Streetwise Professor

Paul Krugman spews bilge routinely, and so for the most part I ignore him.  But his most recent op-ed piece is about my adopted home state of Texas, so it warrants–I wouldn’t say “merits”–a reply.  In a nutshell (which fits Krugman quite well, thank you), he argues that (a) in the conservative narrative, Texas is the “role model” for conservative state governance, a foil for basket cases like New Jersey, California, and Illinois, but (b) its fiscal situation is as dismal as any of these other states.  Thus, he concludes, we shouldn’t look to Texas as an example.  Indeed, since Texas is cruel and mean, it is not worth emulation.

As usual, Krugman gets arm weary punching at straw men.  Texas has received positive attention because its economy has weathered the recession better than most, certainly better than other states that are heavy in manufacturing and natural resources.  It was among the last states to enter the recession, and suffered smaller than average declines in employment and income; its GDP fell by less than the national average in 2008-2009, and it did better than all the large states.  The positive coverage has not been mainly about the “modern conservative theory of budgeting,” as Krugman would have it.  And contrary to what Krugman says, serious people never labeled Texas as “recession proof”–they’ve just noted that Texas has done a lot better in this recession than its peers. (Rick Perry, for instance, never did a Vladimir Putin and claim that the financial crisis would not affect Texas.)

Even where the government’s financial situation is concerned, Krugman’s case is weak.  It is no secret to those in Texas that the state’s budgetary situation is hardly ideal.  As a member of the Faculty Senate at UH (I participate because I hear it counts against purgatory), I have heard Chancellor Khator and Provost Antel detail–and bewail–the state’s straitened circumstances, and the dire implication of that for the UH budget.

But it is not as bad as Krugman portrays it.  He picks an outlier number–a $25 billon deficit estimate over two years–and goes from there.  But other estimates put the number at $15 billion over two years.  (Texas works on a two year budgeting cycle.)

To put things in perspective, California’s deficit is around $25 billion over one year, or about 3 times the Texas deficit, whereas the California economy is less than twice as large as Texas’s.  Illinois–$15 billion budget deficit for one year, but its economy is about half the size of Texas’s.  (H/T, commentor Charles.)  New York–about $10 billion, with an economy smaller than that of Texas.  New Jersey–also about $10 billion, with an economy about a third the size of Texas’s.

So not great, but it could be far worse.  And it is indeed far worse, in most other big states around the country.

Moreover, it would be worse–a lot worse–had Texas not been conservative in its budgeting, as compared to other states.  Texas is dealing with its budget strains a lot more constructively than California or New York or Illinois.  (Of course, especially with regards to California “more constructively” is a very low bar.)  Take Illinois particularly.  It is facing a shortfall equal to about 40 percent of its budget–yes, 40 percent–and has just announced a barrage of new taxes.  These will doom it to the tax death spiral that many cities have already experienced, e.g., Detroit, my other sort of home St. Louis (city); in the spiral taxes go up, employers leave, exacerbating the budget problems, so taxes are raised more until the local motto becomes “Last One to Leave–Turn Out the Lights.”  (This is happening in Michigan at the state level too.) Texas is choosing and has already chosen a different route: it didn’t get itself as badly into the financial quicksand, and isn’t trying to get out by flailing about imposing new taxes on everything (including internet purchases, in Illinois).

So yeah, Krugman, tax increases are pretty much out of the picture, because Texas doesn’t want to join the death spiral parade.

Krugman notes that the Texas unemployment rate is below the national average, but argues that this is due to “high oil prices.”   Really?  Uhm, oil prices cratered–absolutely cratered–in 2008-2009, falling from $140 in July 2008 to around $35 in early 2009.  Natural gas prices cratered too, falling by about two-thirds.  Under Krugman’s theory, Texas should have suffered more in 2009 than the rest of the country; the fact that it didn’t is another fact in its favor.  Oil prices have rallied, but only relatively recently, and gas prices have remained in the doldrums.  Also, Texas is far less dependent on energy than it was in, say, 1986.  So Krugman’s attempt to attribute Texas’s relative good performance in the great recession to “oil prices” is just lame–and idiotic.

Krugman claims that Texas balances its books on the backs of the poor:

Texas has indeed taken a hard, you might say brutal, line toward its most vulnerable citizens. Among the states, Texas ranks near the bottom in education spending per pupil, while leading the nation in the percentage of residents without health insurance.

Is this the reasoning that gets you a Nobel Prize?  Then how come every idiot doesn’t have one?  I mean, really.  First, how does the spending on school students averaged across all pupils in the state–which includes those in the richest districts and the poorest ones–have any bearing on how the state treats “its most vulnerable”?  Second, I’m sure Krugman might have heard somewhere that the connection between per pupil spending and academic achievement is tenuous at best.  Third, what does the percentage of citizens without health insurance have to do with the state budget?  The state, like other states, pays for Medicaid, the eligibility rules for which are set by the Federal government.  The state provides health insurance for its employees.  The decisions of private employers and their employees regarding insurance is a matter of private contract, and has nothing to do with the state budget.  He further says that Texas is “willing both to impose great pain (by its stinginess on health care).”  Again–if by “it” he means the State of Texas, he provides no evidence that “it” is stingy, because the fraction of individuals without health insurance is driven primarily by decisions in the private sector, not in the state government.  (It’s also worth noting that the same figures that show that Texas has the highest level of uninsured demonstrate that the state’s growth in the uninsured over 2007-2009 was below the national average.  So does that mean that Texas became less “brutal” in recent years?  Or that other states–including many quite blue ones–have become more brutal?)

