Streetwise Professor

I may have to start calling Timmy! Rodney instead–as in “I don’t get no respect” Rodney Dangerfield.  The latest Timmy!/Rodney  smackdown came from German Member of European Parliament Werner Langen, a major player in European financial regulation: the FT calls it a stinging rebuke, and if you read the article, you’ll find that a fair characterization. Langen accuses Geithner of misstating the changes in derivatives regulation that the G20 agreed to, and attempting to force Europe to do things that it did not commit to do.

The undiplomatic rhetoric–disses, really–directed at Geithner is pretty astounding.  As I said earlier, I cannot recall anything like them directed with such regularity at any other US cabinet official.

Take it away, Rodney!:

I have written often of “Putin’s Purgatory” and the “hamster wheel from hell”, meaning that under Putin and Putinism, Russia is destined for stasis and stagnation.  As the country slouches towards its next presidential election, or the simulacrum thereof, this conclusion is becoming widely accepted.  Medvedev warns of stagnation.  First Deputy Prime Minister Shuvalov says stability is overrated.  The IMF says that Russia is recovering, but its post-crisis economic performance is “unimpressive” (not that Russia is alone in this).  The IMF analysis focuses on conventional macro issues like budget deficits, but acknowledges the crippling effects of Russia’s yawning institutional deficits:

Compared with its emerging market peers, Russia experienced a greater degree of economic instability during the past decade and a larger output loss in the recent crisis, owing to its continued dependence on commodities, poor governance, and procyclical economic policies rooted in weak policy frameworks. Unless these weaknesses are addressed forcefully, growth is likely to be modest—less than 4 percent in the medium term. Moreover, the economy will remain highly vulnerable to external shocks. For example, a sharp drop in the oil price would trigger another recession and reduce medium-term growth further.

But as if to prove it still doesn’t really get it, the IMF encourages Russia to use the opportunity given by high oil prices to push institutional reform:

But Russia can do much better, if it leverages the commodity boom to strengthen policies. The challenge is to overcome the complacency that in the past has set in when oil prices are high. The high oil price affords Russia an opportunity to build buffers and introduce growth-enhancing reforms which could lift medium-term growth to 6 percent or more. The focus should be on further scaling back the anti-crisis measures as the economy recovers, reducing fiscal vulnerabilities, reining in inflation, promoting a stronger and more competitive banking system, and creating a better environment for investment. Improvements to policy frameworks and a reinvigoration of long-stalled structural reforms should be central elements of this strategy, and would send a positive signal to investors and boost Russia’s growth potential. This would also generate positive economic spillovers in the region.

But insofar as real and constructive institutional change is concerned, high energy prices are a bug, not a feature.  They permit the present system to function and survive: when oil prices are high, the country has the free cash flow problem from hell that enables all sorts of dysfunctional practices to survive.  Crisis concentrates the mind: high energy prices encourage complacency.  In other words, the IMF is delusional to think that high energy prices provide an opportunity to transition to a more modern economic system: to the contrary, they perpetuate the stint in purgatory.

The ability of the Putin model to produce a vibrant economy is becoming far more widely recognized, as the contrast between the vibrancy of other BRICs and Russia is becoming more and more manifest:

Russia is falling behind other BRIC economies in global competitiveness and growth, according to The Russia Competitiveness Report 2011, released Monday by the World Economic Forum.

The country ranked 63rd out of 139 countries based on the report’s 12 pillars of competitiveness.

The report noted that Russia can improve its poor ranking by reforming its institutions, improving the quality of education, stabilizing financial markets and moving away from a focus on natural resources.

“It is becoming increasingly evident that the current growth model, which is centered on high oil prices and leveraged facilities, is no longer effective,” Sberbank chief executive German Gref wrote in the report. “New drivers of growth are needed for Russia to achieve sustainable development.”

But the WEF commits the same mistake as the IMF:

The report’s authors recommended taking a “three-plus-five” approach to increase Russia’s competitiveness. This approach involves capitalizing on Russia’s three key economic advantages and addressing its five key challenges.

Natural resources, the size of the domestic and foreign markets, and a highly educated population are listed as Russia’s key strengths in the report. Challenges include inefficient and corrupt institutions, quality of education, low market competition, unstable financial markets and unsophisticated business practices.

Again, the problem is that one of the “key economic advantages”–natural resources–is a crucial driver of what the report euphemistically calls “challenges”–most notably “inefficient and corrupt institutions” and “unstable financial markets.”

Meanwhile, dinosaur-like, Putin lumbers on, promoting the status quo.  His most recent statements have touted that Russia will recover to pre-crisis levels “by next year.” (Russian Railways head Vladimir Yakunin apparently missed the memo, as he has stated that full recovery will not occur until 2013.)

Even that is not that impressive, as it means that Russia will still be far below trend (again, the country is not alone in this.)  Putting it as optimistically as possible, if the country recovers to 3Q 2008 performance by the end of 4Q 2011, given a pre-crisis growth rate of about 6 percent per year, the country will be about 21 percent below trend.  (If Yakunin is right, the number is closer to 33 percent.)

Nonetheless, Putin promises the country a rosy future:

“And, as for GDP per capita, to increase this figure from $19,700 to more than $35,000 per capita [in the next decade], per person.  But, to do this, we need to increase the productivity two times …and in non-raw material, high-tech sphere three or four fold.”

