Streetwise Professor

February 21, 2010

Not So Glorious

Filed under: Economics,Politics,Russia — The Professor @ 8:51 am

The dust jacket blurb of  a history of the Glorious Revolution, 1688, says:

James II developed a modernization program that emphasized centralized control, repression of dissidents, and territorial empire. The revolutionaries, by contrast, took advantage of the new economic possibilities to create a bureaucratic but participatory state. The postrevolutionary English state emphasized its ideological break with the past and envisioned itself as continuing to evolve.

Sound familiar?  It should; James’s England was a natural state, just as Russia is today–322 years later.  The Glorious Revolution was the beginning of the end of the natural state, and the birth of an open order.

Russia, alas, cannot count on William of Orange, a Dutch fleet, or a Protestant Wind.  It has its oligarchy, but that is firmly under the heel of the state.  So it will attempt, yet again, a Jacobean program of “centralized modernization”–if it tries seriously to modernize at all.

Russia Profile’s weekly expert panel addresses the prospects for modernization in Russia.  Vladimir Balaeff (whose views are orthogonal to mine, when they aren’t perfectly negatively correlated) opines:

Medvedev’s appeal to Russian business – to become more involved in economic and technological modernization – is neither surprising nor exotic. The proposal is contrary to deeply seated habits (vices) of corporate egotism, short-term planning and greed for the “quick buck.” In our present global crisis the pursuit of obscene short-term profits at the expense of society and reckless disregard for the long term are no longer seen as legitimate, quaint or endearing. Democratic governments serve the interests of large societies; when these are forced to rescue commercial corporations from the consequences of their folly and greed – the beneficiaries are required to reciprocate. So there is nothing wrong with Medvedev’s reasoning.

What Balaeff misses is (as I wrote about a great deal in 2006-2007) is that the intense short-term focus that he laments is a perfectly predictable consequence of natural state Russia, and particularly the precariousness of property and contractual rights.  Under such circumstances, it is perfectly rational to focus on the short term, take what you can today, and let tomorrow take care of itself–and the devil take the hindmost.  For there is no guarantee that you will be able to reap the benefits of your investments.

As usual, Stephen Blank nails it:

It is so Russian to believe that the state can force private business to innovate and that it, rather than business, knows what to innovate and where to go for exports. And it is equally Russian that this gambit will fall flat on its face as it always has in the past. If insanity consists of doing the same thing over and over again and expecting a different result, then Russian policy is insane.

If indeed Medvedev has opted for a statist approach (and nothing I’d seen suggested opting for a truly liberal approach), then it is because he has signally failed to modernize his domestic political and economic structures along the paths he wants, so maybe he will try more coercion and/or go along with Putin’s preferred course, which is to rely on import substitution, the energy and defense industries.

These strategies have long been discredited and the resort to them merely indicates the bankruptcy of the current course which, however, has a lot of muscle and vested interests behind it. Russia’s oligarchs, in any case, are not technological modernizers whatever other skills they possess, so this is not the audience for such sermons.

But then there is no truly independent business class in Russia, as property rights are not secured and entrepreneurial ambitions are distorted into short-term actions or corruption, or stunted by government regulations. Even those who are true entrepreneurs cannot reach their full potential in such a system.

While there are incentives that the regime can offer in terms of tax breaks, subsidies, etc., they don’t get at the basic problems of this oligopolistic system. The main incentive he could give is the security to do as you will, with property rights under law and a truly free or at least freer market, but nobody should hold his breadth.

Medvedev is no Mikhail Gorbachev, nor even an Alexander II, just another bureaucratic reformer in a long line of such who inevitably fall short before the accumulated obstacles of vested interests, autocracy, despotism, and the absence of the rule of law.

Sad, but true.  Russia’s basic problem is institutional, and there is no reasonable prospect of a Glorious Revolution to fix that problem.  Truly, Russia is no stranger to revolution, but its revolutions tend not to be glorious.  Moreover, public apathy and atomization (encouraged mightily by a combination of propaganda and crackdowns on any signs of organized protest) mean that coordinated opposition will remain at the margins.  So, as Blank suggests, the Putin purgatory of “vested interests, autocracy, despotism, and the absence of the rule of law” will likely remain the order of the day–for today, tomorrow, and many tomorrows to come.

February 18, 2010

Russia Speed Round

Filed under: Economics,Energy,Military,Politics,Russia — The Professor @ 7:39 pm

Many Russia related stories to comment on, but not a lot of time, so here’s a quick recap.

Actions Speak Louder Than Words.  It is now apparent that Dmitri Medvedev’s anger over the Magnitsky killing was so much codswollop.  Or, if it wasn’t codswollop, recent events demonstrate just how irrelevant the President of the Russian Federation is.  Specifically, American lawyer Jamison Firestone, an outspoken critic of the Russian government’s criminal treatment of Magnitsky and the events that led up to it, has fled Russia because Interior Ministry personnel made two attempts to reprise the theft scheme that ultimately led to Magnitsky’s imprisonment and death:

Firestone, 44, a U.S. citizen and former board member of the American Chamber of Commerce in Russia, said Interior Ministry officials made two attempts to obtain $21 million in taxes that a company he’s a director of paid to the government. He said the perpetrators forged his signature and corporate seals to seek tax rebates, similar to the $230 million in claims made by funds expropriated from Hermitage Capital Management, a $1 billion investment firm run by his client William Browder.

The alleged fraud underscores Russian President Dmitry Medvedev’s challenge reining in what he has called “legal nihilism.” Perceived lack of law is one reason Russia has attracted less than one-fifth the investment in China and Brazil and half of what’s invested in India, its fellow members of the so-called BRIC group of emerging nations, according to three years of data compiled by Cambridge, Massachusetts-based fund- tracker EPFR Global. The nation’s economy shrank the most on record in 2009. [Perceived?  Like there’s any doubt?]

