Streetwise Professor

February 28, 2010

The Amazing Powers of the CFMA

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Financial crisis,Politics — The Professor @ 12:16 pm

I knew that the Commodity Futures Modernization Act (CFMA) was a powerful piece of legislation, but I was unaware just how powerful.  It apparently has the ability to alter the space-time continuum, and affect events even prior to its passage.  How did I learn this?  From a letter signed by senators Feinstein, Cantwell, Snowe and Dorgan to Chris Dodd.  (I haven’t been able to find a copy online.)  The senators state:

As you know, in 2000 Congress made the mistake of exempting energy from commodities regulation in the Commodity Futures Modernization Act.  This exemption, known as the “Enron loophole” led directly to the Western Energy Crisis.

Uhm, compromise language that was ultimately incorporated into CFMA passed the House on 14 December, 2000, and was introduced into the Senate on 15 December.  A conference committee hashed out differences, and the bill was ultimately signed into law (by Bill Clinton) on 21 December, 2000.

Meanwhile, the California/Western energy crisis had been building throughout 2000.  Power prices first spiked in May, 2000.  The first blackouts were in June, 2000.  San Diego Gas & Electric made allegations of market manipulation in August, 2000.  FERC rejected California’s request for a price cap on–wait for it–15 December, 2000.  The peak prices observed during the entire crisis occurred in December, 2000.

In other words, the energy crisis was well underway long before the passage of the CFMA, and reached its crescendo at the very time that the bill was being passed, and well before it could have, let alone did, affect one transaction in energy or anything else.  Since cause must precede effect, for these senators to say, in the very opening paragraph of their letter, that the Act “led directly” to the crisis is complete and utter bilge.

What’s more the underlying causes of the crisis are well known, and had nothing to do with the matters addressed in the CFMA, and everything to do with the wretched market design put in place by the California legislature.  Indeed, to the extent that derivatives were involved at all, it was the legislature’s ban on the ability of CA utilities to enter into long term purchase deals or hedging contracts that exacerbated the crisis.

Insofar as Enron is concerned, its actions (e.g., Death Star, Fat Boy, Ricochet) were designed to exploit flaws in the market design (particularly the design of the Power Exchange–PX–and differing price caps across markets).  They had nothing to do with the kinds of things addressed in the CFMA.

(I would also add that the exemptions in the CFMA were not quite so broad as the senators suggest in their letter.)

So, the senators got off to a very bad start.  What about other matters raised in the letter?  Well, better, but not much.

The basic thrust of the letter is to argue against providing end user exemptions from clearing requirements, or treating end users more liberally generally.  The essence of their argument is that systemic risk is unpriced, and that clearing internalizes this externality.

This represents just another example of clearing as deus ex machina that magically addresses systemic risk concerns.  The authors of the letter, like many others who have discussed the subject, assume that (a) counterparty risks are not priced properly in OTC markets, and (b) central counterparties will do a better job at pricing counterparty risks.  As I’ve written extensively, neither claim is necessarily true, nor even plausible.

The letter commits another factual gaffe when it claims that there was a “systemic failure caused by the Enron bankruptcy.”  Certainly counterparties lost money as a result of the Enron bankruptcy, but there was no systemic failure, particularly if one defines “systemic failure” to mean a contagion effect.

The Enron failure did not cause a major upset in the energy markets.  The implosion of the merchant energy sector occurred some months later.  The key event was the SEC’s announcement that it was investigating Dynegy’s accounting on 25 April, 2002.  Subsequent to that time, merchant energy stocks declined by about 90 percent in value, and other companies went bankrupt (e.g., Mirant).

But this wasn’t a systemic contagion event.  Instead, it was the result of a widespread recognition that the energy trading boom was overdone, that profitability estimates were probably inflated, and profit projections would not be realized due to overbuilding of capacity and other reasons.  That is, every firm in the sector was overvalued, and when the market reached that conclusion, they all fell  in value.  There was a common shock, and the affected firms fell in common.  That implosion would have occurred, clearing or no.

This point about confusing contagion effects (in which the demise of one big firm induces financial distress in otherwise healthy firms to which it is connected) and simultaneous collapses of multiple firms caused by a common shock is quite important, and gets too little attention.  The common shock in the recent financial crisis was real estate price declines, communicated to large financial institutions through their holding highly correlated positions in real estate price sensitive investments.  That’s different than a contagion resulting from the bad decisions or bad luck of one firm bringing down others just through contractual connections.

We can barely expect such more discriminating analysis, alas, from senators who are either completely ignorant of the legislation that they write about, or who don’t understand the basic fact that cause must proceed effect.

Update (3/1/10): SWP daughter #1 wonders if a silver DeLorean and a wild haired professor were seen in the vicinity of either Congress or California when the CFMA passed.

