Streetwise Professor

August 15, 2011

An Illuminating Contrast: HFT Are Not Sunshine Soldiers

Filed under: Economics,Exchanges,Financial Crisis II,Politics,Regulation — The Professor @ 2:30 pm

High frequency trading firms came under heavy fire in the aftermath of the May 2010 Flash Crash because they largely withdrew from the market shortly before the Crash.  Indeed, the lack of liquidity (which is nowadays largely provided by HFT firms) was likely a necessary condition for the Crash to occur.

In light of that, and of last week’s market craziness, it is therefore quite interesting to read this:

The stock market’s fastest electronic firms boosted trading threefold during the rout that erased $2.2 trillion from U.S. equity values, stepping up strategies that profit from volatility, according to one of their biggest brokers.

The increase from Aug. 1 to Aug. 10 over their 2011 average surpassed the 80 percent rise in U.S. equity volume, showing that high-frequency traders made up more of the market during the plunge, Gary Wedbush, executive vice president and head of capital markets at Wedbush Securities, said in a telephone interview. Wedbush is the largest broker supplying bids and offers on the Nasdaq Stock Market, according to exchange data.

“We’re seeing a tremendous amount of high-frequency trading,” said Wedbush, whose company is one of the biggest execution and clearing brokers catering to high-speed firms. “Their business is a trading business, and volatility creates far more opportunities. Some of their algorithms and automated systems are trading two, three or five times as many shares as they would have in a more normalized volatility environment.”

It is therefore incorrect to say that HFT firms are Sunshine Liquidity Suppliers who head for the hills when things get volatile.  Sometimes HFT reduce the amount of liquidity they supply.  Sometimes they increase it.  And volatility alone is not enough to spook HFT firms.  Indeed–and this shouldn’t be surprising, really–volatility can be a huge profit opportunity for them.  Note, moreover, that their profit-spurred entry almost certainly reduces volatility below what it would be otherwise and improves efficiency.

One should hope, therefore, that regulators and others who blame HFT for every market outcome they don’t like will take this more recent experience into account in order to develop a more mature understanding of HFT, and use that understanding to develop sensible policies that encourage beneficial HFT.  Policies that don’t throw the baby out with the bath.

A study of what caused the differences between the first two weeks of August and the Flash Crash could be quite illuminating.  Market making, whether old school on the floor of an exchange or new school on computer at high speed, is vulnerable to toxic order flow–that is, order flow driven by private information.  Any market maker who wants to survive has to have the ability to determine when order flow is toxic and when it is not.  Old school traders could intuit the likelihood that the guy who wanted to buy from or sell to them was trying to pick them off because he had better information.  HFT uses algorithms to try to sniff out such opportunistic order flow.

It is pretty clear that on May 6, 2010 HFT algos were flashing warning signs that the order flow had turned toxic,  and they cut back as a result.  It is also clear that despite all the volatility in these days of Downgrade and Debt Crises, the algos are not picking up evidence of an increased intensity of privately-informed trading.  As a result, the HFT firms are sufficiently confident that the risk of being picked off is low that they can profitably supply liquidity.

One interpretation of this is that HFT firms are primarily responding to market conditions, rather than creating them.  One implication of this is that regulators should try to develop tools that would allow them to pick up the same warning signals that HFT algos do in order to anticipate potential market disruptions a la 6 May 2010.  This would permit the implementation of precautionary policies that could reduce the likelihood and intensity of Flash Crashes.  This would be a far better policy than micromanaging HFT trading through things like order time limits or commitments to make markets even when that is unprofitable.  Micromanagement is likely to be counterproductive as it raises the costs of supplying liquidity, and inducing exit of market making capital–which would make prices more volatile during conditions like those that have prevailed this month.

August 12, 2011

Is It Just Me That Finds It Weird That Firms in the Business of Discovering Prices Don’t Use Prices?

Filed under: Derivatives,Economics,Exchanges,Financial Crisis II,Regulation — The Professor @ 8:06 pm

Exchanges are in the business of facilitating the discovery of prices.  The whole rationale for exchanges is that discovering more accurate prices encourages the efficient allocation of scarce resources.  That’s the value that they produce for society.

Which is why it peculiar, to say the least, that exchanges consistently don’t use prices to allocate a scarce resource at the heart of their businesses: communications capacity.  The recent volume surge caused by the intense volatility over the past week has taxed this capacity heavily, as this FT article shows.  Four major exchanges faced technical problems due to an avalanche of message traffic, most notably Borsa Milano.