. . . .

“Corrupt law enforcement is the single biggest risk to business in Russia,” Firestone, co-founder of law firm Firestone Duncan, said in an interview in London, where he is looking for temporary office space. “Police have to stop being the mafia. These people are stealing the country.”

Magnitsky Death

Since Magnitsky’s death in November after a year in pre- trial detention and incidents such as a Moscow police officer beating a man to death, Medvedev has proposed reforms of law- enforcement agencies. The head of the Moscow police’s tax-crimes department, Maj. Gen. Anatoly Mikhalkin, and the chief of the Moscow prison division were fired.

Justice Minister Alexander Konovalov said at a press conference on Feb. 16 that the Russian government “is taking certain steps to ensure that the situation with Magnitsky will never be repeated.”

That’s not enough, said Browder, the 45-year-old U.S.-born founder of Hermitage, once Russia’s largest foreign investor.

“Those who have been fired were the least important part of the conspiracy to steal tax money and kill Sergei,” said Browder from London, where he has been based since Russia refused him entry in 2005. “We’ve written well-documented complaints to the top law-enforcement officers in the country that a number of police officers, judges, organized criminals and businessmen have been involved in the theft of almost $500 million from the state, and were involved in imprisoning Sergei Magnitsky. So far there have been absolutely no consequences for those people.”

. . . .

In an interview with Robert Amsterdam, Firestone makes it plain that Medvedev’s words mean exactly squat:

RA: Medvedev has ordered mass firings of prison officials and other gestures, yet you are literally back in the same position as before the death of Magnitsky. What are we to take away from this in terms of the position of the Kremlin on these issues?

JF: Well I can’t tell you what’s going on inside the Kremlin, but I can talk about what’s going on inside the Prosecutor General’s Office. I can specifically confirm that there are individuals within the Prosecutor General’s Office, such as Andrei Pechegin, who have obstructed the investigations into the Hermitage cases and the Magnitsky case and the attacks against me at every single turn. I think that Medvedev has a genuine interest in at least Magnitsky’s death, but any real attempt to investigate the MVD officers who were behind the theft of Hermitage companies and the theft of state budget, as well as those responsible for the arrest, torture, and eventual killing of Magnitsky has been completely obstructed. So what Medvedev did is fire a bunch of prison officials are tangentially responsible for the welfare of all prisoners, but he completely missed the MVD officers who had orchestrated all of this.

There’s the wonder of “centralized modernization” for you.

More Evidence of Medvedev’s Awesome Authority.  Medvedev has criticized the adulation of Stalin. Fat lot of good that does:

Muscovites will be able to learn about Soviet leader Joseph Stalin’s role in the World War II victory from street stands, a source in the Russian capital’s advertising and design committee said Wednesday.

“Information stands telling of Stalin’s role will be placed at sites where militia detachments were formed,” the source said, adding that the stands will be set up ahead of the 65th anniversary of the Soviet victory.

Stalin’s name, which has not been present in Moscow’s festive decorations since Soviet times, came to the focus of public attention last summer, when the Kurskaya station of the capital’s subway was under reconstruction.

Somehow I don’t think that Medvedev has to worry (or dream) about becoming the object of a personality cult.

And speaking of “centralized modernization.” Brian Whitmore had another quote from Surkov:

We have a school of thought that teaches that political modernization — by which is meant political debauchery and ‘anything goes’ — is the key to economic modernization. There is a different concept, to which I hold, which considers the consolidated state as a transitional instrument, a tool for modernization. Some call it authoritarian modernization. I do not care what it is called.

This is an even better example of the false choice that Surkov–and most other defenders of Putin, and too many commenters on this blog–offer to justify an authoritarian system.

Apology via Twitter will be acceptable.  In his every-word-a-lie-including-it-and-the oped in the NYT some time back, Russia’s Ambassador to NATO (with emphasis on the ass) Dmitri Rogozin slandered US and other NATO troops by claiming that unlike brave Soviet conscripts, US/NATO soldiers and Marines did not fight their adversaries face-to-face, preferring to bomb from on high.  The US Marines and NATO and Afghan allies are assaulting a fortified urban area, Marjah, in Afghanistan.  For a few takes on the close combat this involves, check here and here.  And for a view of urban combat from a major, major badass who knows it up close in personal, try this.    Oh, and Dmitri, if there’s not enough face-to-face bloodshed for your liking, it’s probably because all but the dimmest Iraqi or Taliban realize that tangling in close combat with a US or Brit or French or Canadian outfit is suicidal.   So, if you have the decency (yeah, I know), and since you like Twitter so much, why don’t you take a break from bragging about ass-kicking and Tweet an abject apology to those you’ve slandered.  Maybe your son can post it on his blog too.  (At least I’m pretty sure it’s his son.  But what’s up with the “!” Alexei! ?  Reminds me of Maury! Povich or something.)

Here we go again.  Again.  Even though BP has taken backseat in TNK-BP, that doesn’t protect it against expropriation.  Gazprom want gas.  TNK-BP have gas.  So Russia take gas.  Specifically, it looks like the expropriation of Kovytka is imminent. The trick this time?  Require that the firm develop its gas reserves in Kovytka to retain its license.  But deny it access to the pipeline necessary to ship the gas.  Then revoke its license because it didn’t develop gas it couldn’t sell due to lack of transport:

But Russia’s Natural Resources Ministry has consistently warned TNK-BP to speed up development or lose the rights to Kovykta.

The joint venture has argued that it cannot ramp up output to the required levels because Gazprom has a monopoly on exports to nearby China. It would need to build pipelines costing billions of dollars to reach its Asian markets.

TNK-BP was originally asked to sell its stake in Kovytka to Gazprom, the Russian state energy monopoly, in 2007 but talks stalled after years of wrangling on price.

