Streetwise Professor

I just finished a marvelous history, James Hornfischer’s Neptune’s Inferno, a chronicle of the naval battles for Guadalcanal.  Most histories of the Guadalcanal Campaign focus on the grueling, bloody struggle between the US Marines (later augmented by Army units) and the Japanese defenders of the island.  But the US Navy actually suffered 4 times the number killed as the Marines and Army groundpounders.

The narrative itself is gripping, but the book raises some broader issues that have meaning beyond the narrow confines of The Slot.  Here are a few at random.

One relates to my earlier blog post on the fate of Enterprise XO Capt. Honors.  In that post, I mentioned that the characteristics that advance careers in peacetime are all too often positively detrimental in wartime commanders. Hornfischer’s history provides many examples of that phenomenon.  Many captains and flag officers at the beginning of the campaign, men who had been comers in the pre-war Navy, were tested and found sorely wanting in the crucible of battle.

Sometimes the critical weaknesses were psychological.  For instance, the commander in the South Pacific, Admiral Ghormley, was not mentally or psychologically suited to the stresses of a fluid, desperate campaign against at redoubtable and skilled enemy.

Other commanders were ineffectual because of their traditionalism, and the resulting blindness to the potential of new technologies, most notably radar.  The courage of Admiral Callaghan at the Night Battle of November 12-13 is beyond cavil, but he completely wasted his only advantage over the Japanese–radar–by his deployment (with radar equipped ships at the rear of his line), his choice of flagship (the San Francisco, his old command did not have the most advanced radar like that on the Portland), and the resulting confusion in communications as Callaghan tried to get information from the radar-equipped ships.

In contrast, the next night, Admiral Willis “Ching” Lee won a virtually single-handed victory in USS Washington because of his flawless use of the ship’s radar.  Lee was a close student of ballistics and gunnery, and unlike most of his peers he had understood the potential of the new technology of radar and mastered it.  As a result, Washington became the only battleship to sink another (the Kirishima) in WWII.

Another fascinating aspect of the book is how it makes plain the differences between sea and land combat.  Hornfischer points out that in naval combat, in contrast to modern land warfare,  the highest commander runs the same risks as the lowest rating.  Indeed, given the exposed nature of the bridges where captains and admirals stood, they were arguably at greater risk.

There are other differences.  Land warfare is often long stretches of tedium punctuated by horrific minutes of violence.  But this was even more extreme in the naval battles off Guadalcanal.  The Marines and soldiers ashore, and their Japanese adversaries, were under some risk almost continuously, but the sailors were in mortal danger for mere minutes.  The Friday the Thirteenth battle, for instance, raged for a mere 40 minutes.  But what minutes they were.  The intensity of the violence that occurred in those brief moments is hard to comprehend.  Massive shells crashing into small ships with horrific explosions.  The unexpected explosions of torpedoes that ripped ships into pieces.  Even one’s own guns wreaked havoc on one’s own ship: the concussion of the firing guns, especially the 8″ cruiser batteries and 16″ battleship guns, knocked men off their feet, knocked some senseless, and knocked about the interior spaces, strewing equipment everywhere.

And so many ways to die.  The sailors faced some of the same risks as the men ashore–death by small arms or artillery fire.  But they faced others.  Drowning.  Scalding.  Asphyxiation.  And burns.  The number of flammable things on a ship almost defies numbering: explosive shells, powder, ship fuel, the fuel and fabric of scouting planes, torpedo fuel, paint, solvents, cooking oil and fat, and even mattresses and bedding and life preservers.  Fighting fires is deadly difficult, because the best way to fight one kind of fire can be the worst to fight another. For a ship, the explosion of a shell or a torpedo is often the beginning of a trip to hell, rather than the end.

And yes, sharks too.  They killed hundreds of Americans in the waters of Guadalcanal: no doubt they killed hundreds of Japanese too. After a Japanese submarine torpedo demolished the USS Juneau as it limped away from the apocalyptic night action, many observers thought that no one could have survived the horrific explosion.   But many did, only to die over the following days of exposure, madness–and sharks.  (The Sullivan brothers, all five of them, died on the Juneau.)

The story of Guadalcanal also illustrates the aphorism that amateurs talk tactics, but professionals talk logistics.  All of the cataclysmic naval battles were part of a broader campaign to supply troops on the fetid jungle island or to deny the enemy the ability to supply his troops.  Both sides were fighting at the very end of their logistical tethers, thousands of miles from their home bases and hundreds of miles even from their forward facilities.  In the end, American logistics were barely enough, and Japanese logistics fell short.

In the end, it was a close run thing.  The Americans prevailed, but just.  In its own way, this was as miraculous as Midway.  At Midway, though, the miracle took about five minutes to complete–the time it took for American SBD Dauntless dive bombers to turn three carriers into burning hulks.  At Guadalcanal, the miracle took six months to accomplish.  In that time, an American fleet that was tactically and technologically and numerically inferior to an enemy that had won numerous smashing victories held on by its fingernails before prevailing.  It survived numerous mistakes–from the beginning at Savo to near the end at Tassafaronga.  It prevailed more by a bloody minded refusal to accept defeat than by smashing its enemy decisively.  It was a victory of will and courage and logistics, rather than tactical or operational virtuosity. It was a victory of survival.

Naval warfare gets short shrift, compared to the land campaigns of WWII.  Midway and Pearl Harbor and to a lesser extent the Battle of the Atlantic against Nazi submarines get most of what attention is directed to naval combat.  But all but forgotten campaigns like Guadalcanal were as decisive, and make fascinating reading on both operational and human levels as well.

