Streetwise Professor

When going for a hike this afternoon outside St. Louis, in the parking lot I pulled in next to a guy driving a Ural motorcycle, complete with sidecar.  It looked pretty old school, and I asked the owner when was it made.  He said “1999.”  I said “looks more like 1949.”  To which he replied: “Well, it’s based on a 1939 BMW design.”  Apparently the Soviets bought some German bikes in Sweden, smuggled them into the USSR, and reverse engineered them.  (La plus ca change.)  They were originally built in Moscow and Leningrad, but the factories were moved to Gorky in the Urals to escape the Germans in 1941.  All in all, this bike is a microcosm of the history of Soviet/Russian manufacturing; industrial espionage combined with the endurance of obsolete designs.

The subject of the Urals brings to mind another encounter, earlier this week in Houston.  (No grass grows under my feet.)

I met with a Russian guy I’ve known slightly for years.  He is a mathematician by training who has a pretty big job in a big bank’s commodity trading business.  Anyways, being interested in all things Russian, I asked him where he is from originally.  He said: “Siberia.”  I asked where in Siberia.  He said: “oh, a city you’ve probably never heard of, Yekaterinburg.”  I laughed and said I know a good deal about it, because I have a very dear friend from there, and know someone else who had spent a lot of time there while she was adopting her children.  He was quite surprised.  He told me of how his family–originally from Moscow–came to (then) Sverdlovsk  His dad was a ballistics engineer, and he was sent to help build one of the secret military factories in the Uralmash complex.  (Uralmash being famous today primarily as the home of the eponymous, and infamous, Russian mafia organization.)  He said that they lived in crude barracks during the construction.  Most of the laborers had been brought (against their will) from the countryside, and many brought some of their animals with them.  He said that for a kid it was wonderful to be around farm animals, but that his mother, a “refined Moscow woman” was understandably distressed.

His memories of Yekaterinburg/Sverdlovsk from Soviet times are somewhat harrowing.  He said that “Yekaterinburg suffered every disaster that was visited on the Soviet Union, from the murder of the Czar, to nuclear accidents (with leukemia being the leading cause of death in my era), to the anthrax release, and so on.”  He says he reflexively wears a hat in the rain to this day because he had to do that growing up because of the presence of nuclear and toxic fallout in the rain when he was growing up.

Two vignettes of Russia, in the middle of the ???.

And, to add to the experience, while writing this post I received an email informing me that “Soviet Russia” is now following me on Twitter.  That actually sounds a little ominous, LOL.

My thanks again to all of you who have expressed their concern for my brother-in-law Andrew, and who have sent their best wishes on a speedy recovery.

Today is a big day.  Andrew returned home.  He is making progress, day by day.  It will be a long, arduous recovery, but after some worrisome days in early May, the outlook is brighter.

Thanks again to all who’ve kept Andrew in their thoughts and prayers.

With the help of Dana at Andrew Lehman Design, I’m experimenting with moving into the 2d decade of the 21st century by (a) installing an RSS button, and (b) creating links on Facebook and Twitter to new blog posts.

Isn’t it interesting that the current mortal threat to the stability of the world financial system isn’t the dreaded “D” word–derivatives–but plain jane government debt?  Isn’t it interesting that the major force behind the last crisis–mortgage debt–and the major force behind this one–sovereign debt–received very favorable capital treatment for banks?; both were considered eminently safe, and banks had to hold very little capital against them.  What’s more, given the favorable treatment, banks loaded up with them by the gross.  Therefore, mightn’t one conclude that perverse bank capital rules are a major systemic risk?  Shouldn’t this raise concerns that centralized price setting mechanisms–such as centrally determined capital requirements–are not going to save us from the next crisis, but create it?

It is inevitable that such a mechanism will underprice some risks; that this will induce financial institutions to overinvest in those instruments; and that as a result, they are likely to be the source of a financial “surprise” that wreaks havoc.

And isn’t it interesting that the capital rules gave very favorable treatment to politically favored instruments–mortgage debt/real estate, and government debt?

