Streetwise Professor

October 31, 2010

Not My Job, Man.

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics — The Professor @ 4:20 pm

CFTC Chairman Gary Gensler gave an extended interview with Reuters on Friday.  A good part of the discussion revolved around budgetary matters, but this gem caught my eye:

The agency likely will stagger deadlines for traders to become compliant with the new regulations — including speculative position limits, Gensler said, declining to give any details about a long-awaited proposal that the agency will unveil in the next month.

Investment funds, which make up as much as quarter of trade in markets like cattle, have already looked for alternative ways to buy commodities, with some buying physical products instead of futures and swaps.

That’s OK by Gensler.

“Congress asked us to do a job, we gotta do what Congress asked us to do,” he said, adding cash markets are not part of his mandate.

Wait just a cotton pickin’ minute.  The whole point about limiting speculation in derivatives markets is that such speculation allegedly distorts prices for the commodities that consumers actually buy and producers actually sell.  That is, that such speculation allegedly distorts cash prices.  Listen to all the crying and moaning and gnashing of teeth about the alleged effects of speculation, and the tales of woe focus on the impact of speculation on cash prices.

I remember distinctly when I testified before Congress on speculation in the summer of 2008: criticisms of speculation at the hearing focused on the impact of derivatives trading on physical commodity prices.  Battling Bob Etheridge of NC took time out from assaulting college students to bewail the plight of trucking companies in his district forced to pay higher fuel prices due to speculation.  The head of the Industrial Energy Consumers of America claimed that chemical producers and others had to pay higher prices for natural gas and crude feed stocks because of speculation in derivatives.

I could multiply these examples by the hundreds, and probably the thousands.  In the 1930s, speculative limits were rationalized as a way of bolstering the prices farmers received on the cash market for their grain.  Suffice it to say that it is beyond cavil that the drive to restrict speculation in derivatives is all about the cash markets.

For Gensler, at this late date, to claim that’s not part of his (or his agency’s) job description beggars belief.  Congress mandated the imposition of position limits for the express purpose of reducing the impact of speculation on cash market prices.  That’s what Congress “asked” CFTC to do.  To proceed with a plan to impose speculative position limits on derivatives, without regard to how said limits could have the unintended consequence of distorting cash market prices is both irresponsible, and at odds with the purpose of the regulation.

Now, obviously, I do not agree with the beliefs underlying the legislative mandate for speculative position limits.  But given that the mandate exists, and that Congress has delegated to the CFTC the authority to implement said limits to achieve a purpose set out in the statute, you’d think CFTC should devise those limits with an eye as to their real effect.  There is now substantial credible evidence that one effect of limits on derivatives will be to shift some activity into the physical markets directly in a way that has more potential for adverse effects on these markets.  It is therefore incumbent on CFTC to take that into account when designing its limits, as otherwise it would impose restrictions that would be directly contrary to the entire purpose of the limits in the first place .

I mentioned the JPM physical copper ETF.  BlackRock just announced another.  This is a growing trend.

Goldman and Standard Chartered argue that physical ETFs should have a limited effect on the market.  In most circumstances, I believe that’s true.  But we’ve seen in the Treasury markets that the limited “float” of some Treasury issues that results from bonds and notes being locked up in pension funds and other buy-and-hold investors can lead frictions that distort prices, and in particular can make it easier to squeeze the market.  Physical ETFs could have the same effect.  Moreover, as a general matter, and as I opined in my original piece on the subject, whereas with derivatives investors can get exposure to particular risks without holding the actual underlying, if physical ETFs are the only way to get exposure to particular commodity price risks, there is an additional constraint that can effect prices as operating under the constraint, to meet portfolio objectives investors may decide to hold inventories of copper that would be released for consumption had investors been able to achieve these objectives through the derivatives market.

At the very least, CFTC should investigate thoroughly the effect of speculative limits on the scale of physical ETFs, and the effect of physical ETFs on the cash markets.  But Gensler’s remark in the Reuters interview makes it evident that he, at least, considers the entire issue irrelevant to the entire position limit exercise.  That’s wrong, and just plain wrongheaded.

You might argue that this development was unintended by the drafters of Frank-n-Dodd.  You can no longer say that it is unanticipated.  Regulators should attempt to determine how market participants will react to their dictates, and plan accordingly.  Saying “it’s not my problem, man” doesn’t cut it.

October 28, 2010

Alfred E. Newman Chooses an FCM: The Moral Hazard of Segregation

Filed under: Clearing,Commodities,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 2:17 pm

The next brawl on the Frank-n-Dodd fight card is over segregation of customer funds in the clearing model.  From the FT:

The “risk” that is in the spotlight centres on how customer assets, such as margins required to cover potential losses on derivatives trades, are held.

Under the current futures model, “futures clearing merchants” (FCMs), which handle cleared derivatives hold these assets in pooled accounts. If one of the FCMs’ customers defaults, and causes the FCM to go under too, then the clearing house can tap into this pooled account – also called an “omnibus” account – to cover any losses that are not met by margin payments or the clearing house’s default fund.

For investors these accounts are an important safety net. And they want the pooled accounts to be replaced by a system of separate, or segregated, accounts. Then, if another investor defaults, their assets are safe.

“It is an extreme event, but it is not impossible,” said Richard Prager at BlackRock at the meeting organised by the CFTC.

. . . .