I have only a couple of quibbles.  Although Hornfischer does not shy from criticizing the judgment of combat commanders on both sides, he seems to shy away from an analysis of the actions of Admiral Callaghan on 13-14 November.  Yes, Hornfischer criticizes Callaghan’s dispositions, his failure to use radar, and the defects in his communications.  But he does not render a judgment on Callaghan’s launching of his force into the midst of Abe’s huge bombardment fleet.  Was it a reckless, insane gambit?  Was it the result of Callaghan’s failure to plan in advance?  (He made no plan.)  Or was it the only way that an inferior, undergunned, thrown together force with a few heavy cruisers could have turned back a task force with as many cruisers, more destroyers, and two battleships?

Hornfischer seems to be following in the footsteps of Samuel Eliot Morrison, who in the Navy’s official history hailed Callaghan’s intrepid bravery, but did not delve deeply into the wisdom of the way he fought.

Hornfischer also does not discuss the role of US submarines in the campaign.  In some ways, that’s fair, because the US submarines played virtually no role.  But why not?  Hornfischer does not say.  Japanese submarines played a crucial part.  They sunk the carrier Wasp and the Juneau.  Their mere threat in “Torpedo Alley” affected American operations.  Why didn’t the US provide a symmetric threat to Japanese fleet operations?

Elmer Potter’s Sea Power (dubbed “Z Power”–“Z” as in zzzzzzzz by generations of USNA Midshipmen) attributes this to fear of friendly fire incidents.  Maybe so.  But deployments between Guadalcanal and Rabaul and Truk would have posed limited risk of fratricide.  One elderly US boat–the S-44–did sink a Japanese capital ship outside of Rabaul.*  What could several more modern Gato-type fleet boats have done?  Could they have disrupted Japanese operations as effectively and efficiently as a few Japanese I-boats did American operations? This deserves some discussion, which Hornfischer does not give.

But as I said, these are mere quibbles.  This is a fantastic book that serves as a fitting tribute to the Americans who fought, and who died horrific deaths and suffered grievous, gruesome injuries, in the narrow waters of Ironbottom Sound.

I have always felt humbled and awed when I step into Memorial Hall in Bancroft Hall at Navy, knowing what I did about the sacrifices made by the men memorialized there.  Those feelings will only be more intense when I return, after having read Neptune’s Inferno.  For the book makes plain how all the failings in command–which are ubiquitous in war–were redeemed by the tenacity and courage of average men who really had no business winning–but did.

* To give you an idea of the antiquity of S-boats, my grandfather served on a K-boat, USS K-2 in 1921.  He tells of watching the sea trials of the newfangled S-boats.  As I recall, in one story, the K-2 was detailed to follow an S-boat undergoing trials to provide assistance in case the newer vessel needed it.  And it did: the K-2 had to tow in the S-boat on one occasion.

With the ink barely dry on the START Treaty, Russia is warning the US on missile defense:

The treaty doesn’t prevent the U.S. from building new missile defense systems, but Russia has warned that it reserves the right to withdraw from the treaty if the United States significantly boosts its missile shield.

Russia’s Deputy Foreign Minister Sergei Ryabkov reaffirmed Monday that a buildup in the U.S. missile defense capability would prompt Moscow re-consider its obligations under the New START treaty.

“If the U.S. increases the qualitative and quantitative potential of its missile defense … a question will arise whether Russia should further abide by the treaty or would have to take other measures to respond to the situation, including military-technical measures,” Ryabkov said, according to Russian news agencies.

The US takes the view that START does not constrain its ability to pursue missile defenses.

Does not! Does so! Does not! Does so! Does not!  Does so!  Always the hallmark of a well-crafted treaty. Somehow I don’t think this one meets Bismarck’s criteria.

The Russians keep flogging the idea of a truly joint defense system, but this makes little sense operationally, strategically, or politically for NATO and the US.  The Russian desire to ensnare US efforts in a joint system over which Russia will have a veto appears to be fears that the Dr. Strangeloves in the Pentagon are pining for the fjords:

Russia’s top brass has convinced the Kremlin that by 2020, the NATO missile defense system would be able to intercept any Russian nuclear missiles fired at the United States along a North Pole trajectory. According to this theory, NATO will try to hide its ships equipped with Aegis missile defense systems in the Norwegian fjords. Therefore, the argument goes, the Kremlin must convince NATO to sign a legally binding agreement promising not to deploy missile defense systems on any territory over which Russia’s nuclear missiles would travel.

The 2020 nightmare date appears to be based on this time line from the US Missile Defense Agency, which sets a goal of 2020 for providing the SM-3/Aegis system with capabilities against ICBMs.  (Earlier versions are are capable against medium and intermediate range missiles–MRBMs and IRBMs.)  Although here it appears that the SM-3/Aegis ICBM capability will be land-based, rather than seaborne.

And the irony is just too much.  Remember just why the US shifted its focus to Aegis/SM-3: in deference to previous Russian hissy fits, the US decided to terminate its plans to deploy land-based ABM systems in Central Europe (Czech Republic and Poland), and replace this system with a sea-based system that would not require the use of radars that would peer into Russia.  (SecDef Gates denied the change was a response to Russian complaints about the Czech-Polish bases: let’s just say that Gates’s denial was taken with massive amounts of salt.)

A Czech-Polish-based system would have posed absolutely no threat to Russian ICBMs on a polar trajectory.  None.  But the Russian military is now afraid that the replacement will. Careful what you ask for, guys.

But it’s more likely that the Russian military is just reprising its well-practiced Roseanne Rosannadanna “It’s always something, if it’s not one thing it’s another” routine (at about the 3:14 mark).

Speaking of START and hissy fits, Senatorial fossil Richard Lugar threw one about it, this time defending the treaty against Tea Party attacks:

I’ve got to say ‘Get real’. I hear Tea Party or other people talking about they were against START. If you want to get into START, let’s talk about it, but realistically as Americans, not as some Republican renegade. [I’m] trying to take warheads out of Russia so they won’t hit Indiana.

