Streetwise Professor

October 24, 2009

A Few Questions on Random Subjects

Filed under: Climate Change,Military,Politics — The Professor @ 9:44 am

The latest pissing contest between the Obama administration and Dick Cheney leads me to wonder: If the Bush administration was so criminally negligent in its waging of the war in Afghanistan, why did Obama retain Robert Gates as Secretary of Defense?  And if Obama has only became aware in recent months of how truly inept the Bush-Cheney-Gates policy was, why does Gates still have a job?  (Note that Gates’s assumption of SecDef duties in November 2006 corresponds closely in time with the serious deterioration of the situation in Afghanistan.)  Put differently, how credible is it for Obama and his minions (although henchmen is probably a better description of some) to claim that the Bush policy was negligent and inept while retaining the services of one of the major architects of that policy, who was also primarily responsible for its execution?

And now for something completely different.  (Yes, I’ve been ODing on the Monty Python documentary and movies on the Independent Film Channel.)

A recent poll reports that Americans are increasingly skeptical about anthropomorphic climate change.  Now, to me it is most likely that what is really going on is that Americans are becoming increasingly cognizant of the costs of measures being advanced to combat climate change, don’t feel that the benefit is worth the cost, and express this belief by casting doubt on the existence of climate change.  That’s neither here nor there, though.  What really interests me is the response to these poll results.

One reaction has been to write them off as the result of relentless propaganda by right wing news outlets, lobbyists, and politicians.  Which leads me to ask: If said news outlets, etc., are such mesmerizing Pied Pipers who can convince large swathes of a gullible American public to follow them down a false path, why is Obama president, and why are the House and Senate solidly Democratic?  And what does it say about the efficacy of the mainstream media outlets–the New York Times, the WaPo, virtually every other major urban daily and weekly newsmag, the used to be big 3 networks, CNN, BBC, etc.,–all of which reliably routinely echo the Chicken Little view?  It doesn’t seem that the Left is getting its money’s worth.

The AP article contains a gem that is quite revealing:

Andrew Weaver, a professor of climate analysis at the  University of Victoria in  British Columbia, said politics could be drowning out scientific awareness.

“It’s a combination of poor communication by scientists, a lousy summer in the Eastern United States, people mixing up weather and climate and a full-court press by public relations firms and lobby groups trying to instill a sense of uncertainty and confusion in the public,” he said.

The point about mixing up weather and climate, and extrapolating from a cool summer in the US, is a fair one.  But what’s sauce for the goose is sauce for the gander, Dr. (I presume) Weaver.  For the most strident advocates of draconian measures to control climate change have shamelessly and repeatedly exploited every weather extreme to raise alarm about climate change.  Indeed, the most famous and influential of climate change Cassandras, James Hansen, first brought climate change (then referred to as “global warming”) to the public consciousness by testifying before Al Gore’s Senate committee during a severe drought in the summer of 1988.  Hansen warned that the drought was the harbinger of our planet’s fate unless measures were adopted immediately to reduce CO2 emissions.  (As I recall, 21 years ago Hansen said we had 10 years to take action or we were doomed).  There is considerable evidence that the 1988 drought was caused by the Southern Oscillation, and was not the effect of AGW; similarly, the 1998 temperature spike was also SO related.  (No, not S-O related, nor So? related.  LOL.)  But global warmists have used both temperature spikes to advance their cause.

So, Dr. Weaver, I would be perfectly happy to be scrupulous about the distinction between weather and climate, as long as you and your confreres do the same.  For you all have been far more sinning than sinned against.

The Michael Jackson Economy

Filed under: Commodities,Economics,Financial crisis,Politics — The Professor @ 9:04 am

For months I have been extremely skeptical about the Chinese economy.  I am not alone.

In the aftermath of China’s release of its GDP numbers, indicating 3Q growth of 8.9 percent, many voices–including those from within China–are expressing doubts about the sustainability of the government’s frenzied stimulus policies. From the FT:

Most fiscal rescue packages stimulated consumption of tradable goods. China, however, has gone the other way. It has been frantically  building roads and power plants.

That approach was based on the assumption that a collapse in exports would be a blip – one that could be offset by state-sponsored splurges on fixed assets. Itsthird-quarter gross domestic product numbers showed that the strategy had been a success, on its own terms. Over the first nine months, the economy grew 7.7 per cent. Of that, investment accounted for 7.3 percentage points and consumption 4 percentage points. The decline in net exports lopped off 3.6 percentage points.

But what if that assumption was wrong? The decline in exports was slowing, yes, but shipments in September were still 15 per cent worse than they were in the month of Lehman’s demise – the 11th straight month of falls, and not much better than the 17 per cent fall in the darkest days of March. The longer they remain sluggish, the longer fixed-asset investment will have to compensate, raising the risk of growth being hit by an investment-led slump.

With unusual frankness, the statement from the National Bureau of Statistics noted that the export picture was “severe”. Otherwise, the gap between rhetoric and reality keeps widening. While regulators and sundry bank executives keep popping up to warn about the  risks piling up in financing new assets, for example, the banks keep lending. September’s total of Rmb517bn of new loans was a quarter bigger than August’s. M2, a measure of money supply, grew a record 29 per cent year-on-year. A gentle contraction from here, as policymakers seem to be indicating, would take years to bring M2 growth down to its long-run average.

A temporary fix is developing more than a whiff of permanence.

Qin Xiao, Chairman of the Chinese Merchant’s Group and the Asian Business Council is alarmed:

While consumer prices are mostly under control, asset price bubbles are growing rapidly because of huge liquidity injections by governments around the world. Globally, there does not seem to be an exit strategy in place to drain this liquidity from the system. Certainly, in China, stock and property bubbles are a concern.

While we have avoided the worst recession since the Great Depression, we are probably  heading for another asset bubble and more financial turbulence. What can we do? Compared with pouring money into the economy, draining money from the economy is a much tougher job for central banks. The dilemma is this: if we tighten monetary policy, there is a high possibility of a “second dip” next year; and if we continue the loose policy, another asset bubble might be not far away.

I do not believe a quick, steep bounce driven by fiscal fixed investment is a good thing for China. Nor is a moderate slowdown anything to be afraid of. Monetary policy must not neglect asset-price movements. Therefore, it is urgent that China shifts from a loose monetary policy stance to a neutral one.

I am also worried about the role of governments after the crisis. There are some who say that this is a crisis of the market economy. It is not; nor is it a time to turn our backs on markets. There have been failures of regulation and oversight, particularly in the west. In China we are still developing our regulatory system. It is a time to strengthen oversight, improve governance and push for freer and more efficient markets in China and abroad.

However, there is growing concern, especially in China, that the temporary stimulus programme might evolve into permanent government control of the economy. The Chinese government should continue to loosen its grip. Prices, especially of energy but including water and food, need to be freed further. The currency needs to be liberalised. Privatisation needs to move ahead. China needs freer markets, not more state control.

