Streetwise Professor

More European jitters–focused on European banks–sent stock markets around the world swooning last week.  So of course Merkel and Sarkozy met and rumors circulated about this plan or that.

This is becoming a tiresome pattern.  Well-justified angst about the fiscal straits of the PIIGS, and the consequences that defaults would have for European banks and the Eurozone leads to crisis meetings.  Some plan is extemporized, and announced with great fanfare.  For a while, investors say I believe!  I believe! and the market comes to life, like Tinker Bell, in Europe’s version of the confidence fairy.  But then reality reasserts itself.  People realize that short of socialization or monetization of debts the risk of default is not going away.  And even under those two alternatives the problems are just transformed, not banished.

So each successive Tinker Bell rally becomes weaker than the one before, and each successive reversal become more bone jarring. I don’t believe, and I won’t believe.  Indeed, the yawning gap between the nature and scope of the problem, and the proposed palliatives (short sale bans, securities transaction taxes) should reinforce one’s understanding of how childlike I believe! really is.

The choice is ultimately Germany’s, and it is being pressed feverishly by France.  Saving the Eurodream will require Germans to go against their deeply ingrained instincts.   But historical scars of more recent origin than Weimar makes them petrified that by saying nein! they will be condemned for destroying Europe for a third time in a century.

In the end, I agree with R that the latter fear will overcome the former: but regardless, theirs is a choice between fears–neuroses, perhaps.   But agreeing to shoulder a disproportionate share of the debt burden to save Europe will expose Germany to financial gangrene.

My trip to Moscow in 2005 revealed that customer service there is, uhm, rudimentary (to be kind).  From the hotel receptionists who apparently learned their craft in the Gulag to the waitresses who returned at about the same frequency as Halley’s Comet, cheery and prompt service was a rarity.

But who was I anyways?  Just a mere American academic, not a big spender.  But the lack of a service mentality extends even to those whom the powers that be want to court in order to get them to spring for big rubles, such as potential customers for Russian military and civilian aircraft:

Russia showcases its latest achievements in the aviation industry at this week’s MAKS airshow outside Moscow, but most of the $10 billion deals sealed are between state-run organizations, while visitors to the airshow are reminded of Russia’s lack of organization.

. . . .

Moments after Mr. Putin had praised the great advances in Russia’s aviation industry, a MIG-29 fighter jet was forced to abort its display flight due to a technical malfunction. Less than 24 hours later, the country’s space agency,

. . . .

For the public, the airshow has become a reminder of Russia’s underdeveloped infrastructure and general lack of organization. The just 35-kilometer distance from the Moscow city centre takes around two and a half hours by public transport.

Getting there by car is no better. The Moscow traffic police shine in their bright white uniforms, but forget to actually do their job and guide the traffic, which leads to massive jams. This year, however, the organizers had anticipated the lack of parking spaces, but instead of actually adding more, they decided to solve the problem by charging 2700 rubles–the equivalent of $93–for a space.

Finding the way around the twelve huge pavilions with hundreds of company exhibitions proves an equal challenge. Organizers provided no information about where each company is located, and when asking at the information stand, an uninformed girl suggested buying the airshow program for 700 rubles ($24).

And then of course there is the ever-relevant issue in Russia: they forgot the toilets! None of the area maps at the airshow shows any, and after a 20-minute search, a single portable toilet finally appeared–without toilet paper, of course.

Those of you thinking of visiting: don’t say you weren’t warned!

Whoops!  He said it again.

Several weeks ago Obama blamed high unemployment on ATMs and the like.  He was widely ridiculed for those remarks, and rightly so.  But apparently he believes it, because he said virtually the same thing yesterday:

One of the challenges in terms of rebuilding our economy is – businesses have gotten so efficient, that, uh, when was the last time somebody went to a bank teller? Instead of using an ATM. Or, used a travel agent instead of going online. A lot of jobs out that that used to require people now have become automated.

And the world is supposed to wait with bated breath for his jobs proposal?  What will it be?  To ban the internet?