Uhm, except this START doesn’t take any warheads potentially aimed at Gary (or anywhere else in the US) out of Russia.  Don’t believe me.  Consider the statement of someone whose opinion really matters, Russian Defense Minister Serdyukov:

In Moscow START III is viewed as essentially a technical agreement to preserve a credible nuclear deterrent against the US by forcing the Pentagon to downsize its nuclear arsenal to help Russia maintain a balance and contain a dangerous opponent. During ratification procedures in the Duma, Defense Minister, Anatoliy Serdyukov, announced: “It is a very useful treaty –it allows us to significantly increase our [nuclear] armaments, while the Americans will have to cut theirs.”

Read that last piece again: “It is a very useful treaty –it allows us to significantly increase our [nuclear] armaments, while the Americans will have to cut theirs.”  Yo, Dick: doesn’t sound like the treaty is getting any missiles out of Russia.  To the contrary.

START, in other words, is aptly named.  It isn’t the end of anything.  It’s just the beginning–the start–of a new round of squabbling and dispute both between the Russians and the US, and within the US.

The big news in Exchangeworld is the likely merger of NYSE-Euronext and Deutsche Borse.

This reflects in some sense a return to financial normalcy in the aftermath of the crisis.  The years leading up to the crisis saw a plethora of exchange mergers and combinations, but the pace of consolidation slowed noticeably in 2008-2010.  Now it is picking up again.

Both NYSE-Euronext and DB operate cash equity and derivatives exchanges.  The former operates NYSE, of course, and also European equity markets in the Netherlands, Portugal, France, and elsewhere, and the LIFFE derivatives exchange in London.  The latter operates the German stock market, a US-based options market ISE (a purchase in the pre-crisis boom which turned out to be a rather bad deal for DB) and the Eurex derivatives exchange which trades equity options and a wide range of financial futures.  DB is highly vertically integrated; most importantly, it operates its own execution and clearing platforms in both equities and derivatives.  LIFFE historically outsourced its derivatives clearing to LCH.Clearnet, but is also vertically integrating into clearing (although it still contracts with LCH for some clearing services).

Cost savings are the major driver of this merger.  There are substantial scale and scope economies in execution systems.  In derivatives, moreover, there are substantial scale and scope economies in clearing.  In particular, margining and netting efficiencies reduce customer capital costs.

The competitive effects are likely to be relatively small, even though that has been a focus of a lot of the commentary.  Cash equities are already ruthlessly competitive, especially in the United States: RegNMS socialized order flow, eliminating any tipping effects, as demonstrated by the precipitous decline in NYSE market share from the mid-80s to the mid-20s in the years following RegNMS.

With respect to derivatives, the LIFFE and Eurex do not compete head to head in any major product.  Cross-product competition is relatively tame in futures.  And just as with the CME-CBT merger, putting LIFFE short term interest rate futures and UK government bond futures and Eurex European bond products on the same platform would facilitate spreading trades and enhance liquidity and reduce trading costs and execution risks for customers.

Nor do LIFFE and Eurex compete head-to-head with any CME product.  Thus, the direct competitive effect of the merger on CME is also likely to be relatively mild.  By reducing trading and clearing costs, a LIFFE-Eurex combination may attract some business from CME product groups to its product groups, but again, these inter-product class cross elasticities do not appear to be large.  Order flow has not been socialized by regulatory fiat in derivatives on either side of the Atlantic, meaning that the order flow network effect is still in place.  This means that LIFFE and Eurex could not credibly compete against CME on its home turf (each had conspicuous failures trying): it also means that a combined LIFFE-Eurex will face daunting obstacles in trying to do so.  Indeed, I doubt they will seriously try; twice burned, thrice shy would be a reasonable motto.

Consistent with this, CME Group’s stock price has been up close to 2 percent since the news of the potential tie up became public.

The biggest uncertainty surrounding the deal involves European antitrust approval.  As noted above, the merging exchanges are not direct competitors in any major product.  In the US, in the mergers of CME and CBT and CME and NYMEX, that fact was decisive in avoiding  Justice Department challenges.  It should be in Europe too, but I’m not as familiar with European antitrust thinking or precedents so I’m not sure they’ll see it the same way.

The most interesting question involves clearing.  European policymakers have been critical of vertical integration in clearing.  (The USDOJ is too, but only disclosed its (economically nonsensical) objections after the CME-NYMEX merger closed.)  They deem vertical integration as anticompetitive, and have failed to consider seriously the efficiencies that integration can generate (a subject I’ve written a lot about on SWP and my academic research).

Given this skepticism, the Euro antitrust folks may view this merger as an opportunity to open up access to clearing at Deutsche Borse and LIFFE.  That is, I could see them conditioning approval of the merger on the parties’ agreement to open up access to their clearing services.  It will be interesting to see whether they attempt to do so: I estimate that there is a non-trivial probability of this happening.  If they try, it would likely be a deal killer.  DB in particular has been adamant that integration is an essential part of its model and strategy, and LIFFE has adopted that view as well.  A deal becomes much less attractive–and, in my opinion, unattractive–if it requires a fundamental transformation of the exchanges’ business models.

The news of the potential deal has sparked considerable speculation about other tie-ups.  One commonly heard belief is that CBOE is the odd-man out, and that it should tie up with CME.  Other than the fact that both have “Chicago” in their names, these entities don’t have a lot in common, or a lot to gain by combining. In particular, there are no benefits on the clearing side. There are no economies on the regulatory/compliance side.  There are not really big advantages on the system side either.  So, other than savings on letterhead and some management salaries, there is nothing to be gained by merging.