FTAlphaville provides some additional background:

And lo and behold — China’s third-quarter GDP  statistics have just been released, and they show an 8.9 per cent growth compared with the same period last year.

Make no mistake, however. This is a growth almost entirely driven by government policies and stimulus packages.

Fixed asset investment, China’s main measure of capital spending, jumped a massive (and probably still  questionable) 33 per cent. At the same time, however, exports are still contracting, falling 15.2 per cent in September, and 23.4 per cent in August. The trade surplus narrowed $45.5bn to $135.5bn.

China’s seems to be a Michael Jackson economy.  Its apparent vigor is the product of a regimen of drugs prescribed to mask organic weaknesses (in China’s case, a massive fiscal and monetary stimulus intended to offset the effect of a collapse in exports)–and to treat the side-effects of previous drug regimens. This putatively therapeutic approach can permit apparently normal function–and even result in seemingly superhuman performance–for some time, but the cumulative effects are ultimately destructive.  In many cases, the denouement is catastrophic–as with Michael Jackson.

China’s Enron-like GDP management seems to be attempting to buy domestic peace by engaging in vast infrastructure investments until such time as export demand picks up, thereby permitting a reversion to the previous model of export-driven growth.  Timing is everything here.  The deleterious effects of the drug regimen cumulate at an increasing rate.  Larger doses need be given in order to achieve the same effect.  The risk of a brutal popping of myriad asset price bubbles, with the consequent shock to the financial system and the real economy, grows with the duration of the fiscal and monetary imbalances.  Unless exports turn around rather quickly, the imbalances in the Chinese economy are highly likely to result in a huge bust.

To the extent that markets outside of China have been bouyed by the ripple effects of that country’s massive stimulus, such a bust would erode asset values and economic growth in said markets.  And nowhere would the effects be more pronounced than in the commodity markets–and commodity-intensive countries.  It is hard–nigh on to impossible, IMHO–to ascribe the robust performance in commodity prices (in the face of persistently high and sometimes ballooning stocks) to anything but the effects of China’s natural resource-intensive stimulus spending, commodity hoarding encouraged by cheap credit, and (arguably) Chinese government stockpiling.  A messy end to the Chinese stimulus would translate into an extremely bloody fallout in primary commodity producing nations.

And that means you, Russia.  In bailing out itself, China has almost certainly saved Russia from an absolute economic catastrophe.  Not that things are rosy in Russia, by any means, but the current situation would be immeasurably worse without China’s stimulus-fueled commodity binge supporting prices. (And it must be noted that Helicopter Ben has pitched in too. I wonder if Putin has sent him a thank you note?)

I am not predicting an inevitable collapse in China, followed by fallout elsewhere.  It is possible that the huge Chinese bet on exports recovering before the baleful effects of the stimulus regimen take hold may pay off.  But the nature of the stimulus does create a significant downside risk in the Chinese economy, and in the world economy, especially in primary resource producing nations.

October 22, 2009

Bulldogs Under the Carpet?

Filed under: Economics,Financial crisis,Politics,Russia — The Professor @ 7:54 pm

In the past couple of years, I’ve often drawn the analogy between Russia and a cartel.  In a cartel, competing interests agree to cooperate, in setting prices for instance.  Cooperation maximizes the aggregate profit, but this cooperation is unstable because by defecting from the cooperative agreement, one cartel member can profit at the expense of the rest.  The fear of retaliation, and the outbreak of profit-destroying competition, is sometimes sufficient to deter such opportunistic conduct.  But there are circumstances in which the short run gains from defection can exceed the long run losses from the resulting competitive phase.  When this happens, the cartel falls apart.  This can often occur in response to shocks that make the old cooperative deal no longer optimal.

In Russia, there are competing interests–the clans.  They cooperate because conflict is costly. But that cooperation is always vulnerable to opportunistic defections; the short run gains from defection may more than offset the costs of retaliation that such defection triggers.

In some earlier posts, I hypothesized that the economic crisis could be the shock that destablizes the cooperative agreement between the clans.  Heretofore that has not happened, but several stories suggest that conflict may be imminent–or may have already begun.

Most notably, Stratfor is about to run a five part series titled “Kremlin Wars,” the subject of which is a breakdown in the uneasy truce between the major clans headed by Sechin and Surkov.  In its email announcing the series, Stratfor writes:

Strange things are happening inside Russia these days. Pro-Kremlin political parties have boycotted the parliament, our sources say lawsuits are about to be filed against some of the state’s favorite companies, and rumors are circulating high within the Kremlin that the Russian economy is destined to be liberalized.

When looked at separately, each of these currents can be rationalized, for Russia has just recently completed elections and the global financial crisis is still hammering its economy. But a deeper look reveals instability inside what is normally a consolidated, stable and politically-locked Russia. Something much bigger and more fundamental is afoot: a war among the most powerful men of the Kremlin is coming.

Stratfor buys into the cartel analogy, and the implications of the economic crisis for the stability of the inter-clan cartel:

It is the classic balance-of-power arrangement. So long as these two clans scheme against each other, Putin’s position as the ultimate power is not threatened and the state itself remains strong — and not in the hands of one power-hungry clan or another.

But having all major parts of Russia’s government and economy fall under the two clans creates a certain structural weakness, a problem exacerbated over the past few years by the effects on the Russian economy of chronic mismanagement, falling oil prices and, most recently, the global financial crisis.

Shocks–such as a financial crisis–can affect the calculus that drives the choice between cooperation and conflict.  The shock can make the old arrangement clearly inefficient, but navigating the way to negotiating a new arrangement is quite difficult.  The necessity of renegotiation presents opportunities for rent seeking, gamesmanship, and brinksmanship that can often result in conflict.  Stratfor believes this is a real possibility in Russia:

[Putin] likes the idea of fixing the Russian economy and making it work like a real economy, but it would mean throwing off the balance of power in the country — the equilibrium he has worked all these years to achieve. And should this balance be thrown off, the effects could ripple throughout every part of Russia — all levels of government, influential security institutions and even the country’s powerful state-owned companies.

When these issues came to our attention some months ago, our first thought was that they were merely the machinations of just another high-level Russian source hoping we would promote his agenda. So we sought confirmation with a number of unrelated sources — and we received it. The final convincing event in our minds was  Putin’s Sept. 29 declaration that some heavy economic reforms are indeed necessary. We cannot rule out that this could all be a disinformation campaign — those are as Russian as vodka and purges — but we cannot ignore our intelligence from such a broad array of sources, especially when it’s combined with signs of  political and  economic instability now cropping up inside Russia.

I will read the Stratfor series with interest, and look for other indications that a breakdown may be imminent.  A couple of possible harbingers.  First, Medvedev has renewed his criticism of the state corporations:

Dmitry Medvedev, Russia’s president, yesterday called for sweeping curbs on state corporations that control swathes of the economy, declaring that many should be closed.