This reminds me of the famous Milton Friedman story:

There’s a story about Milton Friedman in China that may be apocryphal but illustrates this point. In observing hundreds of Chinese workers clearing land for a new building using shovels, Friedman asked his hosts “Why are they using shovels? Why not use heavy equipment like an earth-mover?” The Chinese official said “If we did that, we’d lose all of those jobs!” Supposedly Friedman said “Oh, you’re trying to create jobs! I thought you were trying to build a building. If you want to create jobs, why not take away their shovels and give them spoons?”

So maybe the jobs program won’t be based on shoveling money to shovel ready projects, but to spoon ready ones.

I have little patience with those who label Obama as a Marxist.  However, his economic conceptions do seem to be little more than warmed over crypto-Marxist drivel; he looks at the nation’s poor employment picture and sees a modern day version of Marx’s description of the plight of the handweavers.  This is not evidence of hardcore Marxism, just the kind of thing one picks up in the intellectually miasmatic swamps of progressivism that Obama has inhabited the last 30 odd years.  Abject ignorance of real economics is the default condition in those swamps, as we find out whenever Obama chooses to bless us with an exegesis on the subject.

I was incorrect to blame the leak of confidential CFTC trade information on the agency itself.  I jumped to a conclusion, and that was wrong.

The malfeasor has been revealed.  It is US Senator Bernie Sanders (Socialist–really–VT):

Oil trading data that exposed the extensive positions speculators held in the run-up to record high prices in 2008 were intentionally leaked by a U.S. senator, sparking broader concern about industry confidentiality as Congress moves on Wall Street reform.

Senator Bernie Sanders, a staunch critic of oil speculators, leaked the information to a major newspaper in a move that has unsettled both regulators and Wall Street alike.

In a June 16 e-mail reviewed by Reuters, a senior policy adviser to Sanders discusses how his office received private data with the names and positions of traders and forwarded it exclusively to a Wall Street Journal reporter.

The e-mail, which also attaches two files with the data, was sent to Public Citizen’s Tyson Slocum asking him to review it and speak with the newspaper about his observations.

In a statement from Sanders provided to Reuters, Sanders said he felt the data needed to be publicly aired.

“The CFTC has kept this information hidden from the American public for nearly three years,” he said. “This is an outrage. The American people have a right to know exactly who caused gas prices to skyrocket in 2008 and who is causing them to spike today.”

No, Senator, the outrage is that you violated confidentiality to engage in political grandstanding.  Moreover, you provide no evidence to support your assertion that the firms and individuals whose identity you revealed “caused gas prices to skyrocket.”  None.

There you have it, ladies and gentlemen.  The Senator from Vermont, providing additional proof, as if any was needed of Mark Twain’s dictum that “America is a nation without a distinct criminal class…with the possible exception of Congress.”

Obama’s bus tour produced this gem:

The best worst part is at about the 2 minute mark, where Obama says: “if we don’t think there’s more benefit than cost to it we’re not going to do it.”

It’s appropriate that Obama made this remark after visiting a livestock judging, because it is just so much bullsh*t.

(That’s a heifer not a bull, btw.)

Why do I call bull? Because this administration has been cavalier, at best, in its use of cost-benefit analysis. This is definitely the case for the financial administrators, notably the CFTC and the SEC. A court just overturned the SEC’s proxy rule for the inadequacy of its cost-benefit analysis. Many in Congress and even some CFTC commissioners have been extremely critical of the agency’s superficial cost-benefit analyses of Frank-n-Dodd rules.

And as for the agency that spurred the question by the farmer that Obama was responding to–the EPA–if truth in advertising laws applied to the government, its “cost-benefit” analysis would actually have to be called “making sh*t up.”

And Obama’s condescending reply to the farmer begging him to get the EPA off his back wasn’t the only gem of his Made in Canada Bust–I mean Bus–Tour-. This guy who never even ran a popsicle stand told the automobile companies that they have everything all wrong:

“You can’t just make money on SUVs and trucks,” Obama said during a town hall forum in Cannon Falls, Minn. “There is a place for SUVs and trucks, but as gas prices keep on going up [thanks in part to you, fella], you have got to understand the market. People are going to try to save money.”

You have to understand the market. No. He really said that. The Great And Powerful Bam who has never worked in the market and who has given zero, zip, nada evidence that he actually understands how markets work is giving advice on how to market cars.

This from the guy who is flogging electric cars. Like the Chevy Dolt–I mean Volt–July sales: 125. Yes. 1-2-5 decimal point zero.

