Streetwise Professor

March 15, 2011

Another Volley in the SWP-BTB Tennis Match

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Regulation — The Professor @ 4:27 am

In what will hopefully be the continuation of a spirited and thoughtful exchange of views on OTC derivatives markets, John Parsons and Antonio Mello at Betting the Business respond to my response to their response to my post on Gensler’s beliefs about the efficacy of central counterparties.  Or something like that.

We agree on some key issues, namely, (a) the amount of margin is not the measure of the total amount of credit firms use up when moving from bilateral to cleared trades, and (b) systemic risk is the crucial issue when evaluating the effects of clearing mandates.

I think we also disagree on some issues.

Netting, for one.  MP state:

The reliance on bilateral arrangements meant that exposures that offset one another at the system level were not offset. Individual market makers did not have sufficient incentives to cooperate with one another to cancel offsetting exposures. A major objective of the reform is to encourage the canceling of offsetting exposures and reducing systemic risk by substituting standardized instruments and clearing, among other things, where possible.

As I’ve written repeatedly before, multilateral netting primarily effects priority; netting effectively places derivatives counterparties in front of other creditors in the event that a firm goes bankrupt.  The systemic consequences of this are ambiguous: yes, derivatives counterparties may be systemically important, but other creditors may be too, meaning that it is not obvious whether this reordering of priorities improves stability.

Insofar as the other claims are concerned, I am somewhat puzzled by the statement that “[i]ndividual market makers did not have sufficient incentives to cooperate with one another to cancel offsetting exposures.”  With respect to bilateral offsetting exposures, presumably market makers relied on set-offs in bankruptcy.  With respect to multilateral exposures, market participants internalized any improvements in capital efficiency from netting (or compression).  They also internalized any benefits that resulted from lower risk of replacing defaulted positions with counterparty A that were offset by non-defaulted trades with B, C, D, etc.  Crucially, they recognized that capturing some netting efficiencies multilaterally could undermine some bilateral netting for deals that could not be compressed or cleared because of the nature of these contracts or their liquidity; they internalized these various netting efficiencies.  They internalized the benefits of customization.  They would have internalized the transfer of wealth arising from the shift in priorities inherent in multilateral netting.  Thus, they could trade-off these various effects and internalize the resulting costs and benefits.  Maybe some costs and benefits were not internalized, so it is literally true that the incentives were not sufficient to lead to a completely efficient outcome, but I don’t consider insufficient netting to be the first order problem.  Indeed, to the extent that netting transfers wealth, there can be too much netting.

I’d also note, as was recognized when the CBT was considering whether to adopt clearing in the early-20th century, that by improving the efficiency of capital utilization (by freeing up credit committed to offsetting positions with different counterparties), netting can also lead to increases in the size of net positions and net risk exposures. (This was also an objection to clearing that was raised vociferously in the aftermath of Black Friday in 1869.)  This can increase systemic risks.

MP also criticize the opacity of OTC markets, and suggest that clearing would make things more transparent:

It lacked transparency. Neither the end-users nor the public authorities had adequate information about the market. This lack of information has handicapped end-users in getting good prices. The lack of transparency has hampered competition. The lack of transparency promoted unsound accounting. Opacity perverted incentives. It distorted compensations. We could go on… It also handicapped the authorities in supervising the marketplace. A major objective of the reform is creating transparency, which will then make it possible to improve the functioning of the market.

Transparency is used in different ways here.  It is used to refer to price transparency and position transparency.  There is another type of transparency–counterparty transparency–that MP don’t discuss but which is relevant to the issues they raise.

With respect to position transparency, this is a bad argument in favor of clearing.  It is possible to achieve such transparency via reporting to repositories without the problematic risk sharing and risk pricing aspects of central clearing.  Indeed, a single trade repository is required because (a) there will be multiple clearinghouses, and (b) some products will not be cleared.  If it’s position visibility that you want (especially to regulators), that should be achieved via reporting to a single repository, not by having multiple CCPs.

With respect to price transparency, I think that MP overstate the lack of competition and price information, especially for the more liquid products that are likely to be traded most actively on SEFs.  Most end users I’ve heard discuss the subject state that they have been able to get good price quotes from multiple dealers.  ISDA recently ran an experiment which found that spreads for liquid products are extremely tight–in the .5bp-1bp range.  Moreover, with respect to many standardized OTC products, end users can compare the bids and offers they get to the prices of exchange traded instruments (e.g., Eurodollar futures, crude oil futures) to determine the quality of a dealer’s quotes.  End users also have the ability to utilize those products–to the extent they don’t, that means that the bundle of services provided by the dealer is more valuable to end users than the different bundle available on exchanges.

Moreover, as I’ve written before, trading in a non-anonymous way by soliciting quotes from dealers can actually be cheaper for end users than trading in an anonymous exchange or exchange-like (i.e., SEF) environment with pre-trade transparency.  The verifiably uninformed are typically going to get better prices in non-anonymous settings than in anonymous ones, where spreads are widened and depths reduced in order to protect quoters against being picked off by the informed.