Unclear on the Concepts

Filed under: Economics,Politics,Russia — The Professor @ 10:15 am

Last week I mentioned Vladimir Balaeff, remarking on a rare moment of (partial) agreement.  In this week’s Russia Profile “Expert’s Panel,” Balaeff provides a pitch-perfect illustration of what passes for serious Russian commentary, which serves to demonstrate why we seldom agree.  Speaking of Medvedev’s proposals to reform the police, he says:

Two factors are critical to the success of any kinds of reforms, in any country, and especially in Russia today: obedience to law by everyone and abatement of corruption in all parts of social activity.
One must point out that disregard for the law and extensive corruption are not exclusively Russian, nor endemic to the Russian society. American history up to the present is replete with examples of major corruption – Tammany Hall and the Teapot Dome are just a couple of egregious examples from the past. Bernard Madoff and the present misdemeanors of the American financial community are good examples of how the “rule of law” is fictitious in the very country that claims to be its staunchest adherent.

. . . .

The status quo of Russia’s Interior Ministry is indefensible and reform is unavoidable. However, it is unreasonable to propose that the Ministry is 100 percent corrupt and completely useless. To suggest its complete dismantling is pedestrian – there are no credible proposals of how the much-needed functions fulfilled by the Interior Ministry in Russia would be allocated in a future configuration, without such a ministry. Proposing the United States as an example is not valid – in America police functions are largely located at the state level, using organizations which in the aggregate are even larger and more costly than the entire Russian Interior Ministry (and also exhibit corruption and propensity to police brutality – consider the current prosecution of New York police officers involved in the Mineo case).

This is self-satirizing.  The irresistible compulsion to soften any criticism of Russia with a barrage of whataboutism is particularly, and tiresomely, characteristic.  I mean, Tammany Hall (19th century)?  Teapot Dome (1921-1922)?  When do we get to the part about the Trojan War?  Yes, there are corrupt police in the United States.  But on the corrupt-o-meter where Russia scores 11 on a scale of 10, the US barely budges the needle.  And what difference does corruption in the US make, anyways, as to deciding what Russia should do to address its “law enforcement” (as if) issues?  Do two wrongs make a right?

And even the examples that Balaeff dusts off to say whatabout (or should it be whaddabout?)  don’t necessarily make Russia look good by comparison.  Consider Teapot Dome.  In that episode, a government official Secretary of the Interior Albert Fall leased oil properties in no-bid contracts to companies run by men who had given Fall large loans.  The scheme was uncovered.  It was the subject of a very public Senate investigation.  Fall was convicted of bribery and spent a year in jail.

Contrast that with the pervasive corruption in the modern Russian energy business, and the complete lack of any public audit thereof by the legislative or judicial branches of government.  (Unless, of course, you happen to run afoul of the power structures for having the temerity to challenge them politically.)  The US comes off quite well in comparison, I think. Russia could very much use a Teapot Dome scandal.  The underlying pattern of misconduct is rife in Russia: all that is missing is the scandal.  And that is the real scandal.

Balaeff’s invocation of Madoff in an attempt to discredit the rule of law in the United States is either despicable, or merely shockingly ignorant depending on Balaeff’s true understanding of what “rule of law” means.  Contrary to Balaeff’s insinuation, “rule of law” does not mean that nobody breaks the law, so the existence of sleaze like Bernie Madoff does not show the rule of law to be a lie in the US.  Like, duh.  The rule of law means, in part, that those who who are accused of violating the law are tried according to a set of standards and procedures that are applied equally to all, irrespective of rank or position or person, and that one may not be deprived of life, liberty, or property by the state without due process.  Of course, in the event, adherence to the standard is imperfect, as is everything in this fallen world.  But the very fact that Madoff is incarcerated, and was so after a regular and relentless application of legal procedure is an illustration of how the process should and can work.  Again, contrast this with what passes for Russian justice for wealthy alleged malfeasors in Russia is quite illuminating.

Sean’s Russia Blog provides another interesting example of fundamental Russian misunderstandings about some basic economic and political concepts.  SRB reproduces an editorial from an editorial in, a “part of the small but emerging Russian New Left which uncompromisingly seeks to restructure Marxian theory and praxis for a new century.”

The editorial’s diagnosis of Russia’s problems is, in a nutshell: 1990s liberalism:

In short, the current backwardness of Russia is a direct, natural, and logical result of liberal reforms in the past 20 years. And if we want to overcome this backwardness, we need to first of all overcome the conditions which reproduce it. Namely the social and economic system that we have built over the past two decades and consign its ideology and politics to the dustbin of history.