If regulators opt for segregated accounts, clearing houses won’t be able to tap into these in the event of a default. Instead, clearers say the current system of using omnibus accounts gives them an extra shield. The removal of this shield would mean they would have to find funds elsewhere, potentially driving up clearing costs for users.

Kim Taylor from CME Clearinghouse said the removal of omnibus accounts could require a 60 to 100 per cent rise in the default fund, the capital put up by the backers of clearing houses. Such a rise in capital costs could lead banks to “think twice” about being in the clearing business, she said.

Point number 1 (which everybody saying anything about clearing should repeat until they internalize it): a primary effect of any priority rule–and the difference between segregation vs. omnibus accounts is first and foremost a difference in who is in what loss position in default–is to shift risk around.  Under the omnibus model, the customers of an FCM are at risk to its other customers and the FCM itself.  If some customers default, and the FCM does not have the resources to cover this, under the omnibus system the clearinghouse can seize the entire customer margin held in the omnibus account to make whole those at other FCMs (including the other FCMs themselves) who are owed money.  This means that non-defaulting customer funds at the defaulting FCM can be used to cover the losses of the defaulting customers at that FCM (though not the losses on the FCM house account).  Under segregation, this can’t happen.  But that doesn’t mean the losses go away: they are borne by the other clearinghouse members who don’t default.  These firms are obligated to pay up to make those owed money whole.

In other words, with an omnibus account system, customer default losses are shared among FCM customers and members of the CCP.  Under segregation, they are shared only among members of the CCP.  The rule shifts losses around.

Note that this is somewhat ironic if the policy objective of a CCP mandate is to reduce the counterparty risk losses suffered by the large, systemically important financial institutions that are among the members of CCPs.  Segregation rules force said firms to bear larger default costs than omnibus rules: losses are shifted in their direction.  (And compared to bilateral markets, it can also be the case that large systemically important financial institutions will bear larger default losses under clearing than without it.)

In other words, just looking at the risk piece, the choice between segregation and omnibus is a choice between different sharing rules.  Default losses are actually spread more widely under the omnibus system, as non-defaulting customers are in a potential loss position.

But whenever you look at insurance arrangements, you have to consider the incentive effects, and most notably, the potential for moral hazard.  The crucial thing to understand here is that the segregation system is more vulnerable to moral hazard than the omnibus system.

This is true for at least a couple of reasons.

First, customer incentives to monitor FCMs are stronger with omnibus accounts.  A customer realizes that if the FCM doesn’t monitor its customers appropriately, or lets them assume excessively risky positions, he is at risk of loss from the FCM’s carelessness.  He therefore has an incentive to choose an FCM carefully, and to monitor that FCM, and potentially move to another FCM (“exit”)  or raise hell with his current one (“voice”) if he finds that FCM is slacking in watching its customers.

Second, under segregation, customers don’t care about the riskiness of the FCM’s trading or financing.  Remember a customer is in a loss position under an omnibus system when (a) there is a default in some customer accounts, and (b) the FCM can’t cover this loss.  Condition (b) is more likely to occur, the riskier the FCM’s own trading, financing, etc.  Therefore, a customer is more likely shy away from a high flying FCM that trades aggressively, or levers up to the max, or chooses fragile forms of leverage when under an omnibus system.  Under segregation, the customer channels Alfred E. Newman: “What, me worry?”  He will choose an FCM only on the basis of commissions, services, the quality of the Christmas party and golf outings, etc.  This means that under segregation, customer accounts will be at riskier FCMs, on average, than under omnibus accounts.

More moral hazard means that default losses will be greater on average under segregation.  And since non-defaulting CCP members are on the hook for the entire default loss with segregation, this means that CCP members have more capital at risk under segregation than with an omnibus system.  That’s why Kim Taylor concludes: “Such a rise in capital costs could lead banks to ‘think twice’ about being in the clearing business, she said.”  A bigger share of a bigger amount translates into a lot more capital.

Given this, it’s no surprise that the omnibus account system has had survival value.  It is a way of controlling moral hazard.  It reduces the insurance benefits of clearing (from the customers’ perspective), but it reduces the costs of providing this insurance.  As is the case with virtually every insurance system, including the most prosaic automobile policy, you need something like a deductible to mitigate moral hazard. Insurance is almost never complete due to the perverse effects of moral hazard. Omnibus accounts play the role of mitigating some moral hazards in clearing.

I would hope that regulators ask why the omnibus system evolved, survived, and dominated before prescribing the sharing rule that CCPs adopt.  (I’ve told one regulator exactly that.)  The survival principle tells you something.  Before changing what is, ask why it is.  Believe it or not, there is very likely to be a good reason for it.  And with omnibus accounts, that reason is control of risk.

I have to quote just one more thing from the FT article:

But the issue highlights the complexities – and costs – of reforms.

Well, no sh*t.  Some people (sounds of throat clearing) have been saying that for literally years.  If only the Sorcerers’ Apprentices had appreciated that before passing Frank-n-Dodd.

October 26, 2010

Not All Biases Are Created Equal

Filed under: Economics,Politics — The Professor @ 8:37 pm

Matt Ridley, discussing a paper Slavisa Tasic presented at the  Instituto Bruno Leoni conference at which Renee also presented*, reminds us that regulators can have cognitive biases too.

This is a pretty unexceptional point.  But it raises the question.  If both individual decision makers in markets and regulators are both subject to cognitive biases, isn’t it kind of a push?