Because Kovytka is a designated “strategic field”, it could fall automatically to Gazprom if TNK-BP is stripped of its licence as expected. TNK-BP and BP declined to comment.

FT adds:

The new pressure could signal that the Russian government is preparing finally to make a decision on Kovykta’s future, analysts said. “This is a sign they want to make progress,” said Chris Weafer, chief strategist at Uralsib, a Moscow investment bank. “It follows a familiar pattern of putting pressure on the other side to force them to make concessions. It is pretty much the modus operandi we saw in the other energy disputes of previous years,” he added, referring to a similar wave of threats that led to Royal Dutch Shell selling control of its Sakhalin 2 oilventure to Gazprom in 2006.

Gazprom has insisted it is no longer interested in Kovykta. But Russia is under increasing pressure to clinch a gas supply agreement with China, which is already signing up alternative supplies from Central Asia and potentially from Qatar.

Even as Gazprom has dragged its feet on Kovykta, its rival Rosneft, the state oil group, has been eyeing the field. Rosneftegaz, a Rosneft vehicle, is due to table a proposal on buying the field from TNK-BP in March, people close to TNK-BP said.

BP sees the field as a long-term prospect and has not booked the gas to its reserves.

Er, maybe they didn’t book the gas as reserves because they knew they’d never see a dime from it.

Going Down! Rusal’s reverse pop continues apace, with the stock down 30 percent since the IPO, and down the last 4 days, including a 6.7 percent drop on one day, after dropping 5.4 percent the day before.  Remind me not to take investment advice from this guy:

“The main problem with Rusal is its debt,” said Kenny Tang, an analyst at Redford Assets Management in Hong Kong. “It relies on the short-term funding and facilities from the banks for its operation, which might be a concern for investors. They are worried about Rusal’s cash flows after the listing.”

What, like the debt is a surprise?  Investors should have been worried about the cash flows before the listing–and then avoided it like the plague.

No wonder the HKEx figures that 10 or so Russian companies will do IPOs there: sounds like a great place to unload overpriced equity!

F22ski Dogfight.  There are diametrically opposed views on the viability of the Russian alleged 5th generation fighter, and hence the threat it represents to American air dominance.  (Still some comments pinging back and forth on my earlier post on the T-50).  First, from the Weekly Standard (via Air Power Australia):

In an open-source assessment of Russia’s Sukhoi PAK-FA, aka the Raptor Killer, Air Power Australia concludes, “once the PAK-FA is deployed within a theatre of operations, especially if it is supported robustly by counter-VLO capable ISR systems, the United States will no longer have the capability to rapidly impose air superiority, or possibly even achieve air superiority.”

. . . .

Can the Russians produce the PAK-FA in considerable numbers? The Russian defense industrial base is in sorry shape (think the Shkval torpedo that likely sunk the Kursk and the Beluva submarine-launched ballistic missile that has offered Moscow one spectacular embarrassment after another). But if the Russians can get the PAK-FA off the ground despite all that, maybe it’s not as hard to build a fifth-generation fighter as the Pentagon thinks.

A more skeptical view from StategyPage (which is, contrary to the assertions of some commentors, a pretty informed and reliable source):

Russia effort to develop an F-22 class fighter (the PAK FA) is going to require a lot of work. The prototype, that took its first flight recently, was clearly the basic Su-27 airframe modified to be stealthier. This included changing the shape of the aircraft to be less radar reflective, and providing internal bays for bombs and missiles. But there’s much more to do in order to achieve anything close to the stealthiness of the F-22. It took fifteen years for the F-22 to go from initial flight, to entering service. The PAK FA could proceed faster, learning from the F-22 experience (especially if some of the Internet based espionage carried out in the last decade was Russian). But such development speed has not been a Russian characteristic.Another problem is the engines, which were not ready for the first flight. Older model engines were used, because initial flights are mainly to confirm the basic airworthiness of the airframe. The new engines, also being used in the Su-35, are suffering development problems. The Russians have always had difficulties with their high end military engines, and that tradition continues. Currently, the Russians say it will take several years to perfect the new engine.

Russia will also need a new family of air-to-air missiles, as the current ones are too large for the internal bays on the PAK FA prototype. These are already in the works, along with more compact versions of air-to-surface missiles. There are also problems with the electronics and, well, you get the picture.

Given all the issues–the ability to do real stealth (for which the US has extensive experience, Russia zip), radar, missiles, and engines (the biggie)–I tend to lean to the SP view.  But y’all can talk among yourselves.

I’ll Bite Your Legs Off! Despite US happy talk that a nuclear arms control treaty with Russia is imminent, it is pretty evident that Russian demands on missile defense will make that very difficult, if not impossible (save a cave from Obama).  This part was amusing to me:

Russia recently embarked on a campaign of military muscle flexing. It regarded America’s missile defense plans in Europe as a threat, and threats must be countered with shows of strength.

Prime Minister Vladimir Putin said Russia must develop new offensive weapons to counter the proposed U.S. missile shield.

“You will see tactics of attack and shooting,” a Russian general said.

“Our soldiers are equipped with new machine guns and we have new tanks. We are far more mobile than before.”

I see.  Answer development of ballistic missile defense with “new machine guns” and “tactics of attack and shooting.”  Does this mean that before, Russia relied on tactics of attack and throwing rocks?  “Far more mobile”?  Uhm, Russian power projection potential beyond, say, Georgia, is basically zip, new machine guns or no.

Don’t Mention the War.  After viewing with shock and amazement the trollfest that broke out over at LR in response to her posts on the Winter Olympics, R beseeched me not to write about the subject.  I wasn’t planning on doing so anyways, but her well advised caution reinforces my intentions.  I’ll leave the critique up to the Duma.