But he provides absolutely no concrete steps to achieve these lofty visions.  He states goals, never means to get there–the classic con man shtick.  He yammers about creating 25 million new high tech jobs.  Just how, exactly?  Especially with an aging and dying workforce, and a hollowed-out education system?   Doubling productivity in 10 years requires productivity to grow at 7 percent per year: how do you do that with capital fleeing?

So Medvedev and his minions give speeches about modernization, but the hamster wheel just keeps spinning.  And more and more people are noticing.

Content warning!: this is a post about clearing minutia.  But believe it or not, there are a select few who actually like that kind of thing–so this one’s for you!

I was thinking more about the segregation issue, and particularly the credit and systemic risk issue.  I think I got the essence of the conclusion right, but was not completely happy with the supporting analysis, so I gave it some more thought and came up with something that I think is a more robust.

The issue is whether segregation or futures-style omnibus accounts lead to more market fragility during times of stress.  My original intuition, and my newer analysis says that segregation is more fragile in times of stress; that is, a CCP is more likely to fail with segregation than with omnibus accounts.  The basic reason is that segregation is more dependent on discretionary credit during times of stress; this dependence is a source of fragility.

The potential problem has its origins in the timing of cash flows in a CCP setup.  CCPs make margin calls on brokers (FCMs) that the FCMs have to meet in a short time period, on both house and customer accounts.  Often the FCM has to make payment on the customer account before the customers have made their variation margin payments; to meet the CCP deadline, therefore, credit has to be extended to these customers.  The FCM’s bank may make the payment to the CCP even though there are insufficient funds in the FCM’s account at the bank to cover the payment.  That is, banks for FCMs often extend credit to the FCMs to permit timely payment of margin calls to the CCP.

With omnibus accounts, the payment that the FCM owes on its customer account is the net payment owed to the CCP by all its customers on all their positions cleared through that CCP.  This means that the maximum amount of credit that is needed to ensure that the bank makes the margin payment to the CCP on behalf of the FCM is this net payment owed.

With segregation, it won’t be possible to net customer payments against one another.  This increases the amount of credit banks have to extend to ensure prompt payment of variation margin to CCPs.  And that is where the vulnerability arises.

A very stylized example demonstrates the point.  It is unrealistic in many ways but the elements of unrealism don’t overturn the basic result.  Assume an FCM has zero capital.  It has 10 customers, 5 who have to pay variation margin of 1000 apiece, and 5 who should receive 900 in variation margins apiece.  Thus, the net amount owed on this FCM’s customer account is 500=5x(1000-900).

Assume that the margin payment is due immediately, but none of the customers who owe have posted the necessary cash. With some probability all will stump up the necessary cash in the future, but with some probability none will.  In the latter event, there is a total loss of 5000 that is borne by others in the market: just who bears it depends on the type of account (0mnibus or segregated).

With omnibus accounts, the FCM owes the CCP 500.  If the FCM’s bank lends the FCM the 500, it can meet the margin call and there is no default to the CCP.  If all the customers who owe pay, the FCM can repay the bank, and the bank and the FCMs other customers get paid all they are owed.  However, if the customers who owe don’t pay, the FCM defaults on its loan to the bank for 500, and also cannot pay its customers who are owed money the 5×900=4500 that is due them.

Note that in this example, the risk that the customers who owe variation margin payments will default is borne by the bank and the other FCM customers.  That’s the “fellow-customer” risk in this setup.

Now consider the situation with segregation.  Here, it is not possible to net customer pays and receives.  Thus, it is necessary to provide 5×1000=5000 in credit to the FCM, or the FCM’s customers, to make it possible to meet the CCP deadline.  If the customers end up paying what they owe, everything is the same as with co-mingling.  If they don’t, however, the bank loses 5000–if it decides to extend the credit.

The total credit loss in the two alternatives is the same–5000–but the distribution is different.  The bank is on the hook for 100 percent with segregation, but only 10 percent under omnibus accounts–again assuming that it extends credit in each case.

That is a crucial difference, because the bank has the discretion to extend credit: that is, it is not a given that the bank extends credit.  It can say no.  If it says no, the FCM goes into default on its obligation to the CCP, and the CCP is on the hook for the loss in the event the customers who owe default.   This loss falls on the CCP’s capital, or on its default fund.  This could conceivably threaten the CCP.

Clearly, the bank is more likely to say “no” to a request to borrow 5000 than a request to borrow 500.  Note particularly this situation is likely to arise when the market is under stress.  That’s when big price moves occur that can raise doubts about the ability of customers to meet their margin calls, and when excess margins held at the FCM are going to be blown through.  It’s also when banks are likely to be more averse to taking on credit risk.

With omnibus accounts, there is credit extended, but much of it is not discretionary.  In the example, the FCM’s in-the-money customers provide 4500 of credit.  They have committed to do so by being customers of the FCM, and being on the winning side of their trades.  In effect, customers provide irrevocable letters of credit to other customers–and in return, receive irrevocable LCs from those customers.  These are not traditional LCs because their payoffs are conditional on market prices (and in a more realistic example, on the financial condition of the FCM).  But in essence, if you are a customer of an FCM under an omnibus system, you commit to provide credit to other customers under some circumstances, and in return receive a commitment from other customers to grant credit to you under other circumstances.

That lack of discretion is crucial in preventing a market breakdown.  “Freezing” of credit markets during times of market stress essentially means that lenders choose not to lend.  The more that you rely on the discretion of lenders, the more vulnerable you are to a market freeze.

