Streetwise Professor

September 23, 2011

A First Step on a Long, Hard Road

Filed under: Commodities,Derivatives,Economics,Energy,Financial crisis,Politics,Regulation — The Professor @ 12:32 pm

James Hamilton and Jing Wu have a new paper on speculation and oil futures pricing (h/t Brian Goff).  The paper is very carefully done and very impressive econometrically.  It presents some provocative results, but IMO the radical simplifying assumptions James and Jing used in order to come up with something that they could estimate cast serious doubts on the results.  I am also sure that the results will be overinterpreted and misinterpreted to advance political agendas, and regret that the authors provide the hook in a few careless statements that should have been heavily qualified, but weren’t.

Here are my initial detailed comments:

  1. The paper focuses on risk premia.  Hallelujah!  The price of risk is what speculators are most likely to affect, because most speculative transactions involve a transfer of risk, rather than the commodity.  A very basic point, but one which is all too frequently overlooked.
  2. The most provocative result in the paper is a huge discontinuity of their estimate of the risk premium in oil futures  between the pre-2005 period and 2005-2011 (see Fig. 5).  This discontinuity is an artifact of HW’s splitting of the sample.  They motivate the choice of splitting date by observing that the growth in crude oil futures open interest increased dramatically beginning in 2004.  It would be preferable to do some testing for structural breaks and estimate accordingly.
  3. More generally, I am very suspicious of such a sharp discontinuity.  I think it is highly likely that it is symptomatic of other changes going on in the market, and the limitations of their model.  (More on the latter below).
  4. The model is not complete, even on its own terms.  Although it discusses the role of speculators (“arbitrageurs” in HW) in absorbing risk from hedgers, hedgers are not formally modeled.  This is a huge hole.  Moreover, “investors”–such as those who trade via index funds–are modeled extremely mechanically.  Yes, once they are in the market, index traders tend to trade mechanically, but the allocation of speculative capital between index funds and other investment opportunities is not as mechanical a process as the paper assumes.  Indeed, in the model the index-fund investors’ trading does not depend at all on risk-return tradeoffs.  They are just automatons that flow in and out of the market based on some autoregressive process. This is extremely problematic: index investor capital allocation decisions are presumably the result of an optimization process that reflects their investment opportunity set and the pricing of risk across these opportunities.  (Again, more on this below).
  5. Relatedly, since hedgers are not in the model, there is no effect of index investors shocks on hedger behavior.
  6. The model of fundamentals is extremely cramped and limiting.  I am no big fan of affine models generally, but even overlooking that, it is definitely the case that more than one (latent) fundamental factor drives spot oil prices.  Thus, the model becomes a two-factor model, with one (fundamental) factor driving the spot price and the “risk neutral” forward curve and the other (index-investor buying) affecting the shape of the forward curve.
  7. One cannot generate interesting forward curve dynamics using a one-factor fundamental model.  One cannot generate interesting and realistic inventory-price relations using a one factor model.  As I show in my forthcoming book, at least two fundamental factors are needed to generate reasonable dynamics.  Furthermore, as I also show in the book, the homoskedastic error structure for the fundamentals variable assumed in the HW paper cannot generate price and inventory behavior observed in the real world.
  8. Thus, the fundamentals model is almost certainly seriously mis-specified.  I can understand the modeling choice, but it has consequences.  It is my sense that this mis-specification is so severe that it casts serious doubts on the results.
  9. In a frictionless world, risk premia for a particular factor are determined by the covariation between that factor and the pricing kernel.  In markets with frictions (as in the Hirshleifer models of the late-80s, early-90s), idiosyncratic risk of the factor may impact risk premia, in addition to the effect of systematic risk (driven by the covariation).  HW is a single market model: the oil market is all there is, and only factors within the oil market affect risk premia.  This is in essence an old-school Keynesian model of the risk premium.  Again, this is highly problematic.  In particular, since the whole movement of financial investors into commodities strengthens the linkage between broader financial markets and commodity markets, ignoring systematic risk (and hence inter-market covariation) is a serious deficiency.
  10. It is a stylized fact that correlations between commodity returns and returns on broad equity indices and FX have changed substantially in recent years.  Although some have asserted a connection between index trading and this change in correlation structures, you can tell fundamentals-based stories as well.  For instance, if supply shocks were dominant in pre-2005, but demand shocks (e.g., the growth of China, the financial crisis) were dominant since, one would tend to observe the oil-S&P correlation to change from negative to positive.  As long as you are not in a Keynesian world with each commodity and investment an island with risk borne only by those living on that island, this change in correlations would lead to a change in risk premia.  The change in sign in the risk premium at the end of the sample corresponds to the financial crisis and associated major recession.  During this time demand shocks were clearly driving oil prices, and the correlation between the S&P and crude prices was very high and positive.  Thus, there was more systematic risk 2007 and later, and this would be expected to affect risk premia, but the model precludes this.