It is precisely our social and political system that produces and reproduces backwardness, blocks development and makes whatever novations that are really meaningful and useful to society unnecessary, dangerous and impossible. Attempts to substitute change with ridiculous “innovation” essentially boils down to the implementation high-cost projects based on the introduction of fashionable foreign technology, the viability and relevance of which is even more called into doubt in the West. Instead of a new society we are getting new toys.


Whatever the grand problem of the Soviet era, we have not reckoned with the fact that the attempts to solve it with liberal capitalism have made the situation worse, not better. De-industrialization, which has occurred in the West under the slogan of the transition to an information society, has also turned into a serious socio-economic crisis that has undermined the foundations of their traditional way of life and the purchasing power of their population.  Almost all of the innovative potential of society has been given to the invention of various high-tech toys, financial speculation and promotion of self-destructive parasitic consumption. But whatever the costs of this process, it was accompanied by the undeniable progress in many areas of life.

This leftist critique of Russia’s current problems is, ironically, quite consistent with the rightist critique advanced by Surkov, although their remedies are different: Surkov claims that it is necessary to preserve and extend the existing state driven system, whereas the neo-Marxists claim that a systemic change is necessary.

But whether from the left or the right, the critique is clearly off-base.  Certainly some of what happened in Russia in the 90’s was done in the name of liberalism, but to call it liberalism (in the classical sense) is laughable.  In part, what happened in Russia was a reflection of the misunderstanding of liberalism by its proponents (recognizing a pattern here?); in part it was the result of a cynical exploitation of the concept; and in part it was due to failures in implementation (likely inevitable given the Herculean nature of the task).  But whatever the explanation, a truly liberal, law-based society never came close to being born in Russia in the 1990s, and under Putin whatever tentative steps had been made in that direction were reversed. But Rabkor’s frequent statements about the system of the “last 20 years” make it plain that they think that Putinism is liberalism.  Clueless or Orwellian?  Your call.

The Rabkor editors also argue that liberals deny the necessity of fundamental systemic institutional change in Russia:

It is precisely our social and political system that produces and reproduces backwardness, blocks development and makes whatever novations that are really meaningful and useful to society unnecessary, dangerous and impossible. Attempts to substitute change with ridiculous “innovation” essentially boils down to the implementation high-cost projects based on the introduction of fashionable foreign technology, the viability and relevance of which is even more called into doubt in the West. Instead of a new society we are getting new toys.

We don’t need to swap computers, but the system. Support for science and education requires more than increasing the budgets of bureaucratic agencies, but a crackdown on these very agencies and the cessation of their guiding policies. Industrial development is possible, but not at the expense of state subsidies to oligarchs, but based on the expropriation of oligarchs’ capital and property.

Society can, and in historical perspective must, formulate its own project of modernization because the only alternative to change is the decline and the actual transformation of Russia into “Burkina Faso with missiles”. And then, really without missiles. But changes require a base – and it’s far from those who offer us chinovniki who distribute money to national projects. Before anything new is done, its necessary to get rid of the old people and organizations responsible for the current situation.

When the president talks about the modernization of Russia, there is no reason to doubt his sincerity. But can the leader of its political system implement the changes necessary for the country?

But the gravamen of the liberal critique is, well, that the “social and political system . . . produces and reproduces backwardness” and that more fundamental changes in these systems–starting with the political and legal systems–are required to move beyond backwardness.  The criticism of technocratic solutions is better directed at the Surkovs than liberals.

In brief, whether from left or right, it is pretty clear that critiques of liberalism in modern Russia are wide of the mark.  Not that I think that substantial progress towards liberalism in Russia has a snowball’s chance in Burkina Faso.  But it would be preferable if those who declaim on the subject had a clue as to what they are talking about.

February 25, 2010

From the Department of Irony

Filed under: Commodities,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 6:17 pm

Matt Leising and Shannon Harrington have been on a roll lately.  Today, they report that big buy side firms are resisting Fed calls to clear a targeted percentage of their deals:

The biggest credit-default swaps investors oppose targets for clearing trades as regulators attempt to curb risk in the $25 trillion market.

Pacific Investment Management Co., BlueMountain Capital Management LLC and AllianceBernstein LP are among asset managers and hedge funds that won’t agree to specific goals before the Federal Reserve Bank of New York’s March 1 deadline requiring them to outline the industry’s next steps to move swaps through clearinghouses, according to people familiar with the matter who declined to be identified because the talks are private.

. . . .

The asset managers, while backing efforts to broaden the use of clearinghouses, want assurances that cleared trades would be protected under bankruptcy laws, the people said. They’re also concerned they may be saddled with collateral costs that are double or triple what they’re paying now because they could lose benefits now granted by prime brokers that give credit for offsetting trades, the people said.

