, about 13 percent of government spending. This year and next, however, that figure is expected to drop to 5 to 7 percent, they said, and that includes the outlays for Vladivostok and Sochi.

Even before the crisis, Russia massively underinvested in its infrastructure.  It is galling in the extreme for Putin to respond to the Siberian power plant disaster by attempting to appear that he is concerned and proactive, when he is more responsible than anyone for Russia’s failures to address seriously its chronic structural problems–more responsible, because he has more power than anyone.

Now, to be sure, Russia’s problems were so daunting that even the most focused and effective efforts over 10 years would have left much still to do.  But despite a lot of talk, this was not one of Putin’s priorities.  More concerned with redirecting rents and restoring Russia’s international and military power, he has largely neglected the hard and less glamorous task of creating a physical and institutional infrastructure befitting a modern country.  So what has he created in his ten years?  A wannabe superpower with feet of clay.

Due to his warped priorities, he has squandered seven fat years, and faces many lean years.  With foreign investors deserting the country (in large part due to Putin’s flagrant disregard for the security of their property), the banking system teetering and requiring huge sums due to cascading non-performance on loans, and the government budget dangerously overextended, to name just a few pressing issues, it is unlikely that the resources needed to strengthen Russia’s infrastructure will be forthcoming any time soon.  Russia has long lived off Soviet capital, and that capital is about depreciated with few prospects to replace it.

So the only real question is where the next big accident will occur.

Putin has been more than willing to take credit for Russia’s supposed resurrection.  He is far less willing to take blame for its problems.  And it takes a special kind of chutzpah to pose as the serious, sober leader acting to tackle Russia’s infrastructure problems after squandering the last ten years doing very little about it.

The only thing more pathetic than that is that he is likely to get away with it.

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