To the extent that exchanges react to message traffic surges, they do so through non-price allocation methods, such as “throttling.”

As I have been discussing since the very first SWP post, exchange bandwidth is a scarce resource.  There can be intense spikes in bandwidth usage.  Some market participants exploit the fact that this capacity is not priced to engage in trading strategies that may be parasitical, predatory, and destablizing.  Even non-opportunistic use of exchange bandwidth can cause serious technical problems, including problems so severe that exchanges must shut down.   There is every indication that there are periodic tragedies of the commons on exchanges.

Pricing capacity, including peak-load pricing, is the obvious way to eliminate tragedies of the commons and abusive uses of system capacity.  You’d think that idea would come naturally to those in the business of pricing everything from stocks to bonds to soybeans.  But despite recurrent, and arguably increasingly serious, problems, exchanges uniformly shrink from this solution.

It was a puzzle to me five plus years ago.  It puzzles me still.

August 11, 2011

Amputation or Gangrene

Filed under: Economics,Politics — The Professor @ 8:12 pm

The recent volatility in the market has been linked with last Friday’s S&P downgrade, but the real epicenter is Europe.  The shock waves that commenced in Greece and then Portugal and Ireland have spread to Italy and Spain, and tremors are being felt in France as well.

Europe has two choices: amputation or gangrene.

The amputation option is to jettison the Euro project by lopping off the weak Med countries, and letting them respond to fiscal crisis in the old fashioned way, through a currency devaluation that would permit these countries to become more competitive, and which would reduce the real burden of their debts.

If Europe eschews amputation, its only real choice is to socialize the debt of the financial zombies on the continent’s southern periphery, and have the Germans and Dutch and French assume responsibility for paying the obligations assumed by the poorer, more spendthrift nations currently in financial distress.

This will not go down well with said Germans, Dutch, and French.  it is often said that such a path will require a fiscal union in Europe, but the details of such a union are crucial.  Fiscal union is not sufficient to ensure fiscal probity.  (Cf., States of America, United.)  Indeed, it is hard to see how any European legislative or executive body  that is remotely representative of the nations currently in the EU could avoid perpetuating transfers between the creditor nations and the debtor ones.  Which means that the Germans and Dutch and even the French are unlikely to sign on.

No, to avoid the moral hazards associated with socialization of debt, the government of the fiscal union would have to resemble the creditor committee of a bankrupt firm, imposing a stringent restructuring plan on the debtors, controlling their expenditures, and requiring them to surrender a substantial amount of autonomy.  But that would not be acceptable to sovereign debtor nations, and it is doubtful that any such creditor committee could enforce austerity, given the nationalist resistance any such attempt would spark.

So the Europeans are likely to try to muddle along, and socialize the debt on the sly via the ECB and the EFSF.  Which will be the worst alternative.  It will not address the moral hazard problem and the debtor nations are likely to scrape along, largely unreformed.  And it will be expensive.  As long as it is clear that the EU/ECB/EFSF will attempt to support the debt of bankrupt nations when their spreads spike, it will be vulnerable to periodic speculative attacks–and these attacks are expensive to fight off.  Very expensive.

The perverse incentives of such a policy, and the cost of implementing it, will doom Europe to a slow demise, as the financial gangrene spreads throughout the system, progressively threatening currently healthy (relatively speaking) nations.  Amputation would be the painful, gruesome, but superior alternative.  There is a chance of saving something that way.  Failing to choose that course threatens the entire body of nations.

But the Euros are so invested psychologically in the Euro, and so many of the elites have their interests tied up in the continuation of the Euro project, that they recoil from making the hard choice.  What’s more, politicians always prefer to let their successors clean up messes, and are therefore loath to admit failures on their watch.  There is also fear that amputation would be very costly to French, German and Dutch banks and insurers, as they would suffer losses on the bonds of the amputated members.

But as I said in March 2010, when the crisis first turned serious, it would be better to bail out the banks directly than bail them out indirectly by supporting the profligates.  That would be a one time expense and the damage would be contained, whereas the current MO will lead to a chronic drain of resources from north to south.  Defending against speculative attack for years will be expensive.  Moreover, the flight to quality and the improved fiscal prospects of Germany et al would lead to gains on the banks’ holdings of non-PIIGS debt that would offset some the losses on the latter.  But it is a cost that would be paid now, and the blame attached to the politicians currently in office–so it’s unlikely to happen.