Without naming specific companies, he told a meeting of Russian business leaders at the Kremlin that the corporations should “simply disappear” or become joint stock companies, with many of their state privileges removed. “I think that at some moment the creation of state corporations got out of control,” Mr Medvedev said.

These corporations are the domain of important siloviki.  A strike at the corporations would be a strike at them.

Second, John Helmer’s Dances With Bears reports a development which sounds like a preemptive strike by the Sechin/Rosneft interests against the Gazprom interests:

Gazprom, Russia’s leading company, has told Fairplay that reports that Deputy Prime Minister Igor Sechin agreed this week with the Turkish government to reroute the South Stream gas pipeline on to Turkish territory do not mean that Gazprom has decided to lay a land segment of the pipeline in Turkey, and bypass Bulgaria altogether (for the route until this week, see map).

Sechin, who is a well-known rival and critic of Gazprom CEO, Alexey Miller, was reported as agreeing on October 19 with Turkey’s Minister of Economics, Taner Yildiz, to reroute South Stream through Turkish territorial waters, and in exchange, to supply Russian crude oil to a new pipeline across Turkey from the Black Sea port of Samsun to the Aegean Sea port of Ceyhan. According to a Kommersant reporter granted special access to Sechin, the new scheme has been in negotiation with the Turks since Prime Minister Vladimir Putin was in Ankara on August 6. Ahead of Sechin’s arrival to meet Yildiz in Milan on Monday, Russian officials were working out a more ambitious scheme, according to the Kommersant report, which has the dramatic effect of replacing Bulgaria as Russia’s energy transit partner for both oil and gas with Turkey.

. . . .

The hint in Kommersant, however, that Sechin has moved South Stream away from Bulgaria altogether produced angry press comment in Sofia, the Bulgarian capital, where the government denies it is losing to Turkey both the gas pipeline and the Burgas-Alexandropoulos crude oil pipeline, which Moscow has been backing for more than a decade — until now. Bulgaria’s Minister of Economy, Energy and Tourism Traycho Traykov flew to Moscow for talks today.

Gazprom’s principal spokesman Sergei Kupriyanov refuses to answer questions, adding to the impression that his company’s leadership is in disarray over Sechin’s moves towards Turkey. A Gazprom source told Fairplay Russia has asked Turkey for permission, and received it, to explore the territorial waters of Turkey to find out whether the area is suitable for the pipeline. A southward deviation of the planned route under the Black Sea is being sought by Moscow in order to skirt Ukrainian territorial waters. “If it is suitable”, the Gazprom source said, “then the pipeline may be laid across the Turkish marine territory. Where it goes next – to Turkey or to Bulgaria or elsewhere – is not decided yet.”

The doubt in that last sentence is challenged by the Bulgarians, who claim they have already signed commitments with Putin to lay South Stream across Bulgarian land territory.

Still somewhat murky, but given the history between the Rosneft and Gazprom interests, it is highly plausible that this represents a glimpse of a fierce row between the two.  (Also, it provides yet another illustration of something that I discussed in a post on BP’s hapless dealings in Russia: what could BP management possibly have been thinking when they went to Sechin for help to broker a deal with Gazprom?)

It will be of great interest to see what specifics Stratfor produces to support its view that a Kremlin war is underway.  The dynamics of the duumvirate are likely to be the most visible manifestation of any tension.  Medvedev’s escalation against the state corporations–a Putin creation–could be one important indication of destabilization.  Similarly, public feuds over privatization and government support for certain businesses would be another indication of political ferment.  Perhaps ironically, efforts to promote political stability and conformity, and stamp out any means by which opposition elements could coordinate and coalesce are another indicator of political fissures; the natural reflex of the insecure is to attempt to extend and strengthen control, whereas the secure can tolerate a modicum (or more) of criticism and opposition.  The almost comical election rigging is consistent with a fear of instability and a perceived imperative to restore control; so are the moves against the last vestiges of (relatively) independent television in the country.

Churchill famously remarked about the bulldogs fighting under the carpets in Russia.  The balance of power between competing interests in a natural state like Russia is tenuous, and prone to breakdown during periods of stress.  Given the opacity of the system, growls emanating from under the carpets are often the first sign that such a breakdown is occurring.  Stratfor claims to hear them.  It bears keeping an ear cocked to determine whether it is right.

Fly the Unfriendly Skies

Filed under: Russia — The Professor @ 4:06 pm

When in Madrid for a conference last week, I spoke to an academic who in a former life worked in the reinsurance business.  One of his jobs was to evaluate the risk of airline crashes.  I asked him whether this affected his comfort level in flying.  He said: “We had huge amounts of data on the maintenance records of every plane in service, and the safety records of pilots and airlines.  Based on our analysis of that data, I feel very comfortable at flying any reputable airline.”  He then, with a roll of his eyes, said: “But I would NEVER fly on a Russian plane.  That is real Russian roulette.”

He said that, I might add, not knowing that I am supposedly a notorious Russophobe.

Don’t say you weren’t warned.

The Socialist Calculation Problem and the Regulation of Financial Markets

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,Politics — The Professor @ 3:56 pm

The European Commission released its “Communication to a Cast of Thousands” on “Ensuring efficient, safe and sound derivatives markets: Future Policy Actions.”  It is, at best, a series of policy proposals based on nothing more than assertions delivered from on high.  These assertions are both logically dubious and completely empirically unsupported.

The main policy recommendations are to force the bulk of derivatives trades into centrally cleared platforms and exchange trading.  This will be accomplished by margin and capital requirements, and mandates.

At one level, the EC report identifies the appropriate objective: to encourage market structures that “allow markets to price risks properly” (p. 2).  However, it provides neither theoretical nor empirical support for its assertions that its policy actions will in fact improve risk pricing.  At root, its argument is that centralized price setting dominates decentralized price setting.

As has been known since Hayek and his peers, the relative efficiency of centralized vs. decentralized price setting depends crucially on the information available to those setting the prices.  Recognition of the crucial issue of information is completely lacking in the EC document.

The Olympian tone of the document is well summarized by the statement that it is adopting a new regulatory approach “where legislation allows markets to price risks properly” (p. 2).  In other words, it is legislation that is the essential determinant of whether markets price risks properly or not.  As if.

The document states “the proposed measures will shift derivative markets from predominantly OTC bilateral to more centralised clearing and trading.”  Putting all this together means that the EC is asserting that the existing market structure is history’s greatest market failure.   One would think that such a sweeping claim would require some supporting evidence and theory.  The EC document provides none whatsoever.

