Streetwise Professor

The Morgan trade that has roiled the bank, and arguably more important, the politics of banking, is coming into clearer focus.

What transpired appears to be a classic collection of trading and hedging SNAFUs.  There are two different issues that should be distinguished.  The first is the motive for the trade, the second is its structure.  The underlying motive makes sense at an abstract level, but the structure was FUBARed.  But once the structural issues are considered, one must seriously consider whether the motive, however attractive in the abstract, is at all feasible, especially for a behemoth like Morgan.

Morgan was apparently looking for a systemic risk hedge, something that would protect its huge exposure to corporate default risk against a Eurocrisis, a dramatic weakening of the US economy, etc. In the abstract, this is a laudable goal.  In the abstract.

Given this objective, it put on a trade in tranches of the IG.9 credit index.  These tranches are very sensitive to credit conditions.  What’s more, their valuation and risk are highly dependent on correlations.

Crucially, given the sensitivity of the tranches to credit conditions, to maintain the desired hedge Morgan had to dynamically manage the position.  It managed the risk by selling protection on the IG.9 index.  Crucially, the structure of the position required Morgan to sell protection as credit rallied.

And credit indeed rallied, due to the ECB’s aggressive actions at the end of 2011.  So Morgan had to go into the market big time, and sell more and more protection.

By doing so, it ran into all the curses that beset dynamic hedges, especially somewhat dirty ones in which what is being hedged (the tranches) and the instrument being used to hedge them (the index) have different sensitivities to parameters-correlations, in this instance-that are themselves moving randomly, and moving a lot.

The hedging instrument was relatively illiquid, meaning that it was prohibitively costly to adjust the hedge in response to every move in the relevant prices and parameters.  But given the structure of the position, failure to adjust continuously gives rise to hedging errors that work against the position. Its value was also buffeted by changes in the crucial parameters.

Moreover, Morgan’s very size worked against it.  Dynamic hedges chase the market: you are buying when prices rise and selling when prices fall.  This is how you pay for the hedge.  But when for a bank as big as Morgan, its hedging trades exacerbated the adverse price movements.  This made the hedge far more costly than a standard model, which presumes that prices move exogenously and are not affected by the trades of the hedgers, would predict.  Morgan’s price impact was revealed by the divergence (“the skew”) between the price of the index and the prices of the underlying credits.

Morgan found itself trying to navigate between the Sybil Scylla of holding an unbalanced position that subjected the bank to market risk (in movements in the index as well as to movements in the crucial parameters) and the Charybdis of massive transactions costs inherent in trading in relatively illiquid markets in immense size.  And in its attempt to navigate that divide, it apparently was bashed by both monsters.

Moreover, once it was in the position, there was-is-no obvious way out, especially given the fact that now everyone and his extended family is aware of Morgan’s predicament.

Looking at all this reminds me of the portfolio insurance debacle on Black Monday, 1987, when dynamic hedging strategies blew up spectacularly.  Morgan has been a one bank portfolio insurance wrecking ball.  A poster child for what can go wrong with dynamic hedges that make sense in a frictionless, complete markets, BSM world, but which can go horribly, horribly wrong in messy reality, where markets are incomplete and illiquid.

Indeed, all of the potential problems with dynamic hedges were/are present in spades for this particular transaction.  Most notably, dynamic hedges are major liquidity users.  Morgan was trading in relatively illiquid products.  Moreover, the risk that Morgan was hedging against was also correlated with liquidity, which is a wrong way risk from hell (which portfolio insurers also found out to their dismay in ’87).  The position was also highly sensitive to parameters-correlations that are (a) hard to estimate accurately, and (b) quite volatile, especially in the very conditions that Morgan was purportedly hedging against.  Furthermore, all of these problems were exacerbated to an extreme extent by the size of the positions and the trades.

A couple of broader points deserve comment.

First, this episode indicates that there is a source of scale diseconomies in banking.  You can be too big for your own good-and your own safety.  So what is to be done about that?  Of course the immediate response-as predicted here-is to pile on more regulations, something that the administration is pursuing furiously, in its tried-and-true let-no-crisis -go-to waste fashion.  But the market imposes its own discipline.  Morgan’s stock price has fallen substantially, its credit rating has been cut, and its financing costs have risen.  These all limit the bank’s ability to grow further, and indeed will likely lead to some contraction in its size. Moreover, the demonstration effect will lead the markets to evaluate the costs of size across financial institutions generally, leading to adjustments in the cost of capital based on updated information about the real costs large entities incur to manage risk.

Second, although hedging against systemic risk sounds superficially attractive, Morgan’s experience, and a little reflection, suggests that the ability to do so is chimerical.  Systemic risks, by definition, affect everybody in the system.  They can’t be diversified away.  Everybody wants to shed them, so they are priced in equilibrium.  You have to pay to get rid of them.  Morgan apparently underestimated the cost of paying other market participants to take on this risk from them.  In part, this was because the need to trade dynamically in order to put on the hedge meant that there wasn’t a sticker price, paid up front, to get someone to take on the risk.  Instead, the cost was paid day after day, via the market chasing, slippage, and transactions costs associated with the trading strategy.  Like portfolio insurance, it looked cheap on the white board or the computer screen, but turned out far more expensive in reality.