  11. The omission of systematic risk in a model of risk premia is a serious, and IMO disabling, limitation.  It is particularly odd to ignore this in a paper that examines “financialization” of a commodity market, since financialization involves financial investors adding commodities to broadly diversified portfolios in order to optimize some risk-return trade-off.
  12. These issues all affect how one interprets the HW findings.  What if risk premia did in fact change?  This could well reflect more accurate risk pricing due to the integration of commodities into investor opportunity sets.  Risks are going to be priced differently–and more efficiently–if there is more trade between islands.  A reduction in frictions, and an increase in the connections between markets, should lead to better risk pricing.  So finding a change in risk pricing could represent a very salutary development.
  13. Indeed, tying some of these threads together, doesn’t “financialization” reflect a normal economic process of equilibrating prices between segmented markets?  Here, the prices are the prices of risk, and the movement of resources (risk) is more abstract than the movement of physical oil between Cushing and the Gulf.  In the latter example, profit seeking traders will drive the difference in prices in the two markets to the cost of transportation between them.  In the case of risk premia, any innovations (which could well include index investing) that reduces the costs of moving resources (risk bearing capacity) between prices will affect the prices in those markets, and tend to equalize them.  Since in the broader financial markets, oil and other commodities are small relative to the broader capital markets, it should be expected that the risk prices of commodities should account for the bulk of the change toward equalization.  It should also be welcomed.
  14. To summarize a bit, the crucial questions include: what risks are priced?  Who participates in the market that determines these prices?  and, What are the investment opportunities available to these participants?  I think on every question, the HW paper is on very, very shaky ground.  The one-dimension model of fundamentals is far too restrictive, and the dynamics are far too simplistic.  Crucial players–hedgers–are left out, and others are treated mechanically.  In a paper that attempts to determine the effect of the movement of well-diversified financial investors into commodities, the Keynesian islands approach is inadequate: these investors have extensive investment opportunities that affect their behavior–and the pricing of risk that is the whole subject of the paper.  Mechanical treatment of one group of agents can make sense in some models, as in noise trader microstructure models.  Mechanical treatment of investors actively and aggressively looking for superior risk-return performance is a serious shortcoming in a model of the pricing of this trade-off.
  15. I sympathize with James and Jing.   The impressive empirical cleverness required to estimate even this radically simplified model demonstrates just how challenging is the task of understanding the pricing of commodity risk.  I could readily believe that it could be impossible to estimate a richer model that includes fundamentals subject multiple, potentially heteroskedastic shocks, and three classes of optimizing investors with diverse investment opportunities. But the very complexity of the problem should make people very reluctant to make strong statements about the effects of “financialization” on price behavior.
  16. In summary, I believe Hamilton-Wu are eminently correct to focus on risk premia as the variable that could be affected by the entry of a new class of market participant, but the daunting nature of that task is evident.  The radical simplification (again, understandable as a practical matter) needed to permit estimation, which involves abstraction from virtually all of the important economic issues makes their conclusions and results highly dubious as a basis for policy.  But there are plenty of fools out there (and let’s be clear, I do not include the authors in that category) who will no doubt rush in where prudent and thoughtful angels fear to tread.
  17. For this reason, I wish they would have abstained from statements likely the valediction in their paper: “We suggest that increased participation by financial investors in oil futures markets may have been a factor in changing the nature of risk premia in crude oil futures contracts.”  This kind of suggestion only encourages the fools.  Every link of the chain of reasoning supporting this suggestion is flimsy.  Most importantly, the suggestion rests on a structural break which corresponds roughly with a period of time during which more financial investors participated in commodity markets.  But many other things changed during the same period.  Indeed, Hamilton himself has repeatedly pointed out that this period was one in which there was a virtual cessation in the growth of oil output.  That’s a pretty important fundamental.  Moreover, this was a period in which emerging markets, notably China, began to impact commodity markets dramatically.  Furthermore, most of the period (say 2007-2011), was one of financial an economic upheaval not observed since the 1930s.  That’s a pretty big change too.  Why put all the focus on index investing?  The model certainly doesn’t support that, because (a) all of these other factors are omitted altogether, and (b) even the model of index investing is crude and mechanical.
  18. That is, to attribute the change in risk premia estimated from a clearly mis-specified model to a single change among many that occurred during the period of change is highly, yes, speculative, and an extremely tenuous piece of post hoc ergo propter hoc reasoning.

