Streetwise Professor

Last Friday I was part of a group of 8 economists who made presentations to the Board of Governors of the Federal Reserve.  Once or twice a year the Board invites academics to discuss a policy-relevant economic issue.  The subject of Friday’s session was Network Economics, and Alistair Milne and I spoke about network issues in clearing and trading.

The Parthian shot in my presentation was that it was essential not to ignore the unintended effects of derivatives regulation.  In particular, clearing mandates, capital and collateral rules, and the like are all intended to reduce the amount of leverage in the financial system.  But even if you require extensive collateral against derivatives trades, market participants can offset the reduction in leverage inherent in derivatives trades by using the freed up debt capacity to add leverage in other forms.  What goes out through the front door can return through the back door.  This can be particularly dangerous if you think you’ve solved the problem when Mr. Leverage walks out the front and ignore that he’s snuck back in.

Put differently, it is very hard to reduce leverage in the system as a whole by regulating just a piece of firms’ capital structure.

Another example.  Reducing derivatives counterparty credit risk through clearing and netting and collateralization works by increasing the priority of derivatives in bankruptcy.  But if you move derivatives towards the head of the line, somebody else ends up further back.  Like unsecured creditors, including money market funds who buy short term bank debt.  They can be systemically important, too, meaning that the regulations have primarily shifted the locus of systemic risk, and not really reduced it.

Focusing on the collateral issue, the numbers here are huge.  Tabb Group estimates that interest rate derivative collateral alone will total $1.4 trillion.  Credit, equity, and commodity derivatives-related collateral will likely add hundreds of billions to the total: although these markets are smaller, they are riskier, requiring more collateral per dollar of notional.

So where is all this collateral going to come from?  I’ve written about collateral management services, by which banks will effectively lend cash that can be used for margins, with the loans collateralized by assets that CCPs will not accept directly.  In other words, Mr. Leverage is  a Back Door Man.

CME Group’s Craig Donohue talked about the need for such services:

“There will be a need and a value for the collateral transformation services,” Donohue, chief executive officer of CME said today during a panel discussion at the Futures Industry Association annual conference in Chicago.

The types of accepted collateral may need to be expanded as thousands of new users seek to back trades. While cash and government securities will always be the least costly way to pay for margin, some who want to pledge “three chickens and an old Ford” will find it more expensive to have non-standard collateral transformed into acceptable form, said Jeffrey Sprecher, chief executive officer of Atlanta-based Intercontinental Exchange Inc.

The demand has created a “cottage industry” of firms and units within banks that will charge a fee to hold securities or other assets for investors in return for acceptable margin, said Richard Prager, managing director and head of global trading for BlackRock Inc. (BLK)

Cottage industry.  Somehow this brings to mind all the stories about shadow banking system in China that mushroomed after the government tried to crack down on bank lending.

And CCPs are looking to expand the assets they are willing to take as collateral.  This exposes the CCPs to higher risks, including valuation risks.  As an example, LCH.Clearnet (which has already begun accepting gold) is going to accept some corporate debt as collateral (no link yet, but it’s from a Matt Leising Bloomberg story that Matt emailed to me):

LCH.Clearnet Ltd., the biggest interest-rate swap clearinghouse, is considering accepting corporate bonds for the first time to meet an anticipated surge in demand for a broader array of collateral in the $601 trillion over-the-counter derivatives market.

“We want to be able to have more clients come to clearing,” Floyd Converse, head of U.S. sales and marketing for London-based LCH.Clearnet, said in an interview in Chicago this week at the Futures  Industry Association annual conference.  The world’s biggest swaps clearinghouses are expanding the
types of securities they accept as regulations force thousands of new users in the U.S. and Europe to use clearing. Among them, CME Group Inc., the world’s largest futures exchange, is broadening the variety of company debt it accepts as margin for its customers.

(Quick thoughts off the top.  “Investment grade” doesn’t really give the warm and fuzzies, does it?  Will corporate debt be accepted as collateral against CDS trades?  I know LCH.Clearnet doesn’t clear CDS, but there is a reason to wonder whether competitive pressure would lead to such an outcome.  Wouldn’t this expose a CCP to substantial credit correlation risk, which is devilishly difficult to quantify and manage?)

And it is becoming far more widely accepted that CCPs will require central bank liquidity during periods of extreme systemic stress.

All of these stories suggest that mandates are first and foremost just leading to a reshuffling of leverage and risk.  There is room for deep skepticism that this reshuffling will reduce systemic risks.

Indeed, if Gary Gorton is right, and shadow banking was first and foremost a mechanism designed to create informationally insensitive debt that could be posted as collateral, the potential increase in demand for collateral could catalyze a similar process.  This process is systemically risky because it increases fragility and creates substantial tail risks, as this new Gorton paper discusses.

There is also reason to doubt that this is a good use of capital, and could lead to lower growth.  Just what we need.  The cost-benefit trade-off appears particularly unfavorable with respect to collateral posting by long-only buy side investors (e.g., pension funds) and “end users” who do not pose substantial systemic risks.

So, do Ben et al get it?  My sense is that they do, although Bernanke was pretty inscrutable through the entire morning.

One person who obviously doesn’t get it, or is pretending that he doesn’t (which would be even more disturbing) is Gary Gensler.  October is sprinkled with major conferences, and Gensler has been doing the rounds.  Despite all of the advances in understanding of the complexity of the issues involved, Gensler continues to peddle his cartoonish morality play:

“While the crisis had many causes, it is evident that swaps played a central role,” Mr Gensler said. “Swaps added leverage to the financial system with more risk being backed by less capital.

“They contributed, particularly through credit default swaps, to the bubble in the housing market. They contributed to a system where large financial institutions were thought to be not only too big to fail, but too interconnected to fail. Swaps – developed to help manage and lower risk for end-users – also concentrated and heightened risk in the financial system and to the public.”