During the Crash of 1987, the reluctance of banks to lend to FCMs was what threatened the major CCPs. Consider that in the context of the example.  In the example, under segregation, the bank is less likely to extend credit, making an FCM default more likely.  Moreover, since there is no sharing of risk among customers, with segregation the CCP is on the hook for a bigger loss: 5000.  With omnibus accounts, it loses only 500.  CCP failure is obviously more likely when it has to bear a 5000 loss than one a tenth as large.  Thus, with segregation, there is a larger probability that the CCP will absorb a loss, and conditional on a loss occurring, that loss is bigger.  This means a greater likelihood of CCP failure–or the need for greater CCP capital.

In brief, the clearing system is more likely to break down during periods of market stress, the greater the reliance on discretionary credit to meet variation margin calls.  This reliance is greater with segregation, than with futures-style omnibus accounts.  The latter reduces reliance on discretionary credit by the use of (implicit) commitments among FCM customers to lend to each other.  That makes the system more robust.

There is considerable symmetry in the commitments that FCM customers make, but that symmetry is not complete.  Some customers are more creditworthy than others.  They essentially subsidize the less creditworthy customers (unless, as I discuss below, commissions or other terms offset this effect).  Moreover, tail risks that create default risks are not symmetric.  Customers who are long stock index futures, for instance, are likely to experience big margin calls than those who are short because crashes are more likely than spikes.  Customers who are short CDS are more likely to experience big margin calls than those who are long because of jump to default risk.

Even though the exchange of commitments is not necessarily of equal value (i.e., a given customer may provide a commitment that is more valuable than the commitment he receives from the other customers due to these sources of asymmetry), there is an exchange of value.  Moreover, more creditworthy customers should be able to negotiate better commissions to reflect the benefits they are providing to other customers–which helps the FCM attract the business of these other traders.  The ability to negotiate commissions and other terms of agreements between customers and FCMs (e.g., margins) reduces the scope for cross subsidies between customers.  This limits the distributive consequences of omnibus accounts.

These credit issues are likely to arise only in rare circumstances, but those are exactly the circumstances in which a market breakdown and CCP failure would occur.  A liquidity crunch occurs when due to heightened risk and asymmetric information, lenders choose not to lend.  This is most likely to occur during periods of market stress–which is exactly when big margin calls increase the demand for liquidity/credit.  That is, stressed conditions reduce the supply of credit and increase its demand.  It is desirable to reduce reliance on discretionary credit in these circumstances.  Omnibus accounts do just that.  They are a liquidity pooling mechanism by which customers implicitly commit to extend credit to one another.  This commitment reduces the need to rely on discretionary extensions of credit by banks in order to raise the cash necessary to make payments to CCPs.  This, in turn, reduces the likelihood of a CCP collapse.

This analysis strongly suggests that the systemic risks of segregation are far greater than the CFTC acknowledges.  Indeed, in its NOPR on OTC derivatives segregation, the agency argues that segregation reduces systemic risks.  Its analysis fails completely, however, to consider the implications of segregation on the demand for credit during times of market stress.  The foregoing analysis implies that segregation leads to higher demands for liquidity and credit precisely under the conditions in which liquidity and credit are likely to be in short supply.  That, in turn, means that the possibility of market breakdown or CCP failure is greater with segregation.

Market participants will adjust on other margins, of course.  CCPs will presumably require greater margins and greater default fund contributions with segregation: these are also essentially precommitments of resources that substitute for the precommited resources lost under segregation.  They are also costly, and it is nigh on to impossible to know whether these costs are larger or smaller than the costs inherent in a system based on omnibus accounts.

But apropos my earlier post, CCPs, exchanges, FCMs, and their customers have strong incentives to adopt the system that minimizes these costs.  They have skin in the game, and a bigger pie to split when the choose the lowest-cost mechanism.  They also have better information to evaluate these costs than any regulator.  No, their incentives aren’t perfect.  Their information isn’t perfect either.  But perfect isn’t an option, so those aren’t meaningful objections to relying on competition and contract to determine the choice of institutions, rather than regulatory fiat.

This one is a little old, but it deserves a quick post.  Anna Chapman is editing a publication on venture capital in Russia, and plans to begin a VC venture to link entrepreneurs in high tech and investors.   Because who could possibly be better to promote Russia to those with sensitive technology and commercial information than a spy?

Apparently not having enough on its plate, the CFTC has seen fit to vote out a NOPR on collateral segregation for cleared swaps.  The Commission decided to jettison the omnibus customer account model used successfully for donkey years in futures markets, and to require OTC CCPs to segregate collateral in their books and records, while permitting comingling of customer moneys in one account.  This legal segregation/operational comingling of customer collateral is intended to protect customers against “fellow-customer risk,” i.e., the risk that  the margins of non-defaulting customers of a futures commission merchant (FCM) that (a) has defaulted, and (b) has customers in default will be used to meet shortfalls in the defaulting customers’ accounts.