I do not want to close on a negative note.  I admire that Hamilton and Wu have focused on the right issue and have brought impressive econometric skills to the problem.  Improving our understanding of these issues would best be achieved by following the direction James and Jing have pioneered, by incorporating some of the features discussed above.  It will be a hard road, but worth taking.  Hamilton-Wu is a helpful first step along that road, and I hope that people understand it is only that, and that much hard slogging remains.


A few technical asides:

  1. The use of NYMEX data in which time to expiration changes presents some complications to the estimation and interpretation.  It would be worthwhile to look at LME metals data (e.g., copper) because (a) it has also been claimed that financial investors have affected metals pricing, and (b) LME trades constant-maturity contracts that are easier to handle empirically.
  2. If the focus is on index investors, who by definition trade in multiple commodities in a mechanical way, it seems that cross-sectional evidence would be quite informative.  For instance, did risk premia change in a way similar to that claimed for oil in other markets that are also part of commodity indices?

September 21, 2011

After Having Jumped the Fence, the Grass Doesn’t Look So Green All of a Sudden

Filed under: Clearing,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 11:23 am

I am in London for the ISDA Annual Europe Conference, where like in the NY version, I moderated a panel on clearing.  Yesterday’s panel was very informative and interactive, and made for some good copy.  As in NY, it was only possible to scratch the surface, but that in itself is revealing because it tells you just how many knotty issues are still unresolved.  Another thing that came through loud and clear was how interconnected these issues are.

The most entertaining debate centered around interoperability.  The looming fragmentation among CCPs has regulators around the world trying to mitigate the cost and risk increasing consequences of fragmentation by pushing for CCPs to interoperate.  The three major clearers represented on the panel–Michael Davie from LCH.Clearnet, Paul Swann from ICE Clear Europe, and Kim Taylor from CME Clearing–were all pretty negative on the idea, with Michael and Paul being adamantly opposed, and Kim only slightly more accepting of the idea.  Michael wins the quip of the day award for his characterization of the idea: “It’s crackers.”

Jurisdictional fragmentation was foreseeable months ago: I discussed the problem in some detail in my 2010 Cato and Journal of Applied Corporate Finance pieces, and again more recently in my ISDA study.  It is on the front page now, with the face-off between the UK and the ECB over the latter’s insistence that any clearer of Euro-denominated derivatives be domiciled in the Eurozone, with access to the European Central Bank.

There is some economic sense to the ECB’s position, but there is also economic sense to having global CCPs that can maximally exploit economies of scale and scope arising from netting and capital efficiency.  But this just illustrates the ill-thought out nature of clearing mandates.  Global banks can access central bank liquidity in a variety of currencies and net efficiently and collateralize efficiently across multiple currencies.  Forcing clearing eliminates some netting and capital efficiencies (but can potentially improve others), but creates thorny issues about access to central bank liquidity that makes global CCPs problematic.

The Canadians are now grappling with the very difficult tradeoff between efficiencies that come from global CCP scope, and the potential systemic fragility that could arise from concentrating so much risk in a single entity.  A Bank of Canada official, Tim Lane, warned:

In carrying out the G20 mandate requiring all OTC derivatives to be centrally cleared, it is essential to ensure that we do not unduly concentrate risk in a relatively small number of institutions that are direct clearing members of global CCPs,” he said.

These were the very institutions that spread and amplified contagion through the global financial system in 2008, Mr Lane told the annual Sibos settlement and payments conference.

Quite a puzzle, no?  Who could have possibly anticipated this?  (You don’t need to answer that.)

And the COO of the DTCC has warned about the difficulties and dangers of clearing CDS.

“We may be creating a much higher level of risk,’’ he said, by requiring swaps to be turned into standardized products, traded on electronic exchanges and where risks are covered by a central counterparty, backing up the two sides of a trade.

He noted, for instance, that a central counterparty failed during the Asian financial crisis of the ‘90s.

Again, who knew?  Again: no need to answer.

Lawrence Sweet, a senior VP at FRBNY replied:

Risk management procedures must be strong and the new systems “sufficiently robust” to guard against failure of central counterparties or firms involved in the trades.

And, he said, those swap contracts that are too complicated or risky to be put into centrally cleared, electronic markets should not be. The question is “how much can we put in there in a safe way,’’ he said.

And the answer is?!?!  [Crickets.]  Stating a set of desiderata without providing a reasonable strategy for getting there is gratuitous, at best, and reminiscent of the Steve Martin “How to Make a Million Dollars Without Paying Taxes” routine.

Why stop now?  From the FT, Jeremy Grant’s article from yesterday (2 SWP bonus quotes) is summarized by the FIA’s news brief as follows: “Complications arise as regulators detail clearing rules.”   I am so shocked that I am speechless.

Witness what the Sorcerer’s Apprentices have wrought.  Perhaps to some clearing mandates sounded like a good idea at the time, but it’s pretty evident that those very same some hadn’t fully thought through the issue.  Everybody is now dealing with the implications of the mandates on the fly, and are learning that the “solution” is just another package of problems.  Gazing across the fence from OTC World into Clearing Land, the grass in the latter seemed so, so much greener.  Now, having jumped, the jumpers are finding plenty of weeds, and plenty of nettles.

September 20, 2011

An FT Correction

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Politics,Regulation — The Professor @ 3:05 pm

Javier Blas at FT was a standup guy about the sentence in his article on the Singleton that made it sound like I had criticized the CFTC for not inviting those taking contrary views to the August confab about speculation and the Singleton paper.  In response to my venting (who? me?), the sentence has been corrected in the online version to make it clear that I did not make any such claim, and the version online now contains this text:

“This article has been corrected since original publication to reflect that only Philip K.Verleger has criticised the CFTC’s move to invite academics, mainly with one point of view.”

I appreciate the rapid and gracious response.