The implications of this are rather grim.  It means that Europe will continue to be the source of economic tremors, whenever there is a run on the debt of any shaky country–or the countries that are supposedly propping up the shaky countries (France being a candidate).  And as we’ve seen in the last week, these tremors will be felt in the US–which is likely to generate more than its share of shocks in the coming years.

It also means that Europe is likely to die slowly, as the financial gangrene spreads progressively throughout the system.  This will be accompanied by slow growth, and social stresses as the promises of the welfare state become impossible of fulfillment not just in Greece or Portugal, but in France and Germany.  What is happening in London could be the  harbinger of things to come on the continent–and that is a much more combustible situation (literally so, if you recall the balieues in Paris, several years back).

Gangrene kills slowly, but it kills.  It is difficult to see how Europe can survive in the long run as currently constituted, with the rot progressively eating its way from country to country.  Amputation is a shattering experience, but it can be survived, and can increase the odds of long term survival.  But politicians typically choose to avoid pain today even if it is beneficial in the long run.  Which means that Europe’s future is bleak indeed.

August 10, 2011

Nice Try, But No Cigar

Betting the Business has a recent post that is a paean to central clearing.  I have some major problems with it.

The problems start with the title: “Central clearing lowers end-user costs.”  That short, unqualified, declaration begs major questions.  Most importantly: If clearing is more efficient, why did cleared markets lose market share to the putatively less efficient alternative, bilateral uncleared OTC trades?

I’m not suggesting that such inefficient outcomes are possible, but I take it as a rebuttable presumption that competitive processes tend to result in the displacement of the inefficient by the efficient.  So I’d like to see a convincing story at least, backed by some anecdotes at least, that would represent a plausible rebuttal.  That’s a low bar: it would be preferable, of course, to have a rigorous model supported by empirical evidence.  But I’ve yet to see anyone clear even that low bar: indeed, very few have tried.  To be honest, BTB don’t in this piece.

And by “convincing,” I don’t mean stories that rely on bankers’ Svengali-like hold on their customers, or customers suffering from some variant of battered spouse syndrome.  These stories are facially implausible, and indeed, counterfactual during the period during which OTC derivatives markets grew dramatically, the 1980s and 1990s.  This was a period in which banks were suffering “disintermediation”: they were losing business and customers to capital markets that customers found more efficient sources of capital.  So, the Svengali thing wasn’t working so good when it came to traditional loan business.  Ironically, many of the big loan customers that banks lost simultaneously began trading OTC derivatives with them.  Also ironically, one of the major reasons that the CDS market began was that banks were losing their traditional loan business.  JP Morgan in particular made a strategic decision to develop CDS business aggressively because it was facing more intense competition from capital markets in making traditional loans.  Which all means that customers–especially big ones–have the ability to adopt more efficient ways of financing and managing risk.

My other big problem with the BTB piece relates to netting:

Central clearing, if managed appropriately, helps to reduce the volume of credit risk by cancelling out many offsetting positions, disappearing some credit risk and leaving us with a smaller, residual credit risk from derivatives trading. One of the problems with OTC markets is that brokers wanting to closely guard their clients don’t have an incentive to cancel out offsetting exposures to counterparties. Critics of the clearing system keep overlooking the fact that risk can in fact disappear. The derivatives market system, depending upon how it is structured and operated, can have more or less total credit risk.

The notion that multilateral netting necessarily reduces risk is incorrect regardless of whether one focuses on credit risks in derivatives alone, or takes the proper perspective of looking at credit risk in toto.

With respect to credit risk in derivatives taken in isolation, clearing some products and not clearing others–which is inevitable given the unsuitability of some products for clearing, and indeed, the refusal of CCPs to clear them–may exploit some scale economies from multilateral netting in a particular product, but can destroy cross-product scope economies.  For instance, clearing a credit index but not all the names in the index destroys the scope economies that a bank can realize by holding positions with customers in both the index and the components.  Or if an interest rate swap is cleared but an interest rate swaption is not, netting economies across these products are lost.  These are simple examples, but they could be multiplied ad infinitum.