Krugman also tries to blow off Texas’s good economic performance in the recent decade by attributing it to “liberal land-use and zoning policies.”  (If it’s liberal, why doesn’t he like it?)  Well, that’s just one of a whole set of policies that make Texas a desirable place to work, live, and operate a business.  And that’s exactly the kind of thing that Texas boosters say that other states would be wise to emulate.

Krugman mentions, but effectively ignores, the elephant in the room: Texas’s rapid population growth.  That’s the best barometer of the desirability of a state’s amenities and its policies.  Do people move to places that are “brutal”?  Do they move to places with crappy schools?  Obviously not.

People move where the bundle of private and public goods is most attractive.  That Texas is gaining population while California, New York, Illinois, etc. are losing it is the most important fact, by far.  Period.

Jerry O’Driscoll and Michael Barone understand this.  Krugman, Nobel Prize and all, apparently doesn’t.

I would have hoped that this was the worst thing Krugman has written in the last couple days, but alas that is not to be.  For not only is Krugman a reflexively ideological and dishonest opinion writer, he is a loathsome human being.

Think that’s too strong?  Well consider this.  The powder smoke was still hanging in the air in Tuscon when Krugman assigned blame.  No prize to those who guessed the obvious: that Krugman blamed conservatives:

We don’t have proof yet that this was political, but the odds are that it was. She’s been the target of violence before. And for those wondering why a Blue Dog Democrat, the kind Republicans might be able to work with, might be a target, the answer is that she’s a Democrat who survived what was otherwise a GOP sweep in Arizona, precisely because the Republicans nominated a Tea Party activist. (Her father says that “the whole Tea Party” was her enemy.) And yes, she was on Sarah Palin’s infamous “crosshairs” list.

Just yesterday, Ezra Klein remarked that opposition to health reform was getting scary. Actually, it’s been scary for quite a while, in a way that already reminded many of us of the climate that preceded the Oklahoma City bombing.

You know that Republicans will yell about the evils of partisanship whenever anyone tries to make a connection between the rhetoric of Beck, Limbaugh, etc. and the violence I fear we’re going to see in the months and years ahead. But violent acts are what happen when you create a climate of hate. And it’s long past time for the GOP’s leaders to take a stand against the hate-mongers.

Yeah, tell us about hate, Krugman: you’re the expert.

If you want a more reasonable conjecture about the Tuscon shooter, I suggest Shannon Love’s piece at Chicago Boyz.  The conclusion is spot on:

The left plays a dangerous and ultimately self-defeating game when in every case to date, they have immediately, often literally within minutes, of a reported act of political violence, sprung out to denounce ordinary non-lefitsts as culpable in the attack. Since it is widely known that such attackers are either seriously mentally ill or individuals with highly egocentric and idiosyncratic ideologies, seeking to link such attacks to their mainstream political opposition makes it clear that they see instances of political violence merely as chances to advance their political power. Moreover, since such attackers have a hodgepodge ideology, one can just as easily blame leftist’s rhetoric for such attacks as non-leftists.

More darkly, by linking ordinary, mainstream political opponents to such political violence, the left appears to be creating a context for suppressing or even violently attacking such opposition. They are desperately trying to create an equation in which disagreeing with a leftists is tantamount to a violent attack.

Words to heed, Krugman.  Not that you ever will.

Yesterday was the 5th anniversary of Streetwise Professor.  Time do fly.

I’ll try to keep the navel gazing to a minimum, but I think a few comments are warranted.

The blog, and most notably its reception, have exceeded all the expectations I had when I started it.  I originally envisioned it as a place to think out loud on relatively arcane issues related to financial markets and market structure, and thought that if a few readers stopped by from time-to-time, that would be nice.  It has played that think-out-loud role, but it has attracted many more readers than I had ever anticipated.  Not a huge number by blog standards, but given the rather arcane and arguably eccentric content, a surprising number.

I think a couple of things are responsible.  The first is the wholly unplanned foray into writing about Russia.  That subject generates by far the most comments, and certainly the most heated and passionate ones.  Given the fact that there would be no readily apparent reason for me to write about Russia, it has also resulted in some rather puzzled inquiries from friends and acquaintances, who have offered some rather entertaining hypotheses to explain it.