Do the Hokski Pokski

Filed under: Uncategorized — The Professor @ 10:50 am

Is Putin in the presidential race or out?  The latest theory, according to an advisor to the United Russia party is that Putin will not run, but will instead carve out a role for himself as “national leader” (h/t R):

“Putin is strengthening his right to rule without a formal status as president or prime minister so he can dodge problems as a leader of a popular front and simply as a leader of the nation,” Mikhail Vinogradov, head of the research group and member of an advisory board at Putin’s United Russia party, said today in a telephone interview.

Is this the way it will play out?  Your guess is as good as mine.  Is this a trial balloon?  Misinformation?  Put out by whom, and for what purpose?  Again, your guess is as good as mine.

But it is not outside the realm of possibility, and would have precedent from Soviet days, when real power did not necessarily rest with those who had formal positions, e.g., the Presidency of the USSR was a largely formal position, and real power was exercised by those with party positions.

Precedent or no, this would represent a further step in the devolution of Russian politics towards personal rule, a cult of personality, and a further de-institutionalization of an already institutionally underdeveloped polity.  It would be presidentialism without the president.  It could potentially reduce some uncertainty in the short run, at the expense of creating major uncertainty over succession in the medium term with no institutionalized mechanism to resolve it.  In other words, it would exacerbate, rather than ameliorate, all of the worst tendencies in Russian politics.  Which would tell a cynic that it’s likely to happen.

The other is-he-in-is-he-out news relates to Prokhorov.  Remember he was in as Right Cause leader, then voted out, then came back, but left of his own accord. Or something like that.   Now he is supposedly negotiating his reinstatement.

Put your Prokhorov in, take your Prokhorov out, put your Prokhorov in, then you shake it all about. . . .

September 19, 2011

Our Three Stories Are . . .

Filed under: Politics,Russia — The Professor @ 1:13 pm

A couple of stories that capture in microcosm Russia’s most acute dysfunctions.

First, the aftermath of the tragic KHL plane crash.  Two competing explanations.

Explanation 1: the pilot left on the parking brake:

The Moskovsky Komsomolets newspaper, citing what it called a “trustworthy source” at the Yaroslavl airport, reported that “the plane began taking off from the runway with the parking brake still on,” which meant that, though “the engines were powerful enough to get the aircraft moving, reaching take-off speed would be problematic.”

The paper also presented criticism of the hypothesis. Test-pilot Sergey Knyshov called it “hard to believe.” quoted another test-pilot, Aleksandr Akimenkov, who was also skeptical: with the brake engaged, “the plane wouldn’t have taken off, or it would have remained in place.”

Will we ever know for sure what happend? Not necessarily. Moskovsky Komsomolets’s source “supposed that . . . ‘the commission [inquiring into the crash] will try not to place all the blame on the crew, for purely ethical reasons, and find that something broke down.’ After all, the pilots themselves died in the catastrophe.”

The last line indicates that someone has a sadistic sense of humor, because it is precisely because the crew is dead that it will be all too convenient to pin the crash on them.

See update/correction below. This is supported by Explanation 2 (which is more of an insinuation, actually):  the plane’s “navigator” was drunk.  As R astutely asked, “Who even has navigators anymore?”  I don’t think  Yak-42s do: they have only 2 man cockpit crews.  Even if the “navigator” was  drunk, that would probably matter only if the pilot was even drunker. Which can’t be ruled out a priori.

The parking brake theory would also imply that there are two failures: one human, and the other mechanical.  Because as one of those quoted in the Bloomberg piece said, if it had been working the plane shouldn’t have moved.

In response to the Bloomberg writer’s presumably rhetorical question “Will we ever know for sure what happened?” I say never.  The pilots (and “navigator”) make convenient patsies.  And if it isn’t laid at the feet of the crew, but instead on the airline, who could trust that judgment either?  That too could be a convenient political drama, and could also serve to cover up potential state culpability (e.g., the de facto price controls that led to fuel shortage and perhaps fuel adulteration).

The second story is the Prokhorov farce.  I have no idea why he got in, or why he got out.  I don’t know whether this was the plan all along (to discredit and confuse any potential opposition), or whether the plan was for Prokhorov was supposed to be a domesticated opposition leader who took the “opposition” thing a little too seriously for some people’s liking, or neither, or both.

And that’s the point.  There are no genuine politics in Russia.  Everything is managed.  Everything is a stage play.  Sometimes the players go off script, but they don’t take over the plot: the author just writes them out, like in a bad soap opera where the star involved in a contract dispute first goes into a long coma, and then dies.

Speaking of going into a coma and dying, Prokhorov does seem to be very chastened in the aftermath.  After some hot words directed at Surkov, he now seems to have gotten his mind right. He is taking pains to make sure everyone notices that he is not being critical of Putin.

It almost seems that he is about to break into a chorus of “I don’t want to go to Chita.”