Russian central bank head Sergei Ignatiev claims that the European crisis poses no threat to Russia:

“I don’t think all these events will have a strongly negative effect on the Russian economy,” Ignatiev said at a conference in St. Petersburg today. “The Russian banking system is better prepared for external shocks than it was in 2008.”

The economy is protected by sufficient liquidity, a “much more flexible ruble,” and large international reserves, the world’s third biggest after China and Japan, according to Ignatiev. While the Russian currency reflects external volatility, it can better withstand external shocks than it did before the global financial crisis, he said.

Of course, that’s what Putin, Medvedev, and even my boy Kudrin said said in 2008, when the storm clouds were breaking in the United States and Europe.  And we know how that worked out: rather than being a safe harbor from the storms buffeting other economies, as Putin and Kudrin had claimed, Russia was hit harder than virtually any economy.  Indeed, only months after boasting about his country’s immunity from the world crisis, in a speech at Davos Putin raged at the West for creating a “perfect storm” that had swept over Russia.

Putin’s confidence in September was based on many of the same factors Ignatiev cites, notably its reserves.  But its reserves have been depleted, and its economy has not recovered from its battering in 2008-2009.  There is also considerable reason to doubt his happy talk about the banking system.

It’s interesting to compare what Ignatiev said to what Kudrin said in January, 2008, when the strains on the world financial system were becoming manifest:

Russian Minister for Finance, Aleksey Kudrin, released a sensational statement Wednesday. Speaking at the World Economic Forum in Davos, the Russian minister offered to mitigate the world credit crisis with the help of Russia’s reserves. Kudrin stated that Russia was an “island of stability in the sea of the world crisis.”

“Investors will continue to invest billions of dollars in the rising Russian economy. Stock market crises and their consequences will not be utterly negative for us,” Kudrin said. “Our country managed to achieve economic stability and to save considerable gold and currency reserves which play the role of an air bag for the national economy,” Kudrin said.

Mr. Ignatiev, it appears, has learned nothing, and forgotten nothing.  Russia’s reserves did not save it from the crisis, let alone the world.  Why would Ignatiev think things would be any different a second time around?  That would be a triumph of hope over bitter experience.

If Europe spins downwards, as is still possible, or if China runs into turbulence (trying to deflate asset bubbles, for instance), the same dynamic that ravaged Russia before will do it again.  A recurrence of the financial crisis, this time driven by a sovereign debt crisis instead of a real estate crisis, would again crater demand for Russian material exports, reducing national income sharply and putting added strain on government finances.  The “flexible currency” Ignatiev touts is unlikely to prove so, as the same terror at repeating the 1998 ruble collapse would induce Russia to spend its reserves to prop up the currency.

If you’ve been following the volatile markets lately, you’ll have noticed that oil prices have swooned as worries about the sovereign debt crisis have waxed, and have rallied as these worries have waned (like today).  You’ll have noticed too that the Russian equity market and the ruble have been riding the same roller coaster.

As I said often during the crisis, Russia is a high beta economy.  Due to its commodity price exposure, and the sensitivity of commodity prices to world economic conditions, Russia remains hostage to world economic conditions; when Europe and/or the US and/or China get the chills, Russia catches pneumonia.  The European debt crisis threatens those conditions, and Russia with it.

So Ignatiev is either a fool, or whistling past the graveyard when he responds with such insouciance to the European crisis.  If the European situation turns for the worse–as I think it is likely to do, today’s market euphoria notwithstanding–Russia will awake to the strains of “I’ve Got You Babe” and relive the terrors of 2008-2009.

Roman Abramovich has been one of the favored oligarchs in Putin’s Russia.  But not even Abramovich is untouchable.  The Russian Federal Anti-Monopoly Service has announced an investigation of Abramovich’s Evraz steel company for “high monopoly-like pricing.” Steel consuming firms, notably car maker Avtovaz, railcar and tank manufacturer Uralvagonzavod, and Russian Railways have bridled at recent price rises.  Uralvagonzavod head Oleg Siyenko had taken his complaints to Igor Sechin. Siyenko has also called for export duties on steel (which would increase domestic supplies, thereby reducing prices). This follows FAS support for an export duty on potash due to price rises by Uralkali and Silvinit.