It is likely that many more possible combinations will be mooted and discussed in the coming days.  I’ll be among those discussing them, but that will have to wait.  For teaching calls.  It’s rough work, but somebody has to do it.

I know that more than a few of you get bent out of shape when I bash Obama.  Sorry, but there are times it just can’t be helped–and which it is justly deserved.

Like now, with regards to his two most recent signature economic initiatives: high speed rail and corporate social responsibility.

I mean, seriously.  If trains get you off, buy a Lionel and spare us subsidizing high speed rail to the tune of billions of dollars.  It’s economic insanity.

Don’t take my word for it.  Harvard’s Ed Glaeser has run the numbers, and they don’t add up.  Not even close.  Not even when you incorporate generous estimates of the environmental benefits.  Glaeser always make assumptions that err on the side of making rail look good, and it never does.

What’s more, I haven’t even seen anyone attempt to make the other standard argument for subsidies, namely, that there is some sort of information externality, arising from learning-by-doing, for instance.

Big government types need to get over their Edifice Complex, and stop deluding themselves that subsidizing the inefficient creates wealth.  And in most circumstances–including virtually all of those things like high speed rail, renewables (e.g., windmills and solar), electric autos, etc., that this administration pushes–the fact that something requires a subsidy to come into existence tells you it is a turkey.

Insofar as the corporate responsibility thing goes, Stephen Bainbridge does a brutal takedown based on transactions cost economics considerations.  But there are other equally good reasons to reject forcefully the corporate responsibility theme.  Most importantly, there is the Knowledge Problem.  Good intentions are not enough.  You need to have information.  Corporations that maximize shareholder value (or profits) respond to economic signals in the form of prices.  Prices summarize vast amounts of information about the value of resources in alternative uses, and in a profit-driven system provide an incentive to direct those resources to their highest valued use.  As that noted right wing radical Bertrand Russell said, efficiency is the highest form of altruism.  In striving for efficiency, using resources efficiently in the way prices direct, corporations are acting in a responsible, altruistic way–even if that is not their intent.

Prices and profits are signals that corporate managers and directors can understand and respond to.  Vapory concepts of “social responsibility” provide no real guide as to the costs and benefits of alternative actions.  This is just a concept that can be enlisted to advance political agendas, and to rationalize the direction of valuable resources to those making claims for them that cannot be justified based on economic calculation.  There is always an unlimited supply of people clamoring that they are truly deserving: how is it possible to choose between these competing–and collectively unachievable–demands?  It isn’t.  And it is pointless and wasteful to expect corporate managers and directors to do so, rather than do what they are capable of doing–directing resources to the highest value resources, as indicated by prices.

Sometimes prices are misleading, because of externalities, for instance–or because of government policies (e.g., tariffs, explicit and implicit subsidies).  But as Bainbridge says, there are other, more targeted ways to deal with those problems.  These include specific legislation, regulations, and the tort system.  All are imperfect–believe me, I know–but at least there are procedural checks and balances that force some attempt to justify the benefits and costs, and provide an opportunity for others to challenge these claims.  In contrast, imposing some sort of vague duty on corporate officers to “do good” is subject to no such checks.  Some may try to do good, but may do ill instead because they lack the incentive or information to do real good.  Others may use “social responsibility” to indulge their own preferences while imposing great costs on others whose resources they utilize in the cause.

But more ominously, creating a presumption that corporations have some broader social responsibility subjects them to political pressure, often verging on blackmail and at times crossing over that line.  It effectively subordinates corporations–and hence their living, breathing shareholders, for those who recoil at the idea of assigning personhood to a corporation–to politicians who arrogate to themselves the role of speaking in the public–“social”–interest.  This is exactly why the idea is catnip to progressives like Obama.  They don’t like government power constrained by Constitutional and procedural checks and limits.  They don’t like limits on their discretion.  Passing laws or imposing regulations that are subject to legal challenge are a lot harder than executing a shakedown.  Once corporate executives concede that their responsibility is not limited to maximizing shareholder value, they become political puppets always vulnerable to such shakedowns.  There are always competing claims on corporate resources, and political entrepreneurs more than willing to exert those claims.

If you want to see extreme examples of how this works, look at Chavez in Venezuela, or Putin, both of whom browbeat corporations and investors to direct resources to their pet causes in the name of “social” objectives.  And no, I’m not saying Obama=Chavez.  I’m only saying that looking at something in its most purified or extreme forms is often the best way of identifying the essential principle.

The corporate responsibility movement is just another flavor of corporatism.  A conscription of private resources to achieve political (and usually redistributive) objectives, but without the procedural hurdles that constrain such conscription via legislation, regulation, or adjudication.  Which is exactly why progressives like Obama find it so attractive.

The SEC is continuing to flog the idea of imposing obligations on high frequency traders:

Regarding market structure, Schapiro said more work needs to be done to shore up investor confidence and transparency amid advances in high-speed trading.

“We are examining trading or other obligations that might be required of today’s de facto market makers: the high-frequency traders,” said Schapiro during remarks at SEC Speaks, a conference hosted by the Practising Law Institute.

“We are asking if these firms should be subject to an appropriate regulatory structure, including with respect to their quoting and trading activities.”

As I’ve said numerous times before: ain’t nothing for free.  Obligations impose costs, and the costs may be large as what Schapiro describes would constrain HFTs to offer more liquidity during times of high risk/uncertainty; if the obligations are binding, it means that HFTs must incur very high costs to supply liquidity during these periods as some prefer to make no market at all, or only very wide markets then.  They only act in that way if it is extremely risky–costly–to make markets then.

These costs must be covered.  Since entry into the market is relatively free, market makers earn a competitive rate of return on their capital.  Higher costs in some states of the world depresses that rate of return, leading to an exit of capital and higher trading costs for liquidity consumers at other times.  Thus, imposing obligations will reduce liquidity on average, and redistribute liquidity over time.