Yeah. Definitely a car guy.

From the bus tour, Obama is heading for Martha’s Vineyard to hang with the swells. He’s being criticized for taking a vacation in these trying economic times. But not by me. Take as long as you like, man. Then stay longer. In fact, take the Ramones’ advice:

Today’s WSJ has an article that lists the positions of several market participants in the oil futures market on 30 June, 2008, shortly before prices hit their all-time high  This information was leaked by somebody in the CFTC.  A CFTC spokesman “said the agency couldn’t comment because the list contains confidential information.”

You don’t say.  [I cleaned that up.]  Apparently somebody in CFTC didn’t get the memo.

This is egregious.  Truly egregious.  This is highly confidential information.  Its disclosure was clearly intended to advance some political agenda.

Let me hazard a guess what is driving that agenda: next month the CFTC is likely to move on its energy position limits proposal.  The disclosures about the positions held by financial players will no doubt help shape the battlefield for that fight.

I cannot emphasize enough what an abuse this is.

And it will hinder the CFTC going forward.  The agency often relies on voluntary cooperation by market participants to supply data that helps it understand what is going on in the market, or to help develop policies.  Is there any doubt that companies receiving such requests will now think twice about cooperating?

And don’t you feel so much better that under Frank-n-Dodd that the CFTC will have access to far more data from far more markets?

I just shake my head.   And speaking of heads, somebody’s should roll over this.  Maybe several somebody’s heads.

I don’t know enough about the technology to comment sensibly about the Google acquisition of Motorola Mobile.  But I’m guessing that there’s a strong transactions cost economics story to be told here.  I’m looking forward to reading the analysis a TCE type that does know the technology.

One thing that strikes me as interesting is the similarity between some of the issues in this merger and the ongoing silo debate in the securities and derivatives markets.  Apple: the integrated producer.  Android/Google, pre-merger: horizontal platform seeking to encourage competition in the production of complementary products (handsets that run the software).  Apple is analogous to the Deutsche Boerse or CME vertical model; pre-merger Google is in some ways analogous to the LCH.Clearnet horizontal model.  Just as the horizontal model is under pressure in the financial markets (note LCH.Clearnet’s recent travails, and the recent news that Markit is in negotiations to buy it), it is apparently under pressure in the mobile phone/device market too.

Again, I don’t know enough about the mobile phone and software markets to judge whether the comparison is more than superficial.  But I’m guessing that although the technological details differ, the underlying economic forces are quite similar.

I was quoted in this WSJ/Dow Jones article about why sovereign CDS are not being cleared.  I think that legal risk has something to do with it.  But upon further consideration, I think the problem with sovereign CDS is far deeper than that.

The problem is not exclusively with clearing vs. bank intermediated-bilateral.  The problem is with wrong way risk which makes it very dangerous to have a bank as the counterparty selling protection in a sovereign CDS.  Clearing sovereign CDS through a bank-dominated CCP means that banks are the ultimate counterparty, and if the protection seller defaults there is a possibility that banks will be on the hook to pay out on the defaulted contracts precisely when they are in financial distress.

The recent crisis in Europe demonstrates that with current monetary arrangements, the default of any sovereign name of any size can trigger a financial crisis that threatens banks.  Note that bank CDS spreads tend to blow out whenever one of the PIIGS looks shaky. I don’t have the data at hand, but I would wager there is a very high correlation between Greek, or Portugese, or Spanish, or Italian CDS spreads and bank CDS spreads.  Which means that there is a substantially elevated risk that a bank or bank-backstopped counterparty (i.e., a CCP) won’t be there if a sovereign defaults.

There are structural reasons for correlation.  Banks tend to hold large amounts of sov debt in their portfolios.  A surge in sovereign default risk tends to lead to funding problems for banks–especially those with large sovereign exposures.  Thus, sovereign debt crises are associated with substantially elevated risk of bank failure.

This is actually a firmer basis for governments and regulators to be skeptical about–and perhaps even hostile to– sovereign CDS than their usual kill-the-messenger bleats about evil speculators.  Sovereign CDS are potentially beset with wrong way risk, and they pose a real systemic threat to banks if the banks sell protection: in contrast, banks buying protection makes good sense as a hedge if the counterparty is likely to be able to perform in a sovereign debt crisis.  The risk is right-way when banks are protection buyers.