For example, hedge funds and other asset managers often will perform trades that seek to profit from price dislocations between index contracts and swaps on companies included in the index. Prime brokers typically will demand collateral on the net amount at risk from offsetting trades.

Tying Up Cash

If one leg of the trade were required to be cleared, while the other contracts aren’t eligible, fund managers may be forced to increase the amount they have to post, tying up cash, the people said.

This is ironic because the best economic case for clearing is that reduces counterparty risk for end-users.  For instance, the classical futures clearinghouse reduces customer default losses (but doesn’t necessarily eliminate them) that could result from the failure of a brokerage firm by shifting the liability to the clearinghouse, and thus, to the other brokerage firms that are members of the clearinghouse.  Note that the Chicago Board of Trade has always argued that no CUSTOMER has lost money as the result of a default; the CME now makes a similar claim.  Thus, if anybody should be clamoring for clearing, it is customers.

But, as the article notes, this doesn’t come for free.  In particular, the article notes that clearing, especially through single-instrument clearinghouses, can eliminate scope economies (achieved, for instance, through netting and cross margining), thereby inflating costs.

So it can be reasonable for customer firms to resist clearing even though if it benefits anybody, it is most likely to benefit them.

Dealer firms have agreed to clear a large fraction of some inter-dealer trades (e.g., CDS trades).  In other markets (e.g., interest rate swaps) banks have elected to clear a decent proportion (around 50 percent) of inter-dealer trades.  But in many respects, inter-dealer clearing offers fewer potential risk sharing advantages than customer clearing (that shifts risks from customers to the dealer-members collectively).

In bilateral markets, there is extensive inter-dealer trading; this creates performance risk between dealers.  Clearing basically does the same thing.  It can reduce some exposure, through multi-lateral netting, but as Duffie and Zhao have shown, and as I have shown, this gain is reduced, and at times non-existent, because clearing can reduce bilateral netting opportunities across a portfolio of instruments.  Thus, the exposure reductions may be limited, especially if the clearinghouse handles only a narrow range of the instruments that dealers trade.  But even if there is some exposure reduction, a lot of what inter-dealer clearing does is to share the same risk among the same players.

The way this risk is allocated can differ somewhat; in particular, it is possible that risk exposures through clearing are less concentrated than the bilateral inter-dealer exposures in non-cleared markets.  But dealers have incentives to limit concentration on their own, and do so through exposure limits and credit limits with each counterparty.  Moreover, dealers have the ability to use their own information to choose these limits in bilateral dealings, whereas the clearinghouse cannot rely on this information.  Thus, clearinghouse members may have exposures that are less concentrated than their bilateral exposures, but they still may be worse off because they take more exposure with some counterparties via the clearinghouse than they would voluntarily take in a bilateral market.  That is, concentrations in bilateral markets are endogenous, and high concentrations can be sensible, based on counterparty risk evaluations.

The resistance of some sophisticated buy side firms to clearing should be another hint to regulators and legislators that mandated clearing is not necessarily a good thing.  If those who, if anyone, would be the biggest beneficiaries of clearing, decide it’s not worth the candle, that strongly suggests that the total benefits are illusory.

Repent! Repent! Before the Inferno Consumes You!

Filed under: Commodities,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 12:59 pm

Yesterday I was exchanging emails with a couple of folks about CFTC Chair Gary Gensler’s increasingly apocalyptic jeremiads against OTC derivatives.  (Indeed, I think I’ll start referring to him as “Jeremiah.”)  I offhandedly wrote “Pretty soon he’ll be saying that OTC derivatives cause cancer.”  Lo and behold, what do I read in today’s FT:

US taxpayers bailed out AIG with $180bn when that company’s ineffectively regulated $2,000bn derivatives portfolio, managed from London and cancerously interconnected to other financial institutions, nearly brought down the financial system.

I personally find it very disturbing that I can channel Gensler’s thinking.

The substance of the oped is more Gensler same-old, same-old.  Clearing is again the deus ex machina of his sermon:

Clearing houses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. Transactions are moved off the books of derivatives dealers, which are part of financial institutions that may be both “too big to fail” and “too interconnected to fail”, and on to those of well-regulated central counter-parties. Centralised clearing has helped to lower risk in futures markets for more than a century.

Uhm, just who backs that guarantee, Jeremiah?  Could it be the very same derivatives dealers?  Meaning that the risk really isn’t moved off their books, and that they’re still interconnected?