One last thing. I guess that would make three–one more than a couple. (Maybe the sight of Obama lecturing about math is getting to me.) The Bloomberg article presents this sunny summary of the preliminary results of the recent census (such as it is–the news accounts of the census methods leave considerable room for doubt about its accuracy):

Russia’s demographic trends are almost as frightening as its transport safety record. The Moscow Times relayed grim tidings from the State Statistics Service: “Preliminary results from a nationwide census last fall put the Russian population at almost 142 million, 3 million less than during the previous census in 2002.” The Service predicts that Russia’s population could fall by as many as 8 million by 2025. That is bad enough, but the paper noted that “A 2008 United Nations report said the decrease may be 11 million, with widespread alcoholism, emigration, poverty and poor medical care to blame.”
The matter has long concerned the highest echelons of the Russian government and poses a grave threat to the economy. A 2010 uptick in the birth rate has not reversed the population drop, said Tatyana Golikova, the Minister of Health and Social Development, according to Interfax. In fact, Russia still hasn’t “returned to the birth rates of 1991” – the year the Soviet Union collapsed.

What a country.

Update/correction. The dangers of blogging while somewhat jet-lagged. The article about the drunk navigator was about another crash, one that occurred in June (I think it’s the one that killed a bunch of nuclear scientists). Very sad to say that have been enough fatal plane crashes in Russia in a short period of time that it is possible to mistake one for the other. Also, (h/t R) there is a 3 man crew on the Tu-134 (the type that crashed in June), so it did likely have a navigator. The NATO reference name for the Tu-134, by the way, is “Crusty”. Somehow that seems very appropriate.

September 18, 2011

Son of AMT?

Filed under: Economics,Politics — The Professor @ 11:02 am

Obama is floating a tax idea that would ensure that “millionaires” would not pay lower tax rates than the hoi polloi.  It is being dubbed the “Buffett Tax.”

Several quick takes.

  1. I know that some are infatuated with “Saint Warren.”  Not I.  In fact, he makes me want to hurl.  For those convinced of his sainthood, I suggest you look into his activities in silver in 1998.
  2. To me this looks like the Son of the Alternative Minimum Tax.  Recall the AMT was originally devised in response to stories that Ross Perot and others had not paid any federal income tax because they had invested in municipal bonds and the like.  This was deemed to be outrageously unfair–although well within the letter of the tax law at the time.  So the AMT was sold as a means of ensuring that the plutocrats would pay some federal tax.  Over time, of course, the program metastasized, and now catches millions of members of the definitely non-plutocratic class in its clutches.  The “Buffet Tax” propaganda of today is eerily similar to the “Perot Tax” propaganda of twenty-odd years ago.  Don’t be surprised if (on the off chance it actually makes it into law–see 4 below) this very “exclusive” tax will grow like Topsy.  (If you take the time to deconstruct the AMT form, you will see that it is effectively a way of eliminating the lion’s share of any deductions.)
  3. To the extent that it is intended to be a tax on capital, it is a horrid idea.  (Per the administration’s usual MO, few details have been released, and very few will be forthcoming.)  Capital taxation is highly inefficient; we should be moving towards consumption taxes, not jacking up taxes on capital.  And for those who think that capital taxes are a just way of stickin’ it to the man–think again.  Retarding capital formation and distorting capital flows into tax-sheltered investments or into investments in jurisdictions that don’t tax capital as heavily reduces labor productivity and thus depresses wages.  It is a great tax if your idea of cosmetic surgery is cutting off your nose to spite your face.
  4. It is highly likely that this is a purely political proposal that Obama knows has no prayer of making it into law.

September 17, 2011

The Dangerfield Zone

Filed under: Economics,Financial Crisis II,Politics — The Professor @ 8:26 am

Felix Salmon heard the big raspberry that the Euro FinMins blew at Geithner, which is good: other coverage (like in the WSJ) downplayed the Eurodis (the FT at least alluded to it).   But then Felix writes this:

It’s pretty clear, here, that in the wake of the debt-ceiling debacle Geithner has lost a significant amount of international heft.

Wrong, wrong, wrong.  The debt-ceiling debacle has absolutely nothing–zip, nada, zero–to do with Timmy!’s lack of “international heft.”  I wrote three posts in June alone remarking on the astounding lack of respect Geithner gets overseas, and those posts referred to even earlier episodes in which various Euros (notably the Germans) had given Timmy! the backs of their hands.  All of these episodes occurred before the debt-ceiling standoff crescendoed in July and August.   No, Timmy! had entered the Dangerfield Zone well before the debt-ceiling circus.

Salmon’s interpretation is a piece with the standard left-leaning narrative that it was the failure to raise the debt ceiling expeditiously, rather than the failure to deal with debt period, that is the main symptom of American political dysfunction.   The debt-ceiling battle pitted those who believe that business as usual can work against those who believe that it can’t, and that the time to change course fundamentally is alarmingly short.  At present, neither side has a decisive advantage, hence the standoff and subsequent cold war.  It’s the issue that will dominate the next election.

No doubt Timmy!’s (and Obama’s) political impotence during the ceiling standoff makes his lecturing them on the need to be decisive now even more galling to the Euros.  But his stature was already sub-Lilliputian well before he rode his limo to the Polish concert hall where the meeting with the merely Lilliputian FinMins (who arrived by bus) occurred.