The issue with clearing sovereign CDS is that clearing makes banks contingent protection sellers, and the contingency kicks in right when banks are least able to afford it.  But even a bank running a balanced book would still pose problems because if a counterparty from whom it bought protection defaults, it would be obligated to dip into its capital to pay off the parties to whom it had sold protection, and again precisely when it is least able to afford it.

This suggests that there are acute systematic risks inherent in sovereign CDS under both bilateral and cleared approaches.  Since we have seen that the potential default of any European sovereign name, even those of middling size, can precipitate financial panic, sovereign CDS are arguably the most problematic derivatives out there from a counterparty risk/systemic risk perspective.  They are likely beneficial as long as banks are not major protection sellers under any contingency.  That’s impossible to achieve with clearing, and likely very difficult to achieve in a bilateral market.

What this suggests to me is that (a) it is unwise in the extreme to clear sovereign CDS, and (b) banks should be subject to a hefty capital charge on their gross sales of sovereign protection.  Gross, not net, because the gross drives their contingent exposure.  Low capital charges on a positive net position in protection purchases would be defensible as that risk is right way and net protection purchases gives banks an incentive to lay off sovereign debt risk on those who can bear it at a lower cost than they can.

Looking at the issue of sovereign debt risk more broadly, this analysis again raises serious alarms about the wisdom of mandating or incentivizing banks to hold large sovereign debt positions, where the incentivizing comes in the form of liquidity requirements that must be met by sovereign debt holdings and favorable capital charges, and the mandating comes in the form of margin and clearing requirements.  But the financial repression pressures driven by the pressing need of governments to get somebody to hold their bonds is driving us in that direction.

Which suggests to me that the systemic risk of the future–and the systemic risk from hell–is the prospect for chronic fiscal crises around the world.

And on that cheery note . . . back to work.

Orwell said “there are some things so absurd only an intellectual could believe them.”

Exhibit One: Krugman on CNN.  Uhm, if we built a lot of stuff to destroy space aliens in the end we’d have a lot of useless stuff to destroy space aliens not stuff that we really like or need.  And using a Twilight Zone episode as the source of economic policy ideas?  What’s next?  Star Trek: The Keynesian Kronicles?  Battlestar Econometrica?

Rogoff’s I-can’t-believe-what-I’m-hearing retort is priceless: “So we need Orson Welles is what you’re saying?”  Yes, Ken, that’s what he’s saying.  Really.  Somewhere Orwell is chuckling and saying “told you so.”

The best worst part is that Krugman (perhaps tacitly acknowledging the primarily libertarian/classical liberal criticism of his what-we-really-need-is-WWIII-to-save-our-economy-like-WWII-did argument) explicitly recognizes that WWII was “negative social product spending”–but he wants to do it again anyways.  It doesn’t get much more Orwellian than that: “War is peace. [Well, prosperity anyways, according to Krugman.] Freedom is slavery. [Krugman probably believes that one.]  Ignorance is Strength. [Then K would be industrial strength.] ”  Krugman’s corollary: “Waste is wealth.”

But Krugman’s week was only getting started.  He also penned a screed attempting to discredit Texas.  (We are so in his head.  I love it.)  His argument, in a nutshell (again, emphasis on the nut): Texas is creating more jobs than other states because people are moving to Texas.

Uhm, this isn’t a natural experiment where people are randomly assigned to states, and told that if they try to leave they’ll be shot.  In that case one would predict that (a) employment would increase in states that have an above average number of people assigned, and fall in states that have a below average number assigned, and (b) the real standard of living would fall in the former states and rise in the latter.

Note that Krugman makes no effort to see whether, in fact, the standard of living has fallen in Texas relative to other places.  Not surprising, really.

No, population movement is endogenous.  And (pace Kevin Williamson at NRO), people don’t move to Texas for the weather for the most part (it was 106 in Houston last Thursday), or the scenery, or (again pace Williamson) because they are “middle class Mexicans” (really!  Krugman said that).