All of this is not to say that OTC bilateral markets were perfect.  Too big to fail provided perverse incentives.  Uncoordinated replacement and hedging of defaulted positions exacerbates price moves.  But clearing presents its own difficulties, so just inventorying the defects of bilateral markets is not sufficient to prove the superiority of clearing.  You have the Churchill democracy issue: something can be the worst thing ever, except for all alternatives that have been tried from time to time.  Moreover, I don’t consider the defects that MP identify to be nearly as problematic as they do.

Thus, it still comes down to a comparative analysis which must make comparisons along numerous dimensions; some of these comparisons may cut one way (e.g., favoring centralized clearing), others may cut the opposite way (favoring bilateral mechanisms).  Moreover, when discussing policy it is important to recognize that clearing bundles many services–risk pricing, risk sharing, netting/compression, default risk management, position reporting–that may be better provided separately.

I still think that a crucial issue that relates to one of my areas of agreement with MP–that firms subject to a clearing mandate will substitute one form of credit for another–deserves further analysis.  I hope that they respond more fully to my analysis of the implications of the degree of substitutibility of different forms of credit.  In my view, that will have very important implications for the effects of clearing mandates.

March 11, 2011

The Obama Sanction

Filed under: Military,Politics — The Professor @ 10:35 pm

I read this headline–“US ‘Tightening the Noose’ on Khaddafy, Obama Says”–and I wondered: Are the rebels advancing?  I thought I just read that Khaddafy’s forces were advancing, so that can’t be it.  Are the Marines returning to the Shores of Tripoli, 206 years after their previous visit?  I knew that wasn’t happening.  So just how is the noose tightening, exactly?

So I read further.  The “noose” is–wait for it–sanctions.  Really:

“Across the board we are slowly tightening the noose on Khadafy,” Obama told reporters at a White House press conference Friday. “He is more and more isolated internationally both through sanctions as well as an arms embargo.”

Because, of course, sanctions have a proven track record of causing murderous, lunatic, dictators fighting for survival to stop in their tracks, quaking in fear.


How many years were sanctions in place against Saddam?  How many against the mullahs in Iraq?  North Korea?  Sudan?  Please, don’t insult us all–and especially, don’t insult those fighting against Khadafy–with high sounding but empty phrases about “the international community” and quack nostrums like sanctions–the last refuge of the policy coward.  If you’re going to do something, do something.  Otherwise, STHU.

There’s more:

Obama stressed that the US and its allies were moving with unprecedented determination to isolate the Libyan leader and invoked the massacres in Rwanda and the Balkans, saying that the international community has an obligation to prevent a “repeat” of those tragedies in Libya.

Obama said the ultimate goal is for Khadafy to step down.

As usual, the gap between words and deeds is vast.  Yammering about sanctions gives the impression of doing something, while actually doing absolutely nothing; that’s actually worse than saying nothing at all, because it would actually take some courage to say that he doesn’t believe that what could be gained by an intervention that could actually achieve something is worth the cost and risk to the US.  That would be cold, but it would have the virtue of honesty.

I’m not saying the choices are easy; it will take military force to stop Khadafy, and the amount of force and the consequences of its use are very difficult to predict.  What and who follows Khadafy are unlikely to be any prizes.  So the case for military involvement is hardly clear-cut.

But I can say with near metaphysical certainty that sanctions will have no effect whatsoever, and that even to suggest that they would have the slightest possibility of forcing Khadafy’s ouster, or preventing a bloodbath is either a lie or a delusion, and a mockery of the people who will be on the receiving end of Khadafy’s wrath.  This is just more moral preening intended to disguise a complete abdication of leadership.  It would be leadership to send in the Marines.  It would be leadership to say, frankly, it’s not in America’s interest.  It’s the inversion of leadership to pretend you’re taking strong action when you are in fact doing nothing that will have the slightest impact.

I’ll bet Khadafy and his thuggish sons are having a great big laugh right now.  “Sanctions!  Stop it Barry, you’re killing me!  No, actually, we’re doing the killing here–but still, you’re a riot, kid!  Keep it up!”

Outside of the Khadafy compound, though, it’s not funny.  It’s sad and pathetic.

Professor Coase Call Your Office

Filed under: Commodities,Derivatives,Economics,Energy — The Professor @ 9:48 pm

The spread between Gulf Coast oil prices (such as Louisiana Light Sweet) and West Texas Intermediate (at Cushing, OK) remains wide.  The March LLS-WTI spread is $14.42/bbl, and is above $10/bbl through October, 2011.

The key to restoring spreads to more typical levels is breaking the logistical bottleneck south of Cushing, thereby permitting Canadian oil that is weighing on prices in the Midcontinent to flow to the Gulf.  The extension of the Keystone pipeline will help do that, but not for a couple of years.  Another way to ease the logjam is to reverse the Seaway Pipeline, now flowing from the Gulf to Cushing, to carry crude in the opposite direction.