I say no.  Decisively no.  For two reasons.

First, the feedback mechanisms are different.  Individual decision makers are subject to market feedback, and this feedback is often quick and ruthless.  For instance, an individual trader who uses a biased decision rule is likely to lose money, and often a lot of money.  Indeed, those who get rich in these markets often do so at the expense of the fools–or should I say, the cognitively biased/impaired?  Evolutionary rationality often trumps individual irrationality.

In contrast, politicians and regulators face very weak feedback, and often no feedback or perverse feedback.  To take an extreme example, what feedback will Barney Frank or Chris Dodd receive if something buried in Frank-n-Dodd runs amok and causes substantial damage in the market?  Answer: nada.  Similarly, a regulator that makes a boneheaded decision is largely immune from being fired, and may well be working for Goldman by the time the bad consequences of his or her decision comes to light.  Evolutionary mechanisms don’t work with anything near the same force to weed out the irrational and the stupid in political and regulatory contexts.

Second, regulatory and legislative mistakes are often systemic in their effects, whereas individual decision errors are less likely to be so.  A regulatory or legislative mistake affects everybody subject to the regulation or law.  For instance, if it turns out that forcing greater use of clearing is actually a bad idea, but regulators and legislators acting under the delusion of competence mandate it anyways, the entire market bears the brunt of that mistake.  And the cost of that can be quite extreme.

In contrast, although herding behavior (correlated cognitive biases) can occur, and may contribute to bubbles and runs and other undesirable outcomes, a lot of individual biases tend to cancel out.  (I would also argue that many herding phenomena that are attributed to biases may in fact be rational responses to perverse incentives.  For instance, the fact that a lot of financial institutions loaded up on AAA mortgage CDOs and PIGS debt was likely the result of the perverse incentives of the Basel system than some mass delusion.)

In other words, laws and regulations tend to put all the eggs in one basket.  Markets and other emergent orders tend to be more diverse, and diversified, and less vulnerable to the errors or biases of an individual or a small group of individuals.

So the Tasic paper that Ridley writes about is a useful antidote to knee-jerk behavioralism that is often used to rationalize the need for more regulation.  But it is only a good start.  Once you understand that both market agents and regulators/legislators are cognitively imperfect, you need to go farther and examine what the consequences of those imperfections are.  To do so, you need to focus on differences in feedback and diversity across regulatory/political mechanisms on the one hand and market mechanisms on the other.

* This was Renee’s first conference presentation.  Papers were selected competitively.  Hers was on the parallels between the forces leading to commodity regulation in the 1930s and today.  Not only was she the only presenter at the conference without a PhD, she doesn’t have any degree yet, being in the last year of a 5 year joint MA/BA program.  Dad is very proud.

The First of Many

Filed under: Commodities,Derivatives,Economics,Energy,Politics — The Professor @ 8:08 pm

Unintended consequences, that is.

ETFs have been a big deal for several years now, including commodity ETFs.  Heretofore, the big commodity ETFs have been in energy, but now several firms have metals ETFs in the offing.

Most traditional ETFs have bought futures contracts.  So the US Oil Fund, for instance, buys NYMEX light crude futures.  As the contracts it holds near expiry, it rolls forward into deferred contracts, buying the deferred and selling the nearby.

But the new metals ETFs will invest in, and hold stocks of, physical metal rather than derivatives.  FT Alphaville, quoting from a JP Morgan prospectus for its new copper ETF, has the details:

Firstly, being physically backed and not futures-based — the trust will escape all regulatory restrictions governing the size and scope of its speculative commodity positions (since there’s no exchange presence). No USO or UNG implosion danger here.

As the documentation states:

The Trust will take delivery of Physical Copper in the form of LME Copper Cathodes. Because the Trust will not trade in copper futures contracts on any futures exchange, the Trust will not be regulated by the CFTC under the Commodity Exchange Act as a “commodity pool,” and will not be operated by a CFTC-regulated commodity pool operator. Investors in the Trust will not receive the regulatory protections afforded to investors in regulated commodity pools, nor may the COMEX or any futures exchange enforce its rules with respect to the Trust’s activities. In addition, investors in the Trust will not benefit from the protections afforded to investors in copper futures contracts on regulated futures exchanges.

Note, too, that as a result it is likely that the ETF will not be subject to position limits.  And I think this is a big part of the reason for going physical.

The construction of the fund to avoid regulation is clear as day.  The effects are not likely to be good.  The advantage of using derivatives (futures or swaps) to construct ETFs is that it makes it possible to achieve an arbitrarily large exposure to the price risk of the underlying (oil, or copper, or whatever) without ever handling the physical.  That is, derivatives allow the unbundling of the price risk and the holding of the physical product.  This lowers transactions costs, and crucially permits investors to achieve portfolio and risk objectives without being constrained by the size of the physical market.

In contrast, physical ETFs cannot exploit this unbundling.  But apparently, the benefits of avoiding position limits and other regulatory costs are sufficiently great to justify the loss of efficiencies associated with this unbundling.  (If the bundled risk-physical solution were better than the unbundled one, you would have seen physical ETFs when the regulatory constraint wasn’t a real threat.)

There is a perverse irony here.  The whole rationale (supposedly) for position limits is that speculation somehow distorts physical markets.  There is precious little evidence, outside of a few extreme examples (e.g., the Hunts) that this is a real problem.  But by driving those that want exposure to metals prices, either for speculative reasons, or for portfolio balancing reasons, regulations are making it more likely that speculation will distort prices and the physical markets.