Indeed, these cross-product netting opportunities are one very plausible explanation as to why clearing lost ground to bilateral markets dominated by dealers.  Dealers trading multiple products can exploit cross-product netting economies and thereby offer their customers lower costs.

What’s more, when we consider clearing-as-it-will-be-in-this-messy-world, as opposed to the Platonic ideal of clearing, even within a single product clearing mandates may reduce netting economies.  Jurisdictionalism is likely to result in the creation of multiple CCPs for a given product type.  For instance, it is likely that regulators in the US and Europe insist that CCPs for particular products be established in their jurisdictions, and that financial institutions subject to their jurisdiction will use these “home” CCPs.  That creates operational headaches and reduces the netting benefits of clearing.

A proper, systemic approach also demonstrates that the disappearance of risk, like a magician’s trick, is often an illusion that works because the audience’s eyes are fixed in one place, and therefore they miss where the real action is.  As I pointed out several years ago, taking derivatives positions and the capital structures of market participants as given, netting redistributes risk from derivatives counterparties to other holders of liabilities on these derivatives market participants.  Yes, multilateral netting (and bilateral netting supported by collateral, rights of offset, etc., for OTC deals under bankruptcy laws) reduces the credit risk in derivatives trades, but the risk doesn’t disappear down the magician-CCP’s hat: it is reallocated to those who have lent money to the firms that hold positions in the netted derivatives.  Netting puts derivatives counterparties closer to the front of the line of creditors in bankruptcy.

Now the issue of the proper priority of derivatives is a sticky one, and I don’t claim to have the answer.  Giving derivatives counterparties priority tends to reduce their incentive to run, but it can increase the incentive of other creditors to run.  And in equilibrium, capital structures will depend on priority rules.  So it may be the case that clearing reduces the risk of runs on derivatives dealers by their derivatives counterparties, but increases the risk of runs by their repo counterparties, or the buyers of their corporate paper. It’s unclear how that cuts.  (No pun intended.)

Though I don’t have the answer as to the optimal priority rules, I do realize that netting does affect priority–and that this means that statements about netting “making risk disappear” are not generally true, and are typically wrong, because these statements are based on only a portion of the total risks.  The risk no more disappears due to a change of priorities achieved through netting than the rabbit really disappears into the magician’s hat.

It should be noted, moreover, that this issue of netting and priority has long been understood in other contexts, notably in payment systems.  Work in the 1990s and early 2000s (by Charlie Kahn, among others) emphasizes that netting systems and real time gross settlement have different affect the priority of payment system participants relative to other creditors of those systems.

There are some other problems with the BTB analysis, but I’ll just mention them in passing.  They say:

Margins are paid by those who use the system. In the OTC markets, banks either correctly price risk, or trade with clients by granting these subsidies from the taxpayer, or from wealth transfers by their bond holders. Clearing and margining is a potent dissuader of free riding on the system by negligent brokers, and also helps to mitigate agency conflicts between bonus motivated bankers and the bank’s stakeholders, which, we have learned, includes the taxpayers/citizens of each country.

I can’t say that I fully track that paragraph, but I will say that I am struck by the free riding analysis.  It suggests a sort of transubstantiation, where bankers are agency-conflicted, or perversely incentivized due to too big to fail subsidies when acting individually, but somehow become less conflicted and better incentivized when they act collectively through a CCP (and most CCPs will be bank dominated).  It’s not obvious how that works.  Indeed, collective action problems and multi-task/multi-principal agency problems usually result in weaker, not stronger incentives.

In this regard, it should also be noted that the homogenization of credit risk in a CCP creates problems.  CCPs make all trades by all members fungible, even if those members bring differing amounts of credit risk to the system.  This tends to reallocate trading activity away from the more creditworthy to the less creditworthy.

I also consider this unrealistic:

And to protect the public, it is necessary for regulators to see and be able to manage the true volume of credit supporting derivatives trading. Clearing is part of making that possible.

Given the fungibility of credit, you will never unambiguously know how much credit is used to support derivatives trades, even in a cleared system.

I have other issues (I can just imagine you exclaiming: “I’ll say!”), but I’ll leave it at that.  Suffice it to say that there are major holes in this clearing paean, and that it certainly does not provide a firm basis for mandating the adoption of central clearing.

