Streetwise Professor

Dmitri Medvedev stepped up what can only be considered his campaign against Putin and Putinism by emphasizing Russia’s dismal economic performance in 2009, and placing blame for the country’s economic malaise on its energy export dependence:

Russia’s economy may contract by a “very serious” 7.5 percent this year as dependence on energy exports left the country more vulnerable to the global financial crisis than expected, President  Dmitry Medvedev said.

“I must admit that we sunk below our lowest expectations,” Medvedev said in an interview to be broadcast today at 9 p.m. Moscow time on state television. “The real damage to our economy was far greater than anything predicted by ourselves, the World Bank, and other expert organizations.”

Initial forecasts indicated the economy may drop between 3 percent and 3.5 percent this year, Medvedev told Channel One. The government predicted last month that the economy will shrink 8.5 percent this year, the most in a decade. Russia will return to growth in 2010, the government forecast in a report published on its Web site.

. . . .

Russia needs to modernize the economy and reduce reliance on oil and gas exports, to protect it against financial crises, Medvedev said. This may take as long as 15 years, he said.

“That is a perfectly plausible time frame in which to create a new economy, an economy that will be competitive with other major world economies,” Medvedev said.

“Once a significant portion of our revenue is generated by something other than energy exports, let’s say at least 30 or 40 percent of it, then we would already be living in a different economy and in a different country.”

Russia should pursue energy efficiency, including creation of new fuels and energy saving, develop nuclear power, information infrastructure, and produce its own medicines, the president said.

“Everything was okay as long as prices for energy and raw materials were high,” Medvedev said. “Then those prices fell. Our economy was hit hard. Our citizens were hit hard.”

Several comments.

First, the tone and tenor of Medvedev’s remarks contrasts starkly with the happy talk that has been Putin’s staple for over a year.

Second, the repetition of the theme that it is imperative to wean Russia from its dependence on raw material exports is by now so frequent, and so contrasting to Putin’s position as the de facto Prime Minister of Gazprom (“Gazputin,” remember?–he’s now off to China to do more gas deals), that these statements must be considered as Medvedev’s framing of his challenge to Putin.  Blood brothers?  Really?  So were Cain and Abel, if memory serves.  It still remains to be seen, however, whether Medvedev has the personal steel and the political support to challenge Putin successfully.

Third, with respect to the economics, even if Medvedev did not face a political battle over the future of the country, comparative advantage is what it is, and will inevitably affect the structure of the Russian economy.  That said, the wealth consequences of Russia’s natural resource factor intensity, and the susceptibility of the country to terms of trade shocks could be mitigated to the extent that these risks could be shared through the financial markets, e.g., by exchanging claims on Russian natural resource endowments for claims on capital assets in other countries.  The inability of Russia to precommit credibly not to expropriate foreign natural resource investments limits, however, the potential for this potentially beneficial exchange.  This will continue to shackle Russia to the vicissitudes of commodity prices, and perpetuate its status as a very high beta (that is, high risk) economy.

Fourth, and relatedly, this inability to precommit in large part reflects the political obstacle that Medvedev is unlikely to overcome.  Skimming resource rents is very lucrative to the siloviki elements, and they are almost certainly unwilling to constrain themselves institutionally and legally even though such constraints would increase Russian wealth–because it would reduce the siloviki wealth.  They are perfectly happy to have a big piece of a smaller pie than a small (or non-existent) piece of a bigger one.

There’s one last thing in the article that deserves comment:

The jobless rate fell to 7.8 percent in August, lower than previously estimated, from 8.3 percent in July on rising seasonal demand for agriculture and construction. The number of unemployed was 6 million, the Federal Statistics Service said.

It is very hard to square the relatively low (compared to the US, for instance) and falling unemployment rate with an economy that sank “below [the] lowest expectations.”  This translates into plunging productivity, and means that true unemployment is almost certainly masked, probably by companies under state pressure and receiving state support continuing to pay unutilized or heavily underutilized workers.  Big Russian companies are almost certainly serving as de facto providers of a social safety net, which does not speak well for Russian state capacity.  Moreover, it means that either (a) these companies will be badly positioned financially to recover, or to exploit a world rebound, or (b) the government will likely provide additional support to these companies going forward, thereby impairing the state’s fiscal condition. Either alternative, or a combination of both, will serve as a drag on Russian economic performance in 2010 and beyond.