I’m not saying this will happen, or will be chronic.  Only that distortions are more likely in the bundled world than the unbundled one in which ETFs trade in derivatives rather than the physical.  ETFs that roll aren’t in the physical market, rolling out of expiring positions before they can go physical.  This limits, and likely eliminates, their effect on prompt prices and consumption, production, and storage decisions.

In contrast, ETFs that hold the physical are by definition in the physical market, and there can be a conflict between the risk and profit objectives of physical ETF holders and the efficient allocation of physical supplies; those desiring exposure to metal price risk might hold onto stocks when it would be optimal to consume them instead.  Conversely, in an unbundled world, traders can maintain exposure to the price risk without having any influence on the use of the metal.

I can also imagine some manipulation strategies that exploit the physical ETF.  For instance, somebody could obtain a big physical position via the ETF, and use that to create or enhance market power in the derivatives market.  That is, the ETF can be a way of “locking up” metal that would otherwise be available for delivery, thereby enhancing market power in the derivatives market.

I said this was a perverse irony.  It’s actually more perverse than ironic.  A policy intended to reduce (probably chimerical) distortions in the physical market actually increases the likelihood that such distortions will occur.  That’s the kind of havoc that Sorcerers’ Apprentices wreak.  Get used to a lot of that going around.

How Low Can He Go?

Filed under: Politics — The Professor @ 3:55 pm

Obama’s campaign rhetoric has become increasingly uglier as the day of reckoning nears.  The last couple of days have seen two pretty outrageous statements coming out of his mouth.

Outrageous statement Number 1:

He said Republicans had driven the economy into a ditch and then stood by and criticized while Democrats pulled it out. [Enough with that metaphor, already.  Geez, he’s beaten it to a bloody pulp.  It was trite the first time out of his mouth.  The thousandth time . . . oi.]  Now that progress has been made, he said, “we can’t have special interests sitting shotgun. We gotta have middle class families up in front. We don’t mind the Republicans joining us. They can come for the ride, but they gotta sit in back.”

How is this wrong?  Let me start counting the ways.

For one, he is not Constitutionally empowered to dictate who “sits” where, and what powers Republican legislators or governors exercise.  The Constitution determines the seating chart, and Obama has bupkus to say about that.  If the Republicans win control of the House and or the Senate, and win additional governorships, they have every right to exercise their powers under the Constitution.  That’s why we have a Constitution, and why we have elections.

For another, Obama implies that there is disjunction between “middle class families” on the one hand, and “Republicans” on the other.  Really?  Hardly.  I doubt that even a weaker claim, that middle class families are preponderantly Democrat, would withstand rigorous scrutiny.  This is, moreover, another example of Mr. Uniter’s divisiveness, and of playing the class warfare card.

For yet another, the “sit in back” metaphor is highly racially charged.  Can you imagine the hue and cry that would result had any Republican suggested that Democrats generally–let alone Obama, specifically–“sit in the back”?  Even if you ignore the racial angle, the metaphor implies that some Americans–and likely, the majority of those casting ballots in a week–are second class citizens.  This relegation of some Americans to inferior status is disgusting, especially coming from an individual who wraps himself in the mantle of civil rights.

Random asides, in order to reduce blood pressure: When I hear of the “back of the bus” metaphor, I remember an old Sanford and Son episode from the early ’70s.  I tried to find the script online, but couldn’t, but know that the dialog went something like this.  Lamont asked Fred (Redd Foxx) what he’d done in the military, and Fred replied something like: “When I was in the Air Force, they wanted me to be a tail gunner, but I wasn’t gonna seat in the back of no airplane.”  I also just found out that  teenagers sometimes say “Rosa Parks” to call a seat.   I think that’s something new.

After that needed comic relief, back to the decidedly unfunny president.

Outrageous statement Number 2:

“If Latinos sit out the election instead of saying, ‘We’re gonna punish our enemies and we’re gonna reward our friends who stand with us on issues that are important to us,’ if they don’t see that kind of upsurge in voting in this election, then I think it’s gonna be harder and that’s why I think it’s so important that people focus on voting on November 2.

Such a post-racial uniter, isn’t he?  Let’s see: a twofer.  A blatant racial appeal and a bonus Nixonian categorization of some Americans as enemies.  Plus an assertion that government is essentially a spoils system to reward friends and punish enemies.

Yes, politics ain’t beanbag, but there certain lines of decorum and rhetoric that should not be crossed.  Obama didn’t just cross those lines with these remarks: he obliterated them.  All the more outrageous coming from someone who portrayed himself, from his very first, as someone dedicated to transcending partisan politics and rancorous division.  Remember this?:

Yet even as we speak, there are those who are preparing to divide us, the spin masters and negative ad peddlers who embrace the politics of anything goes. Well, I say to them tonight, there’s not a liberal America and a conservative America – there’s the United States of America. There’s not a black America and white America and Latino America and Asian America; there’s the United States of America. The pundits like to slice-and-dice our country into Red States and Blue States; Red States for Republicans, Blue States for Democrats. But I’ve got news for them, too. We worship an awesome God in the Blue States, and we don’t like federal agents poking around our libraries in the Red States. We coach Little League in the Blue States and have gay friends in the Red States. There are patriots who opposed the war in Iraq and patriots who supported it. We are one people, all of us pledging allegiance to the stars and stripes, all of us defending the United States of America.