I wrote about this last year in a post titled “Alfred E. Newman Chooses an FCM: the Moral Hazard of Segregation.”  I argued that it is necessary to understand why futures exchanges would choose–and stick with–the omnibus model that exposes customers to the risk of each others’ default.  The most likely answer is that it provides customers with an incentive to monitor their FCMs.  FCMs that are undercapitalized, or which do not manage risk properly, pose a greater risk customers.  By giving customers skin in the game, they have an incentive to monitor the FCM’s capitalization and the adequacy of its risk management.  With segregation, customers can play Alfred E. Newman: “What?  Me worry?”  They have zero, zip, nada incentive to monitor their FCM.  Their money is safe even with an undercapitalized, or even crooked, broker.  This lack of customer monitoring leads to the survival of riskier FCMs, thereby increasing the risk in the system.

The CME and ICE Trust made a similar argument in letters to the CFTC.  Their letters apparently, uhm, cut no ice with a majority of the commissioners.  The CFTC evaluated the argument and rejected it.  In a nutshell, the Commission bought into the argument advanced by big money managers and pension funds that they don’t have the information to monitor FCMs.

This assertion has problems on many levels.  Yes, customer information about the safety and soundness of FCMs is imperfect.  They can’t evaluate that risk perfectly.  But they can see things like whether the FCM is overcapitalized, and by how much.  They can get some kind of idea as to what kind of customers the FCM serves.  They can observe first hand how the FCM manages the risk of that particular customer: does the FCM insist on prompt payment of margins?  Does it collect and evaluate information on the customer’s creditworthiness?  To the extent that a customer perceives that an FCM is slacking off with him, he can infer that’s a more general problem.  So they can–and do–observe signals on FCM safety and soundness.

And note that there is monitoring by multiple customers.  Each one might observe a noisy signal of FCM creditworthiness, but collectively they may get a relatively precise signal.  The literatures on global games and bank runs suggests that there are mechanisms whereby customers who decide whether to patronize an FCM based on a noisy signal of its riskiness can provide effective monitoring.

A sketch of a model would go something like this.  Customers observe a noisy signal on FCM riskiness.  They know other customers are observing noisy signals.  Each customer adopts a cut-off rule that says “I leave if I get a signal that the riskiness of the FCM rises above a certain level.”  In equilibrium, when enough customers get a bad signal, they run.  Sometimes that’s inefficient because they are fooled by bad draws of the signal.  But with enough customers, that’s relatively unlikely.  Instead, runs tend to occur when the FCM is in fact risky.  The prospect of being destroyed in a run gives an FCM an incentive to control its risk.

Things appear to work this way in practice.  Runs on FCMs often precede revelations that there is something seriously remiss.  There was a run on Refco before it imploded.  Ditto Lehman:

Some argue that the futility of relying on risk mutualisation in the default waterfall was illustrated by the fact that Lehman’s omnibus customer account dropped by roughly 75 percent during the week prior to its default. However, others say this proves the current system works.

“It shows market participants have the incentive to monitor the financial health of their FCM. Moving to an LSOC regime may well undermine this incentive,” said Taylor at the CME.

Exactly, Kim.

There is also empirical evidence that monitoring of relatively opaque financial institutions does occur when there is an incentive to do so.  In the 19th century, notes of different banks sold at varying discounts to reflect creditworthiness, and market participants would often run on banks that were perceived to be unduly risky.  Evidence presented by Calomiris and Gorton and others shows that these runs were not Diamond-Dybvig “sunspot” runs, but reflected bad fundamentals.  Rates in the Fed Fund market depend on the creditworthiness of the borrower.  Similarly, prices on CDS depend on creditworthiness of the counterparties.

As I noted earlier, big money managers and pension funds were pushing for segregation–indeed, greater segregation than the CFTC actually settled on.  Their protestations of their inability to monitor should be taken with a grain of salt–and would be quite alarming if true.  No, I think that the main motive is that they do in fact incur costs to monitor FCMs, but that other customers effectively free ride of their monitoring.  Segregation allows them to play Alfred E. Newman, and not worry about their FCMs risk–and thus not have to incur the costs of monitoring.

If the foregoing analysis is correct–and the CFTC’s arguments certainly don’t convince me otherwise–the proposal will increase total risk in the system, and shift costs from one kind of customer (the money managers and FCMs) to other customers.  This will come in the form of higher initial margins and higher default fund contributions because the inability to mutualize risk among customers requires shifting that risk elsewhere.  It will also come in the form of greater–and perhaps much greater–operational costs.  But note that these will all hit the big money managers and pension funds less than smaller entities.  They typically have lower funding costs (and hence are less impacted by the margin increases) and since many of the increased operational expenses are fixed costs, they have a bigger impact on the smaller firms.

Note too there are other possible regulatory responses that can reduce monitoring costs without interfering with incentives to monitor by fiddling with segregation.  In particular, improving FCM disclosures would help.  These could include providing customers with statistics on the fellow-customer risk they face, based, for instance, on stress tests.  CCPs perform such evaluations to estimate the risk they take on from FCMs and their customers, and properly protected and presented, such information would allow customers to make discriminating choices among FCMs based on risks and rewards.

There are other problems with the proposal.  In particular, given the concern about systemic risk in clearing, the proposal is particularly troubling.  CCPs mark-to-market on a daily or twice-daily or greater basis.  Thus, once or twice a day it is necessary for FCMs to meet variatio margin calls on both customer and house accounts.  Frequently the FCM needs to meet the call before the customer has provided the funds.  So in meeting the call, the FCM extends credit to the customer.  Moreover, settlement banks typically extend credit to the FCM to meet the variation margin payment.  In the omnibus system, banks view the credit as being collateralized by the omnibus account.  This is well diversified, usually, across customers and across products in the customer accounts.