There is an explanation, convoluted, but an explanation nonetheless.  Several interests serendipitously converged on the subject of Russia.  I attended the Naval Academy in the Cold War, which generated an initial interest in Russia.  I took a year long Russian Civilization sequence at the University of Chicago after I transferred from Navy, taking classes from major scholars Arcadius Kahan and Richard Hellie (both now passed, sadly), which fed that interest.  The interest went into hibernation as I launched into my profession, but as my career developed, I became deeply involved in energy issues (an unexpected departure in its own way with its own story), and also became very interested in institutional economics issues, including property rights economics and political economy.  Russia represented a fascinating case study regarding energy and institutions, and that’s what started me down the path of Russian commentary.  After that, my tendency towards serial intellectual obsessions (which started with Civil War history as a kid) took over, and led me to read and write more; one damn thing led to another, and reading about one thing led to related issues and on and on.  Conditioned response played a role too: I naturally wrote more about the subjects that generated the most feedback.

The second major factor explaining SWP’s unanticipated trajectory was the financial crisis.  As a result of the crisis, aracana that I’d written and researched about for years–financial market structure and clearing, most notably–to the collective indifference of a big swathe of the economics/finance academy all of sudden became extremely topical.

It’s funny, actually.  In October, 2008, (note the timing) I received a rejection letter from a journal for a paper I’d written about the economics of clearing and OTC markets and which had been under review since mid-2007.  The letter said that the topic was of insufficiently general interest to warrant publication.  (It took 18 months to figure that out?)  Well, virtually all of the issues discussed in that paper were soon at the center of debates over financial reform and clearing mandates.  If the journal had actually published it in a timely manner, the editor would have looked prescient.  Instead . . .

But the blog gave me the opportunity to write about topical things in a timely way without having to deal with editorial gatekeepers (whose value added is not necessarily positive).  Although I know a number of who come here to read about Russia, or broader financial issues, groan when they see another clearing post or market structure post, these have served their role as first drafts for some serious academic work, and moreover, have had some influence in business and policy circles.  I’ve been gobsmacked on more than one occasion when some pretty prominent people have mentioned a specific blog post–by title–that had influenced their thinking.  I’ve also had the pleasure of hearing, sometimes directly, sometimes through back channels, that I’ve ticked off a few people.  Given who said people are, I consider it an honor.  I’ve been warned that if I want to have more influence, I need to be more politic.  (The other day somebody at a major financial institution told me that I risked being burned for heresy.)  Well, that cuts against my personal (Jacksonian) grain, and what’s more, being “politic” usually involves pulling punches and leaving important things that need to be said unsaid.  So, that’s not likely to happen.

Where will things go from here?  Who knows?  The moral of the story so far is that the trajectory of SWP is highly contingent on developments in finance, regulation, and yes, Russia, and those are all extremely dynamic.  The subject matter will probably stay in the same general ballparks–financial markets, especially their regulation; Russia; energy; climate issues from time to time–but the specifics will depend on how the world turns.  And the past five years have shown that the world does turn in highly bizarre directions.

I appreciate all of you that have come to visit SWP over the past five years.  It is truly gratifying, and completely unexpected.  It’s been an interesting and rewarding five years, and I look forward to engaging with you all in the years to come.  Thanks, and Happy New Year.

Bart Chilton has come out in support of a position “point” plan that would permit the CFTC to monitor trader positions, investigate positions larger than pre-set “points,” and vote to require traders to reduce any such positions.  As a result, it appears that this interim plan will go forward.

In some respects, this is better than hard limits, but many issues remain.  The proposal gives the Commission considerable discretion, and discretion can be misused and abused.

Here are several open questions.

First, what conditions would permit the ordering of a position reduction?  Must there be some showing of a market disruption?  In the language of the CEA, must the Commission show that the position in question represents “excessive” speculation?  How would that be defined, and what criteria would be used to evaluate whether it has occurred?  Must the Commission show that the position has caused “unwarranted” price fluctuations?  Or must the Commission merely show that the position has the potential to cause such unwarranted flucutations?  (“Bart doesn’t like it” shouldn’t be sufficient to justify a required reduction.)  If not, what is the statutory basis for the authority?

Second, what evidentiary burden must the CFTC meet to support any order to reduce a position?  That is, what evidence must the CFTC produce to support a finding that the position has caused a disruption/unwarranted price fluctuation (or has the potential to do so)?

Third, what recourse does the affected trader have to an order to reduce his position?  Can he appeal the decision?  To whom?  Can the trader get injunctive relief?

With respect to this third question, there’s an interesting case from 1979:

On Thursday, March 15, 1979, the Commission, pursuant to this section, issued an order to the Board of Trade of the City of Chicago (Board of Trade) to suspend all trading in the March 1979 Wheat Futures Contract (Contract) for the following day, Friday, March 16, 1979. The order stated that the Commission had reason to believe that an emergency within the meaning of Section 8a(9) of the Act existed with respect to the Contract in that significant transportation and warehouse facility shortages had caused a major market disturbance which prevented the market from accurately reflecting the forces of supply and demand. The order additionally specified that the Commission had reason to believe that there existed a threatened manipulation or corner in wheat as a consequence of this market disturbance and as a result of the combined long open positions maintained in the Contract by a small number of speculative traders.

. . . .