Rings pretty hollow now, doesn’t it?  Was he lying for effect then, or has he just found these noble sentiment to be inconvenient today?

We Have the Stuff: They Have the Benjamins. Who Has More Power?

Filed under: Economics,Financial crisis,Politics — The Professor @ 11:57 am

I exchanged IMs with Renee yesterday, in which she was describing the attitudes of virtually all of the students in her economic development class towards US debt with China.  She wrote: “people are crazy paranoid about the chinese taking over the US with our dollars. . . . they are all asking, what happens when they call in our debt.”  To which I responded: “They gave us stuff.  We gave them paper.  Pretty good deal.”

Lo and behold, what should I read in today’s WSJ, but an excellent oped by John Cochrane, from my alma mater, the Booth School at the University of Chicago, saying the same thing:

What’s the right policy toward China? They put a few trillion dollars worth of stuff [same word, even] on boats and sent it to us in exchange for U.S. government bonds. Those bonds lost a lot of value when the dollar fell relative to the euro and other currencies. Then they put more stuff on boats and took in ever more dubious debt in exchange. We’re in the process of devaluing again. The Chinese government’s accumulation of U.S. debt represents a tragic investment decision, not a currency-manipulation effort. The right policy is flowers and chocolates, or at least a polite thank-you note.

Yet Mr. Geithner thinks that the Chinese somehow hurt us. There is at work here a strange marriage of Keynesianism and mercantilism—the view that U.S. consumers supported the world economy by spending beyond our means, so that other people could have the pleasure of sending things in exchange for pieces of paper [again–same word choice].

Cochrane is also spot on in skewering the policy Goldilocks who claim to be able to discern what level of trade, investment, and saving is “just right”:

This is all as fuzzy as it seems. Markets and exchange rates are not always right. But it is a pipe dream that busybodies at the IMF can find “imbalances,” properly diagnose “overvalued” exchange rates, then “coordinate” structural, fiscal and exchange rate policies to “facilitate an orderly rebalancing of global demand,” especially using “medium-term targets” rather than concrete actions. The German economics minister, Rainer Brüderle, called this “planned economy thinking.” He was being generous. Planners have a clearer idea of what they are doing.

He also makes a point that I’ve belabored over the past two years, but which I’ve seldom seen in print:

So Mr. Geithner knows that trade surpluses in the end come down to saving and investment. And he knows that in the U.S. people are trying to save right now. Our government is undoing their efforts with massive fiscal deficits. Mr. Geithner recognizes that most of the trade “imbalance” comes down to a big fat fiscal imbalance centered in Washington, D.C.

Abso-effing-lutely.  It drives me crazy (short trip, I know) to hear “analyses” of Keynesian-style stimulus policies that are predicated on the belief that Americans are programmed automatons, rather than deciding, active, acting, and reacting, agents.  They want to restore their ravaged balance sheets, and do so by saving.  They understand, perhaps not intellectually, quoting Ricardo, but certainly intuitively, that expanded government spending today is nothing but tomorrow’s tax bill.  So they react to stimulus, and threats of more stimulus (and “threat” not “promise” is the right word), by making decisions that largely reverse government actions.  Maybe not 100 percent, but substantially.  Which means that the fact that stimulus has not stimulated shouldn’t be surprising to anybody who understands that American households are not inert blobs that can be manipulated at will by Washington mandarins.  (I understand that excludes a good fraction of the 202 area code and vast swathes of the commentariat.)

No, talk of governments or the IMF correctly discerning “imbalances” and crafting appropriate policies in response is like Cochrane says: a pipedream (if not worse).  The main thing that is unbalanced in the American economy right now is the administration’s economic policy, and those responsible for it.  And Timmy! is at the top of the list.

One more thing about the Chinese and debt.  The implicit presumption underlying the fear of Renee’s classmates is that the creditor has the power and calls the tune.  But as far too many of Donald Trump’s bankers have found out to their dismay over the years, if you lend somebody enough, he has tremendous power over you.

With respect to China, we already have the stuff, thank you.  We’ve promised to give you stuff in return in the future.  Just what is the mechanism for enforcing that promise?  This has been the conundrum in sovereign debt markets from time immemorial.  Just look at how the Greeks can tie the Euros in knots.  I’m not saying it will come to this, but insofar as debt is concerned, China is more vulnerable in many ways than the US.  They have the Benjamins, yes, but (a) the amount of stuff the Benjamins can buy is outside of their control (and in the control of another Ben, ironically), and (b) there is always the risk that we tell them that their Benjamins are no longer exchangeable for stuff.

October 25, 2010

Uhm, That’s Not How I Remember It

Filed under: Politics — The Professor @ 9:59 pm

Jimmy Carter has a, shall we say, revisionist view of history:

America is no better off now than it was in the late 1970s and early 1980s, says former President Jimmy Carter. From national politics to relationships with other nations, there is a lot of room for improvement.

“We had almost complete harmony with every nation on Earth,” the Nobel Peace Prize winner said of his administration. “We not only preserved peace for our country, we never went to war. We never dropped a bomb. We never fired a missile.”