This can have large social payoffs.  Here are some back of the envelope calculations.  Assume the marginal cost of moving oil on Seaway is $1/bbl, and a LLS-WTI spread of around $12/bbl when no oil flows south.  Also assume that the relevant derived demand curve for oil in the Gulf and the supply of oil to Cushing are linear.  The capacity of Seaway is 350,000 bbl/day.  The standard welfare triangle analysis implies that the opening of the pipeline would increase the sum of consumer and producer surplus by at least $1.925 million per day.*

I have been digging for estimates of the cost of reversal, and haven’t found any.  I did find that the reversal of the smaller but longer Spearhead pipeline cost $20 million.  The reversal of Line 9 in Canada cost $100 million.

At a reversal cost of $20 million, the investment would pay for itself in 10 days.  Even at $100 million, it would pay for itself in less than two months.  From a social perspective, this is a no brainer.

But the half-owner of Seaway, Conoco Phillips, says it is not interested in reversal:

ConocoPhillips isn’t interested in reversing the Seaway pipeline that brings crude from the U.S. Gulf Coast to the fuel hub in Cushing, Oklahoma, where inventories of crude oil reached a record high last month.

“We don’t really think that’s in our interest because we need more crude in the area” to supply the company’s refineries in the Midcontinent, Jim Mulva, ConocoPhillips’s chief executive officer, said during a conference call hosted by ISI Group today.

“We don’t think that’s in our interest.”  Which points out that the opening of the pipeline would have distributive effects.  Those are fairly straightforward to figure out.  Opening Seaway would raise crude prices in the Midcontinent, and reduce them in the Gulf, although probably only slightly (as the marginal barrels will be imported).  Gulf refineries are suppliers of the marginal refined barrels in most markets in the Midwest, South, and East, so product prices would probably fall slightly too.

These changes would benefit Gulf refiners (probably slightly), and harm Midcontinent refiners.  Due to the crude price differential, Midcon refiners are operating at higher rates of utilization than Gulf refiners; through February PADD II refiners were working at mid-90s utilization, PADD III in the low 80s, although that differential narrowed in the last couple of weeks with Midcon utilization falling into the mid-80s, probably due to the rise in crude costs resulting from the Mideast turmoil.  Opening Seaway would raise Midcon crude prices, harming refiners there (which would be reflected in reduced utilization).

The main beneficiaries of the rising Midcon prices resulting from a Seaway opening would be Canadian and Bakken crude suppliers.  So the opening of Seaway would transfer wealth from Midcontinent refiners to firms supplying crude to the Midcontinent.

Although the opening would redistribute wealth, the calculations above show that the pie would get bigger.  This means that there is the potential for a Coasean bargain** that could make refiners (including Conoco) and crude suppliers better off.  Roughly speaking, the deal would involve crude suppliers buying Conoco’s 50 percent of Seaway.

Easier said than done, of course.  There are costs of assembling the coalition of buyers (because there are multiple suppliers of crude), and costs of negotiating a deal with Conoco.  The negotiating costs exist in part because there are information asymmetries: Conoco, for instance, knows more about how the profitability of the refinery varies with the price of crude than would the purchasers of Seaway.

But the potential for the expansion of the pie is an enticement for doing an deal.  Perhaps Conoco’s expressed indifference is just a bargaining pose.  Perhaps somebody will make a bid that will make it worth Conoco’s while.  The money is there–on the order of $2 million per day.  Who will structure the deal to make it happen?

* .5 x 350,000 bbl/day * ($12/bbl-$1/bbl)=$1.925 mm.  Note this assumes that  when Seaway operates at full capacity, the LLS-WTI spread equals the marginal cost of shipment.  This means that the shadow price of capacity is zero.  If at full utilization the difference between LLS and WTI exceeds the marginal cost of shipment, the shadow price of capacity is positive and the welfare gain from opening Seaway is greater: there is a welfare trapezoid that contains the welfare triangle whose area I just calculated.  If in equilibrium Seaway operates below capacity, the welfare gain is smaller that I calculated.

** A phrase Coase dislikes, but which is widely used.

March 9, 2011

Clearing Mandates, Credit, Capital Structure, and Systemic Risk

Filed under: Clearing,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 1:31 pm

John Parsons and Antonio Mello have a series of posts taking aim at the notion that requiring end users to post collateral on derivatives trades will impose a large burden on them that will cause them to reduce real investment.  Their basic point is that OTC derivatives trades often embed an unsecured credit line, and that firms that are forced to post collateral can fund it with an explicit borrowing transaction and/or credit line. This ability to substitute one form of credit for another should dampen the impact of clearing and collateral mandates on corporate end users.

I agree with the essential point.  It was one of the reasons why I long ago opined that requiring AIG to post collateral (initial margin/independent amount) likely would not have materially caused them to reduce their positions in CDS because they would have been able to borrow–and would have wanted to borrow–to fund that collateral.  Less debt in one portion of the balance sheet would have made it possible to borrow more in other ways.  I discussed that point more generally in my Cato Policy Analysis piece.