The assertion that markets have systematically failed to price risks occurs throughout the document.  For instance, it says: “the function of prices to allocate resources must be restored: derivatives should be appropriately priced in relation to the systemic risk they entail.”  The necessity of a “restoration” implies that: (a) the market has done a bad job in pricing these risks in the past, and (b) regulators can do better going forward.  Although one may agree with (a), it is essential to avoid the Nirvana fallacy: the crucial element of a policy recommendation is the comparative performance of imperfect markets and imperfect regulators.  Thus (b) is the crucial issue.  Sadly, the EC consistently falls prey to the Nirvana fallacy, and asserts without providing the least support that of course regulators will do it better than markets.

The document reeks of the Olympian disdain of Eurocrats in love with their own superiority.  It is the Nirvana fallacy distilled into 9 pages of text.

For instance, we get pearls like: “Such contracts will continue to be cleared bilaterally with counterparties exchanging collateral to cover their exposure.   However, current collateral levels are too low.”  What is the basis for such an assertion?  Who knows?  And, even granting the possibility that some collateral levels may be too low, there is also the possibility of setting them too high.

You’ll search in vain trying to find any reasoned discussion of (a) the relative costs of excessive or deficient collateralization, or (b) the information available to regulators and market participants that they can use to set these levels.

The document suggests that initial margin levels “will be specific to counterparty characteristics.”  This has to mean measurable characteristics.  But what information does a regulator have to measure the counterparty characteristics necessary to set initial margin levels?  Is that information better or worse than the kind of information that large dealers have?  I have very strong priors on the answer to that question: the dealers.

If you think differently, fine.  But before you decide, I suggest that you consider the entire credit rating agency fiasco, in which credit risk evaluations based on measurable characteristics were made by a small number of (centralized) entities.  Not only were these evaluations systematically flawed (thereby raising similar concerns that regulatory decisions regarding initial margin levels will be so too), crucially they were extremely brittle because of the lack of diversity in evaluations and the information on which they were based.  Thus, the errors the agencies made had broad systematic effects.  In contrast, a more diffuse mechanism for establishing initial margins, in which multiple agents possessing different information evaluate counterparty risk and price it appropriately is less susceptible to such systematic errors.  Since systematic errors can translate into systemic risk–as the AAA CDO disaster demonstrated–this is a very serious concern.

Bad pricing of relative counterparty risks across transactors will lead to a misallocation of trading activity and counterparty risk exposure across them.  Those whose counterparty risks are underestimated will trade too much; those whose risks are overestimated will trade too little.  These errors are inevitable, so the crucial question is what sort of market arrangement will minimize the costs of these errors.

This depends on the information available to those making the decisions.  In my view, major dealers will almost inevitably have more information individually than would a central regulator or clearinghouse.  Moreover, since in a market structure like that has evolved heretofore numerous entities are collecting information and making these judgments, there is the possibility of the aggregation of diffuse private information.  This possibility is absent in a highly centralized structure.

Put differently: the EC (and its American counterparts) are acting as if they had never heard of the socialist calculation controversy.  (Which is probably true–all the worse for them if so.)  Namely, how does a central agent set prices in a world with diffuse private information about costs and value?  Information about counterparty risk is highly diffuse, and largely private.  How can a central agent set the “right” prices in such an environment?  Can markets do it better (even if not perfectly)?

We have all too much experience with the defects of central price setting as compared to decentralized price setting in markets (cf. the USSR) to be at all confident with the relative superiority of centralized counterparty risk pricing.  At the very least it is incumbent on the advocates of such a centralized approach to address seriously the possibility (demonstrated by vast experience in many contexts) that centralized price setting in derivatives markets will founder on the same information problem that has wreaked havoc with other efforts to set prices centrally.  Tragically, they don’t even acknowledge the problem, let alone provide a convincing analysis supporting the contention that centralized pricing will dominate private, decentralized pricing.

Similar problems are inherent in the EC’s recommendation of differential capital charges for cleared and non-cleared derivatives contracts.  Again, what is the basis to believe that the regulators have the information to set this differential (or the levels) properly?  This ability is blithely assumed in the EC report; again this crucial issue is not even acknowledged.

It does not inspire confidence that the EC paper invokes the authority of the Basel Committee on Banking Supervision as the model for the setting of capital charges.  That would be the source of the same Basel rules that made it very attractive for systemically important financial institutions to load up on AAA CDOs.  We all know how that worked out.  Another illustration of the socialist calculation problem in action.

Beyond the complete failure to engage the fundamental informational questions, the paper says things that cast serious doubt on the competence of the EC to make such sweeping changes to financial markets.  For instance, there is a statement in the paper that strongly, strongly suggests that the EC does not understand the first thing it is talking about.

Specifically, on p. 6, it asserts, in a completely conclusory way, with no supporting evidence or argument whatsoever, that counterparty risks of “contracts that are cleared on a CCP” are lower than “the counterparty credit risks of those [contracts] where clearing is done bilaterally.”

If one defines counterparty credit risk as being the probability distribution of default losses, this statement is completely wrong.  Holding positions and the portfolios of the transacting parties constant, the probability distribution of default losses is the same between centrally cleared and bilateral contracts.  All central clearing does is change the allocation of those default losses across market participants.  That is, holding the market and credit risk exposures of market participants constant, the total dollar amounts of defaults is the same in every state in the world in cleared and bilateral markets.  Clearing changes the allocation of these given dollar losses across market participants, not their magnitude, or their probability distribution.

It is possible that this re-allocation of risk can be efficiency enhancing, but that is not a given.  Moreover, the fact that the EC apparently believes that CCPs somehow make counterparty risk magically disappear, it is almost certain that it has not thought seriously about the efficiency implications of this reallocation.  Why think about allocation of something that you believe won’t exist due to some form of financial alchemy?

This raises very serious concerns.  Read literally, the EC document implies that the Commission believes that clearing makes default risk disappear.  This is wrong, wrong, wrong.  It is understandable that someone operating under such a delusion would be very enthusiastic about clearing.  It should also be understood, however, that the enthusiasm of someone operating under a delusion is very, very dangerous.

The foregoing analysis assumed that positions would be the same in cleared and bilateral regimes.  However, the adoption of central clearing will almost certainly affect the sizes of positions that market participants take.  This, in turn, will affect overall default risks, and the allocation of these risks.  Indeed, given that clearing involves the mutualization (i.e., socialization) of risk, there is the distinct possibility that the effect of these changed positions will be to increase total default exposures; mutualization means moral hazard, and moral hazard tends to encourage risk taking.  Although CCPs can control this risk taking through margins, this is costly.  I have pointed out in my academic work that clearing can lead to increased overall risk exposures for other reasons as well.  Not that you would know this from reading what the EC–or any American official–has said on the subject.

Nor would you know that under certain types of structures, default losses borne by systemically important institutions can be higher under clearing because under these structures, CCP members guarantee customer trades, whereas in a bilateral market customer counterparties of a defaulting firm suffer default losses.  This is part of the allocational aspect of clearing, and means that systemically important institutions that backstop CCPs can actually suffer greater default losses in a cleared market than they would absent clearing.