It’s also important to remember that the withdrawal of capital will offset even in volatile times the liquidity-enhancing effects of the obligations.  Yes, those market makers who remain will put a bigger fraction of their capital at risk during those periods, but there will be less of it overall to risk.  The net effect is likely to be positive during these volatile times, but probably not as much as Schapiro and others believe.  It seems that they assume that the obligations are costless and will not affect the supply of market making capital.

It is also costly to enforce these obligations.  It is costly to specify them.  This is especially true with HFT.  Liquidity has many dimensions.  How do you specify obligations on all dimensions?  What happens if crucial dimensions are left out of the rules?  How can programmers game the rules?  I have seen no serious discussion of these issues from Schapiro et al.  Economists are often–rightly–ridiculed for assuming the existence of 100 story ladders to rescue them from burning high rises, but regulators and legislators are far, far worse in this regard.

Historically, the NYSE imposed obligations on specialists.  But it compensated the specialists by giving them privileges: these privileges inflated trading costs during periods when the constraints weren’t binding.  Enforcing the constraints wasn’t easy, and in periods of extreme stress–such as 19 October, 1987–it is hard to judge whether they really performed the way their advocates would like.

Other markets–the futures exchanges, most notably, and the OTC stock and derivatives markets–have never imposed obligations.  It’s by no means clear that they’ve suffered as a result.   If these constraints are beneficial, why wouldn’t exchanges implement them unilaterally?

For once, I would like to see a serious analysis of the costs and benefits of obligations.  Schapiro keeps touting them, hyping their benefits but never even acknowledging the costs.

A serious argument would require identification of some sort of externality.  There have been papers (Greenwald-Stein in the aftermath of the ’87 Crash comes to mind) that have done so.  But even in the context of those models, it’s not obvious that market making obligations are the best way to respond to uncertainty shocks.  Greenwald-Stein argue that trading halts–circuit breakers–can handle the problem.  In the old NYSE, specialists could call trading halts when order imbalances became extreme.  This has some advantages over price-based circuit breakers, but in the current decentralized market structure, it’s hard to observe aggregate order imbalances–ironically, this is a consequence of an earlier SEC initiative, RegNMS.

Schapiro talks a lot about market maker obligations.  Well, what about regulator obligations?  Like the obligation to make a serious case based on a well-thought out diagnosis of the problem, and a careful identification of the sources of costs and benefits, and quantification thereof.  Liquidity was in short supply during the Flash Crash, but regulators acting in such a responsible way are in chronic short supply, especially in the world of Frank-n-Dodd.

This article from John Helmer’s Dances With Bears provides a fascinating case study on the operation of the Russian natural state.  He describes how the government, in the forbidding form of Oleg Sechin, guides (to put it euphemistically) negotiations between consumers and producers of metals:

Deputy Prime Minister Igor Sechin, who supervises the Russian metals and mining sector, convened a meeting with the federal government’s industry administrators and price regulators, along with representatives of the steel and carmakers. Mordashov attended for Severstal, along with Igor Komarov, chief executive of AvtoVAZ, Russia’s largest carmaker. Others attending included the two other domestic auto sheet suppliers, Magnitogorsk and Novolipetsk, and other automakers — GAZ, Sollers, and Kamaz, which builds mostly trucks, buses, and utility vehicles.

Sechin listened to the applications, and then issued his orders. Steelmaker Severstal was told to reopen negotiations with AvtoVAZ over the former’s proposed 30% price hike for auto steel supplies. The Federal Antimonopoly Service (FAS), which had earlier ruled that the Severstal price was in line with raw material cost growth and international price benchmarks, was also ordered to reopen its inquiry with different comparative criteria.

That last touch, with Sechin directing the FAS to get its mind right and revise its methodology in order to generate the politically approved results, is priceless (no pun intended).

Note too how the government is more than willing to use tax and trade policies in order to manipulate domestic prices in order to achieve the desired allocation of rents between consumers and producers;

The cane wasn’t mentioned or waved about. But Sechin didn’t need to remind everyone in the room that the government is considering a tax or duty on exports of steel, maybe iron-ore too, unless the producers curb their appetites and make an agreement on a new domestic price.

Documents leaked fron the federal Ministry of Economic Development, and published in a Moscow newspaper on January 27, reveal that two options for the export duty level have been proposed — one fixed at 10% for steel and 30% for iron-ore; and one a sliding scale tied to international prices for these commodities. The more the Russian exporters try to capitalize on rising international steel and iron-ore prices, the bigger the margin the Kremlin plans to take from them as their cargoes leave the port, possibly to add as cost and sale price subsidies to the carmakers.

According to Vladimir Zhukov, steel analyst for Nomura in Moscow, “we have been told that the prime cause for the government thinking in this direction is an attempt to help the domestic car industry which struggles to achieve decent profitability levels (if any profitability at all).”

Zhukov’s report for Nomura’s clients suggests that rises in coking coal, scrap and iron-ore are likely to engender a steel price rise over the year of about 15%. Zhukov adds that “we understand from industry sources that Russian auto manufacturers are already buying galvanized steel (the main steel product supplied to car manufacturers) at some 10-15% discount to Europeans (approximately $850/t vs $930-1000/t). Therefore, introducing export duties on steel will widen this discount even further.”

States like Russia use state power to fine-tune the allocation of wealth between different individuals, firms, and sectors.  (Yes, this happens in the US too, but the process is quite different; in particular, it is fenced in with a variety of political and legal constraints that make Sechin-like interventions impossible.)  This is a linchpin of a broader strategy to maintain political equilibrium.  Creative destruction is an anathema there: these efforts to maintain stability are antithetical to economic dynamism and innovation.  Hence, the actual operations of the government undermine the soaring rhetoric about modernization.