I further agree with Parsons’ and Mello’s conclusion that this means that looking at the total collateral that end users will be required to post is a misleading measure of the financial burden that collateral, clearing, and capital requirements will impose on end users.

That analysis is as fine as it goes, but it’s worthwhile to push it further–much further.  In particular, to push it to examine the effects on systemic risk, which Parsons-Mello also (rightly) identify as the key driver of the ultimate impact for good or ill of clearing mandates.

There are a couple of cases.  In the first case, firms have access to perfect substitutes for the unsecured credit embedded in many OTC derivatives trades.  In the second, there are not perfect substitutes.  (It seems to me that M-P believe there are pretty close substitutes–feel free to correct me if I’m wrong, guys).

In the first case, clearing mandates and required collateralization will have no appreciable effects.  Firms will just substitute an economically identical form of financing/credit for the proscribed bundled credit.  New labels will be slapped on old bottles.

But that means that the systemic effects of the mandates will be minimal–and perhaps non-existent.  That’s because the mandates will not affect the quantity, character, and crucially, fragility of the capital structures of either end users or financial intermediaries.  The same banks will end up extending the same amount of credit of the same risk characteristics to the same counterparties. It will just go by a different name.

In the second case, where there are not perfect substitutes, things are much more complicated.  Firms will adjust on many margins.  They will substitute different kinds of financial claims (debt and equity) for the proscribed financing embedded in derivatives: the systemic effects of this are very difficult to know.  Firms will engage in less risk management, most likely: again, the systemic effects, and efficiency effects more broadly considered, are hard to predict.  And yes, firms will likely reduce the scale of investment as limited pledgeable capital will be diverted from supporting real investments into liquid assets to support derivatives positions.

It is interesting to note that corporate end users–manufacturers, airlines, energy companies, and the like–have been the most outspoken critics of clearing mandates and margin requirements, while financial firms have been relatively mute on the subject.  This is particularly interesting given that to address end user concerns, CFTC Chairman Gensler has emphasized that financial firms are the main targets of the mandates and margins.

To me, this makes sense in light of the foregoing analysis.  Banks and other financial institutions likely can substitute other forms of unsecured credit for credit bundled in derivatives trades more readily than can end users.  Banks engage in massive amounts of unsecured credit transactions (e.g., interbank funding) with other banks with which they trade derivatives and extend and receive embedded credit.  (Many interbank trades are not collateralized.)  A mandate that says “thou shall not extend unsecured credit via derivatives trades” is unlikely to be hugely burdensome on the banks, because they will just increase other unsecured  financing to substitute for the decreased credit embedded in derivatives trades.  It is plausible that end users have fewer such options.

Why might end users have poorer substitutes?  Here are some conjectures.

For one, the mandates may reduce the set of firms from which end users may obtain credit.  Consider a firm that is looking to hedge natural gas prices.  It can do a swap with Goldman, sure, but it it can also do a trade–and get credit from–BP, or Cargill, or myriad other firms.  With the mandate, the firm won’t be able to get credit from those counterparties.  It may still trade with them, but it would have to finance the necessary collateral either out of its own resources or by borrowing from a bank.

This creates many potential difficulties.  For instance, due to concentration limits and other factors, any given creditor may incur increasing marginal costs to extend financing to a given borrower.  This means that it is often more efficient to get a given total amount of credit from multiple sources, rather than just one.  Reducing the number of potential suppliers of credit can therefore raise the costs of credit.

Moreover, narrowing the sources of potential credit may expose end users to greater opportunism.  It is well understood that banks obtain information about the firms that they finance which gives them an advantage over other potential sources of credit.  They can exploit this information advantage opportunistically.  Firms seeking credit can limit their vulnerability to such holdups by dealing with multiple creditors.  Margin and clearing mandates that force end users to get credit to support derivatives positions through banks may therefore increase their vulnerability to holdup–thereby inflating the cost of trading derivatives.

I also wonder whether the credit embedded in derivatives trades is likely to represent a more robust commitment to extend finance in the future than other forms of unsecured lending.  This is more conjectural, but I find it a plausible conjecture.  If the suppliers of other forms of credit can more readily renege on commitments to supply liquidity to support a derivatives position, the liquidity and funding risks are greater in a clearing/margin mandate world.

These are just thoughts off the top as to how bundled and unbundled credit can differ.  I suspect that there must be some difference, at least for end users, based on revealed preference grounds.  This essentially turns the Parsons-Mello point on its head.  If the form of credit associated with a derivatives position is a matter of indifference, why do we see a decided preference among many users for non-collateralized trades that bundle credit from the counterparty?  Why are end users so vociferous in their opposition (granting that some of their vociferous arguments don’t really hold water)?

But these are the kinds of questions that have to be addressed to understand fully how clearing and collateral mandates are going to work.  And these are the kinds of questions that the advocates of the mandates haven’t even acknowledged, let alone answered.