Arguendo ad AIG makes its stock appearance (see the first quotation).  George Stigler once wrote that data is not the plural of anecdote.  What’s unbelievable is that Gensler (and Geithner and others) can’t even find multiple anecdotes, let alone anything rising close to the level of data.  What’s even more unbelievable is that his use of the AIG anecdote is deeply misleading–so deeply, that Gensler is either very dishonest or very badly informed.  First, although OTC derivatives deals were one source of AIG’s loss, they were not responsible for anything near the entire $180 billion bailout, but Gensler insinuates that they were.  Second, since it is unlikely that the AIG deals were clearable then, or would be today, it is misleading to use them to advocate clearing.  Third, Gensler doesn’t address the counterfactual question of what would have happened if AIG hadn’t written protection on mortgage CDOs; arguably, the crisis would have been worse.

Gensler also asserts that OTC derivatives were the underlying cause of the financial crisis.  He provides no evidence whatsoever–other than the tired AIG trope.  This is a complete misreading of the history of the crisis.  If you don’t believe me, I suggest you read Rene Stulz’s piece on derivatives and the crisis in the most recent issue of the Journal of Economic Perspectives.

Gensler also makes some assertions that are categorically incorrect.  For instance, he says: “The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk.”  It is, in fact, well known that excessive transparency can reduce liquidity.  There is NOT a monotonic relation between transparency and liquidity, as Gensler asserts.

More generally, on the transparency and exchange trading arguments, Gensler implies that market participants that willingly choose to trade on OTC markets instead of readily-available exchange alternatives don’t know their business.

I could go on and on, but I’ll let it rest here for now.

If the substance is tiresomely familiar, Gensler’s rhetoric reaches new heights.  He pegs the metaphor meter with his lurid comparison of the role of OTC derivatives in the financial crisis to the Chicago Fire, and the banks to the cow in Mrs. O’Leary’s barn that kicked over the lantern that ignited the fire.  (At least he spares us the apple story.)  (The reference to Mrs. O’Leary’s cow is actually quite fitting here, as that poor creature is almost certainly the least plausible cause of the Chicago fire; the editor of the Chicago Republican admitted he made up the story for its entertainment value.  He’d be more accurate talking about meteorites or Pegleg Sullivan–he should check out the Alkaline Trio song about old Pegleg.  But accuracy is merely an obstacle, it appears, in Gensler’s shrill attacks.)

(And another parenthetical about the metaphor overload: is cancer “interconnected”?  Usually cancer is used as a symbol of something maliciously that spreads, which is somewhat different from interconnection.)

Perhaps this remarkable performance is actually good news.  Gensler apparently believes that he has to ramp up the rhetoric in order to achieve his (defective) policy goals; that’s usually a sign of desperation, and a lack of success in previous efforts to persuade.

And that lack of success is not surprising.  Yes, it might have something to do with the fact that incumbents don’t want major changes in the ways they do business.  But it’s also due to the fact that faulty analysis unsupported by reliable facts or data is usually unpersuasive.

But perhaps there’s an upside; we have a new entry in the Bulwer-Lytton fiction contest: it qualifies both because it is fiction, and because of its overwrought writing.

February 23, 2010

Obamacare Delenda Est

Filed under: Uncategorized — The Professor @ 6:29 pm

Thirteen months into his administration, Obama has deigned to release an outline of his proposal for his signature policy issue: health care “reform.”  So glad he was able to make the time, even though what has been produced in all these months is only slightly more complete than the infamous produced-over-a-weekend-under-crisis Bernanke-Paulson TARP legislation outline.  It is quite a performance.

In a nutshell: it strips out from the pending bills noxious but irrelevant-in-the-scheme-of-things elements like Bribes for Ben; takes the worst elements from the House and Senate bills; and adds (as hard as it is to believe) even more destructive elements.

Two features are particularly destructive: the creation of a body empowered to review and reject insurer premium increases, and taxes on capital income to finance the huge costs of the proposal.

Price controls like those included in the Obama proposal are the last refuge of economically illiterate.  Lenin called anti-Semitism the socialism of fools: the epithet fits price controls as well.  Like anti-Semitism, Obama’s call for price controls is economically ignorant demagoguery.

There are examples stretching back over millennia demonstrating the destructive effects of such controls.  Except in exceedingly rare cases of true monopoly—which the health care insurance market is most definitely not—these controls result in shortages, rationing, declines in quality, rent seeking, regulatory arbitrage and corruption.  (Regarding regulatory arbitrage and rent seeking, some of the provocatively-named Enron California electricity trading strategies were intended to circumvent price controls, pure and simple.  Price controls also lead to otherwise-inefficient organizational choices, such as excessive vertical integration.)

Price controls will be the death of a private market for insurance.  But perhaps that’s exactly the intent, no?

Hard as it is to believe, the Obama proposal is even more costly than the Senate bill; definitive estimates are unavailable (and would be unbelievable in any event) due to the paucity of details, but guesstimates put the cost within hailing distance of a trillion dollars.   (Leading me to endorse the wisdom of a bumper sticker I saw: “I hope Obama doesn’t know what comes after trillion.”)