It is gratifying to see Oliver Williamson and Elinor Ostrom receive the Nobel Prize in Economics (or, more exactly the Swedish Central Bank Prize).  They are deserving individuals who have brought much insight–and wisdom–to important, but hard to formalize, issues of organization and governance.  Moreover, as someone who has published in transactions cost economics, new institutional economics, and property rights economics it is quite satisfying to see these areas of research get some, er, props.

One sentence in the Nobel Committee’s announcement of Obama’s award stood out in my mind:

His diplomacy is founded in the concept that those who are to lead the world must do so on the basis of values and attitudes that are shared by the majority of the world’s population.

Besides being nauseatingly (but predictably) pompous in its presumption to speak for humanity, the italicized phrase is almost certainly false.  To say that the world’s population indulges in the transnational progressive pieties of the Nobel Committee, or Obama, is farcical.  Even overlooking the fact that vast swathes of humanity give little thought to issues of diplomacy, having to worry instead about mere survival, billions identify themselves by tribe, caste, nation, or faith.  “Kumbaya” and “We Are the World” are not on their playlist.  Nationalism, and even more particularist allegiances, are far more potent and pervasive than transnationalist sentiments.

It would have been far more accurate for the Committee to say “on the basis of the values and attitudes that are shared by the vast majority of the people we meet at cocktail parties.”

There is a deep irony here.  No doubt the Norwegian posers of the committee would be horrified to called Neocons.  But they share with Neocons a fundamental belief in the existence of universalist values and beliefs.  More pointedly, they believe everyone in the world shares their values and beliefs.  This error has led Neocons astray, and it leads the transnational progressives astray too.  Indeed, its effect on the latter is even more perverse because it tends to empower the very ones who reject these values and beliefs–the Kim Il Jongs, the Ahmadinejads, the Putins, the Hamases, the Chavezes.  The Neocon error is to believe that overthrowing the Kims, etc., is a sufficient condition to ensure the advance of their values: The TNP error is to believe that diplomatic deference to the Kims, etc., will do so.  In fact, this is a near inversion of reality.

PS.  Reading the bloviations of the the Nobel Committee makes me thank God that some Norwegians (notably my great-great-grandparents) had the good sense to leave.

PPS.  Speaking of transnational, I will be in Spain for the next week speaking at Universitat Pompeu Fabra in Barcelona and Universidad Carlos III in Madrid (with a side trip to Peryperteuse in Languedoc).  As a result, posting is likely to be erratic.

Beltway hearts are all aflutter that the CBO has established that the Baucus health care plan is   deficit neutral–or even reduces the deficit.

But, the important thing is that the total cost of the bill–almost certainly underestimated–of $1 (or maybe $2) trillion.   The bill is budget neutral (again, taking the numbers on faith, which would be wholly foolish IMHO) only because it imposes substantial taxes (including taxes on doctors in the form of substantial cuts in Medicare reimbursement) and shoves many of the costs off-budget through the mandate.   All of this is is not considered a tax increase only the Washington Wonderland.

(I should note that the budget analysis is almost certainly flawed, as (1) it presumes that Congress will implement Medicare cuts that it has consciously declined to pass in the past, and (2) it doesn’t take into account that the “Cadillac plan” tax will almost certainly not raise the amount of money projected as these plans will shrink dramatically when subject to such a large tax.)

The relevant question is: does the total cost imposed on the citizens of the US provides a larger benefit?

That is, the question is NOT, as in the old Fram Oil Filter commercials: “Do you want to pay me now, or pay me later?” (That’s the deficit question.)   The correct question is: “Do you want to pay me at all?”

And to me, the answer to that question is a resounding No!

that Russia has made a deal to restore gas flows from Turkmenistan exactly when the weather is starting to turn cold?

Accident, my foot.

Even to someone who is familiar with facts of the case, this video about the trials (word used advisedly) and tribulations of Hermitage Capital Management in Russia is chilling, and deeply disturbing.  The “moral” of the story, if one can apply this word to the depraved conduct described in the film, is this: agents of the Russian state will stop at nothing to steal from foreigners, and if they fail in that, they are perfectly happy to steal from the state that they allegedly worship.  First corollary: the highest authorities and judicial organs of the self-same state will do nothing to prosecute this threat.  Indeed, they will persecute those who dare bring it to light.

Keep this in mind anytime “anti-corruption campaigns,” or fights against “legal nihilism,” are announced.  Keep this in mind when the heads of state and government tempt foreign investors, and mouth soothing words about a market economy.  The agonies of Hermitage give the lie to all these high sentiments and intentions.