There’s another issue here that deserves special attention.  Clearing and margin mandates must be met by the posting of high quality, liquid collateral such as cash and Treasury securities.  Where is the increased supply of these instruments going to come from?  (Manmohan Singh at IMF has written about this issue.)

Here I think that the Holmstrom-Tirole distinction between “inside” and “outside” liquidity is important.  They distinguish between liquidity supplied within the corporate sector (“inside liquidity”) and liquidity supplied by households, or through the government (via taxing the household sector) (“outside liquidity”).  My thoughts here are very preliminary–this is really thinking out loud–but I sense that the effects of clearing mandates on inside and outside liquidity is actually the crucial issue, and one that deserves probing analysis by knowledgeable people.

One plausible conjecture is that much of the liquidity that currently supports derivatives trading is inside liquidity, and that mandates, by requiring posting of collateral in the form of cash and high quality securities, will increase the demand for outside liquidity.  Some of this may be supplied by the corporate sector as they adjust investment policies to favor more liquid assets.  But a good portion will have to come from the household sector or the government sector.

This is unsettling.  It is unsettling in part because it means that the efficiency of derivatives markets will be intertwined even more closely with fiscal and monetary policies that affect the supply and demand for outside liquidity.  It is also unsettling because as Gary Gorton, Bengt Holmstrom, and Jean Tirole (and others) have argued, one impetus for securitization–including subprime securitization–was the need for high quality collateral, i.e., it was a response to demand for liquidity from the corporate/financial sectors. To the extent that clearing and margin mandates make the corporate and financial sectors more dependent on outside liquidity, it would tend to drive a similar dynamic.

Moreover, when systemic risk is considered, correlated/aggregate/macro shocks are the most difficult to address through the design of liquidity supply mechanisms.  If we are worried about the financial system’s vulnerability to aggregate shocks–more generally, shocks that can’t be diversified away within the corporate sector–we have to think seriously about legislative and regulatory changes that may affect the reliance of the corporate/financial sector on outside liquidity.

In sum, I think it is worthwhile to think long and hard about some of the indirect effects of clearing mandates–especially their effects on capital structure and the demand for liquidity, particularly specific forms of liquidity.

To try to close the circle here, Mello and Parsons analyze a crucial issue: the effects of clearing mandates on capital structure.  In a Modigliani-Miller world, this wouldn’t matter, and that might be their point.  But if capital structure is relevant, legislatively mandated changes in the way companies finance themselves and the way credit is extended and used will have real effects.  What’s more, some of these effects may be systemic.  After all, research on systemic risk focuses on the ways that imperfections in financial markets can lead maximizing firms to choose capital structures that lead to inefficient, and often destabilizing, responses to economy-wide shocks.   Therefore, to understand the systemic effects of major policy changes like mandatory clearing and collateralization of derivatives trades, we need to understand how these policies will affect financial contracting generally.  I don’t think we understand even remotely what those effects will be.  I am far from convinced that those effects will be salutary, or even benign.  But that’s the kind of thing academics and policy makers should be focusing on.

Krugman’s Economics Are Going Pear Shaped Too

Filed under: Economics,Politics — The Professor @ 10:50 am

Paul Krugman’s political commentary has been unhinged for some time, and that has affected his thinking as an economist.  As Steve Landsburg notes, Krugman’s most recent column about the economic impact of computerization, and the appropriate policy response, is nonsensical:

Paul Krugman’s latest gets my vote for his most incoherent column ever. As I understand his argument, it goes like this:

  1. Computers are good at routine tasks.
  2. Therefore the rewards to performing routine tasks are falling. This is true at all skill levels.
  3. Therefore education does not always make people more productive. It makes people more productive only when it trains them to do tasks that are not better done by computers.
  4. Therefore we need stronger labor unions and universal health care.

Say what?. The basic thesis — that there’s no point in learning to do something difficult if a computer can do it better, and that this is significantly affecting the returns to certain kinds of education — is an interesting one. The moral, of course, is that you can’t imitate your way to prosperity. If we want to be rich, we have to innovate.

Landsburg identifies one major problem with Krugman’s diagnosis and prescription, but there are many more.

For one, the entire history of economic growth and progress has been marked by the use of capital–machines, technology–to perform routine tasks, thereby relieving humans of untold drudgery, and allowing them to pursue more productive, interesting, and challenging activities.  As one example, consider how various appliances have dramatically increased the productivity of household labor, thereby freeing (mainly) women from mind numbing tedium, and allowing them to perform work in the marketplace, rather than the home, and to enjoy more leisure if it suits them.  More examples could be produced ad nauseum.  Think farm work was fun?  Old time factory work?

Yes, technological shocks can often depreciate the value of some skills–some human capital.  But part of the genius of the market system is to find new ways to utilize resources that are freed up by these technological shocks. that’s part of the function of entrepreneurship: to respond to changing circumstances by discovering new and productive ways to utilize available resources.