No recognition of the ability of firms to substitute swap-based leverage with other types of leverage, and their willingness to do so.  No acknowledgement of how mandates re-order priorities in bankruptcy, and the implications thereof.    No appreciation for the potentially destabilizing effects of rigid variation margin mechanisms, and the pro-cyclicality of these mechanisms.   And yeah, Gary: clearing mandates don’t concentrate risk and create their own interconnections.

Gensler is also still pushing the transparency nostrum.  He links the crisis of ’08 to the opacity of the swaps market.  Well, lack of pricing information was arguably an important problem with AIG in particular, his proposed cure–the SEF mandate–will have no effect on this.  The problem with the instruments that AIG bought wasn’t that they weren’t traded on transparent markets: it was that they weren’t traded.  Markets are not the Field of Frickin’ Dreams: If you build it, there’s no guarantee anybody will come.  Comparisons of markets for illiquid products to exchange traded futures are superficial and silly.

In sum, Gensler continues to say foolish things.  Is he a fool, or does he just believe his audience is?  He batters straw men.  He sticks to a cartoonish narrative of the events of 2008.  He pushes nostrums.  He ignores deep complexities, and the huge potential for unintended consequences of the policies he advocates.

Nonetheless, he is not shy about telling others what to do. @OTCderivatives tweets that Gensler said the CFTC should be “top dog” in IOSCO because of the size of US markets.   In London, he chided the Europeans for not including exchange traded derivatives in Emir:

It is critical, though, that those swaps traded on regulated exchanges also are subject to the clearing requirement to bring the benefits of clearing to swaps, regardless of where they are traded – on exchange or off exchange.

This will no doubt thrill the Germans, because an expansion of the Emir remit would also force open access to exchange CCPs.

But given that the Germans have been quite adept at slapping Timmy! around, I doubt that a mere agency head will give them much trouble.

[Interesting aside.  Risk Magazine’s Laurie Carver tweeted that Gensler blew him off to allow “other less aggressive journalists ask him comfy things.”   Go figure.]

To sum up.  Dodd-Frank has set off a very complex dynamic of unintended consequences, many of which will undermine the intent of the law.  One of the figures primarily responsible for implementation of Dodd-Frank has a very simplistic view of the world that ignores these complexities.  What could go wrong?

Two seemingly disparate stories involving Russia are linked to a subject I’ve written about a few times on SWP.

The first story is the Tymoshenko trial.  Let me start out by stating the the trial is a travesty, an example of the corrosive effects of criminalizing political disputes.  I would also add that the irony is thick enough to cut with a dull knife.  The firebrand of the (allegedly) anti-Russian  Orange Revolution being hauled into the dock by the man who was widely believed to be a pro-Russian toady, with the Russians criticizing the trial and its outcome as anti-Russian.  You could not make up this stuff.

Now to the linkage with the SWP subject.  The issue of the trial was the gas contract Tymoshenko negotiated with Gazprom and Russia in 2009.  It was like a subprime mortgage: a low teaser price, combined with a floating price in out years.  Specifically, Ukraine negotiated a low price for 2010, but the price was indexed to oil for the remaining 9 years. With the rise in oil prices in 2011, this hit Ukraine hard.  Prices for the 4Q, which are linked to prices of oil in the 3Q, will likely reach $400/mcm, in contrast to the $230 in Q1.  In other words, to get a political boost in the impending election 2010, Tymoshenko traded a widely-trumpeted short term price cut for a millstone that will hang around Ukraine’s neck for a decade. Like a subprime borrower, the end of the teaser rate and the kick-in of the indexed price is driving Ukraine to the brink.

Again, the punishment for this should have been purely political, not legal.  But it does not redound to Tymoshenko’s credit.

Oil-indexed contracts are also the (somewhat hidden) centerpiece of the second story.  Putin traveled to China this week.  The primary immediate purpose of this trip was to finalize agreement on a gas deal that Russia and China have been hammering out since 2006.  They’ve agreed on everything!  Uhm, except the price.

Russia/Gazprom insists on the oil linkage formula.  China refuses.  After numerous statements that a deal was imminent, it wasn’t.  (The photo of Putin dwarfed by the Chinese honor guard in the first link is a riot).  Proving, yet again, that you should discount heavily any representation about Gazprom’s coming contractual coups.  How do you know a Gazprom spokesman is lying?  His lips are moving.

The oil linkage mechanism is under pressure from the west and the east.  Gazprom clings to it desperately because it likely–and realistically–perceives that the market price of gas will fall relative to the price of oil in coming years.  Shale and LNG and the development of deeper spot markets will tend to keep gas prices down, but there is no corresponding bright spot on the horizon for oil.  Indeed, the likely peaking of oil production in Russia puts upward pressure on the price, which redounds to Gazprom’s benefit.  Thus, oil-linkage is a hedge against the financial impact of long term declines in Russian oil output.

Gazprom obviously sees this, but so do those whom it wants to sell to.  They realize that the good deal for Gazprom is a bad deal for them.  The Chinese can afford to be patient.  Customers in Europe, especially in Germany (finally!) are not willing to fall into Gazprom’s long-term contract trap.  The weak or politically driven–like Ukraine–may succumb, but others are pushing back.

Thus, it is increasingly likely that Gazprom will not be able to operate under the oil price umbrella, and exploit the fact that future expansions of oil supplies will be much harder to come by than future gas production increases.

This hits Russia hard in many ways.  First, it will limit a huge source of money flowing to connected parties in Russia.  Second, as pahoben pointed out in the comments, Gazprom is a notoriously inefficient company, with far more employees and far more capital employed to produce an mcm of gas than western companies.  It can survive under the oil price umbrella, but its prospects are far less favorable if it actually has to, you know, actually compete on price in the gas market.  Third, Gazprom subsidizes Russian gas consumers, and provides considerable sums for the budget.  A less profitable Gazprom produces domestic political problems, and creates fiscal challenges.