The Board of Trade complied with the Commission’s order, and all trade in the Contract was suspended on Friday, March 16. Throughout that day Board of Trade officials and the Commission communicated with each other concerning further trading in the Contract. On that Friday afternoon the President of the Board of Trade advised the Commission that under its own rules it had declared an emergency in the Contract and that trading would be limited to “liquidation only (except new sales for delivery only).”2 In response to the Commission’s inquiry concerning what reasons the Board of Trade intended to announce for issuing the order, the President of the Board of Trade stated that the true reason was the shortened trading period remaining due to the one day suspension of trading ordered by the Commission.3 After the Commission notified the Board of Trade President that such a reason was unacceptable, the Board of Trade issued its order which stated that “various factors” led to the conclusion that trading in the Contract should be limited to liquidation only.

That same evening the Commission issued a supplemental order. The supplemental order recited that the Commission continued to believe that an emergency existed with respect to the Contract, and that further action was appropriate. The Commission ordered the Board of Trade to:

(1) immediately terminate all trading in the Contract on March 19, 20, and 21, 1979, the three remaining trading days in the Contract;

(2) permit deliveries of wheat to be made in fulfillment of current open positions in the Contract through the last day permitted for delivery under the rules of the Chicago Board of Trade at the settlement price for the Contract in effect at the close of trading in the Contract on March 15, 1979; and

(3) settle all positions in the Contract remaining open as of the close of business on March 30, 1979, at the settlement price for the Contract in effect at the close of trading in the Contract on March 15, 1979.” (App. 5a)

On the next day, Saturday, March 17, the Board of Trade instituted this action in the district court seeking review of the Commission’s March 16 supplemental order. The complaint asserted that the Commission’s order was arbitrary, capricious, an abuse of discretion, not in accordance with law, and in excess of the Commission’s statutory authority because no emergency existed within the meaning of Section 8a(9) of the Act. The Board of Trade’s complaint sought an injunction restraining the Commission from enforcing its March 16 supplemental orde

Could a trader ordered to reduce a position initiate a similar action?

In my opinion, there is a legitimate reason for emergency authority (although I have argued frequently that ex post deterrence is superior to a market intervention) in cases of manipulation.  Given the inherent vagaries of the idea of “excessive speculation,” however, I have serious concerns about giving the Commission discretion to intervene selectively in order to force individual traders to reduce positions when manipulation is not suspected.  Any such authority should be constrained.  The Commission should be required to set out a coherent rationale for any such intervention; provide evidence that but for such intervention the existence of said position would cause prices to diverge substantially from the competitive level justified by fundamentals; offer the target of such action the opportunity to present contrary evidence; and permit review by a court.

Absent such protections, the market would be at risk to arbitrary actions based on flaky theories that have not been subjected to serious empirical test.  This would create an unnecessary regulatory risk.  Moreover, political economy factors could further distort the exercise of this discretion, as some traders (or other interested parties) may attempt to influence the Commission to take action against market rivals, or to bail out traders caught on the wrong side of the market.  Given the political and popular frenzy that sometimes accompanies big price movements, such perverse outcomes are well within the realm of possibility.  Indeed, I argued in my 1995 JLE piece on self-regulation that fear of such opportunistic intervention was a major reason why exchanges in the past failed to pass rules permitting the exchange to force traders to liquidate or take other actions that would potentially influence market prices.  I think these exchanges were on to something.  The CFTC should ponder that.

The Navy has relieved Captain Owen Honors* of command of the nuclear carrier USS Enterprise (CVN-65).  He was relieved over some videos he shot while executive officer of Enterprise in 2006-2007.  You can see some of the “XO Movie Night” vids here.  Warning: potential bandwidth issues.

Some would claim that the videos need warning for content too, and indeed, the Hampton Roads Pilot includes all sorts of scary warnings about the offensiveness of the content.  Hell, in the videos even Capt. Honors says some may be offended.

But seriously.  I’ve watched them.  Yeah, they are crude and vulgar. The humor is sophomoric–though at times pretty funny.  (At other times, not so much.)  There are gay jokes.  But anybody–anybody–who doesn’t think that every damn bit of this is, was, and always has been typical military humor is deluding themselves.  There’s a long tradition of Navy skits–in the fleet, and at the Academy–that were no different in content and tone than what’s in those videos; the main difference is that those skits weren’t recorded for posterity, to bite their creators in the butt years later.  And the every day conversation of sailors, soldiers, and Marines is peppered with similar material.

Ya think that just maybe that’s why the XO Movie Nights were apparently very popular?  That the crew of Enterprise understood that Honors understood them, connected with them, could relate to them?

XOs are usually the designated a**hole. They do all the captain’s dirty work.  They are the disciplinary heavies.  A popular XO is almost a contradiction in terms.  And a popular, and by all accounts I’ve read effective, XO seems almost miraculous.

But Honors crossed the gods of political correctness, so Off With His Head!

There is a lot wrong about this.  First, it’s not like this could have been a secret years ago, and was just discovered today.  Hell, these videos were played to an audience of more than 5000 crewmen.   Repeatedly.  If his commanders had a problem with it, they should have dealt with it then.  (The Enterprise had two officers senior to Honors aboard–the CO and an admiral.)  A probably apocryphal saying of John Paul Jones that all Midshipmen are required to memorize is: “Criticize in private: praise in public.”  At the very beginning, if this was a problem, somebody should have taken Honors aside–in private–and told him to knock it off.  That didn’t happen, and so today somebody with an agenda takes a run at Honors, and the Navy does a classic CYA.  That’s hardly a profile in courage.