No, those at the margin move to Texas because it offers a higher standard of living, all things considered, than other places.  Why this is true is complicated, and would be a complete mystery to Krugman who apparently believes that Texas is a Dickensian wasteland with horrible schools and horrific health care.  (Memo to Krugman: visit the Houston Medical Center someday, dipstick.  If you ever get cancer–and no, I am not wishing it on you–you will be damn glad it exists.)  “Standard of living” encompasses the entire bundle of attributes associated with a place–after tax income, housing prices, social amenities, employment opportunities, and yes things like schools and health care and weather.  Revealed preference suggests that Texas offers a bundle that is superior to other places.

Just how much of that is attributable to this policy or that (zero income tax, tort reform) or this exogenous factor or that (e.g., resource endowments like energy) is difficult to determine.  But the fact remains: people are choosing to leave places like California and New York, and move to Texas.  Krugman’s “argument” assiduously avoids any discussion of choice, and makes Texas’s relative performance seem like the outcome of some natural experiment.

This shouldn’t be surprising, actually, because real economics is about the determinants of individual choice, and Krugman is becoming less of a real economist with each passing day.

Maybe his body has been taken over by space aliens . . .

Michael Giberson at Knowledge Problem has an excellent post that illustrates perfectly three fundamental problems with the metastasizing regulatory state.   EPA rules on air toxins and mercury are going to force–or at least accelerate–the closure of large numbers of coal-fired power plants especially in the East and Midwest.

Problem One: making uncoordinated policy decisions that have myriad impacts in tightly connected systems.  The EPA decision focuses on one thing: air quality.  But its chosen remedy has the potential to cause major disruptions in areas outside of EPA jurisdiction, considerations that EPA did not take sufficiently into consideration.  Specifically, the loss of such large quantities of baseload generation threatens electricity supply, and electricity reliability.  The stability of the grid depends crucially on the spatial configuration of load and generation; those have to be balanced tightly in order to ensure reliability.  Shutting down just one plant can upset that delicate balance in a way that greatly increases the system’s vulnerability.  So in its zeal to do good, EPA has created a huge potential for bad.

Problems Two and Three have their roots in EPA’s response to Problem One.  EPA says: “Don’t worry!  We’ll use our discretion to try to mitigate these bad effects!  We might give waivers!”

As Richard Epstein pointed out, Government by Waiver has at least two serious defects.  First, it is an invitation to rent seeking, lobbying, and politicking–all just different flavors of corruption.  Resources are wasted in competing for favors.  And favors are allocated to those who have a comparative advantage in politicking, not those who have a comparative advantage in producing or consuming efficiently.

Second, it creates substantial uncertainty.  Investments in generation and transmission (which can be both a complement to or a substitute for generation) have very long lives.  The return on any investment can depend decisively on regulatory decisions.  Yeah, EPA can say it is striving “to provide a rational basis for utility planning,” but anyone out of diapers knows how the game is really played.  The outcome of the regulatory process is very difficult to predict because it depends on the uncertain outcome of the rent seeking process, fluke events (e.g., one utility is the subject of a damaging revelation, perhaps untrue, which makes it a political pariah), and other unfathomable possibilities.  “Regulatory discretion” is a recipe for radical uncertainty.  Anyone contemplating making a huge investment that can turn into a long-lived white elephant at a regulator’s whim will often decide to wait until that uncertainty is resolved.  Thus, this policy uncertainty tends to retard investment, leading to higher prices and lower reliability.

Markets rely primarily on the price system to coordinate the actions of millions of dispersed decision makers acting on little pieces of information.  Prices tell people about the consequences of their actions, give them an incentive to act efficiently and take these consequences into account even if they could not possibly articulate what those consequences are.

There is no analogous mechanism to coordinate the actions of regulators.  Regulators routinely take actions that are perfectly sensible within their narrow, legally circumscribed spheres, but which impose huge costs elsewhere.  There is a feedback mechanism of sorts, but the ways that regulators respond to the feedback creates its own problems.  In this instance, EPA did something in pursuit of its legislative mandate which will have severe adverse consequences outside of it.  The affected industry howled, providing feedback, so EPA is extemporizing a response.  But that extemporization brings on its own bad effects, in the form of corruption and investment-killing uncertainty.

Like Reagan said: The nine most terrifying words in the English language: “‘I’m from the government and I’m here to help.”