Part of this additional cost is due to undoing Bribes for Ben and related special favors with a “free ice cream for EVERYONE not just Ben (or Mary)” strategy.  But what the heck, it’s not their money, right?  Well, not yet, anyways.

As is his wont, Obama attempts to deflect criticisms of budgetary impact by striking the Fiscally Responsible pose by claiming that the proposal includes sufficient sources of additional revenue to make it budget neutral.

Several things.  First of all: IT’S THE SPENDING, STUPID.   The deficit issue is of the Fram Oil Filters you-can-pay-me-now-or-pay-me-later variety.  What really matters is whether the spending is justified.

Second, some of the purported sources of money to cover the cost are, quite frankly, figments of the imagination.  A big chunk is from cracking down on Medicare waste, fraud, and abuse.  Well, what has been done about that in the last year?  (Crickets chirping.) Well, nothing.  Not because waste/fraud doesn’t exist, but because it’s virtually impossible to eliminate.  Promises to eliminate “waste, fraud, and abuse” were baloney when Reagan made them to argue that his policies would not create deficits.  They are baloney now.  Indeed, at this late date, claiming to pay for any huge program by eliminating waste, fraud, and abuse is itself an abusive fraud.  (And again, if waste can be wrung from Medicare, the question remains: is this health care proposal the best way to spend that money?)

Third, and most importantly, the tax elements of the proposal are extremely destructive.  In particular, not only (like the existing bills) does it effectively increase substantially marginal tax rates (through the phase out of subsidies on insurance premia), it increases taxes on capital income by extending Medicare taxes to various sources of capital income (pejoratively described as “unearned income”).

Capital taxes are a terrible idea.  Capital is already heavily taxed.  What’s more, as elegantly described by Steve Landsberg here and here, capital taxes are particularly distortive.  As Landsberg notes, capital taxes are really a tax on “earned income” because in the first instance you have to earn the income that you save to generate capital income.  It is, therefore, categorically false to sell these as taxes on “unearned income.”

As a result of these distortions, these taxes are inimical to growth.  They discourage capital formation and bias decisions towards current consumption rather than future consumption.

But we should not be surprised.  Obama demonstrated his ignorance of, and indeed disdain for, the economic consequences of capital taxation during the Democrat primary debates.  He said he didn’t know whether capital gains tax cuts would cause revenue to rise or decline, and what’s more, didn’t care, because it was all about “fairness”:

GIBSON: And in each instance, when the rate dropped, revenues from the tax increased; the government took in more money. And in the 1980s, when the tax was increased to 28 percent, the revenues went down.

So why raise it at all, especially given the fact that 100 million people in this country own stock and would be affected?

OBAMA: Well, Charlie, what I’ve said is that I would look at raising the capital gains tax for purposes of fairness.

We saw an article today which showed that the top 50 hedge fund managers made $29 billion last year — $29 billion for 50 individuals. And part of what has happened is that those who are able to work the stock market and amass huge fortunes on capital gains are paying a lower tax rate than their secretaries. That’s not fair.

And what I want is not oppressive taxation. I want businesses to thrive, and I want people to be rewarded for their success. But what I also want to make sure is that our tax system is fair and that we are able to finance health care for Americans who currently don’t have it and that we’re able to invest in our infrastructure and invest in our schools.

And you can’t do that for free.

. . .  .

GIBSON: But history shows that when you drop the capital gains tax, the revenues go up.

OBAMA: Well, that might happen, or it might not.

Obama says he wants growth, but virtually all of his policies are aggressively anti-growth.  The tax features of his health care proposal are just a particularly egregious example of that.

The climax of the conflict over healthcare is impending.  Nothing in Obama’s plan addresses the fundamental, and completely merited, sources of widespread hatred of the existing legislation; indeed, it incorporates all of these, and adds more.  Thus, it will only further stoke the political conflict.  Despite Obama’s Nixonian denials that he is not an ideologue, he has decided to wage an all out battle over a highly divisive ideological vision.  One can only hope and trust that the checks and balances baked into the system for the very purpose of stemming such recklessness are sufficient to overcome what has become the greatest act of political adventurism in American history.

February 22, 2010

Cert Denied

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 10:32 pm

In a matter of personal interest:

The U.S. Supreme Court rejected an appeal by Pacific Investment Management Co., clearing the way for a lawsuit seeking more than $600 million for the company’s alleged manipulation of the price of Treasury futures contracts on the Chicago Board of Trade.

The justices today let stand a federal appeals court ruling that said traders could press their suit against the company as a class action. Pimco, manager of the world’s largest bond fund, argued unsuccessfully that many of the investors in the class actually would have made money had the market manipulation taken place as alleged.