Moving to segregation basically makes this credit mechanism unworkable, or at least far more costly than under the omnibus system.

This credit mechanism is extremely important.  Indeed, the possibility of its breakdown during times of market stress is one of the things that poses threat to the viability of a clearing system.  The near failure of this credit mechanism on 20 October, 1987 is what threatened the collapse of the major Chicago CCPs.

So what replaces it? It’s not immediately obvious how credit could be extended to meet variation margin payments in a segregated system in the way it is in an omnibus system.  With segregation, a bank extending credit to an FCM doesn’t have recourse to the entire portfolio of customer funds.  Individual accounts pose more risk, and are more difficult for the bank to evaluate.  It is also more operationally difficult to evaluate creditworthiness and to extend credit on hundreds of single accounts rather than a single omnibus account. So it will be much more costly to use credit to meet the metronomic variation margin calls.

But margin calls will still need to be met, and fast.  With credit being far more costly, FCMs will have to hold more liquid assets, and will likely require customers to post higher margins in order to have the cash necessary to meet the calls: in effect, segregation increases–perhaps dramatically–the precautionary demand for liquid assets. Moreover, during periods of market stress, even these additional holdings of liquid assets may not be enough to meet margin calls.  Riddle me this, Gary: What happens then, when they can’t be financed by credit?

This represents a major change in the operation of the market.  Given that it was possible for CCPs to operate in the past, but chose not to, it is reasonable to conclude they did not do so because it is more expensive than the omnibus system.

There’s also a monitoring angle here too.  Banks that extend credit to FCMs monitor them.  They are not going to extend credit to FCMs that are undercapitalized, or which do not manage properly the risk in the customer accounts.  So the omnibus system gives settlement banks an incentive to monitor FCMs.  Go to segregation, and that bank incentive to monitor vanishes.

There is a broader issue here.  Why does the CFTC perceive that it is necessary to impose a particular mechanism on market participants?  What is the market failure here?

The choice of segregation mechanism, and the specification of the default waterfall more generally, involves complicated trade-offs and incentive effects.  Yes, fellow-customer risk is a bummer, but we don’t live in Nirvana: we can’t make it disappear.  To reduce fellow-customer risk you either have to push the risk elsewhere or pay real costs to reduce it.

Exchanges and CCPs internalize many of the costs and benefits of those trade-offs and incentives.  If they choose an costlier mechanism, or one that allocates risk inefficiently, or one that provides bad incentives to control risk, the demand for their services declines.  They see lower volumes and lower prices as a result.

Now this may not work perfectly to achieve a first best outcome in the omniscient social planner sense.  But exchanges and CCPs (and integrated exchanges that operate CCPs) tend to have better information and stronger incentives than any regulator.  Absent some convincing demonstration that there is some major externality or other problem that leads them to choose badly, there is no basis to prescribe just how they should operate their businesses.

But no.  The CFTC just can’t seem to leave well enough alone.  It has again arrogated to itself the authority to impose a system on the marketplace, without making any showing whatsoever that competition and private contract lead to inefficient outcomes that can be improved by regulatory fiat.  This is especially perverse in this particular instance given that the likely outcome of the dictat is to increase risk–and indeed systemic risk.  All in the name of implementing an act ostensibly implemented to reduce risk.

How much irony can we take?

The annals of presidential idiocy on economics could fill libraries, but Barack Obama deserves pride of place for this gem:

President Obama explained to NBC News that the reason companies aren’t hiring is not because of his policies, it’s because the economy is so automated. … “There are some structural issues with our economy where a lot of businesses have learned to become much more efficient with a lot fewer workers. You see it when you go to a bank and you use an ATM, you don’t go to a bank teller, or you go to the airport and you’re using a kiosk instead of checking in at the gate.”

Read it.  Savor it.  Breathe deep the inanity.

Where to begin?

Let’s start with an easy one–the empirical issue.  What, did automation start in the past 2+ years?  Wasn’t there growing use of automation in the ’80s, ’90s, and early ’00s when employment was growing and the unemployment rate shrinking? No, Obama can’t blame the jobless non-recovery on some technological boom.

Now for something only slightly more mentally challenging–the economic logic.  Growing use of capital makes individuals more productive, which increases their standard of living, ceteris paribus.  Yes, automating some functions eliminates some functions: just a couple of days ago, to their disbelief and amazement, I was telling my kids about how once upon a time actual real, live people dressed in jaunty uniforms operated elevators (“5th floor! Lingere! Ladies’ footware.  Housewares.”)  But that frees up labor and human capital that can be used to do other things, and if labor markets are allowed to function, that’s just what will happen.  People will flow to their highest value occupations.  With greater technology and more capital, the same number of people can make more stuff, meaning there is more stuff per person.  (Yes, the transitional and distributive impacts of technological shocks are complex, and can harm some workers.  But that’s a completely different issue from the impact of technological change and capital accumulation on employment and total output.)

Obama, on the other hand, seems to believe that there is only a certain amount of stuff to be produced, and if each person becomes more productive, that means fewer people are required to produce it.  That gets an F- in Econ 101.  It’s the kind of muddled non-thinking that led to such marvelous innovations as the mandated 35 hour work week in France.