In brief, we’ve had several centuries of technological innovation that made certain skills obsolete, but we’ve grown remarkably wealthy nonetheless (pace Deirdre McCloskey’s factor of 30–or 100).  The ability to do some things more efficiently has allowed us to do more of those things, and more other things too.  Why should things really be different this time?  Maybe they will be–but then it’s incumbent on people like Krugman to explain why.

In prescribing unions as a way to mitigate the impacts of technological change on those possessing a particular set of skills readily replaced by technology, Krugman really goes off the rails.

He ignores the general equilibrium effects of unionization.  Unions raise the wages in unionized sectors by restricting the amount of employment in those sectors.  But this increases the supply of labor in non-unionized sectors, reducing wages there.  Thus, unionization does not raise the wages of all of those of a given skill level and type: it raises the wages of some, and depresses those of others.  Moreover, the market power rent in unionized wages induces rent seeking–people expend resources trying to get a union job.  (This can include choosing to remain unemployed and hoping to win the union lottery.)  This is wasteful.

Indeed, the very conditions that Krugman identifies as being the reason for unionization exacerbate these effects.  His premise is that computers are close substitutes for people with a certain set of skills.  Unionization, by raising wages, actually induces firms to substitute capital for the (artificially) expensive labor.  Moreover, if computers and this kind of labor are very close substitutes, the demand for this type of labor will be very elastic, meaning that to raise wages in a particular sector substantially, it is necessary to cut labor usage in that sector dramatically.  This exacerbates the depression of wages in other, non-unionized sectors.

I could go on.  Suffice it to say that Landsburg is right to point out the non sequitur in Krugman’s analysis.  He–and I–only scratched the surface of the problems in Krugman’s diagnosis and quack cure.

It’s also interesting to contrast Krugman’s argument with Tyler Cowen’s Great Stagnation hypothesis.  Cowen argues that the main economic problem is that we face a dearth of revolutionary productivity enhancing innovations, and indeed, that the post-70s era is one of economic stagnation due to a slowing of the pace of technological innovation.  But that’s a subject for another day.

March 7, 2011

Oil and the Stock Market

Filed under: Commodities,Economics,Energy,Financial crisis — The Professor @ 9:11 pm

Historically, oil prices and stock prices were negatively correlated, or exhibited a close to zero correlation.  During the financial crisis, the equity-oil correlation spiked.  In recent weeks, it has plunged, and become sharply negative.

Some people try too hard to explain this pattern.  To me it has little to do with QEII, and the explanation is relatively simple.  It depends on what are the important shocks at any particular time.  When macro demand shocks predominate, correlations will be positive; when oil supply shocks are important, correlations will be negative.

During the financial crisis, there was slack oil production capacity, and price movements were demand driven.  Prices plummeted when demand crashed in the post-Lehman days.  Prices rebounded when economies around the world started to recover.  The economic crash and recovery drove stock prices lower then higher.  So during the crisis and recovery period, the state of the macroeconomy drove oil demand, and drove stock prices and oil prices in the same direction.

In contrast, the Mideast turmoil has generated oil supply shocks.  Declines in oil output, and increased likelihood of greater future output declines cause oil prices to go up.  These output declines also tend to reduce economic growth, and if severe enough, can tip economies into recession.  Thus, these adverse output shocks tend to cause stock price declines  because stock prices reflect the health of the broader economy.

In brief, the historically high positive correlation between oil and stock prices during the late-2008-early-2010 period reflected the fact that the primary shocks driving both markets during that period were macro shocks that influenced the demand for oil.  The negative correlation we observe now is due to the fact that the predominant shocks are oil supply shocks that will adversely affect the real economy.

The title of the FTAlphaville piece I linked to asks whether the correlation breakdown is “permanent.”  I permanently wonder why people have a tendency to believe that the most recent change will last forever.  No, the correlation shift is not permanent.  When supply shocks abate, and when (macro) demand shocks intensify, the correlation will tack again.

In God We Trust: Not Ben

Filed under: Economics,Financial crisis — The Professor @ 8:51 pm

Ben Bernanke really worries me when he says things like this:

When Rep. Jeb Hensarling (R-Texas) asked yesterday about the spike in prices for gold, oil, wheat, and other commodities , Fed chief Ben Bernanke—whose expansion of the money supply over the past three years amounts to a highly confident gamble on the Fed’s ability to control the devaluation of the dollar—dismissed the idea that this inflation was related to Fed policy, noting that “commodity prices have risen just about as much in other currencies as they have in terms of the dollars. So while I take those commodity price increases very seriously I don’t think they’re primarily a dollar phenomenon.”

This is disturbing for at least two reasons  First, it stretches the limits of the meaning of the phrase “just about as much.”  Since September, 2010, as measured by US dollar index futures, the US dollar has fallen by about 7.5 percent.  There was a rally into the first part of 2011, but then the decline resumed: it has fallen nearly 5 percent from the end of 2010.  This means that commodity prices in non-dollar currencies have risen by about 7.5 percent less than dollar prices in the period that commodity prices have risen substantially.  That doesn’t seem “just about as much” to me.  If 7.5 percent is close enough for government work as far as Bernanke goes, that’s grounds for serious concern.