The lawsuit, filed in 2005, accuses Pimco of cornering the market for contracts on 10-year Treasury notes during May and June 2005. Pimco allegedly used its holdings to drive up the price for traders who had sold short — that is, contracted to sell notes on a specified later date — and needed to cover their positions.

And that’s all I have to say about that.  Here, anyways.

Transparency for Thee, But Not For Me

Filed under: Economics,Financial crisis,Politics — The Professor @ 10:23 pm

I am reading Reinhart and Rogoff’s This Time Is Different.  Interesting, in a scary sort of way.

One thing that struck me with particular force, particularly in light of recent news, is their lament at the difficulty of ascertaining just how much debt governments have issued.  They state quite forcefully that government accounting is notoriously opaque, and that governments are the enemies of transparency.

Ripped right from the headlines, that.  Think all the news stories emanating from Europe, focusing on Greece, but making it clear that dodgy accounting and budgetary gamesmanship is rife throughout Europe.  Not that the US is much better.  Just look at the steadfast refusal to account honestly for the impact of the Federal takeover of Fannie & Freddie–which follows the refusal of the government to account honestly for the contingent liability inherent in the implicit guarantees extended F&F (which weren’t all that implicit, were they?)

This is of direct relevance to current fiscal policy debates.  Krugman and other pro-stimulus/pro-deficit types argue that the current debt/GDP ratio of the US is nothing to worry about.  We had a higher one after WWII, and we grew out of that, right?  But things are very different now.  The demographics are extremely different.  The US’s relative economic standing is very different.  Moreover, and most importantly, the true debt burden is far larger than the “official” figures would suggest–think Social Security, Medicare, Medicaid, and the vast unrecognized but very real contingent liabilities and guarantees and implicit commitments the government has undertaken.  And it makes sense to borrow from the future to fund an existential conflict like WWII; the spending proposed by Obama, let alone Krugman et al, is certainly not needed for any such existential end.

So, remember: most of what you read about the government’s finances is incomplete and/or misleading, when it isn’t an outright lie.

This, of course, from the very same people who lament the lack of transparency in various private endeavors (e.g., dark pools, OTC derivatives, corporate accounting).  Yes, there are some concerns in these areas, but the systemic consequences of government finance here and abroad are far more important.  Far more.  Those in government–legislators, Treasury, the Fed, regulators–who want to mandate greater transparency for private actors should therefore start their sunshine campaign a little closer to their work.  A lot closer, actually.

Like that’s going to happen.

Position Limit Landmines

Filed under: Commodities,Derivatives,Economics,Politics — The Professor @ 7:18 pm

My original take on the CFTC energy futures position limits was that they were sufficiently generous so as to not represent much of a constraint on most market participants.  Upon further thought, I concluded that the “crowding out” provisions that would (a) limit swap dealers to double the spec limit, and (b) preclude those benefitting from the hedge exemption from speculating, or acting as swap dealers are landmines that could inefficiently constrain the operations of the futures markets as risk shifting and price discovery tools.

Christopher Doering of Reuters picked up on this phrase, and found others concerned about the same issue.  In effect, the rule will segment the market, creating ghettoes for hedgers, swap dealers, and speculators.

There are good economic reasons to believe that some hedgers might be able to compete effectively as swap dealers, or can speculate in addition to hedging.  (Indeed, as Working pointed out eons ago, hedging is really just speculating on price relationships.)  Moreover, some swap dealers might have hedging needs, or can efficiently supply speculative capital to the market.  The 2x limit on swap dealers is also problematic.  Why 2x?  Why not 3.14159x?  This limitation could constrain the ability of some swap dealers to achieve efficient scale, and may indeed have the perverse effect of shifting business to less well capitalized market participants.

What is truly scary is the “rationale” for this limit offered by that noted industrial organization economist, and expert on scope economies, CFTC commissioner Bart Chilton:

CFTC Commissioner Bart Chilton, a strong proponent of position limits, was unapologetic, arguing exemptions have given too much flexibility to players without stakes in the physical commodity.

“There should be zero patience for trading on your own book, if you have an exemption,” Chilton told Reuters, defending the new proposal as a safeguard against the impact of large traders roiling markets by making risky bets for their own accounts.

“Perhaps, if our proposal goes into effect, some will have to choose a business model,” he said. “Are they a speculator, a swaps dealer or a hedger? Part of the problem we have had over the years is that some wanted to be everything to everybody.”

Loaded with deep economic insights, that.  “There should be zero patience for trading on your own book, if you have an exemption”: a purely conclusory, unsupported, assertion.  Hedgers with substantial physical market information are often the most profitable speculators.