Believe it or not, I could go on and on in this vein. But dammit Jim, I’m just a doctor, not a miracle worker, so I’ll leave it at this. Besides, there’s only so much I can take of this stuff. I think to relax, I’ll watch something that’s lighthearted by comparison, you know, maybe the documentary titled “Siberian Apocalypse” about to play on History International.

February 16, 2010

Muscovy It Was; Muscovy It Is; and Muscovy It Will Remain

Filed under: Economics,Politics,Russia — The Professor @ 6:21 pm

At least according to “gray cardinal” Vladislav Surkov:

Vladislav Surkov, the Kremlin’s political strategist, defended the system of state control he developed, saying Russia can only modernize if it has a strong central government.“Consolidated power is the instrument of modernization,” Surkov said in an interview in Vedomosti today. “Some call it authoritarian modernization. I don’t care what they call it.”

“Consolidated power is the instrument of modernization.”  Sounds kind of like “Communism is Soviet power plus electrification.”

And consolidated power is decidedly not the instrument of modernization, when “consolidated” means power that is not subject to constraint by the rule of law.

Surkov’s remarks provide a fascinating glimpse into the mind of many in power in Russia.  Here’s what he says, with my comments in brackets:

“Spontaneous modernization” only worked in Anglo-Saxon countries because of particular cultural attributes, while France, Japan and South Korea relied on “dirigiste methods” to achieve economic development, Surkov said in the interview.

Medvedev wants Russia to establish its own Silicon Valley, Surkov said, possibly outside Moscow or in the Pacific port city of Vladivostok. The main problem facing Russian innovators is a lack of demand, he said.  [No Silicon Valley in France, Japan, and SoKo.  “Dirigiste” methods have proved decidedly ill-adapted to spurring such innovation; dirigism is the antithesis of creative destruction.  The failures of industrial policies in encouraging true innovation, eg MITI, are well-known.  Moreover, dirigiste or no, each of these countries has legal protections of contract and property, not to mention life and personal liberty, that have never existed in Muscovy, past or present.  And why the lack of demand?  Could it be that they haven’t produced anything anybody wants?  It will certainly be the case that nobody will want anything produced by a state monstrosity.]

“Raw resources companies dominate, and the people who got rich and super-rich made their fortune not from new ideas and technology, like Gates and Edison, but from dividing up the property amassed by the Soviet people,” Surkov said.  [This is true, but suggests a false choice between state-direction and banditry.  The question is, how can Russia cultivate Gateses and Edisons, neither of whom were the product of state enterprises, but of law-ordered, competitive systems.]

The government must help stimulate demand via state-run corporations, Surkov said. The Russian Silicon Valley will be populated by local and foreign experts in “super-modern” settlements financed by public and private money.  [State-run corporations are death to innovation.  The whole idea of “super-modern” settlements populated by scientists/entrepreneurs who come there voluntarily–as opposed to the coerced movements of Soviet times–is utter fantasy in Russia if there is no security from the predation of the state.  Just how is the state supposed to contract for this innovation with these individual innovators?  How are the contracts to be enforced so as to prevent ex post opportunism by the state? ]

“The Russian economy is like an old armored train without a locomotive,” he said. “Liberal hopes for the invisible hand of the market were unjustified.” [Another false dichotomy.  Liberal hopes were indeed dashed, but it is categorically false that Russia was ever an economy with the property and legal institutions necessary for the invisible hand to work.  What Surkov and others believe to be a liberal economy in the 90s was in fact a predatory, lawless one.  It wouldn’t be surprising if Surkov doesn’t know the difference.]

The Institute of Contemporary Development, headed by Medvedev, published a report this month saying economic modernization depends on political reforms that will turn Russia into a U.S.-style democracy.

While Surkov allowed that centralization has reached its limits, he said Russia is already a democracy.

“If they criticize democracy in Russia, that means it exists,” he said. “If there are protests, that’s democracy. In totalitarian states there aren’t any demonstrations.” [This is beyond parody.  What a logician is Mr. Surkov! Orwell is smiling, somewhere.]

In a nutshell, Surkov is saying: “We’re Russian!  We don’t know any better!  Even though we’ve tried this same thing numerous times, and it’s failed every time, it’s what we do.  And we’re going to do it again.  Muscovites once, now, and forever.”

Surkov’s belief is that something innately Russian condemns its people to remain forever on the hamster wheel from hell (to reprise a metaphor).  To justify this position, he has to present false choices and distorted pictures of the alternatives.

Not that the odds of making the institutional changes necessary to create a truly humane, innovative society are high.  They definitely are not; it has proved devilishly hard to transplant even a simulacrum of the institutions that have contributed to western development.  The obstacles are particularly daunting in Russia.  There are so many in power–and with guns–in Russia who would lose out in in a law-ordered, competitive society that they will fight tooth and nail even halting steps towards its adoption.

Indeed, Surkov’s performance is a salvo fired in that very cause of obstructing progress.  In this, it provides telling insights on the Putinite-Muscovite response to Medvedev’s tentative liberalization effort.  To derail this effort, Surkov is appropriating the ostensible goal–modernization–but making it clear that the same old Muscovite means will prevail, Medvedev or no.  Note well that Medvedev has explicitly singled out state corporations as an impediment to progress; by endorsing them Surkov is making it quite clear that the Putinists reject completely Medvedev’s plans.

Sure, what Surkov proposes will fail, if true modernization is the metric of success.  But Surkov (and Putin) are just paying lip service to modernization.  They really want to perpetuate the Muscovite rent seeking society by which they prosper, although Russia does not, has never, and never will.