Second, it is disingenuous in a way similar to other, earlier Bernanke statements.  It is not honest to say that one cannot attribute rises in commodity prices denominated in other currencies to an expansion in the stock of dollars.  Foreign central banks don’t want to see a dramatic strengthening of their currencies relative to the dollar.  They therefore respond to US monetary expansion by expanding their own money supplies.  In a fixed exchange rate world, inflation rates will be equal in all currencies, and a US monetary expansion would lead to world inflation as to maintain the fixed rate foreigners have to expand their money supplies to match the US expansion.  Exchange rates aren’t fixed today, but they are not passively floating either.  To the extent that foreign central banks attempt to fight appreciation of their currencies, they import some American inflation.  Thus, the fact that commodity prices are rising in other currencies does not mean that commodity inflation is not a dollar phenomenon, and it is disingenuous of Bernanke to claim otherwise.  The initiating shock is the US monetary expansion: the channel of transmission is the monetary policies of other countries attempting to avoid a sharp appreciation of their currencies.

To the extent that Bernanke and the rest of the Fed governors truly believe that sharply rising commodity prices are not a harbinger of inflation, and hence ignore danger signals from the commodities markets, there is a real danger that inflation in other prices can spurt quickly, before the Fed can act.

The monetary base has expanded dramatically.  It is common to downplay the importance of this phenomenon by pointing to the fact that most of the reserves that constitute the vast bulk of the expanded base are held as deposits at the Fed, and that as a result, velocity has plunged.  That raises two questions: (a) if the expanded money base is just sitting around, how is it doing anything to generate a rise in real output?, and (b) what happens if velocity ticks up, even modestly?  Question (a) casts doubt upon the benefits of a dramatic expansion in the monetary base.  Question (b) raises serious concerns about its dangers.

Here’s an analogy.  There’s a huge amount of dry kindling lying around.  It’s not doing anything damaging at present, but it’s not doing any good either.  It represents a fire hazard, but it’s not burning now, so the fire marshal calmly states that nobody should worry, and he can readily douse any flames, so there’s no reason to clear the kindling.

Somehow, that’s not very comforting.  What’s the upside for having huge amounts of fuel lying around, doing nothing?  The downside is clear: it could explode into a major conflagration.  The calming words of the fire marshal don’t inspire true confidence, especially when he tells everybody to ignore smoke rising from a part of the woodpile.

The reserves are the kindling; Bernanke is the fire marshal; and the rising smoke is the rise in commodity prices.  The risk of an inflationary conflagration breaking out–a big one–seems very real to me.

The US currency says “In God We Trust.”  The problem is, when it comes to avoiding a substantial inflationary spurt, we have to trust in Ben.  But Ben ain’t God, and that’s cause for worry–especially when he gives such dubious justifications for his policies and its effects.

President Litella

Filed under: Military,Politics — The Professor @ 3:49 pm

Remember Obama’s repeated denunciations of Guantanamo?  His consistent assertion that it was a moral stain on America?  His insistence that not only was closing Gitmo the right thing to do, but the pragmatic thing to do? That closing it, eliminating military tribunals, and trying accused terrorists in civilian coursts would improve American security?


When moral preening meets reality, bet on reality.

March 6, 2011

I Agree That Oversimplification Will Not Do: That’s What I’ve Been Saying All Along

Filed under: Clearing,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 9:32 pm

John Parsons of MIT takes issue with my post arguing that CFTC Chairman engages in magical thinking on clearing.  John claims that my criticism is based on a (non-existent) “conservation of risk” principle.  I respectfully disagree.  I am criticizing the arguments that Gensler has in fact advanced, whereas John is generously attributing to him arguments as to how changing rules (including clearing rules) can reduce risk that I have not seen Gensler make.

In contrast, I have written extensively that clearing affects both the allocation of risk for given economic decisions, and the amount of risk through its effects on myriad decision margins; I do so explicitly in “Do You Believe in Magic?”  From the very beginning of my writing on clearing mandates, dating back to late-2008 when the issue became a salient one, I have made that point repeatedly.  Indeed, my analysis of AIG–Exhibit A-to-Z in many pro-clearing mandate arguments–has emphasized this point.  See here, here,  and here, and my piece in the Journal of Applied Corporate Finance; I also raised it in an exchange with Jeffrey Gordon of Columbia Law School in my presentation on clearing that you can view here.  This working paper, written in the fall of 2008, details a variety of ways in which clearing (via its effects on margining, netting, monitoring, and risk sharing) affects both the amount of risk exposures and the allocation of these exposures.  I could go on and cite additional papers and presentations: suffice it to say, most of what I have written about clearing focuses on how clearing affects incentives and information, as compared to bilateral mechanisms, and how these changes affect the amount of risk in the system and the way that risk is allocated.  That’s far more than a start, I think it’s fair to say.