It is kind of pathetic, actually, that Obama is resorting to such lame excuses for the appalling state of the US labor market–the main threat to his re-election.  He cannot admit that his proposed solutions have failed to perform as promise.  He definitely cannot admit the very real possibility that his legislative and regulatory onslaught, and the likely prospect for far higher taxes, is a drag on growth and hiring.  So he is reduced to blaming it on ATMs.  Like I say: pathetic.

We’ve been told so often how smart and informed this guy is.  Repetition does not create truth.  I’m still waiting for evidence of said smartness and knowledge.  Any evidence.  Because what I read and hear on a daily basis is evidence of the exact opposite.

In 1974 or 1975, the Chicago Bears were unhappy with the condition of their home, Soldier Field.  They made noises about moving to Arlington Heights, a Chicago suburb.  Da Mare, Richard J. Daley, was having none of it.  I recall his angry statement at a press conference, delivered in his very imitable Bridgeport accent: “If da Bears wanna move to Arlington Heights, dey can call demselves de Arlington Heights Bears.”*   Daley laid it on the table for Bears owner George Halas:

“I think that’s fine, George. You’re a businessman. Do what you have to do. By the way, our lawyers say you can’t take the name Chicago with you out there. We’d have to take you to court. That could take years. I wonder how many people will come out to see The Arlington Heights Bears? I wonder how excited the network people will be about broadcasting The Arlington Heights Bears? You’re a fine businessman, George. You make the call.”

[And you wonder where Obama learned about Gangster Government?  He was raised in its American cradle.]

Fast forward nearly 40 years, and another Chicago icon–The Exchange Formerly Known as the Chicago Mercantile Exchange Now Called the CME Group–is making noises about leaving Chicago.  But not for Arlington Heights, because that would not solve its problem.  Its problem, you see, is that the corporate tax in Illinois is high and going higher–30 percent higher, in fact, due to a measure rammed through the state legislature by Governor Pat Quinn by means fair and foul, but mainly foul.  CME Group is thus facing the prospect of paying a far higher tax if it stays in Illinois than if it decamps for more favorable tax climes, like Indiana.

As the linked WSJ piece notes, the threat is likely a negotiating ploy by the CME.  (This is Illinois/Chicago, and the people at CME know how the game is played.)  The likely outcome is that they will get relief.  Rule by Waiver at the state level.

That would be a swell outcome for the CME Group, but would be symptomatic of far deeper problems.

The first is the desperate financial condition of the State of Illinois.

The second is that the attempts to escape this condition by raising taxes is doomed to failure.  Businesses and people can move.  Businesses can die.  Businesses can not be born.  Raising taxes at the state or local level often sets off a death spiral: the tax base contracts as businesses flee or are never born and people leave, so taxes are raised more, contracting the tax base further, and on and on.  Want to see the results?  You don’t have to go far from Illinois to do that.  Go to St. Louis, where it has happened at the city level.  Go to Michigan, where it is happening state wide.

The third is that this sort of tax bargaining favors the big and connected; is inimical to the rule of law; and feeds the Gangster Government phenomenon.  Yes, it’s nothing new.  But with the increasing fiscal desperation of many major states, it’s a growing problem.

So my guess is that the CME Group will continue to call Chicago home.  But the process by which that occurs will be a depressingly instructive example in the country’s slide towards the Natural State.

* This is one of Daley’s great quotes.  My favorite was uttered at the height of the chaos at the Democratic Party National Convention in Chicago in 1968: “Da police are not dere to create disorder, da police are dere to maintain disorder.”

About three and a half years ago I wrote a post discussing how Russia routinely uses “vapor pipelines”, “vapor contracts”, and other “vapor investments” in order to deter entry that would pose a competitive threat to Russian energy businesses, most notably Gazprom.  Today’s NYT runs an article about the South Stream pipeline which asks rhetorically “could the plan to build the world’s most expensive natural gas pipeline turn out to be an elaborate bluff?”  That is, is South Stream a viable investment for transporting gas, or is it so much vapor?

On its face, South Stream makes little economic sense.  For all of the scorn that Putin and Medvedev have heaped on Nabucco’s lack of gas supply, South Stream has the very same problem–only worse, because it is bigger.  It is very expensive to build.  It is getting more expensive and more unrealistic by the day as Gazprom has on multiple occasions boosted the the planned capacity on the line.  It makes sense only as a means of sowing fear, uncertainty and doubt about the prospects of Nabucco, and to put pressure on Ukraine with regards to transit deals and gas prices on sales to that country.

I found two bits in the article entertaining.  South Stream’s CEO scoffed at the idea that Russia is spending real money on the pipeline, and wouldn’t do that if it were merely a bluff:

Marcel Kramer, the Dutch-born chief executive of South Stream, denied during a recent interview that his pipeline was little more than Moscow’s attempt to squash Nabucco.

“To do such a major exercise as a sort of defensive move would be highly irrational,” Mr. Kramer said. “There is no doubt that this is very serious, and money is being spent — considerable amounts of preparatory money is being spent — by Gazprom itself.”

This conveniently overlooks the fact that with Russia generally, and Gazprom particularly, much of that “preparatory money” being spent is likely being vectored into the pockets of those doing the spending, or their buddies.  With Gazprom, wasteful spending is more feature than bug.

Here’s the other amusing bit:

“Frankly, neither of these pipelines make economic sense,” said Massimo Di Odoardo, a senior global gas analyst at Wood Mackenzie, an energy consulting firm. “It would be much cheaper for Russia and Europe to accept their interdependence and get to work making Ukraine an even more reliable gas corridor.”