Second, and perhaps more importantly, it is emblematic of a conformist Navy that punishes anybody who doesn’t toe the line.

I recall reading that a famous WWII admiral (I think it was Arleigh Burke, but it might have been Nimitz) said he didn’t want officers who didn’t get demerits at the Academy because it indicated that they were conformist, risk averse, unimaginative.  Those kind of officers make good bureaucrats, but bureaucrats don’t win wars.  Fighters and winners take risks.  They innovate.  They push the envelope. Great officers strike a delicate balance between obedience and independence–independence that can at times verge on insubordination.

Zero tolerance has become a plague in the armed services, and the Navy in particular.  That’s a recipe for creating a service dominated by colorless and timid officers who are neither inspiring to their subordinates nor likely to exhibit the daring that is often the difference between winning and losing in war.

There has always been a cycle in militaries.  The traits that are conducive to advancement during peacetime are not the traits you need to win wars.  So when wars break out, the upper ranks are stuffed with excellent bureaucrats who all too often make lousy combat commanders.  Those people end up getting shunted aside so that those who have a flair for command can take over.  Unfortunately, a lot of people get killed while the bureaucrats are in charge.

I mentioned Nimitz earlier.  Early in his career, he grounded a ship he was conning.  He was court martialed, but won over the court by arguing that destroyer commanders had to be devil-may-care types who took risks.  The court was lenient with him, and only reprimanded him.  I can’t see that happening today.

So what bothers me most about this Honors business is what it says about the Navy, and the message it sends to officers and sailors.  Be a good little do-be.  Don’t do anything that anybody might find offensive.  Be a bland, officious, and unimaginative bureaucrat.  That makes for a colorless Navy.  And when it counts, it makes for a far less effective one.

* Very distant personal connection to Capt. Honors: he was 34th company, class of 1983 at Navy.  I was 34th company, class of 1981.  Honors entered Navy in the summer of 1979, which is right when I left (in August), so I was not in 34 when he was.  But my classmates and friends in 34 were upperclassmen (2d classmen) when he was a plebe.  So I blame them for not crushing all originality and fun out of him.  Now, I’m sure that 34th company class of ’79 would have tried, but they were gone by then.  (Let’s just say that I had my issues with the ’79 guys in 34, and they had issues with me.)

In October, 2007, I wrote a post titled “Cocaine Blues” in which I noted the association between oil prices, and Soviet/Russian aggressiveness/obstreperousness/cussedness/hey-ma-look-at-me-top-of-the-worldness.

Anne Applebaum just noticed the connection:

Why the change of tone? Why now? Many complex theories have been hatched to explain it. This being Russia, none can be proved. But perhaps the explanation is very simple: Oil is once again above $90 a barrel – and the price is rising. And if that’s the reason, it’s nothing new. In fact, if one were to plot the rise and fall of Soviet and Russian foreign and domestic reforms over the past 40 years on a graph, it would match the fall and rise of the international oil price (for which domestic crude oil prices are a reasonable proxy) with astonishing precision.

To see what I mean, begin at the beginning: In the 1970s, oil prices began to rise significantly, along with the then-Soviet Union’s resistance to change. The previous decade (with oil prices at $2 or $3 a barrel, not adjusted for inflation) had been one of flux and experimentation. But after OPEC pushed prices up in the 1970s, oil revenue poured in – and the Soviet Union entered a period of internal “stagnation” and external aggression. Soviet leader Leonid Brezhnev invested heavily in the military, halted internal reforms and in 1979 (when oil was at $25 a barrel) – invaded Afghanistan.

Brezhnev was eventually followed by Yuri Andropov, who had the good fortune to run the Soviet Union when oil prices were still high (at his death, in 1984, they averaged $28 a barrel). Andropov could thus afford both an internal crackdown on dissidents and a continued tense relationship with the West. But Andropov was followed by Mikhail Gorbachev, who took over just as prices plunged. In 1986 (with oil down to $14 a barrel), he launched his reform programs, perestroika and glasnost. By 1989 (when oil was still only at $18) he allowed the Berlin Wall to fall, freed Central Europe and ended the Cold War.

Prices fluctuated, but they did not really rise again in the 1990s (plunging as low as $11 in 1998), the years when Boris Yeltsin was still trying to be best friends with Bill Clinton, the Russian media were relatively free and there was still talk, at least, of major economic reforms. But in 1999 (when oil prices rose to $16 a barrel), Yeltsin’s prime minister, Vladimir Putin, launched the second Chechen war, the West bombed Belgrade, and the mood in Russia turned distinctly anti-Western once again.

The fortunate Putin took over as president in 2000, at the start of a long and seemingly inexorable rise in oil prices. Indeed, Gorbachev’s calls for internal reform were long forgotten by 2003 (when oil prices were creeping up to $27 a barrel). The days when Yeltsin pushed for Russia to join Western institutions were a distant memory by 2008, when Russia invaded Georgia (and oil was at $91 a barrel).