The process Helmer describes also provides an illustration of a point I’ve made several times before.  Namely, that the Russian government relies heavily on  export and import taxes as a means to manipulate rent distribution for political purposes.  This is incompatible with WTO obligations, meaning that when Russia joins the organization it is almost certain to be involved in chronic conflicts with it.  (For corporate analogies, just look at the ongoing warfare between AAR and BP over TNK-BP, and between Telenor and Vimpelcom.)

And speaking of broad strategies to maintain political equilibrium, another element in this strategy is information control.  Along those lines, Russia has denied entry to Guardian reporter Luke Harding, a consistent critic of Putin specifically and the Russian government generally.  The beat goes on.

Fed Chairman Ben Bernanke’s flippancy in dealing with serious questions is becoming more and more disturbing.  He responded to legitimate questions about the credibility of the Fed’s promises to cut back on its expansive policies if inflation appears to be picking up by saying that he could raise interest rates in five minutes, if need be.  Procedurally, this is true, but substantively, this is a non-answer because it completely ignores the credibility issue: would the Fed have the political will to implement controversial rate hikes when the economy is still less than robust (as today’s employment report makes plain)?

But yesterday his flippancy soared to new levels (sort of like the monetary base and the Fed balance sheet).  In response to questions about the effects of QE2 on inflation around the world–notably food price inflation that has helped spark unrest in Egypt and elsewhere–Bernanke was dismissive:

Answering questions after a speech at the National Press Club in Washington, Mr Bernanke said that rising food prices in the emerging world reflected the growing wealth of their populations and, in some countries, a failure to tackle inflation.

“They can, for example, use monetary policy of their own. They can adjust their exchange rates, which is something that they’ve been reluctant to do in some cases,” Mr Bernanke said.

Here’s more:

“I think it’s entirely unfair to attribute excess demand pressures in emerging markets to U.S. monetary policy, because emerging markets have all the tools they need to address excess demand in those countries,” he said in answering a question from the audience. “It’s really up to emerging markets to find appropriate tools to balance their own growth.”

Here’s an analogy.  Neighbor Ben is lighting bonfires in his yard in a windstorm.  He responds to your complaints that the flames and sparks from his fire have torched your bushes and threaten to set your house alight by saying: “You have all the tools you need to address the problem.  You could buy a fire extinguisher.  You could soak down the roof of your house.  You could move.”

Food price spikes in particular have been fueled largely by supply shortages, but the boom in commodity prices is so widespread–from copper (now over $10K/tonne) to oil ($100+ for Brent), to cotton (leading to an extraordinary exchange intervention) that it is difficult to deny that expansive US monetary policy has something to do with it.  I say again.  Bernanke has justified QE2 by citing deflationary fears: when–ever–has a deflationary cycle been accompanied by spiking commodity prices?  Usually commodity prices plunge the most.  At least, this should be sparking some cognitive dissonance, a recognition that this isn’t your grandfather’s Depression–even if said Depression was the focus of your academic research.  (Generals fighting the last war are very dangerous–to their own side.)

Bernanke is also rhetorically slippery.  He says that “it is entirely unfair to attribute excess demand pressures in emerging markets to U.S. monetary policy, because emerging markets have all the tools they need to address excess demand in those countries.”  That is a non sequitur.  It is entirely possible–and indeed extremely plausible–that US monetary policy has a lot–a lot–to do with excess demand pressures in emerging markets.  That’s the underlying shock: at least it’s one, big, undeniable shock.  The channels of transmission are plainly evident.  Whether countries have the policy tools to respond to that excess demand is an entirely different issue; whether they use them is another.  The source of excess demand pressures and the response to it are completely distinct.  Your failure to buy a fire extinguisher to defend yourself against Neighbor Ben’s pyromania does not mean that the pyromania is an illusion.  It is illogical to claim that because countries have not responded to X the way Bernanke would prefer, X therefore does not exist.  And QE2 is the big X factor.

Bernanke may have let the cat out of the bag and revealed an important–but not publicly emphasized–rationale for QE2 in his remark that countries “can adjust their exchange rates.”  Namely, this suggests that QE2 is intended primarily to reduce the value of the dollar.  To put pressure on countries–most notably China–to let their currencies rise relative to the dollar.  By a lot.  This is, in essence, a big game of chicken between Bernanke and policy makers around the globe–and most importantly, in Beijing.

Inflation is painful.  Currency appreciation brings its own kinds of pain, in the short run, anyways.   Countries are understandably–predictably–reluctant to let it happen.  QE2 has put them between a rock and a hard place.  And the choice is particularly discomfiting in China.  The Chinese have their own rather deep concerns about the robustness of the economy and the potential for social unrest.  Moreover, historical grievances and a current sense of ascendency make them particularly reluctant to knuckle under to the US.  So the game of chicken is likely to continue, and end with a crash rather than a saving swerve by the Chinese.

But even if the game is between the US (and the Fed in particular) and China, the repercussions are global in scope.  The collateral damage is already large, and threatens to spin out of control.  We are in a Year of Living Dangerously, and despite Bernanke’s flat (but illogical) denials, a major source of that danger is US monetary policy.

The controversy over the merits of the CME-NYMEX crude oil futures contract (West Texas Intermediate, WTI, also known as light crude, CL) vs. the Brent alternative is heating up again. In recent months, the spread between WTI and other crudes has widened, with WTI trading substantially lower than Brent, and US Gulf Coast prices (e.g., Louisiana Light Sweet–LLS–and Mars blend).

Critics of WTI question the long run viability of the contract. This is economically non-sensical. If there is a problem with WTI, it is a short run one; the very price relations that have drawn criticism provide the signal and incentive that will lead to its correction in the “long run”–as economists define it. Not “in the long run we are all dead” long run, but in the time frame that it takes to make adjustments to fixed capital such as pipelines and refining. This long run will arrive far before most of us are dead (based on reliable actuarial information:)–a period measured in months, rather than many years.