John states that the effects of clearing on the amount of risk in the system is “the very heart of the original argument behind clearing which Gensler is making.”  I’d like to see exactly what argument John is referring to.  I’ve read a lot of what Gensler has said and written in the last three years, and I haven’t even seen that issue even at the peripheries of his arguments.  Typically Gensler argues that shifting the risk to the clearinghouse eliminates interconnections and eliminates counterparty risk because the CCP stands behind trades, or because CCPs will require collateral that make sure that firms will have the resources to pay for their derivatives losses.  That’s it.  Nothing related to how clearing will affect incentives or information in a way that reduces the amount of risk in the system.

Consequently, I think the magic box metaphor is a very apt characterization of what he has been pushing since 2008.  Or, since it’s Sunday, it’s fair to say that he is promising a miracle that is sort of the inverse of the loaves and fishes: rather than taking meager fare and feeding multitudes, he is claiming that clearing will take risk from multitudes and make it meager.  There is certainly nothing as nuanced in what Gensler has said publicly as what John is attributing to him.

John closes by saying:

Let’s have a good discussion about which rules of the game produce the lowest total social risk and the greatest social payoff from the operation of the OTC derivatives market. It’s a tough problem to tackle. Oversimplification will not do.

Welcome to the party!  Seriously.  Compare that to what I wrote at the end of the piece in Regulation, “The Clearinghouse Cure,” published in 2008 (linked above):

The nature of this analysis is inherently qualitative. It is difficult for anyone, be they academics, market participants, or regulators, to determine definitively whether a clearinghouse would improve the  efficiency of the CDS market. I certainly do not claim to possess such definitive knowledge. It is troubling, however, that basic considerations relating to the economics of risk sharing and information have been almost completely absent in the public discourse over CDS clearinghouses. It is also troubling that the  potential pitfalls have not been fully aired. Nor has there been an extensive comparative analysis of alternative risk-sharing mechanisms. Therefore, at the very least, this article aims to raise the quality of the debate by identifying crucial issues that have been largely ignored until now, and to challenge a consensus that threatens to engineer a fundamental transformation of the financial markets without proper regard for fundamental economic issues. Moreover, the considerations identified herein should be kept in mind when designing a CDS clearinghouse to ensure that information problems do not make this prescription worse than the disease it is intended to cure.

I’ve been calling for a good serious discussion around these issues for arguably longer than anyone, and have written extensively about many of the “hard problems.”  There is indeed an oversimplification problem in this debate–and that’s precisely why I’ve been so hard on Gensler (and Geithner): because they’ve been the ones oversimplifying repeatedly and consistently, and as a result, we run the very serious danger of adopting arrangements that do not generate the greatest social payoff.  If I seem combative making that point (Combative? Moi? Nobody’s ever accused me of that before!) it’s primarily a response to the repeated oversimplification by the advocates of clearing mandates.

I know I can have a constructive discussion with John Parsons, even though it is highly likely that we would disagree on crucial issues.  But it would be a real discussion about real issues, and based on my extensive reading on the entire regulatory and legislative discussion leading up to Dodd-Frank and clearing mandates, that’s precisely what’s been missing in the 202 area code.

March 5, 2011

Nothing is Wrong, But the Americans Did It

Filed under: Military,Politics,Russia — The Professor @ 12:46 pm

The most advanced Russian GLONASS satellite, a Geo-IK-2, is space junk after an aborted launch.  Two reactions were oh-so-Russian that I just couldn’t let them pass unmentioned.

Reaction 1:

For some time it was unclear, as to whether the Geo-IK-2 is totally useless, or may only partially do its job. The Geo-IK-2 orbit was designed so its solar batteries are constantly in the sun, providing power to its radar and other equipment. The abnormal orbit put it intermittently in the Earth’s shade, disrupting the power supply (Interfax, February 3). Popovkin told journalists that the Geo-IK-2 is useless (Interfax, February, 20). “This week Deputy Prime Minister in charge of the defense industry and former defense minister and KGB official, Sergei Ivanov, announced “there are no serious problems with the Geo-IK-2” (RIA Novosti, February 28). It turned out Popovkin was better informed: the defense ministry announced that Geo-IK-2 has fully lost power and turned into space junk after a week of malfunction (Interfax, March 1).

So, 1 day after the Deputy Prime Minister and former defense minister says everything is copacetic, the defense ministry says the IK-2 is a total writeoff.  How many times have I seen that movie?

Reaction 2:

When the extent of military reform and defense modernization failure is contemplated by Russia’s supreme leaders, heads may roll and in anticipation plausible excuses are being prepared. A “reliable space industry source” told Interfax news agency that the Briz-KM booster failed during the Geo-IK-2 launch, “because of possible external electromagnetic interference from a sea, land or air-based source,” while the platform was on the other side of the globe out of sight of the Russian control center (Interfax, February 14).

The implication, of course, being that the Americans used some of their technical deviltry to disable the satellite. Another golden oldie.

To summarize: there are no major problems, but they were caused by the Americans.  Some things never change.

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