Words mean nothing.  Actions mean everything.  Watch the film to see just how utterly ruthless and depraved the actions of the minions of the power vertical–from top to bottom–can be.

The FT has the vapors over the stunning news that Dmitri Medvedev has . . . wait for it . . . hired two new speechwriters.  What an earth shattering development.

Of all the lame-o exercises in neo-Kremlinology, this is about the lamest.  Wake me up when he fires Sechin.

The essence of my earlier criticism of Obama’s strategic re-review was that it is idiotic to decide on a strategy without considering the resources necessary to implement it.   Today’s Washington Post reports that this idiocy is apparently habitual in the Obama White House: the reason a re-review is needed is because those performing the original review also failed to evaluate thoroughly the forces needed to implement the counterinsurgency strategy the administration chose:

To some civilians who participated in the strategic review, that conclusion was much less clear. Some took it as inevitable that more troops would be needed, but others thought the thrust of the new approach was to send over scores more diplomats and reconstruction experts. They figured a counterinsurgency mission could be accomplished with the forces already in the country, plus the 17,000 new troops Obama had authorized in February.

“It was easy to say, ‘Hey, I support COIN,’ because nobody had done the assessment of what it would really take, and nobody had thought through whether we want to do what it takes,” said one senior civilian administration official who participated in the review, using the shorthand for counterinsurgency.

The failure to reach a shared understanding of the resources required to execute the strategy has complicated the White House’s response to the grim assessment of the war by the top U.S. and NATO commander in Afghanistan, forcing the president to decide, in effect, what his administration really meant when it endorsed a counterinsurgency plan. Gen. Stanley A. McChrystal‘s follow-up request for more forces, which presents a range of options but makes clear that the best chance of achieving the administration’s goals requires an additional 40,000 U.S. troops on top of the 68,000 who are already there, has given senior members of Obama’s national security team “a case of sticker shock,” the administration official said.

It would be wrong to say I’m speechless. It’s just that most of the words that come to mind are modified with another word that begins with “f” and ends with “ing.”   Reading this kind of thing evokes a load of f-bombs that only a B-52 could carry.

A couple of issues.

First.   Is it really true that NOBODY had done the assessment?   Nobody in the Pentagon?   Really?   Or is it more accurate to say that nobody in Hope and Change-land had done the assessment, or paid attention to the assessment, or had a clue of what counterinsurgency really entails?

Second.   Wasn’t there anybody in the administration capable of asking a question?   Oh, I dunno, like: “How many troops are required and over what time period to implement this strategy?”

Do these people buy a car or a house and not inquire about the price?   Just asking.

This is yet another example of “senior administration officials” damning themselves with their own lame excuses.

Like Casey Stengel once said: Can’t anybody here play this game?

Some other Caseyisms that fit:

“Most games are lost, not won.”

“Been in this game one-hundred years, but I see new ways to lose ’em I never knew existed before.”

The 1962 Mets are not a good foreign policy role model, but Team Obama would have to look up in the standings to see them.   It’s both pathetic, and tragic.

Exactly 36 minutes after I wrote this:

At least Barney Frank has made a step towards understanding the intricacies of something as complex as clearing.  Would it be too much to hope that he keeps pulling on the string until the entire case for clearing mandates unravels?  Probably.

Matt Leising at Bloomberg sent me this:

Legislation proposed by U.S. Representative  Barney Frank would weaken an Obama administration  guideline requiring the most common private derivatives to be traded on exchanges or regulated systems.

The Massachusetts Democrat, who heads the House Financial Services Committee, released a  draft bill Oct. 2 that allows for no change in how standardized over-the-counter derivatives are currently traded as long as they are reported to regulators. The Obama plan, released in August, specifies “mandatory trading” on exchanges or swap-execution platforms that would have to be registered with the Commodity Futures Trading Commission or the Securities and Exchange Commission.

“Nothing will really change” the way trades are executed under Frank’s draft proposal, said  Kevin McPartland, a senior analyst in New York at TABB Group, a financial-market research and advisory firm. “There’s no reason, at least that I can see, why anybody would go to an exchange.”

Moreover, Frank’s proposed bill does NOT mandate clearing, although it does empower the CFTC to require clearing of some contracts:

The Commission shall monitor swap activity and transaction data  and by rule or regulation identify specific swap contracts that it determines are required to be cleared  consistent with the public interest, after taking into  account the following factors:

[List omitted.]

I keep having this mental image of Barney Frank falling off a horse on the way to Damascus.