The new Russian president, Dmitry Medvedev, did try to sound nicer in 2009 (when oil prices averaged about $53 a barrel), leaving Putin, now the prime minister again, grumbling in the background. Medvedev locked a draconian treason law, invited democracy activists to the Kremlin, denounced the Belarusan dictator and even seemed to some to have liberalized Russian television just a bit.

But now it is 2011, Putin is very much in the foreground, and Khodorkovsky has just been sentenced by a kangaroo court. As I write these words, oil is at $92.25 a barrel.

Is this analysis too simplistic? Sure it is. But I haven’t yet heard a better explanation.

That’s because there isn’t one.

And as Sergei Guriev and Aleh Tsyvinski note in their “Challenges Facing the Russian Economy after the Crisis” (in the volume Russia After the Global Economic Crisis, Aslund, Guriev, and Kuchins (eds.)), this is a big problem for Russia’s future:

Russia’s internal problems relate to the “resource curse.”  If oil prices remain high, Russia will probably delay much-needed economic reforms.

. . . .

But in Russia it is especially problematic [to improve economic and political institutions] as the ruling elite is not interested in building such institutions.  The “resource curse” provides and explanation.

Guriev and Tsyvinski argue that higher oil prices are antithetical to the political reforms that Russia requires to become a truly modern, innovative, entrepreneurial economy and more humane polity.  To which I would add they are also antithetical to the development of a more neighborly, less revisionist Russian foreign policy.

There’s another interesting implication of the rising oil price that hasn’t drawn attention, at least that I’ve seen.  In particular, it will intensify conflict between Gazprom and its customers.  Gazprom has historically sold gas under contracts with prices tied to the price of oil.  But oil and gas prices have diverged in recent years (for a variety of fundamentals-based reasons).  As a result, Gazprom’s big European customers want to change the contract terms and pricing, but Gazprom does not–and that’s an understatement.  The increase in oil prices has increased the divergence, putting Gazprom’s gas prices even more out of line with cash market values.  Which will only crank up the tension between Gazprom and its customers.  And since there is nothing that happens to Gazprom that doesn’t have a political angle, this will result in some political tensions as well.  (EG, how will BFFs Berlusconi and Putin deal with the issue?)

In a nutshell: higher oil prices will stymie domestic reform in Russia and fuel external tensions.  A fun time will be had by all, because Putin et al can’t lay off that whiskey, and let that cocaine be.

A couple of days back the WSJ ran a rather long article about the demise of the pork bellies contract at the CME. The story has an interesting historical angle, because about 50 years ago the bellies saved the Merc from its own demise.  In the 1950s, onions were the exchange’s lifeblood–its only really active contract–and onion trading was banned in 1958.  The Merc leadership seized on pork bellies as a replacement, and the contract was introduced in 1961.  It soon became a success, and likely saved CME from oblivion.  Given that the CME is now the world’s dominant futures exchange, and has been among the most innovative exchanges since the 1970s, the onion-pork belly saga is one of those contingent events that influenced the way the history of a major industry evolved.

It’s nice that the WSJ spilled some ink on the subject, but the economics in the article is something of a muddle.  Or, perhaps, to be charitable to the writers, they are channeling some muddle thinking.

To wit, the article states that in the absence of an actively traded pork belly contract, market participants have no reliable information about prices:

For independent bacon processors, the decline of the pork-belly futures contract has meant that belly prices are becoming a mystery. The amount they pay for spot bellies is now based on a daily price quoted by the Agriculture Department, which collects it from producers on a voluntary basis.

So what’s the proposed solution?  Cash settlement:

The CME and industry executives are trying to rejuvenate the pork-belly future. The exchange is looking at modifying some of the contract’s specifications, such as allowing traders to settle in cash instead of actual slabs of meat. Currently sellers, if holding a contract through expiration, must deliver 40,000 pounds of inspected frozen pork bellies with a producer certificate within 15 days, and a buyer must take possession. Another exchange idea: to trade fresh pork bellies instead of frozen ones.

“We are keen to change things as soon as we can,” said Tim Andriesen, managing director of commodity products at CME.

. . . .

Changing the contract from physical settlement to cash settlement could help. Financial traders have largely shunned the contract because it requires buyers to take possession of massive quantities of meat.

“For a contract to be successful, you have to have fund participation” from hedge funds and commodity funds, said Dan Norcini, an independent livestock trader in Idaho who has been trading commodities for more than 20 years. “There’re not enough volumes for them to move in and move out.” Mr. Norcini stopped trading pork bellies about three years ago.

So, because of the lack of active futures trading there’s no good information about cash market prices, so the contract should be changed to cash settlement to rejuvenate futures trading.  How does that work, exactly?  The circularity is dizzying.

Whenever a contract exhibits problems, regardless of the cause, it is too often the case that the knee-jerk response is to call for cash settlement.  (As another example, consider calls for cash settlement to fix perceived problems in wheat convergence.)  Usually this response is completely irrelevant to the contract’s real problem.

Cash settlement works if there is an independent, reliable, relatively unmanipulable source of cash market prices that can be used to set a futures price at expiration.  The markets for which these conditions prevail is very, very small.  Cash settlement works in equities for contracts like the S&P500/eMini because there is an active, transparent cash market for stocks.  It works pretty well for live hogs because the USDA collects data on the price paid for every animal bought by processors.