A Financial Contagion–of Cluelessness

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 1:57 pm

The House financial regulation “reform” bill passed last year includes the Lynch Amendment, which puts limits on the ownership of central counterparties/clearinghouses by financial intermediaries.  I blogged about this a bit.  The essence of my argument was that although there are potentially competitive concerns arising from dealer control of CCPs, there must be an alignment between economic interest and ownership structure.  Whoever bears the default risk is going to demand an influence over the governance of the CCP.  If you expect the big banks to bear the risk, they are going to require some control over the operations of the clearinghouse.  If you deny them this control, you have to find somebody else to bear the risk.  Competitive concerns are best addressed through anti-trust tools.

Sad to say, the “thinking” behind the Lynch Amendment has jumped the Atlantic, and the European Parliament is contemplating a similar restriction on dealer ownership:

Derivatives dealers should not be allowed to own stakes in central counterparties (CCPs) or their risk management systems – and CCPs should not be allowed to compete with each other, according to advice from the European Parliament’s committee on economic and monetary affairs (Econ).

The (anonymous) reactions of a European banker are spot on, and echo my earlier analysis:

“It’s ludicrous. Clearing houses were mutual organisations. They were originally mutually-owned and their job is to mutualise risk, so to say that users shouldn’t have any influence or ownership of governance or direction – it just betrays complete ignorance of what the function of a clearing house is and how a clearing house can be built and become operational,” says one head of market structure at a European bank.

. . . .

“It is our money in the default fund of the clearing house. For dealers to have some kind of oversight or some kind of say in the functioning of the clearing house is entirely reasonable. We’re not going to support a clearing house if we’re not satisfied with the risk management processes it operates. To think that the smart way to make this all happen is to remove the big dealers from the process is just dumb,” says the head of market structure.

“Complete ignorance.”  “Just dumb.”  That’s about right.

There’s a very simple choice here.  If you don’t want banks to exercise control over a clearinghouse, don’t look to them to bear the default risk.  If you want them to bear the default risk, you’ll have to give them considerable influence, and arguably de facto control.  And if you choose the first alternative, you need to answer: who is going to bear the default risk, and what price are they going to charge to do so?  And if you’re worried about competition, you should worry that the price this non-bank-owned CCP is going to charge, because it will almost certainly have market power.

The Lynch Amendment and its proposed European cousin both reflect a fundamental misunderstanding of just what clearing is about.  It is a risk allocation mechanism.  Which immediately should raise the question: who is going to bear the risk?  Clearing is not a risk fairy that makes risk disappear.  Those that bear the risk will almost certainly demand an active role in the organization that measures and manages it.  So if you make a governance and ownership choice, you’ve ruled out some risk allocation choices.  Our Solons, and Europe, apparently haven’t figured that out; they haven’t provided any idea on whom they expect to bear the risk, and are mandating or threatening to mandate models that have seldom, if ever, been tried in practice.  Which is very scary.

February 15, 2010

Shocked! Shocked!

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 9:49 pm

Like Claude Rains in Casablanca (which was on Turner Classic Movies yesterday), the Germans and others are Shocked! Shocked! that Greece used swaps priced off the market to borrow, for all intents and purposes.  For all purposes, that is, but one: accounting for the public debt to determine its adherence to European Monetary Union requirements.

Except that it wasn’t a secret at all.  Risk wrote about one of these deals back in 2003. S&P issued a note describing these types of deals in 2002.   The New York Times reports that there were many of these deals, from the very outset of the European experiment:

For all the benefits of uniting Europe with one currency, the birth of the euro came with an original sin: countries like Italy and Greece entered the monetary union with bigger deficits than the ones permitted under the treaty that created the currency. Rather than raise taxes or reduce spending, however, these governments artificially reduced their deficits with derivatives.

. . . .

But with the help of JPMorgan, Italy was able to do more than that. Despite persistently high deficits, a 1996 derivative helped bring Italy’s budget into line by swapping currency with JPMorgan at a favorable exchange rate, effectively putting more money in the government’s hands. In return, Italy committed to future payments that were not booked as liabilities.

The NYT also reports that these types of deals were a subject of fierce debate among European finance ministers going back to 2000.

In other words, nobody in government finance has any more reason to be shocked about these transactions than Captain Reynaud had to be shocked about gambling going on at Rick’s.

Some of the debates that are going on about the probity of these deals reminds me of discussions of who is to blame for drug addiction: the addict (Greece, for instance), or the pusher (e.g., Goldman, Morgan, Deutsche Bank, etc.):

“Politicians want to pass the ball forward, and if a banker can show them a way to pass a problem to the future, they will fall for it,” said Gikas A. Hardouvelis, an economist and former government official who helped write a recent report on Greece’s accounting policies.

In other words, politicians were being politicians, and bankers were being bankers, and they were engaged in mutually beneficial transactions.  The difference being, of course, that there are other people–millions of other people–who will pay costs.

If forced to choose, I guess I’m have a less favorable view of the politicians, for two reasons.  First, they never cease to tell us how morally superior they are, whereas bankers are for the most part (not universally) less sanctimonious.  Second, the politicians are ultimately violating a responsibility that they are entrusted with, whereas the bankers are actually carrying out their responsibilities to their principals.

But this is really all a side issue.  The central issue is what to do about Greece, and ultimately, the other countries that are at risk to following it over the edge.

I tend to lean towards what John Kemp writes in Reuters:

Most commentators have concentrated on the need for the EU to bail out Greece. But in reality any rescue would be another subsidy for excessive-risk taking by the country’s bankers and the institutions that have sold credit default swaps (CDS) on Greek debt.

Forcing the country into an austerity programme and arranging an emergency loan from other EU members or the IMF would ensure the bankers got their money back (again), but inflict years of misery on the country’s households and businesses.

If market discipline is ever to be re-established after the boom and bailouts of the last five years, it is imperative creditors face the real prospect of making losses if they extend large loans and fail to price the risk on them properly. The sellers of CDS insurance must face up to making real payouts in return for all the premiums they pocket.