August 9, 2011

Chinook Down

Filed under: History,Military — The Professor @ 7:08 pm

The latest reporting about the loss of the SEALs in Afghanistan over the weekend is that the men were lost in an ambush, but one that played out differently than how I hypothesized.  These new reports suggest that rather than having the raid tipped off by an inside source, the Taliban had leaked intelligence that a high value target was in a village in Wardak Province, knowing that the US would mount a raid to try to nab or kill him.  The Taliban were lying in wait, and jumped the Ranger unit sent to conduct the raid, knowing that the Americans would launch a rescue mission to extricate the Rangers.  The Taliban further knew that the rescue operation would have to fly down a single, narrow valley, and were in ambush on either side of the flight path, and shot down the helo.

In other words, the Taliban re-enacted a version of the Fetterman Massacre.  In 1866, Indians attacked a woodcutting party outside of Fort Kearny, knowing that soldiers in the fort would sortie to defend the woodcutters.  When the mixed force of cavalry and infantry ventured from the fort, a decoy party of Sioux led by Crazy Horse took off, and the soldiers followed them.   Chasing them over a ridge that took them out of sight of the fort, the soldiers were set upon by a far larger group of Indians, who killed them to the man.

You have to be aggressive in war, but aggressiveness can be turned against you.  This wasn’t the first time that happened, nor will it be the last.

August 8, 2011

A (Very) Few Good Men

Filed under: History,Military,Politics,Russia — The Professor @ 8:14 pm

Harvard’s Dmitry Gorenburg (with whom I will be on a panel at this November’s Association for Slavic, East European, and Asian Studies meetings) has an interesting post about the Russian military manpower dilemma at his Russian Military Reform blog.

He posits that Russia has two alternatives to address its problem: (1) increase the use of contract personnel in lieu of draftees, or (2) reduce the size of the military.

In my view, option (1) is a non-starter.  Conscription isn’t working because of the serious demographic problem.  It’s bad now, but will be particularly acute in the next couple of years due to the birth implosion in the early years following the collapse of the USSR.  But that same demographic problem means that the potential pool of kontraktniki is small as well.  Indeed, the shortage of physically fit, reasonably intelligent young men will tend to elevate their wages, thereby making the cost of a predominately volunteer military prohibitively expensive.  This is especially true if Russia plunges ahead with its plan to spend huge sums on new hardware, rather than software.

In other words, changing the means by which Russia obtains soldiers cannot alter its basic constraint: the pronounced lack of men available to serve.  So option (2) is the only realistic one.  And, not surprisingly, one that the government seems singularly uninterested in pursuing.

And if the economic problems in the US and Europe persist, Russia’s budgetary constraints will become even more acute.  Note that oil fell about 4 percent today, and is currently well below the level needed to balance the Russian budget.  And to bring home the point that Russia is a high beta economy, the RTS index fell even more than the S&P and Dow.

My recent reading–Fuller’s Strategy and Power in Russia, 1600-1914–makes plain that manpower problems are a hardy perennial on the steppes.  A good portion of the book details how manpower and recruiting problems have long been a major constraint on Russian strategy.  Serfdom permitted the army to rely on long term–and I mean long term (25 year)–service terms.  This facilitated the development of an experienced soldiery, with great esprit and comradery.  Indeed, the soldiers were effectively dead to their families–who often held mock funerals when they went off to the army.  The army became their family.  The soldiers formed artels–cooperatives–that were their households for life.  Also, since the soldiers were effectively cut off from the wider society, they were largely immune to the social conflicts that rent Russian society.

But this system had its problems.  First, landowners had an incentive to pick the least fit, least intelligent, and least tractable serfs to go into the army.  Second, as the other armies of Europe moved to a system of conscription with short service terms, these countries could accumulate a large force of reserves that could be called up in the event of war.  Russia, in contrast, could not do that.   It tried to work around this, by releasing soldiers who had served for 15 years who could be called back during an emergency.  But these men were outcasts.  They could not return to their villages, where they were strangers and extra mouths to feed to boot.  So many became tramps and bandits–and hence lost to the army.

The problem with military recruitment–made painfully obvious in the Crimean War–was a major factor behind the abolition of serfdom in 1861.  But Russia’s vast distances and economic backwardness made it impossible to create a system that worked like the Prussian/German military.  Moreover, eliminating the long-term service system destroyed the tight bonds between soldiers that made them so formidable in the field.  And making the army more like society, the changes subjected the army to all the frictions, factions, and fissions that characterized Russian society at the time.