Beyond those examples, cash settlement is problematic, or in many cases, actually counterproductive.  In the late-90s/early-00s, cash settlement in natural gas indexes was rife with misreporting and fraud.  In 2008 I wrote a few posts about reports that banks were putting the lie in LIBOR.

Virtually no commodity market has enough active, transparent cash markets to support cash settlement.  In grains and soybeans, cash prices reported by the USDA are bids and offers from country elevators, barge loading terminals, and processors.  These aren’t bona fide cash transactions, and if these prices were used as the basis for futures settlement prices the temptation for the kind of monkey business that went on in nat gas in the Enron days would corrupt the grain business too.

Frequently the developments that create problems for a particular delivery-settled contract would create problems for cash settlement too.  For instance, the decline in terminal grain markets–most notably Chicago–created problems for the Chicago-based delivery system for corn, wheat, and soybeans in the 1970s and 1980s.  But the decline in terminal grain markets also meant that there were no longer vibrant centralized cash grain markets that could have been used to settle futures contracts.

In commodities in particular, the facts that futures markets are the locus of price discovery, and that market participants rely heavily on futures prices to set cash prices means that cash settlement is often problematic due to the circularity problem I mentioned earlier.

I would also note that, contrary to conventional wisdom, cash settled contracts are not necessarily less vulnerable to market power manipulation that delivery settled ones.  As I showed in a 2000 JOB paper, it is always possible to design a delivery settled contract that is less vulnerable to long market power manipulation than any given cash settled contract, but this delivery settled contract is more vulnerable to short market power manipulation.

Furthermore, the assertion that delivery creates headaches that financial players want to avoid should not be taken seriously.  Financial players trade vast amounts of delivery-settled contracts in a wide variety of commodities from aluminum to corn to crude to wheat to zinc.  (Indeed, isn’t that what keeps Bart Chilton up nights?)  They can–and do–liquidate/roll their positions before they need to make or take delivery.  (Which is why Bart should sleep better.)  The folks active in the delivery market are those who have the expertise and infrastructure to handle the physical commodity.  And ironically, some financial players are realizing that it can be quite profitable to develop that expertise and invest in that infrastructure for some commodities.

Finally, it should be recognized that delivery settlement has a compelling advantage.  At delivery, people have to put their money where their mouths are.  If they think futures prices at expiration deviate from cash market values, they can make or take delivery to take advantage of that perceived disparity.  Delivery is a bona fide transaction: an exchange of the thing for money.  Prices are intended to measure the terms of such transactions, and delivery–or the mere potential for delivery–ensures that happens.  In contrast, with a few exceptions, with cash settlement it is often very, very difficult to collect data from such bona fide transactions, or to execute the trades necessary to exploit perceived divergences between cash values and futures prices (with stocks again being an exception).

It’s long been known that most futures contracts fail because underlying conditions prevent their viability.  Frequently, these underlying conditions relate to industry structure (with vertical integration, for instance, being inimical to futures trading) and marketing practices.  These conditions can evolve over time, making once thriving contracts no longer viable.  That’s what’s happening in bellies, and cash settlement is not a magic formula that will change that.

My post on the Khodorkovsky verdict elicited a very nice comment from Deirdre McCloskey, whose “Bourgeois Dignity” hypothesis I had applied to Russia and its prospects for change.  The comment was–is–greatly appreciated, and in responding, another connection came to mind that deserves mention in a separate post.

McCloskey argues that the revolution in thought and attitude that laid the foundation for the miracle of modern economic growth began with the Dutch in the 17th century.  She notes that the “revaluation” of commercial and entrepreneurial activity began in the United Provinces, and that this elevation in the social status of merchants and entrepreneurs led to a flowering of technological and organizational innovations that was the real source of the explosion in incomes that occurred first in the West, and then worldwide.  Her arrow of causation is: beliefs/values/rhetoric=>innovation.  The former is a necessary condition for the latter.

In thinking about this in the context of Russia, what came to mind was that Peter I traveled (incognito) to Holland early in his reign and was astounded by the technology.  He attempted to bring as much of it back to Russia–a nation he considered backwards–as he could, in the hopes of wrenching the country into modernity.

But if McCloskey is right, Peter saw the results of a deeper underlying cause, but missed that cause altogether.  He saw the material technology, but missed entirely the social and intellectual and rhetorical and spiritual revolution that spawned it.  What was innovative about Holland was not its ships or its manufactures.  Instead, what was innovative–revolutionary–about Holland was its beliefs and bourgeois ideology.  Those created the conditions in which innovation flourished.

But Peter completely missed that.  He saw the superficial but missed the essential, and tried to make Russia modern using methods that were inimical to the Bourgeois Virtues (as McCloskey calls them).  Bringing Dutch technology to Russia, but deepening and intensifying Russian autocratic, anti-bourgeois institutions and values did not result in a self-sustaining modernization as was experienced in Holland, and later elsewhere in Europe.  That is consistent with McCloskey’s hypothesis: in her story, it is the beliefs and rhetoric that give free rein to human creativity that generate the innovation.  By failing to understand that, Peter failed to make Russia truly modern, and a center of self-sustaining innovation.