Such government interventions–which almost certainly require Putin’s consent, especially where somebody like Abramovich is involved–are an integral part of the operation of the natural state.  The natural state restricts competition and access in order to provide streams of rents to the rich and powerful, in order to purchase their support for the political order.  (Khodorkovsky’s great strategic error was to use his rents to challenge the status quo.)

This equilibrium is upset if the distribution of rents becomes too skewed.*  In the present instance, a recovering world commodity market has boosted demand for steel and potash.  At the same time, Russian domestic consuming industries have not benefited because they are not competitive internationally and are still suffering from the after effects of the economic crisis.  These shocks have unbalanced the distribution of rents, threatening the equilibrium in the natural state.  Matters are particularly delicate because Avtovaz and other big metal bashers are major employers; their continued financial troubles could threaten the delicate social order, already somewhat unsettled due to the Raspadskaya mine explosion (Raspadskaya being another Abramovich property).

So the government intervenes to maintain the balance and preserve the equilibrium.  This is the way the natural state works.

The use of export duties is particularly interesting.  As the steel and potash examples demonstrate, shocks to world commodity prices are a primary source of threats to the natural state equilibrium.  Some Russian raw material and semi-processed product industries are internationally competitive, and their fortunes wax and wane with the global economy.  (The energy industry is of course in this category, and is subject to export duties that are adjusted regularly, although this is in part done for fiscal reasons since these duties are a major source of government revenue.) In contrast, Russian material consumers are almost entirely dependent on the domestic market.  Thus, global demand shocks that help the raw material firms can have very adverse effects on the domestic consumers, requiring a reset to maintain balance.

This raises questions about whether Russia can really join the World Trade Organization.  WTO membership would constrain its ability to respond to global shocks so as to maintain the political equilibrium.  The natural state cannot tolerate truly open markets as these markets are destabilizing to the status quo.  Russia has indicated its intention to rejoin WTO talks, and Medvedev has expressed hope that the US will support its candidacy.  But given past Russian diffidence about the WTO, and Putin’s dalliance with a trade union of Russia, Belarus, and Kazakhstan, there is considerable doubt as to whether when push comes to shove the country will accede to the constraints that the WTO is likely to impose.

* Sam Peltzman’s famous article presenting a formal theory of regulation is useful in understanding these dynamics.  In Peltzman’s model, skewed profits under competitive conditions lead to regulation as politicians by political support through redistribution.

After Putin elbows him aside in 2012, Russian president Dmitri Medvedev should move to Branson and open a theater.  His standup routine is priceless.  (At least I think he’s standing up–with the diminutive Medvedev it’s always hard to tell.)

Yesterday’s routine was delivered before a group of US venture capitalists.  It’s a howl:

Boosting Kremlin plans to transform Moscow into a global financial center, President Dmitry Medvedev told visiting U.S. fund managers that his country was a haven for equity firms suffering from stricter financial regulation at home.

Medvedev said tough policies enacted by a host of governments after the financial crisis should raise the appeal of the Kremlin’s plans.

“We invite all those who suffer at home to come to Russia,” Medvedev said, according to a transcript posted on his web site.

Suffering at home?  Come to Russia, where they really know about suffering!  They consider it a national virtue!

I agree Europe and the US are slouching towards far less free capital markets (although the egregious Dodd “angels” provision died a merciful death).  But things would have to get worse by orders of magnitude for the situation to be anywhere near as bad as they are in Russia.  Let’s just come up with a little list about the dangers of investing in Russia: (a) lack of a rule of law, (b) no secure property rights, (c) constant risk of expropriation, (d) no real protection of intellectual property, (d) corporate raiding a la Russe, (e) corruption, (f) crime, (g) mafia shakedowns, (h) government shakedowns, (i) decrepit infrastructure, (j) declining working age population, (k) decaying educational system (hopefully later I’ll comment on a story documenting the massive bribery in Russian education–starting in pre-school (!), (l) acute dependence on raw material exports, which hold the country’s economy hostage to world economic conditions (meaning that if things go bad in Europe and the US, they’ll go even worse in Russian), (m) relatedly, the resource curse in all its manifestations.  I could go on, but you get the point.