In brief: Russia has been looking for a solution to its military manpower problems since the early-19th century.  Back then, it didn’t have the demographic problems it has now.  Which means that it will be looking for solutions–and not finding them–for years to come.

I recommend Fuller’s book more broadly.  It does an excellent job at analyzing the interaction between state capacity, finance/economics, and strategy over the vast sweep of the Romanov dynasty.  I have a greater appreciation for the sources of Russian insecurity, especially post-1856, and especially, especially post-1905.  The analysis of how its pessimism about its strategic situation led to its decision to go to war in 1914, and more importantly, its decisions on how to go to war (by attacking Germany and Austria) is fascinating.

Fuller argues that Russia’s strategy was realistic and well-adapted to its capabilities in the 18th century, but this was no longer true starting with Nicholas I.  Whereas Fuller is highly complimentary of the sagacity of Russian leadership from Catherine II to Alexander I, he is scathing in his assessment of all the Tsars that followed, and their advisors.

Truth be told, I would say that the current leadership has much more in common with the latter lot than the former.

One last thing: today is the anniversary of the beginning of the Russo-Georgian War in 2008.  Which reinforces the last point.

Oliver Cromwell Lord Protector of England

Filed under: History — The Professor @ 7:20 pm

Here’s a dramatization of Cromwell’s speech dissolving the Rump Parliament, from the eponymous biographical movie.  The speech is somewhat different than the one I quoted, but Richard Harris gives a convincing portrayal.  The speech starts around the 2 minute mark:  start watching from about 1:30 to get an illustration of the dissoluteness of the Parliament.

And for those who want some biographical detail on Cromwell, here you go!:

Real Men of Genius

Filed under: Economics,Financial Crisis II,Politics — The Professor @ 7:07 pm

I don’t have much to say about today’s kamikaze market.  The truly fascinating thing is how bonds rallied big time–the 10 year Treasury yield fell 25 basis points, the 30 year 21.  German Bund yields were down too, but not nearly as much.  There is a very wild dynamic going on here.  The downgrade is part of it, but the European debt crisis is the bigger driver right now.  It is difficult, however, to deny the interaction between the dual debt crises, which feed off one another.  Everything is relative, in the near term Treasuries look a damn sight better than banks.   In the longer term. . .

And whose brilliant idea was it to send Obama out there, while the market was open, to get up and say . . . well, say the exact same bilge he’s been spewing for the past month?  That went well, didn’t it?  He came.  He spoke.  It sank.

Apparently someone hadn’t remembered their Mark Twain: “It is better to keep your mouth closed and let people think you are a fool than to open it and remove all doubt.”  Even with a teleprompter.  Or should that be, especially with a teleprompter?

August 7, 2011

It Doesn’t Take a Rating Agency to Tell Which Way the Debt Grows

Filed under: Economics,Financial crisis,Politics — The Professor @ 4:36 pm

After the close of the markets on Friday, S&P downgraded US long term debt from AAA to AA+.

This is news, but shouldn’t be a surprise.  The rating agencies are like the cop who draws the chalk line around the murder victim’s body.  They just validate the obvious.

No, the arithmetic tells all.  When the government spends roughly 25 percent of GDP, is currently generating revenue at less than 15 percent of GDP, and historically has had receipts no more than 20 percent of GDP, the debt will grow at between 5 and 10 percent of GDP per annum.  The debt is already at high levels, both historically, and relative to levels that have sparked fiscal crises in other countries.  The official debt, moreover, is only a fraction of the government’s commitments.  Add it all up and the blind should be able to see the writing on the wall.  It reads “fiscal crackup coming to a country very near you.”

The administration and its acolytes have two stock responses.  The first is to screech that S&P made a “math error.”  As John Taylor notes, it’s not a math error: it’s a disagreement about assumptions.  The administration claims S&P should have assumed that discretionary spending would grow at the rate of inflation.  You know, because all the king’s horsemen and all the king’s men have pinky sworn on it.  They passed a bill and everything.  In this scenario, due to real GDP growth, spending would fall as a fraction of GDP.

S&P assumed that discretionary spending would rise at 5 percent, roughly the rate of nominal GDP growth (real growth plus inflation).  In this scenario, discretionary spending as a fraction of GDP would remain constant.  Given the historical record, this may in fact be conservative.  But under this assumption, the increase in debt over 10 years totals $2 trillion more than the administration claims.