Gas contracting practices may seem to be a very arcane subject.  But they are a matter of freedom–literally–in Ukraine, and a matter of huge financial import in Russia, both nationally, and in the bank accounts of its corruptocracy.  Look for this issue to be a source of increasing conflict and controversy going forward, in Asia and in Europe.  If you had to choose one leading indicator of Russia’s future economic and political course, you could do worse than to focus on how it fares in gas contract negotiations.  Every compromise on oil linkage, every customer that walks away from an oil linked deal (as Turkey did, and as China has just done), is a thorn in Putin’s vitals.

In other words, Gazputin’s fate depends on his ability to browbeat buyers of gas into entering into oil-linked contracts.  He may be able to beat up on countries like Ukraine, but my sense is that he will have a much tougher row to hoe in Germany, and especially in China.  Again: music to my ears.

Two related stories.  The first: unofficial price controls on refined petroleum products in the runup to the Russian elections:

Russian authorities have unofficially reined in retail fuel prices, a sensitive issue for motorists before key elections, traders and sources in companies said Thursday.

The oil companies already had effectively put a lid on gasoline prices at pumping stations since mid-August, fearing a backlash from the government before the general elections in December and presidential poll in March.

Salesmen are now talking about direct verbal orders from the government not to increase prices.

“There won’t be any moves before the elections, although there are no written directives from Moscow,” said a worker at a TNK-BP retail station in Saratov, 880 kilometers southeast of Moscow.

“We were about to increase the price, but we were told to draw in our horns. ‘Are you crazy? There are elections coming!’ they told us,” said an official with LUKoil in Volgograd.

Retail prices have flatlined across the country despite skyrocketing wholesale prices for petroleum products.

After anti-monopoly regulators slapped companies with hundreds of millions of dollars of fines for expensive fuel over the past year, retail stations have been wary of raising prices, and their margins have been squeezed almost to nothing.

The second story: shortages of jet fuel:

Russian traders are alarmed at the sudden disappearance of aviation fuel from the market.

They say a hike in prices is imminent, with a fuel deficit likely before the end of October.

The main factor behind the deficit is thought to be the growing number of passengers using airlines in Russia, whereas the oil refineries around Moscow and Moscow regions ceased operating at full capacity. Additionally, in September, the Defense Ministry made a large order for aviation fuel.

Uhm, don’t believe the explanations given in the quoted bit, except to draw a direct line between the below-capacity operations of refiners, and the first story about unofficial price controls.  Although the price control article relates to motor fuel, it is highly likely that (a) there are also unofficial price controls on aviation fuel,  and/or (b) since gasoline and distillates are produced in relatively constant proportions, cutbacks in refining runs driven by the unprofitability of selling motor fuel at sub-competitive prices are also causing reductions in aviation fuel output.

This also adds credence to the earlier conjectures that the KHL air crash was the result of poor quality fuel, because reductions in quality are another predictably consequence of price controls.

Several articles in today’s news pertain to predictions or recommendations I’ve made over the last couple of years.

One relates to Europe’s handling of its sov debt crisis.  Walter Russell Mead writes today that:

Chancellor Merkel has, I think, turned an important corner — or realized that German public opinion has now turned one.  Public concern about the German banking sector is now acute enough that it is politically easier for her to arrange to bail out German banks than to drum up support for new funding for the PIIGS.  Flinty German taxpayers hate to throw money away, but if throw they must, better to save the German banks in which the taxpayers keep their savings.

Rather than pushing hugely unpopular bailouts of lazy Latin and Mediterranean foreigners through a restive Bundestag, Merkel thinks it is better to dedicate any new bailout spending to rescues of innocent German banks. Instead of using taxpayer money to prevent defaults in Greece and elsewhere, use taxpayer money to insulate German banks (and their depositors) from the consequences of the defaults and “haircuts” when they come.

This is the good news underlying last week’s market rallies: the German political establishment seems to have figured out a way to pry much more money out of German taxpayers to prevent a total European meltdown.  Germany can and, it now looks like, will, put any amount that is necessary into the banks to make sure the German banking system doesn’t do a Titanic impression.

Let defaults happen, make the banks take large haircuts when they do, and then bailout the banks.  From a German point of view, this is a workable and sensible plan.  Defaulting will allow Greeks and perhaps others to shorten the painful austerity and begin to escape recession while staying in the euro; the”haircuts” satisfy the German urge to punish the wicked and discipline the private sector; the bank bailouts will prevent the consequences of Club Med defaults from destroying the European financial system.  At the same time, this approach limits the need to rely on politically toxic country bailouts; Germans do not want to send their hard earned money to bail out “thieving, lazy” Greeks.  The EFSF does not have to be increased, but Europe can still be saved.  Merkel and her colleagues have found a creative way to match the preferences of German voters with the needs of the European financial system.  Well done, but now comes the hard part.

I remember making that suggestion in several SWP blog posts.  In March, 2010.  (I distinctly remember talking about it in a class right before heading to a DKM show in that month.)  Europe–and the world–would be in much better shape if it had come to that realization then.  But no, they chose to live with the gangrene.  Methinks its now too late.

Mead also observes something that was highlighted in my Sunday post on the Euro sovdebt crisis: the difficulty of crafting an agreement to share burdens.  This is always difficult when there are serious distributive effects, as there are here.  In particular, the two euroheavyweights, France and Germany, have very different interests.  Sarko is, as I suggested, trying to buy insurance from the Germans after getting the cancer diagnosis:

Underneath all this is the ugly reality that the French are not sure that they can get through this crisis without money from Germany — and that the Germans think they have their hands full already.  The Germans have come up with a plan that substitutes domestic bailouts of troubled banks for international bailouts of troubled governments; the French are looking for a plan that substitutes international bank bailouts for domestic ones.