I must say again: the case for forcing changes in market structure, most notably forcing adoption of clearing through either carrots (differential margin and capital charges) or sticks (mandates) has not been made.  Not in the least.  The key issues have not even been raised, let alone addressed.  The informational challenges that clearing poses have been assumed away.  Policies based on ignoring core issues do not inspire confidence, to say the least.

Sad to say, the Olympian, arrogant, government-knows-best attitude embodied in the EC paper is also manifest in the pronouncements of US regulators.  Most notably, Gary Gensler of the CFTC has come out in favor of trying to force virtually all trading onto exchanges and clearing.  And none of the arguments he makes in support of this view–none–grapple with the fundamental informational issues.

Unless and until those advocating a radical restructuring of the financial infrastructure, complete with implicit and explicit government pricing of counterparty risk, acknowledge and address the informational and incentive challenges associated with such a change, there can be no confidence that the change will be a beneficial one.  Indeed, given the sorry experience with centralized, hierarchical, regulatory price setting mechanisms in environments where information is private and diffuse, the odds favor the opposite result.

When make cartoon arguments for clearing (and for exchange trading), I have a sinking suspicion that the results will be anything but funny.


By all appearances, both the US and Europe are on the fast track to a complete restructuring of the financial system based on a shockingly incomplete understanding of the true trade-offs.  In so doing, we are laying the groundwork for the next crisis, and a loss of efficiency until that crisis materializes.  Heaven help us.

October 20, 2009

Better Late Than Never

Filed under: Commodities,Energy,Financial crisis,Politics,Russia — The Professor @ 4:42 pm

Old hat to SWP readers (I wrote about this repeatedly from last December through March), but apparently “news” to the NYT:

While OPEC members limped through a period of painful production cuts this year, Russian oil companies enjoyed an extraordinary run.

The year that has gone by since Russian officials floated — and then retracted — a proposal to coordinate production limits with the Organization of the Petroleum Exporting Countries illustrates why the Kremlin is unlikely ever to actually do so.

Already the world’s largest oil producing nation, Russia, pumping prodigiously through the downturn, this summer passed another milestone. As Saudi Arabia tightened its belt to live by OPEC cuts, Russia surpassed it to become the world’s largest exporter.

. . . .

Improbably, the once-neglected oil sector has emerged as one of Russia’s few growth industries, helped by the tax cuts, a devaluation of the ruble that aided exporters and a change of policies that may invite foreign companies back into the sector.

“OPEC made a concerted effort to stem its exports,” said Alex Fak, an oil analyst at Troika investment bank in Moscow. “The result of that action was higher oil prices. So Russia was encouraged to produce more and sell more. Which is what it did.”

Yet, for a time, officials had seemed ready to revise the long-held axiom that Russian national interests were not served by cooperating with OPEC. Sharp price declines had turned Russian oil companies, just a few months earlier seen as money printing presses for the government, into money losers. Far from propping up the Russia government, which relies on oil exports for about 40 percent of its budget, they needed help themselves.

Anyone who really believes that Russian officials were ready to cooperate with OPEC is incredibly credulous.  The Russians are notorious for playing double games, and for double crossing.  I just wonder if OPEC was as credulous as the New York Times.

Hillary’s Excellent Moscow Adventure

Filed under: Military,Politics,Russia — The Professor @ 4:34 pm

“Excellent,” in the same way that an unanesthetized root canal would be.

At the beginning of the Obama administration, Hapless Hillary handed Russian Foreign Minister Sergei (“The Tarantula”) Lavrov a button that was supposed to say “reset” in Russian, but actually said “overcharge.”  The Russians find the overcharge idea quite appealing, thank you, and are doing their best to take advantage of HH’s generous offer to overcharge the US at every turn, as Vladimir Socor makes clear (depressing reading alert):

On October 13, the Secretary Security Council Nikolai Patrushev announced the Kremlin’s intentions to change Russia’s military doctrine with regard to the use of nuclear weapons. The amendments substantially lower the threshold for such use. They envisage the possibility of Russian nuclear strikes at an operational-tactical level in regional and local conflicts. Under the amendments, Russia explicitly reserves the right to carry out preventive nuclear strikes in such conflicts; and also the option of first use of nuclear weapons if necessary to prevail in a conventional regional or local conflict (Izvestiya, Interfax, international news agencies, October 14).

The U.S. delegation failed to respond to this well-publicized, clearly pre-planned, and apparently unanticipated challenge to core U.S. positions.

The Obama administration has made the political objective of nuclear disarmament a top priority of its Russia policy. It has also given up the planned anti-missile shield in Central Europe, hoping for a Russian quid-pro-quo on U.S. concerns in other theaters (a deal precluded, however, from the outset by the administration’s own arguments for abandoning the shield). Nuclear disarmament and non-proliferation topped the agenda of Clinton’s visit. Moscow’s public response through Patrushev amounts to a rejection of the U.S. administration’s nuclear disarmament and non-proliferation goals. It suggests that Russia will not cooperate in bestowing a nuclear disarmer’s mantle on the American president; and that the anti-missile shield’s abandonment has failed to restrain Moscow, while possibly emboldening it.

Relegating Georgia to the back burner and abandoning the missile shield in Central Europe has not elicited Russian cooperation on Iran sanctions. The U.S. delegation returned empty-handed from Moscow on the sanctions account. In the run-up to the visit, the White House and State Department had optimistically interpreted a highly ambiguous statement by Medvedev at the United Nations that Russia does not necessarily rule out support for another round of sanctions against Iran. With the administration’s own timetable for imposing “crippling,” or at least “biting” sanctions on Iran expiring, and with the missile shield’s abandonment expected to elicit Russian cooperation at the last moment, the U.S. delegation hoped to demonstrate success on that account in Moscow.

. . . .

Faced with multiple U.S. solicitations at every high-level meeting, Moscow feels that it can wait out and manipulate the process through arbitrary linkages and trade-offs.

The U.S.-Russia joint working group on civil society issues is widely seen as representing a U.S. unilateral concession, rather than a classical trade-off.

All take, no give.  Nothing for something.  That’s the essence of overcharge.  And unilateral concessions and repeated solicitations are an invitation to ask for more, more, more; to jack up the price; to overcharge at will.  The administration literally asked for it with the lame mis-labeled button.  Now they are figuratively asking for it again and again by repeatedly playing the supplicant.

Sadly, this is becoming a pattern, as Iran’s gladly taking the quid and telling Obama to fuggidabout the quo makes plain.

Apparently the operating principle behind the administration’s diplomatic approach is predicated on a form of projection: everybody is just like us and will reciprocate gestures of goodwill.  It is diplomacy by the golden rule.

The Russians and Iranians (and the NoKos) make it plain, moreover, that they view this as chumplomacy, and have no interest whatsoever in reciprocity.  They’re quite happy at taking what the chumps naively offer.