Yeah.  That will happen.  Back-to-back monopolies located in distinct and highly corrupt countries in which contracts are inconveniences rather than commitments are antithetical to “reliability.”  These conditions are the ingredients in a classic recipe for conflict.  South Stream and Nabucco would make no sense in sensible countries, a category that does not include Ukraine and Russia.

So don’t expect South Stream to die anytime soon.  It creates FUD, and FUD has its uses.  It provides a vehicle that can be used to tunnel funds out of Gazprom.  Those are more than enough reasons for Putin et al to keep it going.

A perhaps more interesting question is whether Nabucco will keep going.  Waiting for it is like waiting for Godot.  I’m not holding my breath–especially given that the Euros have other much bigger fish to fry.  Like whether there’s going to be a Euro or a Euroland, for instance.

Scott Irwin at UIUC brought to my attention this paper by Kenneth Singleton*: “Investor Flows and the 2008 Boom/Bust in Oil Prices.”  As one would expect from Singleton, it is carefully done and thoughtful.  It is appropriately cautious about what can be achieved, given the complexity of the problem and the available data.  He characterizes the empirical part of the paper as “guidance” to efforts to create “much richer structural models.”  Knowing intimately the challenges of this structural modeling, I can say that even given extensive guidance, the challenges to actually incorporating “price drift owing to learning and speculation based on differences of opinion” into models of intertemporal resource allocation (e.g., dynamic models of storage economies).

The headline result in Singleton’s paper is that he finds a statistically significant and positive association between excess returns on oil futures contracts of different maturities and (a) the lagged thirteen week change in imputed positions of index investors, and (b) the lagged thirteen week change in managed-money spread positions.  He also finds that the one-week change in repo positions on Treasury bonds by primary dealers predicts price moves  Unlike Hong and Yogo (a paper I discuss below), he finds that open interest has no predictive power over oil futures excess returns, once these (and some other) variables are controlled for.

Two issues arise here.  The first is the interpretation of the results.  The second is their policy implications.

Singleton appeals to two explanations: limits to arbitrage (LTA) and differences of opinion (DOE).

LTA explanations make sense.  Speculators are subject to various constraints: informational frictions, information costs, fixed costs, etc., limit the amount of capital speculators have.  Moreover, this capital is subject to economic shocks, and various institutional features (e.g., the use of Value at Risk or other similar mechanisms for constraining speculation by agents) can lead to self-reinforcement of these shocks.  Furthermore, hedger demands can vary randomly due to shocks to their balance sheets and to broader financial market conditions.  This can lead to changes in risk premia in equilibrium. (A paper by Acarya, Locstoer, and Rmadorai explores these issues.  This is really an extension of Hirschleifer the Younger’s work on segmentation of commodity markets and the broader financial markets due to fixed costs of market participation.) (My work with Martin Jermakyan on electricity derivatives pricing documents (a) large premia for risks that should be diversifiable, and (b) substantial declines in these risk premia as constraints on speculation declined.  We use LTA-type explanations to explain these results.)

I have worked through the numerical analysis of a structural storage model in which the market price of risk varies randomly as a way of incorporating LTA factors into a dynamic storage model.  Quite intuitively, shocks to the market price of risk affect prices.  When the market price of risk falls, the commodity price rises and interestingly, inventories rise too.  Indeed, the inventory effect is more noticeable in simulations than the price impacts.  The intuition is straightforward: when the market price of risk falls, due, for instance, to an easing of constraints on speculators, it is cheaper to hedge inventory risks, so it is cheaper to hold inventories, and inventories go up.  The only way for inventories to go up is for spot prices to rise to reduce consumption and increase output.

I view this work as complementary to Acharya et al.  They model the factors that affect risk aversion of hedgers and speculators, but have only a crude model of the storage economy.  I treat the risk aversion affects exogenously, but have a more rigorous model of the storage economy.  It would be nice to both in one model, but that’s not really tractable.

But my reduced form model is sufficient to demonstrate that LTA-type phenomenon which lead to fluctuations in the market price of risk in a particular commodity market can be associated with price and inventory movements and with changes in speculative trading.

The DOE explanation is more, well, speculative.  They can rationalize departures from rational expectations equilibrium pricing, and hence can explain some anomalies.  But testability is problematic.  Moreover, per Hong and Stein’s 2007 JEP survey article, the main thing that separates DOE from LTA is that the former predicts much higher trading volumes.  That doesn’t map in that clearly with Singleton’s findings.

Moreover, although Singleton does a good job at presenting the state of understanding in rational expectations-type models of storable commodities (including some nice cites to my work), and mentions evidence relating to quantities, I still don’t think he confronts fully the fact that commodities are different than speculative stocks–which are the main motivation for much of the DOE literature.  Commodities are consumed and produced in the here and now, meaning that distortions in prices affect consumption and production decisions.  That should show up in quantity data.  To figure out exactly how, you’d need to integrate a model with storage and differences of opinion among market participants.  That’s a very tall order.  Similarly, you’d like to have the model make predictions about the entire forward curve.  Another tall order.