One of Medvedev’s best one liners: “I will not take time listing specific advantages of the Russian economy today.”  Why not?  That wouldn’t take much time at all.

Captain Obvious also made an appearance: “”As regards the mood of American and foreign investors in general, who are often guided by the negative experiences of their predecessors.”  Who knew?

I actually sympathize for Medvedev.  He knows, I am sure, of Russia’s debilitating handicaps–virtually all self-inflicted–as a market for investment.  Indeed, he acknowledged some of these handicaps in his remarks.  But he offered nothing concrete in the way of palliatives.  Indeed, he cautioned against expectations that the only specific measure discussed–an agency to protect foreign investments–would actually accomplish anything:

As regards the possible creation of an agency for protecting foreign investments, Medvedev noted that the powers of this body were at issue, as judicial protection or intervention by prosecutors is often needed due to business conflicts. He said that all such an agency could do is give “a political impulse, which is sometimes a good thing”.

“There should be a body which reports to the country’s leadership about what is happening, but the question is its scope, because there are arguments both for and against,” Medvedev said.

He rather pathetically argued that Russia’s laws “are quite reasonable” but “often this legislation may not be properly observed by business entities and may not be always interpreted accurately in judicial proceedings. Besides, there is a problem of court awards enforcement.”  Other than that, things are great!

But Medvedev is actually powerless to do anything to address these problems.  He can point them out–and bully for him for at least acknowledging them–but the fact that he can diagnose but cannot cure only points out his basic irrelevance.  In the end, Medvedev was reduced to the Tinker Bell Strategy (has he been talking to Krugman?): “It is the position of those investors who admit positive changes in the Russian investment climate that could be used to change the view of foreign businesses with regard to investment in this country, Medvedev said.”  Problem is, if the dogs don’t like the dogfood, all of the happy talk advertising in the world isn’t worth a damn.  Especially since everybody knows that Putin is making the dogfood, and that Medvedev is just the pitchman.

Medvedev’s words count for little when corporate raiders who work for him and the jailers–murderers–of Magnitsky- walk free.

The fact is, long after Medvedev retires to take up residence near Yakov Smirnov, the Osmond Brothers, and Silver Dollar City, investors would be well advised to pay little attention to his blandishments, or those of his successors, and instead pay heed to the warning of American venture capitalist David Kronfeld: “There is a widespread feeling that there are thousands of ways to steal your money in Russia.”  Yes, that’s the punchline, but it’s no laughing matter.

Whatever emerges from the House-Senate financial regulation conference committee, the CFTC’s power and responsibilities will be greatly expanded.  Most notably, the agency will have vast power and discretion over the OTC derivatives markets.  It apparently will have considerable say in determining what contracts must be cleared and what firms must subject their trades for clearing.  Moreover, it will have responsibility to oversee the operations of central counterparties, which will have important implications for the stability of the financial system; misteps here could induce a serious systemic problem.

Just a few years ago, the chairman of the CFTC, Walt Lukken was bemoaning the agency’s lack of funding, claiming that it had insufficient resources to carry out its (then far narrower) duties.  The agency’s funding has increased, and its head count has increased about 20 percent.  It is slated to increase further to permit it to carry out its new charges.

But, as I’ve pointed out before, the CFTC was never renowned as an extremely effective regulator.  Indeed, it was often something of a Congressional whipping boy because of its perceived shortcomings.  (Example: I remember well the agency’s humiliation when then-Chair Wendy Gramm was forced to stand silent in the background while the Justice Department and the FBI announced indictments against Chicago floor traders for assorted misdeeds.  The clear implication was that the CFTC was not capable of policing the markets.)