This is not a good match and the very different priorities of the two plans suggest that the French and the Germans will have a hard time coming up with a common approach.  But that isn’t the biggest problem Europe is facing.  The biggest problem is the possibility that the crisis is moving north to France.  The need to fling tens of billions of euros into the banking system could cut France’s credit rating, increasing the size of the interest payments it must make on its large national debt.  That in turn would cut France’s creditworthiness even farther, driving the interest rates up yet again.  This is the same disabling spiral that has thrown one euro country after another into crisis; if France goes, there is nothing left to defend.

Is the European financial crisis so severe that France can’t ride out the storm without help from Germany?  The French are behaving in ways that suggest that they are worried; if this is true, then politically and economically this crisis is just getting started.  Germany can protect itself from meltdowns in Greece, Portugal, Spain and even Italy; France is something else again.

The other articles relate to China.  Here, going back to 2009, I have been a China bear.  I have believed, and continue to believe, that a system that is still largely government directed and centrally planned, will fundamentally distort the allocation of resources.  If there is a lot of slack and inefficiency to begin with (definitely the case in China), these efforts can lead to impressive measured growth (and arguably mis-measured growth, given the dubious nature of Chinese statistics).  (Cf. Soviet industrial development under Stalin.)

But the structural inefficiencies and imbalances build, and more and more drastic measures are necessary to offset them.  This leads to the Michael Jackson economy phenomenon, where artificial measures permit performance to continue for a while, but inevitably ending in a rather gruesome end.

The decrepit Chinese financial system is the key point of vulnerability.  The Chinese have had several banking crises over the years, which they routinely “solve” by taking bad assets off banks’ books, putting the bad assets in Fastow/Enron-like vehicles, and filling the holes in bank balance sheets with claims on the government that are less than ironclad. (They’re not officially government debt, and the willingness of the state to perform on them is very difficult to gauge.  The credibility of these promises in a crunch is questionable.)

Historically state owned firms were the major bad borrowers.  (Go figure.)  Now the debt in question is owed largely by local governments.  (Again, go figure.)  It’s owed not just to the banks, but to shadow banks.  The off-loading of loans and risk to shadowy financial entities has picked up steam as the Chinese government has tried to rein in the effects of its stimulus by cracking down on bank lending.

There has been a growing debate in recent months about whether China will continue to grow, or have a soft or crash landing.  In just the last two days, the WSJ, the FT, and Reuters have run articles on the fraught state of the Chinese banking and shadow banking systems. The articles were sparked by news that China is purchasing equity in major banks.  Jim Chanos has also continued to hammer on the theme of dodgy Chinese banks.

In other words, a meme is developing: China is teetering.  Combine that with the situation in Europe, and our less that sunny circumstances, it’s hard to find any silver linings out there.  This is particularly true given the linkages: European weakness will put strain on Chinese exports.

I remain convinced that China is extremely brittle.  Its resource-intensive growth has been papered over–almost literally–leading to deep problems in its financial market.  That growth is almost certainly overstated in terms of the actual value created: yes, empty housing units and underutilized infrastructure contribute to GDP when built, but represent a massive misallocation of capital: GDP accounting (not reality) and economic accounting (reality) are different things, though eventually the economic reckoning always triumphs in the end, resulting in much lamenting and tearing of garments.  Eventually, that misallocation is recognized and corrected, and with a vengeance, through massive asset revaluations.  And the channel through which that is felt is usually the banking system (pace the subprime crisis in the US, and the sov debt crisis in Europe).

So look west or look east, and there are heavy clouds on the horizon.  We’ll soon know how good a weatherman SWP has been.

Following Europe’s plan of the week to deal with its sovereign debt crisis (and directly associated banking crisis) can make one’s head spin.  It might therefore help to try to identify a few central concepts that can help put the details of this plan or that into perspective.

A key distinction is between measures intended to prevent things from getting worse, and those intended to allocate losses already incurred; the interaction between those issues is an important factor in the dynamics, and will play a huge role in determining the ultimate outcome.

In terms of preventing things from getting worse, the near-term danger Europe faces is runs on sovereigns, especially Italy.  The mechanism for a run on sovereign debt is that lenders will refuse to rollover their holdings as they mature, making it impossible for a government to finance its operation; a similar mechanism is at play for bank wholesale lending, where banks with exposure to dodgy sovereign debt are facing problems rolling over their maturing funding.

A run is one of several equilibria in a coordination game: coordination games typically have multiple equilibria.  I have no incentive to run if no one else runs, but if everybody else runs I have an incentive to run.  In this particular instance, I will rollover my maturing Italian bonds if everybody else but I won’t if nobody else does.

Expectations play a crucial role in determining which equilibrium prevails: whether I run or not depends on what I expect others to do.  Thus, crisis management plans often focus on influencing expectations.   That is why the term “confidence” is bruited about so freely: you want everybody to be confident that nothing bad happens so they won’t run.

It is also why backstop funding mechanisms are typically a part of managing these types of crises. The more public  money available to fund the renewal of maturing sovereign debts, the bigger the flight of private investors required to spark a full-blown run.  These private investors calculate that the likelihood of a big flight is smaller than the likelihood of a small flight, so they are more confident that a run will not occur when there is a big public backstop, so they will not run themselves.  This means that the backstop ideally will not have to be drawn on, because private investors continue to roll their lending to troubled countries.  This is basically the Paulson “bazooka” idea.

Or another analogy.  Someone with a weapon is confronted by a crowd of 100 people.  If all 100 rush him, he’s had it.  But someone has to start the rush, and the first mover is at greatest risk of getting shot, so each person may hold back wanting someone else to take the lead, allowing the outnumbered gunman to escape unharmed.  But some in the crowd may be hotheaded and charge.  Here’s where the nature of the weapon matters.  If it’s a single shot pistol, once the hothead is shot the rest of the crowd knows its in no danger and will charge.  If it’s a revolver, it takes six hotheads to start a run.  If it’s an automatic with 10 rounds in the magazine, it takes even more hotheads. (To make the analogy fit, there has to be some advantage of being first to get to the guy with the gun.)