Bailing out Greece would be wrong. Not because it would harm the eurozone’s credibility, but because it would reinforce the rampant moral hazard in financial markets. It would perpetuate the inequitable and politically unacceptable situation where structuring fees are retained by the banks as private profits while credit losses are socialised and passed onto taxpayers.

Greece would do everyone a favour by declaring a moratorium and forcing a rescheduling. The country faces years of misery in any case. The threat of being shut out of capital markets rings hollow. But by triggering losses on these derivative transactions and a credit events under the CDS it would help ensure a much more prudent approach in international banking markets.

Bailing out Greece so everyone can pretend the country can remain “current” on its loans when it patently cannot would simply deepen the moral-hazard crisis. If market discipline is ever to be re-established (something which everyone agrees is desirable) then at some point creditors must take a loss. Greece is a good place to start.

Yes.  As I discussed in an earlier post, it is the lenders–the creditors–that are ultimately the source of moral hazard.  If they are convinced that they will be bailed out, they will continue to feed the bad habits of profligate borrowers, including sovereigns.  Bailing out Greece, or others, will just increase expectations of future bailouts, and we’ll be in a sort of moral hazard Groundhog Day. Only it won’t be quite so funny.

February 14, 2010

When Speculators Attack

Filed under: Derivatives,Economics,Financial crisis,Politics,Uncategorized — The Professor @ 8:46 pm

Spain’s intelligence service, Centro Nacional de Inteligencia (CNI), is investigating “speculative attacks” against the country (via the CDS market), and Europe generally (via the currency market).  This article in El Pais tells the story.  Based on my shaky Spanish, it seems that Zapatero is blaming “Anglo-Saxon” speculators and journalists and pundits with conspiring against Spain, and the European project generally.

The speculators are indeed out in force, and there is a game of chicken between them and the European governments individually and collectively.  But the speculative attack is driven by the shaky finances in the Eurozone, and especially in Greece, Spain, Portugal, and Ireland.  The politicians have created the opportunity through profligate fiscal policies, and it is more than a little rich to hear them take umbrage at the markets holding them accountable.

If you chum the waters, Mr. Zapatero et al, why are you surprised when the sharks appear?

Not So Tiny Bubbles?

Filed under: Economics,Financial crisis — The Professor @ 8:23 pm

I’ve written some about the sustainability of Chinese economic growth, expressing the opinion that it is a “Michael Jackson economy” kept going with artificial stimulants that are resulting in massive distortions in the allocation of capital.  These concerns are becoming more widespread.  The most notable skeptic is noted short seller (and sometime SWP lurker by proxy) Jim Chanos.  Here’s a video of Chanos laying out his views on why China is a bubble.

Bloomberg has a long article today that quotes Chanos’s views and many more as well:

nvestor concerns have spread beyond real estate. Among 15 major Asian markets, the benchmark Shanghai Composite Index is valued third-highest relative to estimates for this year’s earnings, after Japan and India, even after falling 8 percent this year.

A glut of factories in China is “wreaking far-reaching damage on the global economy,” stoking trade tensions and raising the risk of bad loans, the European Union Chamber of Commerce in China said in November.

More than 60 percent of investors surveyed by Bloomberg on Jan. 19 said they viewed China as a bubble, and three in 10 said it posed the greatest downside risk. The quarterly poll interviewed a random sample of 873 Bloomberg subscribers and had a margin of error of 3.3 percentage points.

Digesting the debt from a popped property bubble may slash bank lending and drag growth lower for years in an economy that Nomura Holdings Inc., Japan’s biggest brokerage, says will provide more than a third of world growth in 2010.

Japanese Comparison

The risks are so great that a decade of little or no growth, as Japan experienced in the 1990s, can’t be dismissed, said Patrick Chovanec, an associate professor in the School of Economics and Management at Beijing’s Tsinghua University, ranked China’s top university by the Times newspaper in London.

The alternative view is that China need not worry about the gridlock of democratic politics, and its central government will be able to play Goldilocks, and make everything just right by intervening at just the right thime, and failing that, will fall back on its dollar hoard.  This, to me, represents a completely unrealistic view of the wisdom of central planners in general, and Chinese mandarins in particular.  I do not see how this can end well.

February 13, 2010

Eni, Meeny, Miny, Mo

Filed under: Commodities,Economics,Energy,Politics,Russia — The Professor @ 3:43 pm

The last couple of days I’ve felt that when I wrote “Teleconnections” I was like that guy in the TV show “Early Edition” who got the paper (the Chicago Sun Times) delivered to him before it was published.  Yesterday Bloomberg had an article about a shale gas bonanza in Europe; today’s WSJ has an article describing how Italian energy firm Eni has renegotiated its contracts with Gazprom, as I suggested would happen in the post, because (a) oil prices and gas prices have delinked, due in large part to increased non-traditional supplies, and (b) the development of LNG has helped spur development of a spot market for gas:

In an interview, Eni Chief Executive Paolo Scaroni said the renegotiated long-term contracts will allow the company to counter deep changes in the economics of Europe’s natural gas market, which has weakened of late.

. . . .

For decades, steady gas prices allowed Eni and other distributors to purchase natural gas supplies from fields in Russia and Norway using contracts linked to the price of oil. Over the past year, however, oil prices have recovered from the financial crisis while demand for natural gas has not. That left European gas companies on the hook to purchase gas supplies at higher rates than their spot market prices.

Natural gas prices have also been hurt by the emergence of new supplies, including shale gas fields in North America and an abundance of liquefied natural gas projects, Mr. Scaroni said. “Around this, the drop in demand and the growth of liquefied gas, we renegotiated some characteristics of our long-term contract,” Mr. Scaroni said, declining to elaborate on the terms of the new agreement.