Whether that reputation is deserved or not, there is considerable room for skepticism about the CFTC’s ability to handle its new duties.  Any dramatic expansion of an organization into new areas inevitably leads to growing pains and managerial snafus.  That goes double for a dramatic increase in the size and scope of a government organization.  And the stakes are extremely high now, given the systemic importance of clearing.  Requiring the clearing of unsuitable instruments, for instance, could jeopardize the stability of clearinghouses–and hence the financial system.  So could lapses in monitoring the operational or risk management activities of CCPs.

And it must be remembered that the agency will have to handle these new tasks in a hypercharged political environment, one more intense than it has to cope with now.  The stakes will be higher, with big players having a far bigger amount of money affected by CFTC decisions.  With greater stakes will go greater pressure, most notably from Congress, which will respond to constituent pressure.  Can the agency handle it?  Color me skeptical.

Some Commissioners are now openly expressing concerns about the agency’s ability to shoulder the load:

US financial reform regulation could place “overwhelming” burdens on the Commodity Futures Trading Commission, the regulator that would have to assume a new role as watchdog for the swaps markets, officials there said.

Sweeping financial legislation approved by the Senate last week dramatically elevates the role of the CFTC, created in 1974 to police trading in futures and options. The commission would gain broad new powers to oversee previously unregulated over-the-counter derivatives, a universe 10 times larger than regulated markets.

“It’s overwhelming. It’s not like right now we don’t have enough on our plate,” said Jill Sommers, one of two Republicans on the five-member commission.

Senior officials warn that to perform its new role, the CFTC, which has long operated in the shadow of the better-funded Securities and Exchange Commission, will strain its expertise, organisational structure and technology. It would have to propose, take public comment on and then adopt as many as 50 elaborate rules in six months, a timetable that Michael Dunn, a Democratic member of the commission, called “pretty much an impossibility”.

. . . .

Gary Gensler, the CFTC chairman, was among the Obama administration’s staunchest champions of legislative language that would route most derivative trades to clearing houses. This would allow regulators to peer at the size of traders’ positions and, so it is hoped, head off the kinds of risky positions that led to the $180bn (£124bn, €143bn) AIG bail-out. While sharing oversight with the SEC, the CFTC would regulate the majority of derivative deals.

. . . .

CFTC officials acknowledge being snowed under. Probes into oil and silver markets announced in 2008 remain unresolved. Mr Gensler has said the agency was overwhelmed by Ponzi scheme cases. Last week Scott O’Malia, a Republican commissioner, said the agency still gets account information by fax and enters it manually. “This agency is about to be hit with a tsunami of trade data,” he said.

Remember, regulation can create systemic risks.  One way to do that is to place extraordinary burdens on a regulator unprepared to handle it.  Which is what Congress is in the process of doing.

At the risk of sounding like one of the Four Yorkshiremen, I have to admit to chagrin at the weenyfication of the Herndon Monument climb during Commissioning Week at the Naval Academy.  The climb’s origins are lost in the mists of time, but in recent memory it was the rite of passage from Plebe to human (i.e., non-Plebe).  The graduating firsties would glue a Plebe cover (a Crackerjack sailor’s hat–“dixie cup”–with a distinct blue ring around the rim) to the top of the monument.  They’d then cover the monument with hundreds of pounds of lard, and hose down the ground at the base until it was saturated.  After the graduation ceremony, the Plebes attempted to climb the monument: as soon as the hat was retrieved, Plebes no more.  It could take hours.

Until this year, however.  The Superintendent deemed the climb too dangerous, and ordered that no lard be used.  So the climb was finished in minutes.

Please.

Was it dangerous the old fashioned way?  Yeah, I guess.  The strategy was to have the bigger guys form a base, the medium sized guys the next layer, and for the smaller guys (and women, when I was there) to clamber up the bodies to try to grab the cover.  I was a relatively light guy when I did it–I weighed in the mid-140s as a Plebe–so I was one of the clamberers.  I tried several times, but each time fell.  When I fell, I wound up sprawled in the mud being trampled by the crowd at the base.  I struggled to my feet, and was then surrounded in a suffocating crush of bodies.