The administration and its pilot fish have also huffed that S&P’s analysis is “political.”  Uhm, isn’t sovereign risk all about politics?  If not, please tell me what the hell it is about.

The second response is purely political–and Orwellian.  It is to repeat ad nauseum the Big Lie that this is the Tea Party downgrade, attributable lock, stock, and barrel to the failure of the Tea Party caucus in Congress to even countenance taxes as a part of any debt ceiling deal.

Like all Big Lies, this one is based on a kernel of truth: S&P did explicitly mention the unwillingness of the Republicans to include tax increases as a part of any deal as one of the justifications for its decision.

But pinning the blame on the Tea Party is fundamentally dishonest because if its adherents had its way on spending and taxes, S&P would probably give the US a AAAA rating.  Indeed, the singlemost important thing driving the Tea Party is concern bordering on obsession that the country is headed into the fiscal abyss.  The Tea Party caucus’s objection to all the proposed debt ceiling deals was–and is–that the deals did not confront this existential problem in a serious way.   They thought that something has to be done now, and the looming debt ceiling would give them the leverage to make such a confrontation possible.  I think their tactics were counterproductive because they did not take into account the objective correlation of forces (to use the old Soviet military phrase).  But they were–and are–the only sizable group that is taking seriously the underlying structural problems that led to the downgrade.

Ask yourself this: if Obama had gotten his original wish, and the debt ceiling had been raised “cleanly”–no deals on spending or taxes–would S&P have downgraded the US?  I can’t see how it could have been otherwise.  If anything, the Tea Party rebellion made a deal with a higher likelihood of slower deficit growth possible.  Under any reasonably plausible counterfactual, it is highly likely that the objective factor that drove the S&P decision–i.e., debt growth–would have been higher without the Tea Party than with it, because the ancien regime would have just gone on with business as usual.  Which means that the downgrade cannot be credibly laid at the feet of the Tea Party.

The reason the divide between the Tea Party and the ancien regime is so wide is that the two factions have fundamentally different views of the problem, based on fundamentally different views of the proper scope and size of government.  The Tea Party doesn’t consider raising taxes to be a constructive part of any effort to address the problem because its members believe that spending is the problem, not the way the spending is financed.  They believe that the government is too big, it spends to much, it spends badly, and that raising taxes just extends, but only for a little while, the life of Destructive Leviathan–whom they would rather starve than feed.

In contrast, the ancien regime–which is dominated by the left, but which includes much of the Republican Political Class as well–doesn’t believe that the government is too big.  Many of them–especially in this administration and the progressives in Congress–think if anything the government is too small.  From that perspective, the only issue is how to fund Constructive Leviathan, which makes taxes the beginning and end of the conversation.  From this perspective, the Tea Party is completely unreasonable in its refusal to raise taxes, and hence responsible for the downgrade.

That’s the divide, and it’s an unbridgeable one.  That should be the issue on which the 2012 election is fought.  If that election produces a new correlation of forces that moves policy closer to the Tea Party ideal of less spending, entitlement reform, and tax reform, there is a very good chance that the US will be upgraded.  If, in contrast, it merely perpetuates the ancien regime–where continued stalemate would constitute perpetuation–we’ve only taken the first step on the Downgrade Trail.  And if Obama prevails, the rest of the trip is more likely to be a sprint than a stroll.

And I cannot close without reminding you all of Timmy! the Treasury Secretary’s unqualified assertion, repeated often, that a downgrade would not occur.  “No risk,” sayeth Timmy!  Asked a second time, Timmy! repeateth: “No risk.”

Another fail.

But be there gladness in your hearts, peasants, for Timmy! will stay through the 2012 election.  For nothing succeeds with this administration like failure.

August 6, 2011

Reset: Another Fail

Filed under: Politics,Russia — The Professor @ 7:36 pm

Some not so random items in the news.

The elfin Medvedev is talking all butch about Georgia, and blaming the US for fomenting the 2008 war.

Russia intensifies a dirty tricks campaign against US diplomats and NGO personnel.

Russian ambassador to NATO and well-known charmer Dmitry Rogozin calls 2 US Senators (Kyl and Kirk) “Cold War monsters” who “eyed him through targeting sights.”  Moreover, Rogozin lied about the substance of the discussion:

Moreover, Rogozin charged that the Senators claimed that the Phased Adaptive Approach (PAA), President Obama’s ballistic missile defense plan for the protection of NATO allies and the U.S. homeland, is directed against Russia.