The European plans are all based on the idea of convincing investors that there are a lot of bullets in the gun in the hope that this will deter a self-feeding run.  This is why Europe is so focused on expanding the size of backstop funds, including the use of ECB leverage.  The bigger the country that is at risk of a run, the bigger the fund must be to reduce the likelihood of a run.  This is why Italy’s problems are a real challenge to Europe.  Italy’s debt is so much larger than Greece’s or Portugal’s that commensurately bigger sums are needed to reassure investors that a run cannot get started.

The expectations idea also helps explain why policy mistakes can have devastating consequences.  Lehman is a good example.  Based on the Bear Stearns experience, investor expectations were that a big financial institution would be bailed out.  This made them less likely to run.  But the decision not to bail out Lehman changed those expectations, and runs began on every major bank. A policy misstep can cause things to go non-linear in a hurry.

This expectations management strategy is most likely to work, the more credible the promise of the provider of the backstop.  Here is where politics comes in, and where the design of the backstop matters.  If funding is not locked in, but it is based on promises by governments to pay in the breach, the backstop is less credible: when called on, governments may find it in their self-interest to renege on their commitments, or voters may force them to do so.  This is a major problem in Europe given its current structure.  Stability is a public good (in the economic sense of the term) and individual nations have incentives to free ride.   But if the backstop is not credible–if investors believe the gun is really empty–it is of limited value in stopping runs.

So the creation of a backstop creates a meta-“global game”* in which there is uncertainty about the credibility of the backstop, and the backstop mechanism may be subject to a run.

Moreover, the public good nature of stability makes it difficult to negotiate the loss sharing agreements in the first place.  There are gains from trade to crafting an agreement that reduces the likelihood of runs, but any such agreement exposes the participants to credit risk.  Yes, an agreement may forestall a run on Italy, but the reason for a run in the first place is the recognition that Italy’s risk for insolvency in the future is greater.  Which means that any backstop fund that acquires Italian debt is at risk of loss as the price of the debt changes to reflect changes in the  likelihood of ultimate repayment.  Each Eurozone county wants to reduce the likelihood of a run, but would like all the other countries to bear the cost of doing that.  Similarly, in the event a run on the backstop does occur, each country would like other countries to pay a disproportionate share of the associated costs.  Negotiating such a loss sharing arrangement, particularly in a polity like Europe, is extremely difficult.

This is complicated even more by the fact that some losses have already been incurred.  This is why Greece matters.  Greece is already a lost cause, and everybody knows that holders of Greek debt have suffered mark-to-market losses.  (The same is true for Portuguese debt too.)  These losses threaten the financial condition of banks and insurers throughout the Eurozone.  The failure and imminent nationalization of Dexia (the Belgian-French bank) and the tenuous condition of major French banks are symptoms of the problem.  The run dynamic threatens the banks, which means that they need to be recapitalized in order to mitigate that potential: this raises the question of where the capital will come from.  Public support may be required here too.

But  the outstanding losses are not distributed equally across countries.  This leads to disputes among EU members over how to provide the public support.  Those facing bigger losses want to use EU-wide mechanisms that spread the losses to other countries facing smaller losses.  The latter want those facing bigger losses to contribute the lion’s share of any public support.

This is quite clear in the case of France (whose banks are acutely exposed) and Germany (whose banks are less vulnerable).  Sarkozy wants to use European Financial Stability Fund monies to recapitalize: that would spread the costs around to all the countries that contribute to the EFSF.  Merkel says “nein”:  private capital first, French government money next, and EFSF money only as a last resort.  In other words, she’s telling Sarko if you want to recapitalize your banks, use your own effing money. Sarko, in essence, is trying to buy insurance from Merkel after receiving a cancer diagnosis: Merkel is not interested.

These distributive conflicts between countries, and the nature of EU governance, are combining to make any resolution an agonizingly long process, and one that may well fail.  It makes it devilish  hard to negotiate an agreement.  It makes the credibility of any agreement doubtful.

Moreover, there is a strong incentive of those governments negotiating an agreement to obfuscate and conceal.  They don’t want their voters to know how big the cost is and who is bearing it.  This helps explain the convoluted financial structures being mooted to provide the backstop support.  These structures would make Enron’s Andy Fastow quite proud.  It is virtually impossible to figure out where the losses would actually ultimately land.  Which is the point.  But convoluted structures raise questions about their credibility as a backstop.  Political self-interest and collective interest are again at odds.

Add all of this up, and you have a situation that is virtually impossible to predict.  Coordination situations are often unstable and result in jumps from good to bad equilibria in the blink of an eye, in response to seemingly trivial information.  The ability to prevent runs on individual countries through the creation of collective backstop mechanisms just transfers the run risk to the backstop mechanism.  The backstop’s run risk depends on the credibility of the commitments made, which depends on political dynamics in numerous countries.  Distributive/rent seeking/free riding problems make it very difficult to negotiate a sharing and commitment arrangement in the first place, and raise doubts about the credibility of commitments.  All of these things are fiendishly difficult to predict, and the resulting uncertainty itself contributes to the likelihood of a run.

Coordination problems.  Problems making credible commitments.  Collective action problems.  Agency problems.  Individually, the knottiest problems in economics and institution design, all in one ugly package.

My read is that although one can construct scenarios in which things play out well, these scenarios are analogous to drawing several inside straights in succession.  Everything has to go right.  Given the natures of the linked problems–coordination problems, the difficulty governments face in making credible commitments, the difficulty of negotiating agreements with distributive as well as efficiency effects–there are many things that can go wrong.   The negotiation and credibility problems are acute given the European political structure, and the uninspiring leadership in place there.  Moreover, feedback loops are positive here, and that’s always very dangerous because small events can have huge consequences that spin out of control.   Put it all together, and there is reason to sweat.