Gazprom head Alexei Medvedev was rather vague about the changes too:

Gazprom Deputy Chairman Alexander Medvedev told a press conference earlier this week that Gazprom had renegotiated the contracts with European companies taking “into account the trends in the European market and the crisis.” However, the “base principles” of the long-term contracts remained unchanged, Mr. Medvedev said without elaborating. Gazprom declined to comment on the matter.

I wonder just what “base principles” and “characteristics” mean. Reading between the lines, I would wager that it means that the pricing mechanism has been shifted (as conjectured in “Telecommunications”) from oil prices to spot gas prices.  It is also possible that the take-or-pay provisions have been altered, as a shift to a more accurate pricing mechanism would reduce the scope for opportunism that TOP clauses are designed to combat.

It is very interesting that even Eni is renegotiating.  The Italians have been particularly slavish in their dealings with Gazprom and Russia.  When Gazprom would say “jump”, Eni would ask “how high, boss?”  The fact that this company has succeeded in wresting contract changes from Gazprom is a very clear indication of how the bargaining power, and the perception of bargaining power, have changed.  And, methinks, the process has only begun.

As I noted in the original post, these changes will have geopolitical effects, not merely economic ones.  One interesting thing to consider is how it will affect Ukraine.  The eastern Europeans and FSU countries generally, and the Ukrainians specifically, will receive less direct benefit from LNG and other new sources of gas.  Moreover, to the extent that western Europe is less dependent on Russian gas–or, put economically, its demand for Russian gas is more elastic due to the availability of alternative supplies–Ukraine is less important to it.  This doesn’t seem to bode well for Ukraine’s ability to fend off Russian pressure.

February 12, 2010

The Horizontal Bop Goes to Europe (or, More Headaches for Vladimir and Gazprom)

Filed under: Economics,Energy,Politics,Russia — The Professor @ 2:24 pm

Perhaps taking a cue from last night’s post “Telerconnections” 🙂 Bloomberg today reports on a shale gas rush in Europe:

Exxon Mobil Corp. and explorers including Chevron Corp. are securing land in Europe to exploit shale gas, a hard-to-extract deposit that could reduce global demand for liquefied natural gas, JPMorgan Chase & Co. said.

Exxon has shale areas in Germany, Hungary and had applied for permits in Poland while ConocoPhillips and Chevron are in Poland and Royal Dutch Shell Plc in southern Sweden to exploit gas trapped in rock formations and impervious to conventional drilling techniques, JPMorgan said in a Feb. 9 report.

“A land-grab has occurred in Europe over the last two years with majors such as Exxon, Conoco, Chevron and Statoil ASA all participating, not willing to miss out as they did in the U.S.,” said Mark Greenwood, a Sydney-based analyst with JPMorgan. “While it’s still early days for European and Chinese shale gas plays, its potential is yet another threat for the LNG supply-demand balance.”

Note to Putin: its potential is yet another threat to the pipeline supply-demand balance too:

The International Energy Agency said in November the world may have an “acute glut” of gas in the next few years because production of so-called unconventional fuel, which includes shale gas, is set to rise 71 percent between 2007 and 2030. Shale is a rock comprising layers of sediment from which oil and gas can be extracted.

The success of shale gas extraction in Europe and China may sap global LNG demand, reduce Europe’s dependence on Russian natural gas and force new Russian gas projects and Qatari LNG to compete with Australian LNG projects for Asian customers, Greenwood said.

. . . .

Qatar had earmarked 25 million tons a year of LNG for the U.S., which doesn’t “appear” to need the gas, according to the JPMorgan report.

Where’s that gas going to go?  Europe and Asia, most likely–in direct competition with Russian gas.  Combine this with the prospect for slow growth in North America and Europe (especially if the sovereign debt crisis continues, or turns for the worse), and it is likely that supply and demand will conspire to put a huge dent in Gazprom’s prospects.

My, how the worm is turning.  Which all goes to show the danger of putting all your chips on one number.

This shouldn’t be news.  The historical experience in commodity markets has been of shocks making a complete shambles of confident predictions.  In the 70s and early 80s, it was widely believed that oil prices would escalate inexorably, reshaping geopolitics as a result.  The exact opposite happened.  Geopolitics were indeed reshaped, but in a very different way.

Indeed, the USSR was the most prominent casualty of this shift.  (See Gaidar’s book for a blow-by-blow account of how the USSR’s fortunes waxed and waned with the upward spiral and subsequent collapse in oil prices.)  How soon some people forget.

February 11, 2010

Moral Hazard, Yesterday and Today

Filed under: Economics,Financial crisis,Politics — The Professor @ 10:54 pm

There is a debate going on in the blogsphere about whether the moral hazard model is helpful in understanding the financial crisis.  One view is that it is not.  For instance, Jeffrey Friedman argues that it does not:

First, the moral hazard of “too big to fail” (TBTF). Empirical problem: Before the bailouts, nothing of this scale had ever happened, so no bank could have been sure they would be bailed out. And if one actually reads accounts of the decision making in the years leading up to the crisis, such as Gillian Tett’s Fool’s Gold and William D. Cohan’s House of Cards, no decision makers factored bailouts into their calculations. Why? Because they didn’t think they were doing anything particularly risky (an ignorance-based human error), so they didn’t even consider the chances of being bailed out.

Second, the moral hazard of “corporate compensation systems,” i.e., bonuses.

Empirical problem #1: When this theory took hold, there was virtually no evidence for it (whereas now there is one study for it and one against it)–see Wladimir’s and my post on the topic (below).

Empirical problem #2: There was, and remains, the following overwhelming evidence against the theory: 93% of the banks’ mortgage-backed securities were either guaranteed by the U.S. government (i.e., Fannie and Freddie) or were rated AAA–the “safest” and *lowest-yielding* securities available. Triple-A bonds are the last thing revenue-seeking, bonus-hungry, risk-indifferent (i.e., risk-knowledgeable, rather than risk-ignorant) bankers would have bought.