The thing about the Dangerfield Zone is that it’s a helluva lot easier to get in than get out.  It’s hard, in fact, to think of an example of someone truly emerging. Which means that we’re stuck with a SecTreas that can’t get no respect during a time of an existential world economic crisis.

Although there is a dark humor to the entire spectacle, it is in fact truly serious.  Financial Crisis II is a truly international event.  Its epicenter is Europe, but a Euroimplosion would suck in everyone, not least the US.  Hence, it is deeply troubling that the American point man is disliked, disdained, and disrespected around the world, and especially in Europe.

Pace Lincoln, changing horses in midstream is usually something to be avoided.  But if the horse you are on has no chance of making it, changing is the best of bad alternatives.  This is unlikely to happen, though, given Geithner’s close relationship with Obama, who needs all the friends he can get.  What is truly depressing, though, is the realization that no one with the requisite standing comes to mind as a replacement.  Which means that the entire country is on the verge of the Dangerfield Zone.

September 16, 2011

One More Time: Commodities are Different than Assets

Filed under: Commodities,Derivatives,Economics,Energy,Politics,Regulation — The Professor @ 6:46 pm

Interesting to note that Ken Singleton and I are commonly being used to personify contending sides in the commodity speculation debate.  One example is this piece from the FT on Wednesday.

Before going into substance, I need to set the record straight.  Javier Blas is flatly incorrect to say that I criticized “the CFTC’s decision to invite academics who mainly defended only one point of view.”  Flatly incorrect.  I have never said that either publicly or privately, and I defy Mr. Blas to prove otherwise.

Indeed, I was invited, so I know the statement to be untrue and I would not make it becuase (a) I just wouldn’t, and (b) I’m not so foolish as to make a statement that could easily be proven wrong.   I decided not to attend the event for a variety of reasons, most of them personal.

So, a retraction and correction is warranted (though I’m not holding my breath).

Now that’s out of the way, let me revisit one more time why the Singleton paper is being grossly misinterpreted, though not by Ken (at least in ear/eyeshot of me).

To recapitulate, Singleton finds that a measure of index fund participation helps predict future returns on oil futures positions.   This measure has serious, serious problems, as Scott Irwin and Dwight Sanders have shown.  Singleton has acknowledged some of the problems.  But that still leaves a puzzle, as why would a very noisy measure of speculative participation have predictive power?  But I’ll leave that puzzle aside and take as given that speculation leads prices.

The question is: why?  Does this mean that speculation has distorted prices?

In a rather stinging response to Singleton, the IEA does a nice job of summarizing my views as to why it does not necessarily support this conclusion, and could support the exact opposite one:

Finally, as suggested by the University of Houston’s Craig Pirrong in his blog, suppose that Professor Singleton’s findings do indicate that excess returns on crude oil futures are predictable, conditional on measures of speculative activity. Nonetheless, such a predictability of returns would not imply that speculation has distorted prices. Rather, predictability is the result of market frictions that might create hedging demand, leading to an increase in the risk premium. Professor Pirrong suggests that, in such circumstances, speculative positions can predict changes in futures prices. To prevent the predictability  of returns, it might be advisable to reduce constraints on the flow of speculative investment to  commodity markets, rather than limiting them.

(The entire IEA piece is worth reading.)

Singleton advances another argument–and it is only that, because his evidence cannot distinguish his explanation from that just advanced–based on various behavioral finance/learning stories.  There are indeed asset pricing models in which investor learning can lead to self-reinforcing price movements.  The key phrase here is “asset pricing models.”  The key question is whether such asset pricing models are applicable to commodities.

I am highly, highly skeptical.  Assume for sake of argument that speculative activity in a commodity derivatives market has distorted the price of the commodity; convergence implies that if nearby futures prices are indeed distorted, physical prices have to be distorted too.

Millions–and in some cases billions–of individual consumers, and myriad producers, face these prices.  If these producers and consumers are not playing the same learning game that is going on in the futures market, the price distortion will affect their production and consumption decisions.  All else equal, if speculators cause the price to be too high, consumption will be depressed, and production will increased.  This will lead to an accumulation of inventories.  If the price distortion is large, the inventory accumulation is likely to be large.

Now, there are circumstances in which it may be difficult to detect empirically the inventory accumulation.  If supply and demand are extremely–extremely–inelastic, large price moves may result in small inventory changes that are hard to detect in the noisy stock data that are available for some commodities.  Moreover, all else may not be equal.  As Singleton (perhaps cleverly) notes, my research shows that a decline in fundamental uncertainty could lead to a decline in inventory that masks the speculation-induced change.  (Although more plausibly, higher fundamental volatility leads to greater speculation, which would lead to an increase in inventory that could be blamed on speculative price distortions.)

But there are historical episodes–like the Hunts in silver and government price-support programs–in which price distortions have been associated with huge accumulations of inventory.  Those claiming speculative distortion need to provide a credible explanation whenever an alleged price bubble is not accompanied by a rise in inventories.  It can happen, but it’s unlikely–so show me how.