The WTI “disconnect” as it is sometimes termed reflects fundamental conditions in the oil market. (As an aside, those who obsess about the impacts of speculation should explain how speculation can wildly distort levels of prices but fundamentals drive intra-commodity price relations/spreads.) Increasing Canadian and US oil production has ensured that the US Midcontinent is well-supplied with crude. Indeed, along with demand that is still somewhat sluggish, this increased supply has led to increased inventories of crude in beautiful, windswept Cushing, OK. Cushing is the largest storage location in the US, and is the delivery point for the CL contract. At present, oil cannot flow from Cushing to the Gulf Coast. Gulf Coast refineries rely on US domestic crudes produced in the Gulf of Mexico (GOM) and imported crudes. The abundant supply of crude to the Midcontinent combined with the current inability of oil to flow from the Midcontinent to the Gulf has led to the widening basis.*

If you have been long WTI and short LLS (or some other Gulf Coast price) that relative price change is a problem (although it has been a boon if you have been short WTI and long the Gulf). But that problem is also an opportunity. It is a signal of the value of investments in capital that can move oil from the Midcontinent to the Gulf, and in refining capacity in the Midcontinent that can soak up some of that additional oil.

And indeed, a pipeline project–the third stage of the Keystone pipeline–is currently awaiting regulatory approvals.  With timely approval, the pipeline could go online in early-2013.

Indeed, adjustments are occurring even in the short run: the price relations are such that it is attractive to ship oil by rail–almost a throwback to the Rockefellar days–from the rapidly growing Bakken fields in North Dakota to the Gulf.  Moreover, Midcontinent refiners are operating at substantially higher rates than those elsewhere in the US.   (It is likely that in the longer run that refining capacity in the Midcontinent will expand relative to capacity in the Gulf to reflect the increased supplies of crude in regions tributary to the Midcon.)

Ironically, environmentalist opposition supposedly intensified by the Mocondo spill is the main obstacle to timely completion of Keystone.  Ironic because pipeline transportation is safer than deepwater production and seaborne transport (although it is not without environmental risk).  So delaying the pipeline only increases reliance on the riskier alternative.

So, like many economic “problems”, this one is self-correcting if the market is allowed to respond rationally to price signals.  Economic actors are ready to respond rationally.  Now it remains to be seen whether the political actors will do so.  Always a much more problematic proposition.

Several people have asked me whether it would be advisable to develop a new futures contract that would price off of seaborne crude or domestic production in competition with seaborne crudes: an LLS contract, for instance.

Having been intensely involved in the design of several commodity futures contracts, I am less than enthusiastic.  Sometimes the “long run” in designing a futures contract–going from the idea to the actual implementation–is longer and more treacherous than doing something like building a pipeline over hundreds of miles of Oklahoma and Texas prairies.  The implementation details are very difficult to get right.  Moreover, there are many parties with conflicting interests who try to influence the design to benefit them.  A futures contract is a one-size-fits-all endeavor, and it is very difficult to choose which suit gives the least bad fit to the most people.

Moreover, there is a kind of Heisenberg principle at work.  Designing a futures contract around a particular location and grade can change the pricing behavior of that location and grade.  You have to be sure that the logistics and infrastructure are robust enough to handle the demands of being a delivery point (or cash reference point).  That’s not easy to do.

What often happens is that dissatisfaction with one delivery design leads to inquiries which prove that that design is the worst possible one, except for all others that could be tried.

With respect to WTI, the economic factors that are the fundamental source of the current criticism could be a boon in the longer run, especially if the market is allowed to function and capital adjusts in response to changes in production and consumption patterns.  Historically, the US market was in supply deficit, and WTI traded at a premium to attract Brent in addition to other foreign crudes.  But currently the forward curves for WTI and Brent show WTI at a discount going out years.  This means that the market is anticipating that Cushing will be abundantly supplied for years–while Brent/North Sea production is inexorably declining.

The major problem that raises worries about the long run viability of a futures contract design is lack of supply.  Long run changes in grain marketing patterns put the terminal market in Chicago into terminal decline (no pun intended).  That caused serious difficulties with CBT corn, wheat, and soybean futures contracts.  Those problems took years to correct, and only after extremely rancorous infighting over how to change the contracts to address the problem.  (Efforts that I was involved in from 1990 through 1997–that timeline alone speaks volumes.  And I can speak authoritatively about the rancor, having had some of it directed my way–almost resulting in a fistfight with a prominent grain trader.  True story.)

The increased Canadian and North Dakota production, reflected in part by the forward WTI discount vis a vis Brent, suggests that over the longer term the Cushing-based WTI contract does not face the prospect of a similar supply problem.  Moreover, the delivery in-store (or through pumpover) design for the CL contract offers many advantages over the much more cumbersome and opaque Brent pricing mechanism, not least due to the fact that Brent trades in huge cargoes whereas delivery in-store at a market served from a variety of supply sources with a variety of demand outlets permits greater flexibility in logistics and trade sizes.

In sum, the conditions that have created the wide spreads are self-correcting:  those self-same spreads give the incentive to make adjustments in transportation (and also production and consumption) that will re-integrate Midcontinent prices with waterborne prices.  And it’s also important not to exaggerate the magnitude of the de-linkage.  As I documented in a study released about a year ago, even during the throes of the financial crisis when spread and basis relations were also well out of historical norms, WTI still exhibited high correlations with other crude prices, including LLS and Mars.  (I am working now to update the main results of that study.)