Oh, what a better world ‘twould be if the golden rule were an empirical fact.  But it ain’t.  Far from it.  In the world as it is, rather than as we wish it would be, such dreamy, delusional approaches are extremely dangerous.  They only encourage the most incorrigible and malign elements, and undermine the safety and prosperity of the peaceable.

It took the Soviet invasion of Afghanistan to awake Jimmy Carter from his similarly naive reveries.  Will it take something so catastrophic to awaken Obama and Hillary to the true natures of the Russians, Iranians, et al?  I hope not, but am resigned to the likelihood that it will.

October 19, 2009

Attaboys Terminated With Extreme Prejudice

Filed under: Commodities,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 2:51 pm

So, here I lie, flat on my back, having taken a full-speed run at the derivatives regulation football, only to have Barney Frank snatch it back at the last minute during markup.  In contrast to the proposed OTC derivatives bill I praised a couple of weeks ago, the bill as passed by Frank’s committee includes both a clearing mandate, and an exchange trading mandate:

The committee, headed by Representative  Barney Frank, a Massachusetts Democrat, is set to complete action today on the legislation, which would require many derivatives transactions to go through central clearinghouses. The administration wants to subject broker dealers such as  JPMorgan Chase & Co.and derivatives users such as  American International Group to new margin, collateral and disclosure requirements.

. . . .

Frank plans to offer today an amendment that would mandate trading on exchanges or swap execution facilities for standard contracts between dealers and their biggest customers. Barr called that provision “essential.”

As I’ve written repeatedly, here and elsewhere, I believe that both of these provisions are deeply misguided.  I won’t belabor the argument, which the interested reader (or those suffering from insomnia) can find by searching the site or clicking the derivatives category link.   I will just say again that Frank is reinventing the wheel, as an exchange trading mandate was the magic bullet of derivatives reform in 1922.  It eventually proved unworkable, and will do so again–only much, much faster.

Raising the cost of managing risk will lead to greater risks.  It’s not that complicated.

Economics of Contempt (a lawyer and former Dem legislative aide) says that Frank sandbagged the dealers:

Frank really sandbagged the dealers with his exchange-trading amendment. The dealers support a central clearing requirement for standardized swaps, but not an exchange-trading requirement (with at least some justification). Frank’s discussion draft had only required central clearing, and then he surprised everyone on Wednesday with his amendment requiring exchange-trading. It was a politically savvy move if Frank was planning to require exchange-trading all along—don’t give the dealers time build up opposition to the amendment and it’s much more likely to pass. My sense is that Frank simply changed his mind at the last minute, for whatever reason.

“Changed his mind at the last minute, for whatever reason.”  A 180 degree turn at the last minute!  With no substantive reason given!  That’s the way to determine the fate of the world’s largest financial markets!  I feel so much better now.

Barney–I take back every nice thing I said about you.  Indeed, I’ve upped my grandfather’s exchange rate of attaboys taken away per attaboys given from 10 to 100.  Or 1000.

Many clearing/exchange trading developments in the news.  Unlike Barney and Geithner and Gensler and the clearinghouse mandate herd in the US, the Europeans are getting nervous about forcing things:

anks should be “incentivised” but not forced to shift privately-negotiated derivatives contracts onto exchanges to cut risk, the European Union’s executive will say next week, according to people familiar with the situation.

The European Commission is expected to publish a policy discussion paper on regulating the $450 trillion over-the-counter (OTC) derivatives markets on Oct. 20.

“I think they want to keep it a reasonably high level so they have room for manoeuvre. Expectations for October 20 were for more detail but the industry will be disappointed,” a source with knowledge of the paper said on Tuesday.

The largely unregulated market includes credit default swaps (CDS), which are used to bet on whether a company will default on its bonds and have been blamed for amplifying last year’s severe financial crisis that hammered economies worldwide.

The Commission published a preliminary paper in July which focused on the need for standardisation and central clearing of CDS contracts, saying the case has yet to be made on mandatory exchange trading.

“It hints at exchange trading by using the word incentivising transition to try to get more use of standardised products,” the source said of next week’s paper.

The July paper was more open on the issue of exchange trading, only saying it needed further study.

Incentives would likely comprise heavier capital charges on banks which trade OTC contracts that are not standardised or centrally cleared, the source added. Cleared contracts already have a zero weighting for capital requirements.

The latest paper is also expected to push for greater transparency and for a central data repository. It reflects global efforts to regulate derivatives and other lightly supervised parts of the system.

I critiqued the EU’s July report when it came out.  If this report is to be credited, the Europeans seem to have adopted the basic approach I have been advocating–more reporting, no clearing mandate.  But then, I said that about Barney Frank too, so I’m not holding my breath.  In any event, I will read the EU report that comes out tomorrow with interest.

The “incentivizing” approach has some problems too, though.  “Holding more collateral”  is a very general concept.  The key thing is choosing just how much, and how much that varies across products, and crucially–since collateral is all about counterparty risk–how much that varies across counterparties.  Choosing the wrong levels, and choosing the wrong relative collateral levels across deals and counterparties can make things worse rather than better.

The collateral rules will induce gaming and strategic product design to mitigate collateral impacts.  Moreover, as demonstrated in the case of “AAA” CDOs, incorrect choices of capital haircuts can lead financial institutions to take highly correlated positions (i.e., hold essentially the same instruments because their capital charges are too low) that actually exacerbate systemic risk.  Moreover, it is important that relative collateral charges be appropriate across cleared and non-cleared products.  If non-cleared products are charged too much, it could increase the risks that clearinghouses face, and if they don’t price their risks properly, this can also contribute to systemic risk.

I am deeply, deeply skeptical that regulators have the information and knowledge necessary to set these charges.  This is a price fixing exercise.  When have governments EVER demonstrated that they have the information, knowledge, and incentive to set the levels of prices properly, or to set relative prices properly?  “Hold more collateral” sounds great in theory, but is a real source of potential systemic risk when one remembers that you have to specify exactly the amounts of capital every market participant must hold against every instrument, and when one remembers further that setting them wrong can be worse than not setting them at all.

Looking backwards to fix the causes of earlier crises frequently results in a failure to comprehend how the supposed “fixes” lays the groundwork for the next crisis.  Regulation of collateral levels could well do just that, in the same way as Basel capital requirements were a major contributor to the last crisis.

In one last piece of clearing news, the Frank bill also attempts to micromanage the organization, ownership, and governance of clearinghouses:

Derivatives legislation approved by a U.S. House panel yesterday would prohibit swaps dealers such as  Goldman Sachs Group andJPMorgan Chase & Co. from collectively owning more than 20 percent of a clearinghouse.

“An inherent conflict exists between broker dealers and clearinghouses and exchanges,” Representative  Stephen Lynch said when he introduced his provision on Oct. 14. “Brokers and dealers should not be able to capture trading and clearing intermediaries.”