If you think that due to DOE, speculators are causing prices to be high, it is pretty clear that this will reduce consumption.  For something like oil, the effects on output are complicated.  If producers have no ability to allocate output intertemporally, the effect of the price rise is straightforward: output should go up.  Thus, if prices are forced up by speculators, this should lead to a rise in inventories.  But for oil, producers may shift output over time.  Producers can store underground by deferring production (and perhaps exploration and development), and their decisions on intertemporal allocation depend on the price today relative to what is expected to be the price in the future.  Thus, you’d need to look at a DOE model of a forward curve that incorporates intertemporal resource allocation through mechanisms other than storage.  As noted before, a tall order.

These types of theories would be necessary to understand fully what is driving energy prices.  I don’t think such an understanding is necessary to evaluate the implications of Singleton’s analysis for specific policy proposals–notably, position limits.

I imagine that the usual suspects will seize on these results to say: “Aha!  The smoking gun showing that speculation impacts prices.  Proof that we need position limits.”

Uhm, not so fast.  To the extent that the results reflect limits-to-arbitrage type effects, where shocks to hedger and speculator balance sheets drive variations in the market price of risk, position limits would be counterproductive.  If the association between prices and speculative positions reflects variations in constraints on speculators’ ability to absorb risk, or on hedgers’ demands to shed risk, constraining risk transfer will not improve things.  Indeed, it will make them worse.

The implications of difference-of-opinion-type explanations are hardly supportive of commodity position limits either.  For one thing, if you really believe that DOE results in price distortions, and this phenomenon is ubiquitous, why focus obsessively on commodities?  Why not restrict speculation in the entire investment universe?  But just how would you do that, exactly?  How would you surmount the knowledge problem and get the amount of speculation right?

But even ignoring that issue, position limits are not a discriminating tool that would eliminate the source of DOE-based distortions, to the extent they exist in this commodity market or that.  They are not a magic wand that somehow homogenizes the opinions of market participants.  Presumably even differences of opinion among hedgers, and between hedgers and speculators not constrained by position limits, would result in price impacts.  In other words, this is a ubiquitous feature of all speculative markets, not just commodity markets in an era of index funds and big money managers.

There is some evidence that speaks to this.  A paper by Hong and Yogo finds that open interest in commodity markets has predictive power over futures excess returns.  They also present a model based on gradual information diffusion (a common feature in DOE models) that can explain this result. The empirical result is hard to explain in a rational expectations context.

But note that the data in Hong-Yogo goes back to the mid-1960s.  Well before commodity index funds.  Well before hedge funds became major players in commodities.  Well before the “financialization” of commodity markets.  Meaning that if you believe that DOE and departures from rational expectations, purely fundamental-based pricing explain the result, it cannot be attributed to relatively recent financial innovations.  The Hong-Yogo results say there was no Edenic past in which commodity pricing was rational, only to be destroyed by the snake of financialization that slithered into the garden in the 2000s.

Meaning further that measures targeted at selected types of traders will not restore the non-existent Eden.  Indeed, given that the implications of these behavioral models are quite sensitive to the composition of traders, the information that each type of trader relies on, etc., it is quite possible that restrictions can lead to even greater departures from “rational” pricing.   I would surmise that if you had good data on the trading of certain categories of entities, from these earlier eras you would be able to find that the trading of some type or types of traders would have predictive power, just as Singleton finds that the trading of index funds and spread traders has predictive power.  So if you constrain index funds and spread traders through position limits, it is quite likely that the old-school categories of traders would represent a greater proportion of trading activity, and recoup their predictive power.

In brief, if you believe the DOE-type stories, you believe that these effects are ubiquitous: they are in the water.  You can’t make them go away by targeting one class of trader.  If you have two traders–you’ll have a difference of opinion.

This relates to an earlier SWP theme.  It is really necessary to be careful in distinguishing between the documentation of speculative effects, and the appropriate policy response.  To justify any policy aimed at curbing speculation, it is necessary, but not sufficient to demonstrate that speculators have somehow affected prices.  You also have to show that they have distorted them; with LTA, for instance, changes in speculation may affect prices, but not distort them in any reasonable sense of the word.  Moreover, you have to show how the specific policy will reduce that distortion.  That depends crucially on the source of the speculative distortion.

DOE-based stories are at least on far firmer ground than the typical hydraulic explanations of how speculation distorts prices.  But as I argue above, they provide weak support for position limits.  LTA-based stories provide even weaker support: indeed, plausible versions of LTA suggest that position limits will make problems worse, not better.  (For instance, if you believe that small noise traders distort prices, constraining big smart money will tend to exacerbate the effects of small noise traders.  Although this kind of story could provide a rationale for constraining ETFs that reduce the costs of noise trading–but can you design position limits that constrain noise-trader dominated ETFs but not big smart money traders?)

So my final take on Singleton’s paper is that the result is interesting, not necessarily that surprising, consistent with some non-behavioral explanations of price movements in which financial constraints and fundamentals affect prices–and a very weak basis for policy recommendations, and a particularly weak basis for justifying position limits.

Not that the usual suspects won’t try.

*That would be Kenneth Singleton the Stanford economist, not Kenneth Singleton, former MLB player.

My daughter Renee’s article, “Commodity Regulation After the Financial Crisis”, was just published in Economic Affairs.  Quite appropriately, the article immediately preceding hers is John Cochrane’s “How Did Paul Krugman Get It So Wrong?”  How much time do you have, John?  Actually, the Cochrane article is a very good read, and resonates with a lot that I wrote during the crisis and the debate over the stimulus.  But Renee’s article is a better read, of course!

Congratulations, R.  First of many!