In a dynamic market, changes in supply and demand patterns are inevitable.  By necessity, futures contract designs are relatively static–particularly so for something like crude oil, where contracts are traded going out to ten years so you just can’t change contract designs willy-nilly and strand a lot of open interest in the out months/years.  This mismatch between dynamic markets and static contract designs means that from time to time the contract will get out of alignment with the fundamentals.  Sometimes that mis-alignment is likely to be enduring–as with Chicago-based grain and oilseed contracts, which necessitated a major change in design.  Sometimes that mis-alignment is fleeting, because the price effects of the mis-alignment lead to adjustments on various margins that tend to bring things back into alignment.  That will almost certainly happen with WTI–if regulators allow it to happen.

And one point deserves repeating: the change in supply conditions that is causing the changes in price relations that are drawing so much attention will also help ensure the long run viability of the WTI contract.  If the supply is there, you can build pipelines to get that supply from low price locations to high price ones.  But you can’t base a futures contract on a market with no supply.

*Note how this represents a fundamental, and salutary change over conditions in the 1990s.  At that time, declining domestic production was turning the Midcontinent into a deficit region, and the Seaway Pipeline was built to bring crude from the Gulf to Cushing and the Midcon.

I wrote my Regulation piece expressing skepticism at arguments blaming speculation for commodity price spikes–“No Theory? No Evidence? No Problem!“–with the US Congress and certain folks at the CFTC in mind.   But commodity Know-Nothingism has gone global.

French President Sarkozy and European Commissioner Michael Barnier have both been demonizing speculation of late, and placing blame for recent commodity price spikes on speculators.  Sarkozy has announced that controlling commodity speculation will be one of his priorities during his chairmanship of the G20, and Barnier has been right behind him giving his full support.

And in carrying out their vendetta, Sarkozy and Barnier are doing a Gallic imitation of Alphonso Bedoya: “We don’t need to show you any steekin’ evidence!”

Indeed, Sarkozy and Barnier are pointedly and almost mockingly ignoring the evidence:

So it is quite a surprise to find the European Commission has censored its own research into food prices under pressure from President Sarkozy. As Andrew Peaple discussed in a Heard column last week, there is no evidence speculation is responsible for the current high food prices. A new E.U. study came to exactly the same conclusion, finding no evidence of “a correlation between the substantial increase in index fund positions and commodity futures prices.” But curiously, the draft report containing this conclusion was first delayed and then finally published today with the offending sentence removed.

Mr. Sarkozy has admirably decided to make tackling high food prices a priority for France’s presidency of the G20 this year. Less admirably, he has clearly already made up his mind to blame speculators regardless of the evidence. As my Dow Jones colleague Caroline Henshaw reports, he even joked about this at a press conference last month saying: “I will recommend a date for the publication of a study showing that speculation does not result in global price rises of raw materials: 1 April.”

In the end, Mr. Sarkozy didn’t need to delay publication because he had an ally in Michael Barnier, the French European Commissioner in charge of markets regulation who saw to it the report contained no mention of speculators either good or bad, thereby ensuring Mr. Sarkozy wasn’t embarassed. Mr. Barnier bizarrely then went on to tell the post-publication press conference that: “Agricultural products are turning into financial assets, which is why we want to share with you our concern about this,” ignoring the fact his own directorate’s report expressed no such concern.

“Don’t bother me with the facts” is not a recipe for good policy. But that probably doesn’t bother Sarkozy and Barnier (and their fellow travelers) because this is about the politics rather than the policy. There is a major problem–spiking commodity prices. Their are no policy tools at hand that will truly address the problem–or those that would have an impact are out of Sarkozy’s hands (and in Ben Bernanke’s), or are politically unpalatable (e.g., reforming EU agriculture, or eliminating ethanol subsidies).

So Sarkozy does the policy equivalent of kicking the dog after a bad day. It does nothing, but it makes him feel better. Or something.

More to the point, it is a demagogic tactic that has wide appeal and resonance.

And it won’t create an additional kernel of corn or drop of oil. Nor will it affect the demand for either. So it won’t have any effect on price. Moreover, by focusing on a non-issue, it distracts attention from devising practical, effective policies.

Sarkozy is one of the most difficult national leaders to peg. He is insightful and cunningly realistic on some issues, and foolish and demagogic on others.

But perhaps not so difficult: you just need to know the code.

Though of Hungarian origin, he is in many ways quintessentially French (perhaps not surprising as this is necessary to get to the top of the French political ladder). On foreign policy matters he is unromantic and realistic and pretty ruthless in his pursuit of French–not European–interests. On matters relating to markets, he is not a socialist, but he is definitely French in his deep suspicion of markets and his fondness for dirigisme. His anti-speculation fulminations are a manifestation of this.

Whatever the origin, the Sarkozy-Barnier approach is intellectually bankrupt. The almost smirking refusal to consider seriously the evidence–indeed, the open willingness to suppress evidence–makes that plain. And makes it plain that they really don’t give a damn.

What passes for law enforcement in Russia is held in very low repute.  But the traffic police are especially loathed for their venality and corruption.  So who does Medvedev appoint to be Russia’s head of transportation security?  Why, the head of the nation’s traffic police, of course.  (The fact that there is a national head of traffic police speaks volumes.)

Medvedev told Viktor Kiryanov: “To work!”

Uhm, work at what, exactly?  Improving the shakedown skills of airport security personnel?  From what I understand, they’re pretty good at that already.

And just what, pray tell, does traffic policing and road safety have to do with securing airports and railway stations from terrorist attack?

Kiryanov is apparently a little safety challenged himself, having struck a woman with his car.  No charges filed, natch.

The otherworldliness of this appointment defies comment.

Well, maybe one comment.  A friend told me now all terrorists need to do is put flashing blue lights on their vehicles and they’ll be able to travel anywhere at will.  That sounds about right.