Jimmy.  Dude.  “Complete harmony with every nation on earth”?  Seriously?  I think you confused your administration with a Coke commercial that was old when you took office.  We were in “complete harmony” with, say, Iran?  (Yeah, that whole hostage thing, and Desert One, just makes me so nostalgic for those days when we were all living life as described by The Seekers.)  The USSR?  I know you and Brezhnev got it on, but then he did that whole Afghanistan thing:

Yes, the US wasn’t in any hot wars at the time, but the ’70s was a pretty brutal, violent period. American fecklessness contributed to an upsurge of violence and yes, war, in Asia, Latin America, and Africa.

Jimmy’s delusions also extend to domestic policy:

While the above issues may be similar, today’s American political scene is vastly different. Carter says he had wonderful bipartisan cooperation, with Democrats and Republicans in both the House and the Senate supporting him.

The Republicans were pretty well neutered then, but didn’t support him.  The funny thing is that not too long into his administration, the Dems didn’t support him either.  Tip O’Neill was often contemptuous.  And Teddy Kennedy ran in the primaries against Carter.

Here’s a choice quote that combines cluelessness on both domestic and foreign policy:

“And I would say, in general, maybe not exactly now when there’s such a negative attitude, but in general, the American people wanted me as president to be successful. Because when I was successful in dealing with jobs and when I was dealing with international affairs and peace and human rights and energy and that sort of thing, then America (was successful).”

I’m sure it would have been true that if Carter had been successful in “in dealing with jobs and when I was dealing with international affairs and peace and human rights and energy and that sort of thing” then (a) Americans would have supported him, and (b) America would have been successful.  The problem is that if those things happened, they happened in some parallel universe, not the one I or any other living soul inhabited.  Jobs–hardly.  (Interesting he doesn’t mention inflation.)  International affairs?  That was the nadir of American power and influence.  Energy?  xike,cip;aci,a#@xk.  Sorry, I couldn’t type through the guffaws.

It’s actually kind of sad that even after all these years, Carter hasn’t been able to come to terms with the history of his administration, and its legacy. I’m sure he would be able to come up with at least a plausible defense of what he did and the decisions he made during challenging times. But to peddle fantasies is just pathetic.

PS. Ironically, Carter is the only President whose hand I have shook. I did so after the Navy-Georgia Tech football game in Annapolis in December ’78. Very wimpy grip, BTW: overall, I was struck by his lack of physical presence. My other USNA connection with Carter was that I was evicted from my room on 8-3 (i.e. the 4th floor) of Bancroft Hall at Navy during Graduation Week (I think it was still June Week that year–the last time graduation was in June) 1978 so that snipers could hole up there: he spoke at the graduation, and his helo landed in the field below my wing of Bancroft, hence the snipers. (My other graduation memory: I was sitting close to where ABC’s Sam Donaldson was doing a standup before the speech. Donaldson and a few of us Mids exchanged insults.)

That Navy-GA Tech game was my closest encounter with a President until last Saturday. I was at the Post Oak Grill in Houston, and who should come in but George H. W. Bush and Barbara Bush. They sat at the table directly next to the one where my family and I were sitting. My daughter Renee is a student at the Bush School at Texas A&M, and President Bush has spoken in some of her classes, and she has seen him in the hallways of the Bush Library (where he has an apartment). So Renee felt a connection, and introduced herself. Needless to say, President Bush and Mrs. Bush were extremely gracious, telling Renee to make sure that she speak to them if she saw them on campus. Renee actually sees Mrs. Bush with some regularity, while the former First Lady walks her dogs around the pond next to the Library. Not like they’re on Babs-NeeNee terms or anything:)

And to pull all this Carter-Bush stuff together, Carter would deserve far more respect if he had conducted himself in the years succeeding his presidency more like GHWB did in the years following his. GHWB didn’t slag his successors as Carter did with some regularity, or engage in the grandstanding and revisionism that Carter has.

At a TIPping point?

Filed under: Economics,Financial crisis — The Professor @ 8:48 pm

Tyler Cowen notes that yields on inflation protected securities, TIPS, have turned negative.  He links to this NYT story for more details.

Tyler argues that this negative TIPS yield indicates that expected real interest rates are negative.  But as I note in a comment to his post, that’s not right.  TIPS have an embedded option resulting from an asymmetric exposure to positive and negative inflation rates.  If inflation is positive, the Treasury gives you the contractual coupon on the TIPS on a principal that is increased by the inflation rate.  If inflation is negative, Treasury gives you the contractual coupon, but doesn’t adjust the principal.  So you get a real return equal to the coupon when inflation is positive, and a real return equal to the coupon minus the rate of inflation if the price level declines; that’s bigger than the coupon.  In contrast, with a nominal Treasury, your real return is the coupon minus the rate of inflation regardless of whether that inflation rate is positive or negative.

Investors bid down the coupon on the TIPS to reflect the value of this option.  The time value of this option is particularly big when (a) expected inflation is approximately zero (as this makes the option at the money), and (b) there is a lot of uncertainty about the future inflation rate.

That’s a pretty fair description of current market conditions.  Inflation is hovering around zero now, but there are real risks of either a big spike in inflation or a deflation.  There is intense debate in the investing and policymaking communities about whether inflation or deflation is now the bigger risk.  You look at the ballooning monetary base, and you recognize that if velocity picks up even a bit and the Fed doesn’t react quickly, and prices could shoot up.  The plummeting dollar and rising commodity prices are also inflationary signs.  But there is also real concern about deflation, a liquidity trap, etc.