Bottom line.  High risk of things ending badly.  Virtually impossible to predict the timing of the bad end, or the exact way the bad end will play out.

* The literature on global games formalizes the logic of equilibria in coordination games.

Vladimir Putin is apparently Kudrin’s shrink, as well as his former boss and friend.  Last week Putin said:

“As for Alexei Kudrin, I must say that he is definitely one of the best specialists, not only in Russia but in the world as well. This is first. Second, he is our very personal and my good friend, with whom I have maintained a very close, intimate relationship for many years, beginning in the 1990s. As we know, this decision [to fire Kudrin] was taken by the President. [It was] taken on the basis of the fact that Alexei Leonidovich made some incorrect statements about the fact that his position does not coincide with the position of the President. What can I say here now? You want me to comment on this? I think that even comments on my part at this point would be incorrect. We spoke with Alexei Kudrin on this score. I want to tell you that – this is my opinion, and that of President Medvedev – despite this emotional breakdown, Aleksey Leonidovich is still a member of our team and we’ll work with him. I hope that he will work with us. He is useful and necessary to our people.”

That sounded sort of familiar.  I vaguely recalled a similar Putin diagnosis, at the height of the crisis.  With a little digging, I confirmed that recollection:

Prime Minister Vladimir Putin, addressing workers at a rail car factory north of Moscow, forecast a return to economic growth in 2010 and said Finance Minister Alexei Kudrin had predicted a longer crisis because he was stressed.

“Alexei Leonidovich (Kudrin) is in a certain state of stress, because he is under a lot of pressure and on the defensive. But I don’t think we will be under this kind of pressure for the next 20 years,” Putin said.

The fiscally prudent Kudrin on Tuesday warned Russia should not expect a return of the favorable conditions it has enjoyed in the recent years for the next “five, 10, 20 or 50 years.”

Raining on Putin’s parade, in other words, is a sign of mental imbalance.

Thinking about the dysfunction of Russian military procurement got me thinking about what is going on here in the US.  Perhaps it’s not quite as dysfunctional, but it is definitely not healthy.  Shipbuilding, for example, is a mess.  The experience with the USS San Antonio is embarrassing.  But everywhere you look–Global Hawk and F-35, as prominent examples–you see huge cost overruns and seemingly interminable delays.  Bright spots appear to be limited to crash programs to develop fixes needed on the ground in Iraq or Afghanistan.  But when it comes to major new weapons systems, it’s a litany of failure.

Back in 1998, I was offered the Admiral Crowe Chair in the Economics of Defense Management at the Naval Academy.  I applied for the chair primarily out of the thought that it would be an interesting experience to return to Navy and stand at the other side of the classroom; getting a chair in my 30s would have also been something of a coup.  But it was too far from my where my research interests were at the time, and I was sure the novelty of role reversal would have worn off quickly.  (Also, I was put off by the cynicism regarding the Midshipmen and the seriousness of the uniformed administration about the importance of education expressed by the civilian faculty I spoke to–many of whom had been my instructors when I was a Mid.  A pretty disillusioning experience, and I didn’t have that many illusions going in.)

To get the job, I had pitched a transactions cost economics-based research agenda.  If I had taken the position, I planned to focus on how the consolidation of the defense industry would change transactions costs–notably, bargaining costs between the government and the contractors, and and the potential for opportunism by those parties.

I haven’t followed the issue closely in recent years (ironically, my research on clearing started about the same time as I was offered the chair), but my intuition is that transactions costs have a lot to do with the chronic problems in procurement, especially for big ticket items.  Shipbuilding for surface ships and submarines is dominated by single firms.  Two firms dominate aircraft production.   Everywhere you look, there are essentially bilateral monopoly contracting situations, and there are heavy investments in specific assets.  Information asymmetries abound, especially for technologically complex weapons.  There is little competition ex ante given the small number of viable contractors, and huge opportunism problems ex post.  Agency problems are likely to be acute: the officers who are supposed to be monitoring contractor performance often have their eyes on more lucrative jobs with the same contractors in the future.

Just looking at production costs and scale economies, you can make a credible case for consolidation.  But production costs aren’t all that matter.  Transactions costs are important too.  And it is my sense that the consolidation wave that accelerated dramatically with the end of the Cold War has dramatically inflated those transactions costs.  They aren’t an accounting item, but they show up in cost overruns on already inflated initial estimates and frequent and extensive delays in bringing systems on line.

The very nature of military contracting means that transactions costs are likely to be high, especially for cutting edge weaponry.  The means of controlling these costs are themselves costly.  You sacrifice scale economies when you support multiple duplicative suppliers who can provide competition and information (based on performance comparisons).  Government-operated suppliers (like Navy shipyards of yore) that also can serve as an outside option that constrains private contractor opportunism are often inefficiently scaled, and subject to low-powered incentives that can impair performance.  But incurring these costs is often a way of saving a greater sum in transactions costs.

Unfortunately, I see no way of reversing what has transpired in the past 20 plus years.  Which means that we are condemned to a future of continued bloated costs and waste when it comes to defense procurement.  Given that this same future will be one of straitened fiscal circumstances, in which defense spending is certain to be cut, defense will be ground between the upper and nether grindstones of inefficient procurement (driven by high transactions costs in dealing with dominant contractors) and reduced procurement budgets.

Defense is a legitimate function of government.  Because it is a legitimate function, it is an area that is not subject to Eugene McCarthy’s dictum that “the only thing that saves us from bureaucracy is its inefficiency.”  Here, the inefficiency gravely compromises the government’s ability to do what it justifiably should do.

I wonder what would have been the reaction to this research agenda, if I had taken the Crowe chair.  Not well, I think.  Not because it was flawed, or likely to be misguided.  No, it probably would have not gone well for me precisely because I think it was likely to identify some serious problems, and that would have made some people and firms vastly more influential than I very unhappy.  Doing that at Navy in particular would have been expounding blasphemy from inside the temple, as it were.  So it was probably wise to choose as I did, and focus on finance rather than defense.