“Part of the problem we have had over the years is that some wanted to be everything to everybody.”  What does that mean, even?  Given the nature of information and information flows, it is quite understandable that there are complementarities between speculative, physical, and customer-facing (e.g., swap dealing) trading functions.  This is a highly competitive market, and one would expect that if there are complementarities that reduce costs, one would observe–as we do–some firms exploiting them.

Siloing physical market, speculative, and customer-facing activities precludes market participants from exploiting any complementarities.  If the complementarities didn’t exist, specialized firms would dominate in practice.  The success of multi-function firms in a competitive environment suggests that these combinations offer efficiencies.  There are no obvious regulatory constraints (e.g., price controls, rate of return regulations) that are (inefficiently) encouraging the evolution of integrated, multi-function firms.

Regulators throughout the government–in the US, but elsewhere too–are repeatedly substituting their judgments regarding efficient market structure for those of the participants in highly competitive markets.  Moreover, like Commissioner Chilton, their rationales for their judgments are often shockingly superficial, not to say ignorant, and fail to engage let alone answer fundamental economic questions.  It would be nice, if at least sometimes, regulators flogging particular proposals to change market structures could provide a coherent critique of why incumbent market structures are inefficient, and how the proposed regulation would remedy these inefficiencies–without introducing even worse ones.

Eni, E.ON . . .

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 6:49 pm

First Eni, and now German giant E.ON have negotiated contracts with Gazprom that weaken, though do not break the oil price-contractual gas price link.  E.On has entered into a contract which ties the price for a fraction of its purchases to spot gas prices:

E.ON’s gas unit has agreed with Gazprom on taking a “low double-digit” percentage of its supply at tariffs linked to spot market prices, Handelsblatt said yesterday, citing E.ON Ruhrgas AG chief Bernhard Reutersberg. The outcome of discussions with Gazprom may have been “more favorable than expected for E.ON,” Oppenheim Research GmbH analysts said in a note yesterday.

Gazprom is at pains to point out that its fundamental contracting practices remain unchanged:

Germany’s E.ON Ruhrgas (EONGn.DE) said on Friday it had completed talks on more flexible gas purchasing contracts with Gazprom, allowing one of Europe’s biggest Russian gas buyers to get a chunk of its contracted supplies at spot prices. [ID:nLDE61I149]

The shares of Gazprom traded 1.1 percent up at 1512 GMT, in line with the broader oil and gas index .MCXOG of Russia’s top bourse MICEX .

“The agreements reached do not put into question the fundamental principles — the system of long-term contracts, the “take-or-pay” principle and the pricing system based on a peg to a basket of oil products,” the Gazprom source added.

That’s all well and good, for now, but if there remains a large disconnect between oil prices and spot gas values, the “fundamental principles” are maladapted to current market conditions, and Gazprom will be under substantial pressure to compromise on these principles.

The European gas market remains fragmented, and the spot market is still early in its evolutionary process; national boundaries still matter, slowing the development of a robust market like that in the US.  (Thanks to Michelle Hallack for a very informative update on European gas market developments.)  Nonetheless, spot market liquidity is improving, and the development of LNG and the lack of need for LNG in the US (freeing up cargoes for the European market) will speed that development.  Moreover, successful shale plays in Europe would also facilitate development of a broader gas market.  All of these developments will undermine the need for long term take-or-pay contracts linked to oil.  The E.ON and Eni deals therefore likely represent just the beginning of a revolution in gas contracting in Europe, a development that will not redound to the benefit of Gazprom.

February 21, 2010


Filed under: Economics,Politics — The Professor @ 9:17 am

There are reports that Obama, Pelosi, and Reid are planning to implement health care deform legislation through a reconciliation procedure that would require only 50 votes (plus Biden’s) to pass the Senate.

Obama assures us that he is not an ideologue.  His supporters assert that he is very intelligent.  But only an ideologue or an idiot would attempt to use such parliamentary chicanery to force the passage of transformational legislation that will affect the life of every American against the intense opposition of a healthy majority of the electorate.

The immediate political consequences of this action would be devastating to those who take it.  The substance is bad enough.  But adding procedural insult to substantive injury will intensify the fury of the backlash.  An idiot would not know: an ideologue would not care.

But an ideologue would be willing to incur these political costs in order to achieve a deeply held desire to increase vastly the intrusions of the state into our lives, knowing that such a change would be (a) very difficult to reverse, and (b) would fundamentally alter the relationship the citizenry and the state in a way s/he greatly desires; the ideologue would reason that the long term political consequences would be well worth the short term political costs.

An idiot would be willing to take this action, not knowing any better, because, well s/he is an idiot.

Pelosi and Reid (and their most ardent lieutenants) are hell-bent on health-care-legislation-at-any-cost because they are idiotic ideologues.  We shall soon see whether this description fits Obama as well.

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