So to me, that means that there is huge uncertainty about the future course of the price level, and that translates into a big value of the option embedded in TIPS.  That in turn, in a situation of an expected inflation rate of zero and relatively low real returns given the sluggishness of the economy, can produce negative TIPS yields.  As a result, I don’t see the negative yields as an indication of negative real returns.  Instead, they are an indication of the huge uncertainty about the future course of prices.

Here’s what I posted as a comment on Tyler’s site:

You need to take into account the terms of the TIPS when drawing conclusions about expected real rates of return. Taking these terms into account, a negative TIPS yield does *not* necessarily mean a negative real rate of return.

The crucial thing to remember is that the principal amount of TIPS is increased when inflation is positive, but the principal amount of TIPS is *not* decreased when there is deflation. As an example, if I own TIPS and there is a 10 percent deflation, I earn a 10 percent real rate of return on my TIPS holdings because the principal amount on the TIPS stays constant, but the real value of that principal rises by 10 percent.

Thus, negative yield could be signaling a high probability of deflation. This means that you cannot conclude that a negative TIPS yield implies a negative real rate of return. If the expected change in the price level is -2 percent, and the TIPS yield is -.5 percent, the expected real rate of return is 1.5 percent.

But an expected deflation should affect nominal yields too. If the real rate of return is 1.5 percent, given an expected change in the price level of -2 percent, nominal bonds should be yielding -.5 percent too.

Right now, TIPS in the 2 year maturity range are yielding about -.85 percent. Nominal 2 year yields are about +.35 percent. TIPS in the 5 year maturity range are yielding about -.3 percent, whereas 5 year nominal yields are about 1 percent.

The features of TIPS can result in negative TIPS yields and positive nominal yields when there is *uncertainty* about inflation. TIPS have an option-like nature. TIPS investors are protected against inflation when the price level goes up, but can benefit from deflation. In contrast to this asymmetry, nominal bond investors are hurt by inflation and helped by deflation in a symmetric way. That is, a TIPS is like a nominal bond plus a call option on inflation struck at zero.

There’s another way to look at this. In real terms, the payoff to the TIPS is its yield minus min[price level change,0]. The payoff (in real terms) to the nominal bond is its yield minus (price level change). The “min” expression in the TIPS payoff and its absence in the nominal bond payoff means, again, that the TIPS embeds an option.

This embedded option reduces the TIPS yield relative to the nominal yield. If the expected inflation rate is zero, then the nominal yield equals the real return. But the TIPS yield must be below the real rate of return to compensate for the value of the embedded option. The more uncertainty about price level changes, the more valuable is this option, and the more depressed is the TIPS yield. The difference between the nominal and TIPS yield is basically the time value (or the “extrinsic” value) of the price level change option. This time value is greater, the more volatile the inflation rate.

So right now, where a zero expected inflation rate is not an unreasonable assumption, the yield on nominal Treasuries is a more reliable estimate of the real rate of return. I would interpret the present situation as being: (a) low but positive real rates; (b) approximately zero expected inflation; but (c) substantial uncertainty about the future change in the price level. This substantial uncertainty is understandable, given the unprecedented nature of the current economic situation, and the equally unprecedented nature of monetary policy.

The Sick BRIC

Filed under: Economics,Energy,Russia — The Professor @ 8:26 pm

Last Friday the WSJ ran an interesting article comparing the ruble to other commodity currencies.  Whereas the Australian and Canadian Dollar, South African Rand, and the Norwegian Kroner have rallied smartly against the dollar since June, with double digit percentage gains, the ruble is down about 6 percent.  This is symptomatic of a sluggish economy.  There is other information consistent with this interpretation:

Russia does not believe that the crisis is over – whatever the government spin might say.

And while the official line is that the country is open for business and investment is not only welcome but safe and secure, both incomes and spending are falling, says the Federal Statistics Service (Rosstat), and this is bumping up inflation as goods stay on the shelves.

“Demand is now in a state of crisis,” warns Association of Retail Companies (AKORT) executive director Ilya Belonovsky.

“We’ll be doing well if mid to late 2011 we return to the pre-crisis levels of consumer spending that we had in 2007-2008,” he told

The economy is at a standstill and worried Russians are squirreling money away for a rainy day as instability stretches further into the future, creating a vicious cycle, Komsomolskaya Pravda reported.

Talking themselves into trouble

Rosstat’s gloomy prognosis does more than make the government look unreasonably optimistic. “[Prime minister] Vladimir Putin has regularly said that everything is in order, that the economy is going uphill. In actual fact there are no grounds for these kinds of statements,” Higher School of Economics (HSE) scientific director Evgeny Yasin told

All it means is that when people see that the good news is not true people will be disappointed and not believe the next swathe of promises, he says. “There is no correlation between what is really happening and what our leaders are saying.”

Russia truly is the sick BRIC.  It should be benefitting from the growth in other emerging markets and the resultant increase in demand for its raw materials.  If it is benefitting, its lagging overall performance indicates even more acute problems elsewhere in the economy; that is, the raw materials sector is obscuring a truly bleak picture in other sectors.

Indeed, emerging markets are the primary beneficiaries of Helicopter Ben’s insanely loose monetary policy.  Their currencies are appreciating too as investors are taking dollars, buying EM currencies, and investing in those countries.  But the ruble is missing out on this: indeed, as the WSJ article shows, private capital is actually flowing out of Russia.  Benchmarking this outflow against the surging inflows in EMs (including other BRICS) makes the Russian performance look even more anemic.