So, for the Singleton story to work, it has to be the case that consumers and producers–or at least a big chunk of them–are playing the same learning game as the investors.  I find this wildly implausible, particularly for consumers.  Would consumers really buy more gasoline today–gasoline which they are going to consume, not store in anticipation of profiting from price appreciation–for speculative reasons because prices have been trending up?  Really? (Perhaps you could argue that they would engage in intertemporal substitution, but this also stretches credulity.)  It might be somewhat more plausible that suppliers would not produce more today in response to a speculative price bubble in anticipation that they can sell at a higher price in the future.

These stories–and they are just that–are not logically impossible, but they are just implausible, to me anyways.  The consumer side is particularly implausible.  To emphasize: most consumers of gasoline or copper or corn or whatever cannot store the commodity, and hence cannot earn a speculative profit.  Thus, they should respond parametrically to prices, and respond to higher prices by reducing consumption.  The decline in consumption in markets (like the US) where consumers are subject to price changes (because there are no price controls or subsidies) during the oil price spike of 2008 supports this view.  So price distortions should lead to inventory accumulation.

This is an excellent illustration of why commodities are a good place to test theories of speculative distortion.  The speculators may play their games in the financial markets, but if they affect prices, consumers and producers who don’t play the game alter their behavior.  Looking for evidence of behavioral changes–consumption and production changes–is a great way to detect price distortions.  That is not possible in asset markets.  Consumers and producers are canaries in the coal mine.

Which all means that to persuade, Singleton, and those who are using his paper to say Eureka!, need to provide a plausible explanation of how learning/behavioral finance effects change the behavior of producers and consumers in ways that what would mean that price distortions do not lead to noticeable changes in quantities like inventory.  That is, he points to models of asset markets in which there are no consumers; to make a realistic and testable model, you would need to include producers and consumers as well–not just demand for a stock of assets, but flow demand and supply.

One last thing.   The Singleton paper has “boom and bust” in the title, and many behavioral finance/learning models predict boom and bust patterns in speculative prices.  There was a boom and bust in oil prices and other commodity prices–but the bust in 2008 was not plausibly the kind of speculative bubble bursting that occurs in the models.  It was definitely driven by a huge collapse in demand resulting from the financial crisis.  Thus the “bust” part of the price movements should not be used as evidence in favor of the theory.  Instead, it fits far better a fundamentals-based story.  As I told many reporters as prices peaked in summer 2008, when they asked what would bring down prices: be careful what you ask for.  A major recession would be the most likely cause of a big price decline.  That’s what happened–not the bursting of a speculative bubble.

Relatedly.  Prices that positively cannot be driven by asset pricing bubbles–because they are are definitively not assets–boom and bust.  During the same period that oil prices were booming and then busting, shipping rates were doing the same thing.  Space on a ship is not an asset.  It is not storable; you use it or lose it.  You can speculate on the price of the ship, but the price of the services of the ship cannot be subject to asset pricing bubbles–because these services are not an asset.  The spike and thudding collapse of shipping rates in 2007-early 2009 is indicative of a rise and fall in the demand for commodities (which are transported by ship), and cannot be explained by speculative distortion induced by learning, etc. Put differently, booms and busts occur in markets in which asset price bubbles are impossible.

To summarize.  1. Singleton’s results are perfectly consistent with rational pricing, no speculative distortions, and financial market frictions.  2.  The conditions that would reconcile the kind of learning/behavioral finance model that would be necessary to explain the lack of inventory accumulation are highly implausible.  If somebody wants to tell a more convincing story about commodity price bubbles, it is necessary to do more than just genuflect to models devised to explain things like the dot-com bubble.   You have to create a model that includes flow demand and supply, and derive testable implications of investor/speculator learning or irrationality for quantities produced, consumed, and stored.   Only then will it even be remotely possible to determine the real implications of these learning models for commodities.

Friday Smackdown–Timmy! Edition.

Filed under: Economics,Financial Crisis II,Politics — The Professor @ 12:46 pm

Yesterday I expressed my wish that German Finance Minister Schaeuble back off the control freak (“ban the OTC market”) stuff, and get back to bashing our Timmy! Well, he evidently reads SWP–and has company:

It was an unprecedented visit designed to spur the euro zone into action. But Treasury Secretary Timothy Geithner’s high-profile trip to Europe left some European officials more dumbstruck than starstruck.

. . . .

But however good Geithner’s intentions, the indications were that the meeting did not go as smoothly as he might have hoped.

Held in a concert hall, the gathering lasted for about 30 minutes. The euro zone ministers arrived together by bus. Geithner was sped to the doors in a private car.

There was no word on whether voices were raised or what the temperature of the exchanges was, but Austria’s finance minister, for one, was less than warm to Geithner’s message.

“I found it peculiar that even though the Americans have significantly worse fundamental data than the euro zone that they tell us what we should do and when we make a suggestion … that they say no straight away,” Maria Fekter told reporters afterwards, recalling a difference of opinion between Geithner and German Finance Minister Wolfgang Schaeuble on how to reinvigorate the euro zone and tax financial deals.

Although some dropped hints of disagreement behind the meeting’s closed doors, few were prepared to disclose Geithner’s full prescription to heal the euro zone crisis.