In brief: no clearing mandate, but mandated reporting of derivatives trades to a central data repository.  Just what I’ve been advocating on this blog, and in my writings (such as here).  CFTC has the power to mandate clearing, but that’s a far different thing than a Congressional mandate.

Color me shocked.  Pleased, but shocked.

But not everyone is pleased.  CFTC Chairman Gary Gensler for one is put out by the lack of a clearing mandate:

Gary Gensler, the CFTC chairman, said he was concerned about a provision in the legislation to require securities and futures regulators to determine on a contract-by-contract basis whether a particular swap needed to go through a transparent clearinghouse.

“I believe it is best for a clearinghouse that is managing its risk to determine if a particular product should be cleared,” he commented.

Gensler pointed out that an Obama administration proposal for derivatives regulation has a presumption that if any standardized product was accepted for clearing, it and all future iterations of the product must go through a clearinghouse, which is an intermediary between the buyer and seller of the swap.

Gensler and legislators support permitting tailored swaps to continue to trade on the over-the-counter market as long as they meet new reporting, record-keeping and capital requirements.

The CTFC official also took issue with a measure in the Frank proposal that he believes could exempt a broad range of entities from the definition of “major swap participant” and help them avoid regulation.

“The discussion draft, perhaps inadvertently, widened this exception such that the major swap-participant category would exclude any entity entering into a swap for risk-management purposes,” Gensler said. “This could have the unintended consequence of exempting a broad range of entities from the definition of a ‘major swap participant’ and thus exempt such entities from regulatory requirements outlined in the proposal.”

I’d say I feel your pain, Chairman, but I’d be lying.

I am still astounded at this development.  Now if only Geithner, Gensler, Collin Peterson, the Senate Finance and Ag Committees, etc., see the light and experience their own conversions we’d be really getting somewhere.  Hey, a boy can dream, can’t he?  I mean, if Barney Frank comes around to my way of thinking, anything is possible.

Needless to say, I doubt there are many things that Barney Frank and I agree on.  There is still great potential for mischief in a lot pending before his committee.  But, for now I will avoid what my inimitable grandfather called “handing out attaboys one at a time and taking ’em back five at a time.”

For now, I’ll just say: ‘attaboy, Barney.

It seems that some in Congress are slowly making it down the clearing learning curve:

Manufacturers such as  Caterpillar Inc. and  Apple Inc. wouldn’t have to post extra cash as collateral for hedging transactions under legislation proposed to tighten oversight of the $592 trillion derivatives market.

The draft bill released by House Financial Services Committee Chairman  Barney Frank on Oct. 2, drawn from Obama administration proposals, would require the most common and actively traded over-the-counter derivatives contracts to be bought and sold on exchanges or processed through a regulated trading platform. It would impose new rules and collateral requirements, except on so-called end users such as Caterpillar.

. . . .

The draft would expand the administration’s exemption of end-users from collateral and clearing requirements. The administration proposal, released Aug. 11, would give a dispensation only to companies that use so-called hedge accounting. Frank’s proposal would exempt all end-user transactions and would let companies post non-cash items as collateral to satisfy margin requirements, Coleman said.

In brief, the new proposal would not require clearing for any deal in which one of the parties was not a swap dealer.  This is an improvement.  I’ve been arguing here on SWP, in my academic research, and my recent paper for Brookings that the cash flow and liquidity demands that clearing and daily mark-to-market impose are very onerous for hedgers and other market participants.  It seems that corporate end users were able to get that message through to Frank.  Good for them.  It also suggests that there may be a glint of understanding–albeit only a glint–that OTC market arrangements have some economic benefits, and are not instruments of the devil.

But it appears that dealers will be required to clear inter-dealer transactions.  This raises many questions, which if addressed forthrightly, would undermine the case for mandate.

Dealers certainly have had the ability to form inter-dealer clearinghouses in the past.  Why haven’t they?  The common story is that they like non-cleared deals because they profit at the expense of their customers from the lack of fungibility and liquidity.  But that argument holds no water when it comes to purely inter-dealer trades.

More fundamentally, a major fear relating to OTC markets is that the interconnections among dealers are systemically risky.  That is, because of all the inter-dealer trading, the default of one dealer affects the financial condition of others.

But, how does inter-dealer clearing change that?  Default losses are shared among dealers now because they trade with one another.  Default losses will be shared among the same dealers via a clearinghouse.