. . . .

The amendment on clearinghouses would restrict swap dealers, “major swap participants,” and any “person associated with a swap dealer or major swap participant” from collectively controlling more than 20 percent of the voting rights in a facility used to clear derivatives contracts. It also would limit membership on boards of the clearinghouses and establish other rules aimed at limiting conflicts of interest.

This restriction on ownership and governance could have serious unintended consequences.  Remember what clearinghouses are.  They are mechanisms to share risk–default risk, in fact. It is well understood that there is typically a close relationship between control rights and cash flow rights/risk exposure (e.g., the ubiquity of 1 share-1 vote).  This makes good economic sense (as Grossman and Hart demonstrated years ago).  A mismatch between risk exposure and control rights means that those with the control don’t bear the full costs of their decisions: the risk is borne by others.  That is a recipe for excessive risk taking and other distorted decisions.

The traditional clearinghouse involves big intermediaries sharing counterparty risk, and since they bear the risk, they control the entity.  This suggests that there will likely be an equilibrium response to the proposed restriction on control rights; firms whose control rights are limited will likely similarly limit the risk exposure they are willing to take.  So, if the big dealers and major trading firms (e.g., hedge funds) that are deemed major swap participants are limited in the control they can exert, they will almost certainly similarly reduce the risk that they will absorb.

If these big dealer firms don’t absorb the risk, who will?  What alternative risk sharing model does the committee have in mind?  I am highly skeptical that the traditional clearinghouse mutualized risk sharing model will work with this governance model.  So what risk sharing model will be used instead?  Will public shareholders bear the risk (through their equity investments)?  That is, will clearinghouses become more like stock insurance companies, rather than mutuals?  Is this wise, given the survival value that the mutual model has demonstrated in clearing over the years?  (If sharing of default risk through the equity markets was the wise thing to do, why hasn’t this been utilized more in the past?)

And the big question: Is there the slightest reason to believe that those who proposed and voted for this restriction have thought even superficially about its consequences?  (I amuse myself sometimes.)

Here we have the spectacle of people who probably hadn’t even heard of clearing a year ago presuming to impose by legislative fiat the most detailed rules specifying what must be cleared, how it must be traded, and how the clearinghouses are organized to do their business.  These decisions will have huge consequences, almost certainly all of them unanticipated and unintended.  And many of these unintended consequences will almost certainly be adverse, perhaps extremely so.

Again, the metaphor of the Sorcerer’s Apprentice comes to mind.  These people think that they are in control, but they are not: they are in fact unleashing forces beyond their control, and the effects are not likely to be good.

October 14, 2009

I Am So Surprised

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 1:43 pm

That Sergei (“The Tarantula”*) Lavrov shot down in flames Hillary Clinton’s attempt to get Russia to agree to tough sanctions on Iran. Actually, I’m not.  I would have only been surprised if Lavrov and Putin had expressed a willingness to do something serious.  I would like to ask, though, that anyone who did fall for Medvedev’s showing a little ankle on this to email me at [email protected]  Have I got some deals for you!

And if anyone is confused on this, consider that Putin has also expressed his deep, deep concern for those oh-so-fragile Iranian psyches, and is recommending that nobody do anything that might scare the poor dears:

Russian Prime Minister Vladimir Putin Wednesday warned major powers against intimidating  Iran and said talk of sanctions against the Islamic Republic over its nuclear program was “premature.”

Putin, who many diplomats, analysts, and Russian citizens believe is still Russia’s paramount leader despite stepping down as president last year, was speaking after U.S. Secretary of State Hillary Clinton visited Moscow for two days of talks.

“There is no need to frighten the Iranians,” Putin told reporters in Beijing after a meeting of the Shanghai Cooperation Organization.

“We need to look for a compromise. If a compromise is not found, and the discussions end in a fiasco, then we will see.”

“And if now, before making any steps (toward holding talks) we start announcing some sanctions, then we won’t be creating favorable conditions for them (talks) to end positively. This is why it is premature to talk about this now.”

Premature, premature, premature.  Manana, manana, manana.  Get the picture, Hillary?  Russia ain’t going to do jack to pressure the Iranians.  Move on to plan B, or C, or whatever one we’re on now.

So just what did we get for the unilateral shafting of the Poles and Czechs?  Just asking.

For an interesting contrast, watch Putin and Russia deal with China. Putin traveled to China to announce big energy deals with great fanfare.  Everything is agreed!  Uhm, except the price.  Details, details.

China has shown no interest whatsoever in agreeing to the same oil-based pricing formula as Gazprom employs in its European sales contracts.  Given the bilateral monopoly condition that would characterize any Gazprom/Russia-China deal, the same sorts of issues that I addressed in my take-or-pay post will make any Russia-China agreement very hard to negotiate and enforce.  So, I wouldn’t hold my breath in expectation of such a deal any time soon.

It is very interesting to note, though, how much more difficult it is for Putin and Russia to deal with China than the Europeans.  The old standby divide-and-conquer gambits that routinely work with the Euros are not an option in dealing with China.  Putin doesn’t look quite so smart or powerful in dealing with a single, hardheaded negotiating partner as he does in rolling divided, squabbling, and politically vulnerable Europeans.  If the Euros were smart they would watch, learn, and imitate.  Note that this is a conditional statement, not a prediction.  I doubt that they will.

Roman Kupchinsky at Jamestown notes that the Chinese are also quite concerned about the Russian ability to deliver on all the blank gas checks they’ve written–a point I’ve made repeatedly on SWP:

[T]he main concern analysts have is Russia’s ability to supply 68 bcm of gas per year to China while meeting long-term commitments to European customers as well as rapidly increasing Russian domestic demand for gas.

Earlier this year, Gazprom announced that gas from the Sakhalin-1 project will not be sold to China, but diverted instead to the gas hungry Russian Far East region of Vladivostok.  Gazprom is holding talks with Exxon about buying all of its gas output from Sakhalin and industry sources say the company is offering prices equal to Russia’s domestic gas prices – which are far below world prices. Exxon said it is studying all options to sell gas from Sakhalin-1.

In addition to making promises to supply China, Gazprom has also stated that it wants to capture  10 percent of the U.S. gas market within the next 5 years by selling some 66 bcm of gas in the form of LNG. The plan envisions that Sakhalin-2 will supply the bulk of this LNG.

The bottom line is whether Russia is capable of building such costly pipelines as Nord Stream, South Stream and a second string of Blue Stream; while at the same developing the Yamal peninsula into a major gas producing center and finishing the Shtokman project? These projects, and others too numerous to mention, are projected to cost hundreds of billions of dollars which Russia does not have and which Western companies might not want to spend given the shaky business reputation of Gazprom and its management.