. . . .

But his language was perhaps too blunt for European ministers, fatigued by the crisis and the countless disagreements it has prompted amongst them.

“We can always discuss with our American colleagues. I’d like to hear how the United States will reduce its deficits … and its debts,” Belgian Finance Minister Didier Reynders said somewhat tartly.

Jean-Claude Juncker, the chairman of the Eurogroup, was even more to the point.

“I don’t think it would be wise for me to report from an informal meeting that we have with the treasury secretary. We are not discussing the expansion or increase of the EFSF with a non-member of the euro area,” he said.

. . . .

For many in the meeting, Austria’s Fekter most particularly, his message fell flat.

“I had expected that when he tells us how he sees the world that he would listen to what we have to say,” she said.

Not that this wasn’t perfectly predictable.  I’ve written several times before about how I cannot recall an American cabinet officer, let alone a Secretary of the Treasury, being treated with the disdain that Geithner regularly encounters abroad.  He is truly DC’s Rodney Dangerfield.  He has yet to learn that gratuitous and hypocritical advice is not the way to win friends and influence people.  The hectoring and lecturing is the last thing people facing an existential crisis need to hear: and it’s not just Timmy!, but Obama too, and the president is rapidly entering Dangerfield territory as a result of his supercilious lecturing to everybody about everything, while pretending that he’s responsible for nothing that goes wrong.

Europe’s leaders are Lilliputians.  But sadly, at times like this they appear to tower over ours.

Take it away, Rodney!

September 15, 2011

Stick to Tormenting Timmy! Please

I have a warm spot in my heart for German Finance Minister Wolfgang Schaeuble, because of his periodic slapdowns of Timmy!  (I think there is another slapdown-ready opportunity arising, given Timmy!’s–and Obama’s–recent penchant for giving the Euros gratuitous advice on dealing with their existential crisis.)

But he said a couple of things recently that give me pause.  First (h/t R) is this speech:

German Finance Minister Wolfgang Schaeuble said that while markets are the most efficient means of creating wealth in an economy, they can also be irrational and therefore need regulation.

“Markets are the best means of finding solutions, but they’re not always rational” and can destroy themselves, Schaeuble said today in a speech in Berlin. “That’s why they need rules and bounds.”

It is the job of the government to create an order that promotes, rather than hinders, moral behavior, Schaeuble also said at an event organized by the Catholic Academy in Berlin.

On an abstract level, that’s not really objectionable, because only some anarchists deny the need for market rules.  (Anarchocapitalists believe that rules shouldn’t be imposed, but created by cooperation and consent.)  The questions are: What rules are the right ones?  Where should the bounds be set?  Who decides?  How?

In this speech, Schaeuble gave an example of how he answers these questions, and those answers suggest that his pro-market rhetoric is boilerplate camouflaging another statist control freak:

German Finance Minister Wolfgang Schaeuble on Wednesday called for regulating all innovative financial products and urged banning so-called over-the-counter trade.

“We must apply the rules of transparency to all market participants–hedge funds and private equity funds,” Schaeuble said at an event sponsored by the Konrad Adenauer Foundation and the Catholic Academy ahead of a planned state visit to Germany by Pope Benedict XVI.

We should ban OTC trade where possible, because we don’t have transparency (in these markets). And then we should try to regulate all innovative financial products. We cannot achieve everything through regulation, but we can try to tighten the rules.”

Another slave to the god of transparency.   Like that will solve everything.  And apparently a market in which consenting adults make mutually advantageous transactions about which they don’t reveal everything is far worse than no market at all.

I would further note that there is no perfectly transparent market.  Futures and stock exchanges have a great deal of pre-trade and post-trade price transparency, but the identity of traders is concealed: the markets are anonymous, and the buyer does not know the identity of the seller.  Thus, even on exchanges not everything is transparent.  OTC, the buyer typically knows the seller, but there is less pre- and post-trade transparency.  There are trade-offs involved, and different mechanisms have developed to permit market participants to choose which kinds of transparency rules work best for them.  The side-by-side existence of exchanges and OTC markets gives choices that can accommodate differences in the costs and benefits of alternative forms and levels of transparency across market participants.

And if transparency is such an unalloyed good in markets, Herr Schaeuble, does the same principle hold for governments?  Is Germany’s government a paragon of transparency?  Do you conduct all of your discussions and decisions in the full public glare?  Does your government have secrets?  Does Europe’s?  Is this a good thing?

We all know the answers to those questions.  It would be quite illuminating to hear why secrecy–very incomplete transparency–is acceptable and even necessary for governments that wield vast coercive powers, but some modicum of secrecy is completely unacceptable for private actors who cannot coerce anybody.

Schaueble’s remarks, and the place where he delivered them, suggest a typical European conservative mindset that is ambivalent, at best, towards markets and individual choice.  Hayek’s essay “Why I Am Not a Conservative” provides an illuminating analysis of this mindset.

So please confine yourself to putting the (verbal) boot into Timmy!, Wolfie.  There are enough control freaks about, thank you.

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