But miracle of miracles!  I lived!  And so has every mother loving Plebe who has ever done it.  It is one of those shared experiences that creates a bond among the 1000 odd Midshipmen in each class, and between classes.  It is a rite of passage, and like all rites, to be meaningful there has to be at least some discomfort involved.

Now, as a result of Vice Admiral Jeffrey L. Fowler’s decision, the class of 2013 will be known as the first of the classes that were just too precious and delicate to run the vanishingly slight risk of somebody being seriously hurt or even dying.

Last time I checked, the military job description involves the possibility of running risks to personal life and limb.

I had–and have–no objection to the elimination of the gratuitous violence and hazing that was rife at the Academies prior to the early-1970s, when Congress outlawed it.  But the Herndon climb was a once-a-year event, done in public with only Plebes participating, meaning that it could not be a place where sadists could dominate and humiliate their defenseless charges, as sometimes happened with hazing.

The training-wheels-and-bike-helmet version of the Herndon climb isn’t a big thing, but it is a symbolic one.  It symbolizes the insanely overreactive risk aversion characteristic of a lot of today’s military.  A risk aversion born, in part, of the zero tolerance, one strike and you’re out policies that are currently in place.  IMO, this is not conducive to an optimized military.  “L’audace, toujours l’audace”* is the credo of a successful military.  And what Admiral Fowler decreed hardly screams audacity.

* This phrase was uttered by French Revolutionary leader Georges Danton, NOT Frederick the Great, as claimed in the movie Patton.

The previous story about the Russian Chess Federation’s battle with the state may shed some light on the fact that foreign direct investment in Russia fell 17.6 percent in the first quarter of 2010.  And it is not that 2009 was such a great year: FDI in 2009 was down 41 percent over 2008.  So despite the alleged recovery in the Russian economy, FDI is not coming back.  This is problematic for Russia because foreign investment was an important driver of GDP growth in the mid-00s.

Not that I’m surprised.  Given the tenuousness of property rights from the predations of the state, or the whims of those who can wield the coercive powers of the state, it is dangerous to invest directly in Russia; fear, uncertainty, and doubt should be foremost in the mind of any potential foreign investor..  If the Chess Foundation is worth siccing the police on, just think of the incentives to call in the muscle when there’s real money to be made.

Kudrin seems to be whistling past the graveyard:

Finance Minister Alexei Kudrin said in February that FDI might climb to a “pre-crisis level of $60 billion to $70 billion in the next two to three years.”

Given that the 2010 pace is for about $10 billion/year, $60-$70 billion seems way, way out of sight for the medium term.

Although FDI was down, total foreign investment in Russia is up.  This is a mixed blessing, at most, for Russia.  It is not a strong vote of confidence in the Russian economy.  Instead, a good chunk of it is likely hot money playing the carry trade, borrowing abroad at low rates (thanks, Ben and Claude!) and investing in Russia at higher rates.  It’s also a play on energy prices.  But this money can flee as quickly–more quickly, in fact–as it arrives.  Flights to safety, concerns about the effects of the European crisis on energy prices, uncertainty about whether China will try to reduce credit growth and its effect on oil prices, or a million other things, can reverse those flows in a hurry.

Not that Russian officials (some Russian officials) are unaware of this:

Improving the investment climate is a priority to boost the share of long-term direct investment in the total capital flow into Russia, Economic Development Minister Elvira Nabiullina said Thursday.

While speculative capital inflows are “a problem,” Russia will not ban short-term investments and needs instead to “create conditions for attracting direct investment,” she said.

True enough.  But how?  That’s the Russian dilemma.  The substantive changes needed to attract FDI–notably, the creation of at least a simulacrum of a rule of law that would protect investors from expropriation–is a threat to the political equilibrium in the Russian natural state.  Meaning that Russia will not escape Putin’s purgatory any time soon.