Not so, say senior sources present at the meeting, who told me:

Senator Kyl never said that the missile defense is aimed at Russia, neither did Senator Kirk. The two sides were unable to agree on the definition of the threat from Iran. So, Senator Kyl said that if there is no common definition of a threat, what is the sense of talking about cooperation on missile defense.

This is a far cry from declaring that missile defenses are aimed at Russia. Besides, U.S. defenses cannot hit the Russian Strategic Rocket Forces deployed hundreds of miles east of the proposed locations in Romania and Poland. The minimal number of proposed U.S. interceptors cannot significantly reduce the horrible power of a Russian strategic nuclear strike.

At least Kirk was suitably dismissive:

“You could say that we’re just not that into him,” Kirk said. “In a potential missile combat scenario between NATO and Iran, Russia is thoroughly irrelevant. So Russian concerns about what we do and not do about the Iranian threat are interesting but largely irrelevant.”

Believe me.  There is no better way to p*ss off someone like Rogozin that to say that Russia is irrelevant.  Indeed, you can explain a lot of Russian actions in the past 20 years as pathetic attempts to demonstrate relevance.  Well played, Senator Kirk.   As was this:

Regarding Rogozin’s comment that Kirk and Kyl were “radicals” and “monsters of the Cold War,” Kirk said, “He should probably moderate his caffeine intake.”


Of course, there’s also the prime minister’s “parasite” comment to the Putin Jugend and the constant background wailing about missile defense.

And the reset has produced what, exactly?  Help with Iran?  Not exactly.  Afghanistan?: any logistics help has been paid for in the very same cash that Putin deprecates.  And remind me who is the parasite?  In the Middle East?: Mischief.

Oh, but Bam did get this way cool birthday postage stamp.  Boy do the Russians know how to play President Narcissus.

And it works.  In part because of the narcissism thing, but also because the administration’s trophy case is so embarrassingly bare that it clings to the Reset like a drowning man grasping at straws.  Sayeth Obama:

“Well, first of all, I think it’s important for us to look back over the last two years and see the enormous progress we’ve made. I started talking about reset when I was still a candidate for president, and immediately reached out to President Medvedev as soon as I was elected. And we have been, I think, extraordinarily successful partners in moving towards reset,” Obama said.

Uhm, he might as well have reached out to the pin boy at the retro bowling alley, for Medvedev matters about as much, and at least the pin boy can actually reset something tangible.

And, pace Medvedev’s flexing noted in the first link, when the 98 pound weakling feels free to kick sand in your face, well, that doesn’t scream respect or “extraordinary success.”

And Rogozin’s big public kiss to Obama’s National Security Advisor, in contrast to his carping about Kyl and Kirk suggests that the administration is in full suck-up mode to keep up the appearances of a success:

“Tom Donilon is a veteran U.S. diplomat and politician, who began his career in 1977. I was pleased to meet with this distinguished man in the U.S. establishment. He is a smart, attentive person on whom you can rely in terms [of] preparing important decisions,” he said. “This meeting was the most enjoyable.”

“Most enjoyable.”  Ew.

The administration did impose some restrictions on visas by those implicated in the Magnitsky murder, but only, it appears, to try to derail more aggressive moves in Congress.  Moves (e.g., S1039) that would really hit where it hurts–in the offshore bank account.  (The bill includes asset freeze provisions.)   But the administration’s softer approach is apparently not enough, and Russia threatening “asymmetric” responses as well as tit-for-tat retaliation.

Though “tit-for-tat” is probably not really accurate, as I don’t think all that many American officials are clamoring for visas to go to Russia, whereas restrictions on the ability to travel west are much more painful for many of the targeted Russians.

No, it was inevitable that the Reset would dissolve into farce sooner or later.  It is being kept alive now only because the administration doesn’t want to admit to another failure.  Well, they’ve yet to admit failure on anything, but given the inattention of most Americans to Russia, people don’t have daily reminders of the magnitude of the fail as with matters economic.

And it’s not just me, by the way.  Walter Russell Mead has also labeled the Reset as an Official Fail.  He promises a longer analysis of US-Russian relations soon.  I can’t wait.

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