Watching Vladimir Putin the last couple of days has been like witnessing a slow motion train wreck.  He’s driving the train, but just think about the poor schmucks that are along for the ride.

Exhibit 1.  Putin says Russia ready to handle Euro debt crisis.

Putin, who turns 59 on Friday, said Russia was ready to handle any fallout resulting from the slowdown in global growth and sovereign debt problems faced by the developed economies of the West.

“I will say straight away that Russia is better prepared than it was in 2008,” Putin said. “We have built up serious experience, a reserve of durability — in the economy and in the financial sector.”

Uh huh.  And that’s exactly what he said in 2008.  Right at the time of Lehman.  When Russia had bigger reserves.  When Russia was coming off several years of robust growth rather than slowly coming back from the ’08-’09 calamity.  When its fiscal balance was better.  When it hadn’t committed to vast increases in social spending, subsidies for utilities, and defense spending.  When there was some prospect, however faint, that the country would modernize somewhat.   When years of kleptocratic stasis did not appear to be fated.

So yeah.  Much better prepared.

Exhibit 2.  In the same speech to western investors, Putin just spun out grandiose fantasies that even the most glassy-eyed Nashibot would realize is utter tripe:

Throughout his remarks, Putin was big on promises. Russia, he said, would soon return to 6-7 per cent GDP growth (versus an estimated 4 per cent this year), while investments would increase to being 25 per cent of GDP instead of 20 per cent.

Twenty-five percent investment.  Riiiggghhtt.  At a time when domestic capital is packing its bags (to the tune of an estimated $50 billion, with the pace accelerating dramatically in September) and foreign investors keep their track shoes laced for a quick getaway—if they are stupid enough to invest in the first place.  Russia has never invested 25 percent of GDP.  Except under Stalin, maybe, and that was literally and figuratively at the point of a gun.

Exhibit 3.  In response to laments that Putin’s standing for election represented a return to Brezhnevian stagnation, his spokesman Dmitri Peskov says: “Hey, that’s a feature, not a bug!”

“Brezhnev is not a minus sign,” Peskov said. He was a “huge plus for our country. He laid the foundations for the economy and agriculture.”

That would be the foundation that is crumbling everywhere, if you haven’t noticed.

Insofar as foundations goes, it reminds me of this bit: scroll forward to the riff about the castles falling into the swamp:

Said spokesman also admitted that the epic Sea Hunt episode in which Putin, doing his best Lloyd Bridges impersonation, recovered the long lost Greek vases was staged.  I’m sure you’re stunned at the revelation.

If you want to get a dose of the reality that is on its way, listen to this interview of my friend Sergei Guriev. Pay special attention to the part where he is asked about whether Russian under Putin risks a Soviet-style collapse. That should tell you all you need to know about where Russia is and where it is going. If you can’t even talk about the prospect for collapse if changes are not made, you are flirting with disaster.

Since Jesus is not on his way, I guess Russians will just have to sing that Brezhnev/Putin is just all right, because that’s what they’re stuck with.

I have often commented on the bizarreness of the obsession of Putin (and lately, Medvedev) to lavish huge amounts of money on the Russian military to purchase hardware at the same time that its software–the men (primarily) who serve in the ranks–is so beset with problems.  This issue has come to a head with Kudrin’s making the issue of military spending the pretext for his outburst against Medvedev (although it really had to have been directed at Putin).  A couple of  articles bring this point home.

From EDM:

Another indication that the Russian General Staff is not overly anxious about a NATO withdrawal from Afghanistan relates to manpower, quite apart from the presence of poorly trained reservists, which would seriously inhibit Moscow’s capacity to maintain forces in theater for anything other than short spells. Indeed, a critical flaw in exercises of this type is that within only a few weeks, much of the manpower will be lost as senior conscripts are demobilized from the units. During Vostok 2010, some conscripts were prevented from demobilizing, while on the other hand many draftees involved in its various stages had been in the army for only a few weeks. One commander summarized the problem, lamenting: “give then a shovel and they will either lose it or break it.” Judging by Tsentr 2011, the “progress” is at best glacial (Krasnaya Zvezda, October 22, 2010).

There are also grounds to doubt the quality or “combat readiness” among these conscripts. Reportedly in an effort to placate the defense ministry leadership who prefer to believe that dedovshchina [hazing] no longer exists within the military system, there was an upsurge in the number conscripts who tried to commit suicide in Chelyabinsk Region and were sent to the psychiatric hospital in Birgilda (RIA Novosti, September 15). Alexei Sevastyanov, the region’s human rights ombudsman noted in his blog that the numbers of servicemen arriving in the psychiatric hospital had spiked, which he linked to preparations for Tsentr 2011. Sevastyanov blamed the psychological and physical impact of dedovshchina for such an upsurge. In the first nine months of 2011, around 22 servicemen from the Chebarkul tank brigade were admitted to the hospital after attempting to commit suicide due to stress. The defense ministry suspended reporting statistics on the number of annual suicide cases in the armed forces, though it is unofficially estimated at around 20 per month, or a battalion per year (http://newsru.com/russia/07sep2011/altay.html, September 7).