This is not a matter merely of historical curiosity.  For Peter’s attempt to achieve technological modernization while maintaining patrimonial institutions has been repeated throughout Russian history.  Indeed, yet another attempt is in progress today, with Skolkovo as the exemplar.  Elements in the Russian state want technological modernization, but don’t want social and political and intellectual freedoms (which they identify with “chaos”) that are the source of technological progress.  Again, McCloskey’s hypothesis would imply that this is a fool’s errand, and will turn out badly, as it has repeatedly throughout Russian history.  Which brings to mind Einstein’s definition of insanity which is the title to this post.

The Khodorkovsky verdict was announced Monday.  I don’t have much to say about the verdict itself that hasn’t been said already.  What I do find interesting is the Russian response to the near-universal foreign criticism of the outcome of the “trial.” 

Specifically, Foreign Minister Sergei (“The Spider”) Lavrov scuttled out to tell everybody (foreign everybodies in particular) to mind their own business.

Be careful what you ask for, Sergei, because as a result of the verdict, and the conditions that it epitomizes, foreign investors will be minding their own businesses thank you very much, and will be minding it somewhere other than in Russia–or at least not at the scale that the apparent opportunities would seem to justify. 

Yes, there will be exceptions, especially in retail and consumer products (as in the Pepsi deal for Wimm-Dann).  But even there the recent decision of Walmart to abandon plans for Russia, and the ongoing IKEA saga, demonstrate the trepidations that even heavy hitters have about investing in Russian retail/consumer markets.  Similarly, just because a politically connected behemoth like GE thinks that it has the heft and the influence to navigate the treacherous shoals of Putinland don’t conclude that others less hefty and less influential will have the same confidence.  Pepsi and GE are more the newsworthy exception than the unremarkable rule. 

And far more importantly, many Russians will conclude that minding a business is not worth the risks.  The Khodorkovsky prosecution, with its attendant absurdities, symbolizes quite graphically the arbitrariness of the system and the contingency of wealth and ownership in Russia.  This is a country where Putin has a call option on a business or a share of its profits; and where Putin deems a business to be unworthy of his attention, some local satrap has the call option.  And so it goes down the line, with the smaller the business, the smaller the thug (or thugs) with an option over the action.  But in the land of the raiders, every entrepreneur knows that his/her hard work–and his/her freedom or his/her life–is at risk to the depredations of some official or some mafiosi (to the extent that these are distinct classes, which too often they are not). 

The low rate of entrepreneurship and business formation in Russia is well known.  The reasons for it are not hard to find.  The Khodorkovsky saga is just the most notorious, larger-than-life, epitomization of a systemic problem.

It should be recognized, though, that this systemic problem is not easily addressed, because its roots are not merely political but cultural and historical: put differently, the political system is consistent with, rather than antithetical to, the beliefs of large numbers of Russians.  If there is anything to Deirdre McCloskey’s “Bourgeois Dignity” hypothesis–and I think there is, although I am not totally convinced–Russia is not fertile soil for modernization because of the widespread hostility towards entrepreneurial–“bourgeois”–values and enterprise. 

Indeed, Russia is McCloskey’s poster child for anti-bourgeois hostility and its corrosive effects on economic growth.  (McCloskey, nee Donald, I might add, was a student of Russian-born Alexander Gerschenkron at Harvard.)  This is not a new thing, but a very old thing, and hence quite difficult to change.

McCloskey points out that historically it was the outcast Old Believers that made up the bulk of the entrepreneurial class in Russia, to the extent it existed at all (and that many of the rest were Jews, also outcast).  Se further points to the zero-sum mindset that is characteristically Russian (and if you have doubts about that look at Russian foreign policy which oozes this mindset).  It is (was) widely believed in Russia that if anyone makes money, he made it by theft.  (Not that such beliefs are alien elsewhere, just that they are modal in Russia.) 

Sadly, there are many examples that support that belief.  (Arguably, Khodorkovsky himself for one, once upon a time.)  But that’s just a manifestation of a vicious circle, in McCloskey’s view.  To her, the cultural devaluation of bourgeois striving gives rise to a sort of Gresham’s Law, whereby the bad actors drive out the good.  If it is widely held that no respectable person goes into commerce, no respectable person will go into commerce.  Only a change in values–or the value placed on commercial activity–can make it possible to escape this fixed point.

So yes, the Khodorkovsky verdict is a bad omen.  But if McCloskey is right–and again, I think there’s a lot to what she has to say–Russia’s deeper challenges in achieving modernization would still remain even in the highly unlikely event that Medvedev were to rebel against the system that created him, realize his airy words about modernization and the ill effects of legal nihilism, and pardon Khodorkovsky tomorrow.  The Russian government and the Putin system are consonant with a set of beliefs that is deeply suspicious of people who mind their own businesses.  This set of beliefs is broadly held and long-established.  The system reinforces the beliefs and the beliefs reinforce the system.  This results in an equilibrium that will be hard to change, at least anytime soon.