Moreover, the sharing mechanisms are different in a crucial way–that does not favor clearing.  In a bilateral market, if dealer X defaults, those who trade with X may suffer losses.  In a cleared market, if dealer X defaults, those who originally traded with it do not bear all the loss: it is shared among all the other members of the clearinghouse.  This reduces the incentive of market participants to monitor X’s creditworthiness, because they are not on the hook directly for the entire amount of counterparty exposure they create by trading with X.  The clearinghouse monitors, but as I’ve argued repeatedly (a) the clearinghouse is unlikely to have as good information as the other dealers, and (b) its incentives are weaker because it is a delegated monitor subject to low power incentives.

There’s another landmine hiding here that hasn’t drawn attention.  Note that the members of a clearinghouse recognize that they have delegated their risk exposure to somebody else: the clearinghouse and other clearinghouse members.  They recognize further that the clearinghouse mechanism thereby creates a moral hazard.  What is the conventional response to such a problem?  To limit recourse.  That is, clearinghouse members will limit the risk exposure that they will take on from the clearinghouse.  This is true of every major clearinghouse: the losses that members have to absorb are limited.

Put it all together, and you realize that (a) moral hazard and monitoring issues can lead to poorer control of counterparty risk, and (b) the limitations on member contributions means that a clearinghouse could well fail because of a loss that exceeds the amount of capital its members are obligated to commit.

Thus, the mandate for inter-dealer clearing doesn’t make any sense either.

In fact, one of the main virtues of clearing is that it increases the fraction of their contractually promised payments that non-members receive.  Note that the Board of Trade Clearing Corporation always used to say that no CUSTOMER had ever suffered from a default loss, not that no member had ever suffered from such a loss.  Inter-dealer clearing slices and dices risks differently; it does NOT eliminate them.  Indeed, it can (due to the moral hazard and adverse selection problems) lead to an accumulation of greater risks, and a less efficient allocation of those risks, than is the case in a bilateral market.

In other clearing news, CFTC Chairman Gensler made some interesting remarks in an interview with Futures Industry Magazine (registration required).  Interesting, but misguided.

First, he comes down to requiring clearinghouses take deals from any execution platform: he says clearinghouses should “not be so inextricably linked to an exchange.”  As I’ve argued for several years on SWP and in my academic writings, basic transactions costs considerations likely make vertical integration of execution and clearing economically efficient.  The argument that this arrangement impedes competition (which Gensler makes) fails on traditional Chicago grounds.  It is certain that there is neither persuasive theory nor convincing evidence that would support as radical a step as Gensler advocates.

Second, Gensler advocates that clearinghouses should be open access in the sense that “membership is open to the non-dealer community” and that clearinghouses should have “open governance” in which non-dealers would have a voice.

Now, I’ve shown in some academic writing that closed membership can be exploited to permit the clearinghouse to in effect cartelize a market, so I am somewhat sympathetic to the idea of open access.  However, I’ve also shown in my academic work that membership heterogeneity can be very, very costly.  It increases the costs of governance because it is necessary to accommodate more diverse preferences and interests.  Moreover, heterogeneity means that it is possible to redistribute wealth among the different members through pricing policies, and in the case of a clearinghouse, margin and capital requirements.  To mitigate rent seeking, cooperative organizations like a clearinghouse with disparate members will (a) implement very low-powered incentives, and (b) erect intricate, formal, and cumbersome governance mechanisms (e.g., committee-dominated decision making).  These arrangements are costly.  Thus, requiring open access and open governance would have unintended consequences: clearing organizations would be sluggish organizations with weakly-incentivized managements.

As always, there are trade-offs.  The question is: who is best situated to evaluate these trade-offs?  I think that it is far more efficient for government to let market participants decide on their own arrangements, and limit its interventions to situations in which these cooperative arrangements stifle competition.  Government is ill-suited to evaluate the costs and benefits of alternative ways of sharing risk–including counterparty risk–and of organizing and managing specialized organizations like clearinghouses.  Barney Frank and Gary Gensler should leave these tasks to people who have the expertise and internalize the costs and benefits, and limit the government to policing anti-competitive behavior by collective organizations like clearinghouses.  And even there, a considerable amount of circumspection is in order, for as Ronald Coase pointed out long ago, not every non-standard form of organization or arrangement is necessarily anti-competitive in nature.  It may be designed instead to economize on transactions costs.

At least Barney Frank has made a step towards understanding the intricacies of something as complex as clearing.  Would it be too much to hope that he keeps pulling on the string until the entire case for clearing mandates unravels?  Probably.