Following allegations made by the mother of a young soldier in Chelyabinsk, on September 15, the Central MD’s military prosecutor opened an investigation and formed special monitoring teams to send to Tsentr 2011. Olga Rodionova’s son, Ivan Golubev, was drafted in July and on September 13, a senior conscript attacked him with a block of wood. She visited the garrison of the 7th Tank Brigade and witnessed first hand life in the “new look” army; beatings of young soldiers were ignored by officers, personnel slept on the ground wrapped in their jackets, their feet rotted as a result of wearing wrong-sized footwear, medical aid was scarce, and inadequate washing facilities featured among other issues. Rodionova observed one soldier being kicked repeatedly in the stomach as officers walked past – evidently accustomed to witnessing and ignoring such violence. She stated that in preparation for Tsentr 2011, conscripts spent 14-18 hours per day digging large holes and building a notional camp. They lived without hot water, sleeping 36 to a tent designed for 22 soldiers. The bathhouse was heated twice weekly, but medics prevented new recruits washing due to the festering sores on their feet. Despite the reported outsourcing of catering, in late August there was a large-scale outbreak of food poisoning caused by soldiers eating rotten fish. Rodionova also expressed concern about the disregard for safety standards for soldiers assigned to unloading munitions. Rodionova concluded “You get the feeling that this is not an army – they are cattle with automatic weapons” (Novvy Region, September 15, 16).

This “new” brutal Russian army contrasts with many of the superficial pretentions to achieving success in the reform efforts to date. Moreover, as the conscripts frequently rotate out of these units, little scope remains for seriously improving combat training. Such reduced capabilities also undermine the assertions by Russia’s neighbors about any conceivable increased military “threat” from the country.

The conscripts serve for one year, and barely have time to become acclimated to the military before they are thrown into conditions that they are unprepared for, and then they leave.  If they are lucky.

And demographic and health problems and draft evasion sharply constrain the numbers that the military can conscript:

The military will significantly reduce the number of conscripts called up in the fall conscription drive amid difficulties finding a sufficient number of young men due to poor health and draft evasion, the General Staff said.

The military intends to call up 136,000 conscripts during the fall draft, which lasts from Oct. 1 to Dec. 31, compared with the more than 218,000 conscripts pressed into service in the spring draft, General Staff deputy head Vasily Smirnov told reporters Friday.

Smirnov said the reduction in the number of conscripts is aimed at “boosting the quality of the entrants” amid a military reform and will be compensated by a growing number of contracted military personnel, Interfax reported.

. . .

Smirnov also said 34.8 percent of conscript-age people were not eligible for military service because of poor health in the spring draft, an increase from 33 percent in 2010.

Moreover, 203,500 young men went into hiding so that draft notices could not be served to them in the spring, Smirnov said. In addition, about 7,300 young men who received the notices still did not show up for duty, he said.

Smirnov’s assertion about the growing number of contract personnel is so much bull, as anyone who has followed this issue knows.  The military has had a very difficult time attracting kontraktniki, and an even harder time retaining them.  Many of the dysfunctions in the conscript force have lived on among the (relatively few) contract soldiers and units.  It is just pathetic when the authorities tell such transparent lies.  The contract force has been a failure, and the hierarchy has fought it at every turn.  The Russians would be far better served spending some of those billions of rubles on building a real volunteer force, instead of dumping money on defense contractors–where it will acquire little of use, and where much of it will disappear without a trace.

Kudrin must have thought the entire exercise was madness.  Spend huge sums in fraught economic times in the immediate aftermath of an existential economic crisis to acquire armaments (theoretically) that have little strategic use, and which in any event will be manned by the unskilled, the unmotivated, the abused, the demoralized–which means that they will be less than useless.

And he’s right.  The entire exercise is madness.  But Putin–and make no mistake, it is his decision, for all Medvedev’s butch posing–has chosen madness.  And not just in this.  This is just one part of a broader effort to create a shambolic simulacrum of the USSR.  No, not in all of its ugly manifestations.  But in those that stir atavistic pride in many Russian breasts.  Those related to Russians’ self-image as a Eurasian hegemon arrayed against the New Carthage. (E.g., Putin’s new intiative to create a new EU–Eurasian Union–that stitches together the pieces of the USSR.  More on this in a few days, time and travel permitting.)

Utter madness.  One guy got it, and that guy is gone.

Your favorite company and mine is under some stress.  Gazprom faced raids from EU officials pursuant to an antitrust investigation of the company against the background of Euro hemming and hawing (so what else is new?) over the creation of a unified energy market.  But perhaps more interestingly, Gazprom’s customers are rebelling against the anachronistic oil-based pricing, take-or-pay contracts under which the company has sold gas since the 1980s.  These contracts made economic sense then, when there was no liquid spot market.  They are not economically sensible now, given the development of such a market.  But given the divergence between oil prices and spot gas prices, they are quite lucrative for Gazprom, so the company is holding on to them with a death grip.

But cracks are appearing.  One long-standing contract (dating from 1986), with Turkey’s Botas, is about to expire.  Botas has terminated the contract citing a dispute over the pricing mechanism.  Perhaps this will give impetus to the efforts of other companies, such as Germany’s E.ON who are also pressing the Russian corruporation to move towards spot pricing.

The Turkey episode is actually quite entertaining, and should make anyone think N times before believing any Gazprom statement.  The initial threat to terminate the contract came from Turkey’s energy minister.  Gazprom then huffily said that the Energy inister was irrelevant, because it was negotiating with Botas not the Energy Ministry.  Uhm, 2 days later, Botas told Gazprom to hit the road, Jack.

I love it when that happens.  A twofer.  Gazprom loses a deal, and then looks foolish trying to deny it’s going to lose the deal.

The disputes over contracting are a short-to-medium term problem for the company.  Longer term, there is the threat from shale.  US shale is developing apace.  There was recently an announcement of a huge shale gas find in the UK (although there were soon naysaying reports–all of which is par for the course in this business).  Poland has also claimed that it has bright shale prospects (although a private correspondent who has investigated the issue closely argues these claims are overstated).

The company has ambitions to raise  its market share in Europe from about 25 percent to 30 percent.  It will not be able to achieve those ambitions and maintain its anachronistic pricing mechanism (which greatly overprices gas).  Moreover, it will face new competing suppliers.  Gazprom will no doubt continue to maintain its swagger, but as the Botas episode shows, cracks are appearing in its facade.  Look for those fissures to grow.

I look forward to hearing more music.