Russ Roberts thinks otherwise:

I don’t think bankers planned on being bailed out. But I think it affected their decision-making. . . .

Hmmm. Not the best evidence. Do you really expect Jimmy Cayne, the CEO of Bear Stearns to tell a reporter that he threw away his firm’s money because he thought he’d get it back from taxpayers? But here’s what he does tell William Cohan:

The only people [who] are going to suffer are my heirs, not me. Because when you have a billion six and you lose a billion, you’re not exactly like crippled, right?

And then there’s this moment from Andrew Haldane?, the Executive Director of Financial Stability of the Bank of England:

A few years ago, ahead of the present crisis, the Bank of England and the FSA commenced a series of seminars with financial firms, exploring their stress-testing practices.  The first meeting of that group sticks in my mind.  We had asked firms to tell us the sorts of stress which they routinely used for their stress-tests.  A quick survey suggested these were very modest stresses.  We asked why.  Perhaps disaster myopia – disappointing, but perhaps unsurprising?  Or network externalities – we understood how difficult these were to capture?

No. There was a much simpler explanation according to one of those present. There was absolutely no incentive for individuals or teams to run severe stress tests and show these to management. First, because if there were such a severe shock, they would very likely lose their bonus and possibly their jobs. Second, because in that event the authorities would have to step-in anyway to save a bank and others suffering a similar plight.

All of the other assembled bankers began subjecting their shoes to intense scrutiny.  The unspoken words had been spoken.  The officials in the room were aghast.  Did banks not understand that the official sector would not underwrite banks mis-managing their risks?

Yet history now tells us that the unnamed banker was spot-on.  His was a brilliant articulation of the internal and external incentive problem within banks.  When the big one came, his bonus went and the government duly rode to the rescue.

I think that both Jeffrey and Russ might be looking for moral hazard in all the wrong places.  If lenders to big financial institutions figured they would get bailed out, they would be willing to extend cheaper credit to these institutions than would be the case in the absence of the expectation of a bailout.  It’s pretty clear that Fannie and Freddie were able to borrow at very attractive rates, and hence grow grotesquely large, because of the expectation that the government would not let them fail.  Similarly, lenders expecting that a Citi or BofA were too big to fail might also have expected that they would be bailed out with high probability, allowing these banks to borrow at rates that did not reflect the true risks.

The managers of these institutions would have faced distorted price signals: debt was cheaper than it should have been (due to the lenders’ expectation that a bailout was possible, or even likely), so the financial institutions became bigger and more leveraged than they should have been.  Importantly, this would have happened even if the bankers themselves had discounted the possibility of a bailout, or believed that a bailout would not save the equity holders (including them) or their bonuses.

Turning to today’s news, this source of moral hazard is exactly why the Euros are playing with fire if they actually do bail out Greece, not to mention Portugal or Spain if it comes to that (as it might).  Once this crisis passes, especially if it passes due to a bailout, lenders will feel quite safe in extending credit to profligate governments in the future, which will just lay the groundwork for another crisis.

There is a serious risk that the EU and the Euro cannot survive a bailout.  Germans in particular are dissatisfied with the Euro as it is; a bailout of the Greeks and whoever else comes knocking will only stoke that dissatisfaction.  Especially if it is not accompanied by credible institutional constraints that will prevent the problem from recurring: the credibility of the original constraints on member country budgets is already in tatters.

But it is not clear that the Euro (and the EU) can survive no bailout either.  The natural course for the affected countries is to go off the Euro and devalue, or default

That’s why it seems that the EU is playing a huge bluff.  There are important sounding announcements of hazy plans to support Greece in its hour of need, even though a bailout could well violate EU law. The Germans, French, etc., are hoping that the promise of a bailout will calm the markets, allowing the crisis to pass without the need for the bailout actually to take place.

Paulson tried that gambit with Fannie and Freddie.  We all know how well that worked out.  The credibility of the promise is so suspect, that it is highly likely that some big funds will bet against it, and call the bluff.  Hence the jeremiads against speculators:

In a joint press conference with Mrs Merkel, the French president, Nicolas Sarkozy. said euro-zone countries were offering “solidarity” in exchange for Greek promises of “rigour and transparency”. This would give Greece’s promises vital “credibility”, he said. Challenged on the lack of detail in the summit declaration, Mr Sarkozy said “speculators should understand” that Europe had agreed a strategy for defending the euro zone, and “we will come up with tactics as needed.”

That swipe at speculators probably offers a hint about the political tactics that Mrs Merkel and other leaders may employ to sell any Greek bail-out to voters. Already, politicians including José Luis Rodríguez Zapatero, the Spanish prime minister, have portrayed market pressure on their countries as part of a broader plot by murky market forces that want to destroy the euro and fight off tougher financial regulation within the EU. Expect to hear more about European political solidarity versus the speculators.

Knowing that his country is also on shaky ground, Spain’s Zapatero also launched a verbal strike against speculators, adding an element of conspiracy theory that would make a truther or a birther proud:

Mr Blanco told Cadena Ser radio that attacks on Spain were attacks on the euro, and were “rather dirty dealings” on the part of speculators, who:

“now that they see we are emerging from the crisis, do not want to see better regulation of their activities, [but] want to be free to carry on pursuing their own interests… None of what is happening, including editorials in some foreign media with their apocalyptic commentaries, is happening by chance, or innocently. It is the result of certain special interests.”

Here is Mr Zapatero:

“There is an attack underway by speculators against the euro, against tougher financial regulation of the financial system and of the markets”.

How dare those speculators say the emperor is naked!

The crisis, arguably born of moral hazard, is by no means over.  And “solving” the crisis may just ensure that moral hazard will survive, bigger and badder, in the future.  Just don’t ask the bankers or national leaders about it.  Ask the people who lend them money.

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