Exactly.  The Chinese presumably extracted something from Putin in exchange for letting him put on this Potemkin/Putinkin-goes-gas display.  But China will almost certainly not rely in a serious way on Russian promises of future energy supplies, because it understands that Russia’s ability to perform on its commitments is so doubtful.  If it does enter into agreements with Russia, it will likely impose contractual terms that will shift the major risk of non-performance due to the inability to obtain the necessary supplies to the Europeans.  Yet more reason for the Euros to get their act together.

* I am counting the seconds until the eruption of howls of protest from Cutie Pie at this arachnomorphism.

October 13, 2009

And the Nobel Prize in Stupidity Goes To

Filed under: Economics,Financial crisis,Politics — The Professor @ 3:06 pm

Louis Uchitelle of the International Herald Tribune, for heaving up this:

The prize committee, in making the awards, seemed to be influenced by the credit crisis and the severe recession that in the minds of man mainstream economists have highlighted the shortcomings of an unregulated marketplace, in which “economic actors” [nice scare quotes there, Louie], left to their own devices will act in their own self-interest.  Classical free-market theory holds that in doing so they enhance everyone’s well being.

The committee, in effect, said that theory was too simplistic and ignored the unstated relationships and behaviors that develop within companies that compete.  “both scholars have greatly enhance our understanding of nonmarket institutions,” the committee said.

Clue telegram for Mr. Uchitelle (a telegram because it’s pretty clear that his clue phone has been disconnected due to nonpayment): Williamson and Ostrom both analyze the private behavior of economic actors acting in their self-interest to enhance wealth and well-being.  Williamson, for instance, shows how economic agents design and choose various forms of organization and governance to mitigate transactions costs and thereby enhance wealth.  Similarly, Ostrom shows how groups of individuals can craft mechanisms to mitigate wasteful exploitation of common pool resources; these individuals are again acting in their self-interest to achieve results that enhance wealth and welfare.

Although Uchitelle seems to be reaching desperately to argue that the Nobel committee was making a ringing dirigiste statement, in fact Williamson’s and Ostrom’s work is actually quite supportive of the view that maximizing agents left to their own devices can craft mechanisms that address many contracting and transactions costs problems conventionally thought to require government action to redress.  Although Williamson argued that transactions costs considerations can make some kinds of regulation beneficial (e.g., the avoidance of auction mechanisms for cable TV franchises), he was also extremely influential in demonstrating that much regulation of vertical relations (e.g., anti-trust actions against vertical integration) was completely wrongheaded because it failed to understand the fundamental economic purpose (transactions cost mitigation) of these arrangements.

Uchitelle’s choice of words reveals his desperation quite clearly.  The committee “seemed to be influenced.”  Translation: They didn’t come out and say it, so I put my words in their mouths.  “The committee, in effect, said.”  Again, the committee didn’t say so explicitly so Uchitelle had to divine its hidden meaning and share it with the world. Also, the “unregulated marketplace” is the flimsiest of straw men.  In effect, Mr. Uchitelle, you are a liar.

Uchitelle’s understanding of economics is laughable.  “Classical free-market theory”? WTF is that?  He presents the most reductive caricature of neo-classical economics, and tries to pass that off as “classical free-market theory.”  Sophisticated economists who are broadly supportive of letting individuals craft their own contractual arrangements, and suspicious of government interference in such individual efforts, do not rely on textbook Walrasian markets to make their arguments.

Indeed, given the ways in which neo-classical economics (since Pigou) has been hijacked to justify heavy-handed government intervention, it is my distinct impression that most New Institutional Economists (including Coase, as well as Williamson and Ostrom) who think about institutions, contracting, and organization more broadly have a greater appreciation of the virtues of private arrangements, and the vices of public ones, than “mainstream” purely neo-classically trained ones.  They take their cue from Coase, who long ago noted that economists operating from a purely neo-classical framework saw every non-standard contracting relationship as a manifestation of market power and monopoly because they had only “pure competition” and “monopoly” hammers in their toolkit.  New Institutionalists understand that “markets” should be interpreted broadly to include all private contracting relationships, not just price allocation mechanisms, and that they are efficient, economizing, wealth maximizing responses to a variety of economic challenges.

Interestingly, the above quote from Uchitelle comes from the International Herald Tribune on Dead Tree that I picked up this morning in the Casa Pairsal in Collioure, France.  When I went online to find the electronic version, Mr. Uchitelle’s deathless prose quoted above was not to be found.  Instead, his online article acknowledged:

Neither Ms. Ostrom nor Mr. Williamson has argued against regulation. Quite the contrary, their work found that people in business adopt for themselves numerous forms of regulation and rules of behavior — called “governance” in economic jargon — doing so independently of government or without being told to do so by corporate bosses.

. . . .

Summarizing their findings, the award announcement said: “Rules that are imposed from the outside or unilaterally dictated by powerful insiders have less legitimacy and are more likely to be violated. Likewise, monitoring and enforcement work better when conducted by insiders than by outsiders. These principles are in stark contrast to the common view that monitoring and sanctions are the responsibility of the state and should be conducted by public employees.”

When I googled various combinations of uchitelle, international herald tribune, williamson and quotes from the print version I read this morning–nothing came up.  When I omitted the quotes from the print version, the version just quoted appeared.  Apparently somebody discovered Uchitelle’s misleading editorial cross-dressing as a news story, consigned it to the memory hole, and had him draft a (somewhat) more accurate story–or drafted it for him.

But even this alternative version gives a distorted view.  In fact, Williamson has argued against particular regulations (e.g., old style anti-trust actions against vertical integration).  Moreover, to call private organization and governance decisions admittedly adopted “independently of government” “regulation” is deeply dishonest, given the government involvement clearly connoted in the word “regulation.”  Look at the last quoted sentence of the committee statement: “These principles are in stark contrast to the common view that monitoring and sanctions are the responsibility of the state and should be conducted by public employees.”  That doesn’t seem like ringing regulation advocacy to me, at least as the word “regulation” is utilized by just about everybody outside of Uchitelleworld.

It is also interesting that Uchitelle gets a quote from Joe Stiglitz of all people.  That is a sufficient statistic for both Uchitelle’s bias and his cluelessness.

Yes, Williamson and Ostrom–and New Institutional Economists in general–are largely heterodox.  They are critical of much economics that is rooted in neo-classical formalism.  But to conscript them and their research into an “anti-market” pro-regulation campaign is farcical.  It tells us much more about Mr. Uchitelle’s prejudices, and those of the papers that run his drivel, than it does about Williamson, Ostrom, or New Institutional heterodoxies.  There is a debate here.  It deserves to be understood by a wider audience.  The Williamson-Ostrom prize (like the Coase, North, and Smith prizes before it) is a wonderful opportunity to do just that.  But nooooooooooooo.  The NYT and IHT feel obliged instead to turn this debate into another act in a morality play in which Mr. Market is the villain.

So wise up, folks.  If you’re looking to learn something about economics, cancel your subscription to the New York Times.

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