This is another indication that putting Russia in the company of China, India, Brazil, and other emerging markets is flawed.  The comparison is not at all flattering to Russia.  Putin can brag as much as he wants, but the numbers tell a far less optimistic story.

If there is a silver lining in this for Russia, it is that the leakage of US monetary stimulus to EMs puts a lot of stress on those economies.  They tend to bubble, and those bubbles can–will–burst.  Russia isn’t bubbling, to say the least, so it has no bubble to burst.  That’s good news in a way, and reduces some of the pressure on Russian policy makers.  But a bursting EM bubble wouldn’t do Russia any favors, as that would hammer demand for its exports (think 1998).   Not a pretty thought.

October 24, 2010

Getting Schooled

Filed under: Economics,Politics — The Professor @ 10:03 am

At the risk of writing something that could be taken as special pleading, I’ll weigh in on the WSJ article “Putting a Price on Professors.”  The risk exists because the article is about state policy towards professors in Texas, and specifically discusses the University of Houston.  I plead guilty on all counts.

The article describes recent state laws that are intended to improve academic performance, specifically by increasing professorial accountability and efficiency, in part by quantifying faculty performance, with the implication that these quantitative measures will eventually be inputs to hiring, pay,  and curricular decisions.

At the outset, I should express my broad sympathy with these objectives.  As to the means, well, just let me say that with respect to the metrics for evaluating faculty performance, those pushing these metrics want to improve education in the worst way, and they’ve found it.

This is in fact a great illustration of the perils of high powered incentive systems in multi-task environments, something first analyzed rigorously by Holmstrom and Tirole Milgrom in JLEO in 1991*.  The basic problem with high powered incentives, in which compensation and perks are strongly related to measured performance, is that these incentives can cause serious distortions when some important aspects of performance are very hard to measure.  Those subject to this incentive system tend to devote excessive effort to the measured activities that determine compensation, and too little effort to the unmeasured–but potentially valuable–activities that do not affect compensation because they cannot be measured with any precision.

A canonical example from education is teaching to the test.  When teacher performance is evaluated primarily by student test performance, teachers have an incentive to teach to the test only, and stint on any non-test related instruction, even though said instruction may be quite beneficial and valuable to the students.

In many ways, this multi-tasking problem is captured by Einstein’s aphorism that not everything that counts can be measured, and that not everything that can be measured counts.  The Holmstrom-Tirole Milgrom corollary is that counting only those things that can be measured means that nobody will produce the things that count but can’t be measured, and are likely to produce things that can be measured but don’t really count.

Higher education is rife with measurability issues.  It is easy, for instance, to count student enrollments and graduation rates.  It is far harder to determine how much knowledge those students have received, especially in higher level and more abstract courses in non-quantitative areas.   It is difficult to monitor and measure faculty engagement with students outside the classroom.   Research is also extremely hard to evaluate.  Yes, you can count papers.  Yes, you can rank journals.  But both are noisy measures–potentially very noisy measures–of research “quality.”

So, it is much harder to measure some crucial dimensions of faculty quality and performance than others.  If you want to have research universities, and faculty who engage with students outside the classroom, etc., high powered incentive systems are not the way to achieve it.

If you take a look at WSJ article’s description of the spreadsheet at Texas A&M used to evaluate faculty contribution, you might be reminded of old Soviet incentive systems.  When the Soviets would try to measure the performance of nail makers by the weight of nails produced, the factories would churn out small numbers of huge, heavy nails.  Not liking this, the planners changed the incentive system to base compensation on the number of nails produced, so the factories produced lots of little nails.  Analogously, if you reward faculty for teaching big sections of basic courses, small specialized electives will disappear, or will be staffed by the least influential (usually, most junior) faculty who are less capable (on average) of teaching them.  If you include grant monies as a primary criterion, faculty members will spend more time grant grubbing and less time doing other things that are also important to the educational and research missions.  Students are frequently not in the best position to evaluate the value or utility of what they are being taught, so making faculty salary and promotion highly dependent on student teaching evaluations tends to skew teacher efforts towards entertainment and achieving popularity, rather than delivering knowledge and constructive (and sometimes painful) feedback.

This is not to say that low powered incentive systems are costless.  All of the criticisms of the modern university have a basis in fact.  Some faculty respond to low powered incentives by mailing it in, or teaching classes that are personally satisfying (or easy) but which are not useful for students.

But in this, as in everything else, there are trade-offs.  If you don’t like things the way they are . . . be careful what you ask for.  Changes intended to address one problem–e.g., faculty sloth/moral hazard–can create other problems that are far more costly.

The modern university is characterized by low powered incentives.  Universities are almost exclusively not-for-profit.  Internal reward systems have low incentive power.  Before rushing in to change that system wholesale, it is worthwhile to stand back and consider why these arrangements have developed, and more importantly, survived.  The well-documented problems with for-profit universities provide a valuable cautionary tale, and a useful contrast to the criticisms of the traditional university.

As in most things, rather than trying to engineer from above (in legislatures or governors’ offices) to achieve superior results, it is better to encourage an environment in which competition not just in price, but in organizational form and internal management and governance, can flourish.  The practices that survive will not be perfect, because perfection is not an option in economics, but it is likely that they will have attributes that are, as a whole, superior to those that do not.

* Error caught by “Anonymous.”

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