This is particularly true for a big, systemically important institution that has to trade in large size to implement such a strategy.  This size magnified all of the pitfalls of dynamic hedging.

In essence, Morgan put on the trade because it wanted to shrink its exposure to certain risks.  It did so by implementing a dynamic trading strategy, which turned out to be a very costly way of doing that.

So how can big banks shrink their risk exposures, if not via dynamic derivatives trading strategies? By getting smaller.  By shrinking their balance sheets.  The market price responses to Morgan’s revelations are likely to lead to that very result, not just for Morgan, but for other big banks as well.  Just as portfolio insurance implemented by dynamic trading shrunk significantly once its true costs were realized, the same thing is likely to happen here.

Attempting to regulate bank activities via Talmudic-and often nonsensical-distinctions between “hedging” and “prop” trades is a fool’s errand.  Hedges can go horribly wrong.  Moreover, quite perversely, regulatory burdens actually tend to create compliance overhead costs that tend to encourage size; the advantage that big institutions have influencing regulators accentuates this effect.  Some combination of capital requirements (with devilish details) and market discipline is a better way to control bank size.

Which means that there is a positive externality to Morgan’s struggles.  Its travails demonstrate vividly the costs of size.  Morgan apparently underestimated the cost of managing risk exposure, and its big loss not only is making it aware of the true cost, but is educating the market as well.  This will affect the cost of capital not just for Morgan, but for all banks, and in a way that will impose a cost on size and complexity.  It is unlikely that this higher private cost will reflect completely the social costs of size, but it is certainly to be welcomed.

An interesting contrast in a couple of disparate articles I came across in my morning news trawl.

Item One: Sechin opposes privatization of Transneft because “public trading of shares would complicate the firm’s debt financing.”

Item Two: NY Fed research paper shows that firms with publicly traded equity can borrow at lower rates than otherwise comparable private firms:

In a 2012 New York Fed study, Chenyang Wei and [Anna Kovner] find that interest rate spreads on publicly traded bonds issued by companies with privately traded equity are about 31 basis points higher on average than spreads on bonds issued by companies with publicly traded equity, even after controlling for risk and other factors. These differences are economically and statistically significant and they persist in the secondary market. We control for many factors associated with bond pricing, including risk, liquidity, and covenants. Although these controls account for some of the absolute pricing difference, the price wedge between public and private companies remains. Despite these pricing differences, private companies with public bonds are no more likely to go bankrupt or to be downgraded than are similar public companies.

One plausible explanation of the Kovner-Wei result is that private firms can more readily divert cash flows and/or are more difficult to monitor than public ones.

And monitoring the diversion of cash flows is almost certainly the “complication” that Sechin wants to avoid.  The NY Fed paper’s results suggest that Transneft would be able to borrow more cheaply if it also floated common equity.  But doing so would reduce the private control benefits that Sechin and his ilk reap from Transneft.  In the end, not surprisingly, the private control benefits win out.

The J.P. Morgan situation continues to metastasize.  As I suggested in my first post, its biggest effect is regulatory/political.  Yes, $2 billion is a lot of money, but it in no way threatens JPM in the slightest.  But the political and regulatory aftershocks are massive. This has changed the entire financial industry regulatory/political dynamic.

The contention focuses on the Volcker Rule, and in particular the “portfolio hedging” exemption. Look.  Financial institutions are portfolios of assets and liabilities.  From a systemic risk perspective, you care about the probability that the value of a big bank’s portfolio of assets will fall below the value of its liabilities-or that funders fear that it might, and hence refuse to rollover the firm’s debt, leading to a liquidity crisis.  What you should care about is the risk of the portfolio.

Derivatives trades are typically the most efficient and rapid way to adjust that portfolio risk up or down.  To evaluate a particular derivatives trade, you have to evaluate its effect on the risk of the entire portfolio.  It makes no sense to evaluate a derivatives trade as a “hedge” solely by pairing it up against another individual transaction.  This is particularly the case when you are talking about macro risks, like broad conditions that affect creditworthiness of entire continents.  Why wouldn’t you hedge macro risks with macro hedges?

So the questions become: How do you evaluate the effect of a trade on the risk of a portfolio? Does the return justify any additional risk (for risk minimization is decidedly not the appropriate objective function)? Can regulators evaluate the risk better than financial institutions themselves?

And there’s the rub. Morgan’s story is thats new risk measurement model deemed the trade as risk reducing.  But the trade didn’t perform as the model said it should.  So Morgan went back to the old model, which showed it to be far riskier than the new model.  Under this interpretation, risk was assumed unintentionally, due to incorrect modeling.  That’s quite a different thing from a speculative punt.

There are many ways that could have occurred, some of which reflect discreditably on Morgan, others not.  My guess is that the new model was seriously wrong about correlations.  These are devilish hard to get right generally, and in credit particularly.  Moreover, any VaR-type model almost always fails to capture properly the effect of position size on risk.  These models take price processes as exogenous, but if you are big enough that’s not true.  The big trader’s actions can themselves cause the model to give wildly misleading results.  Any risk model has flaws, but these flaws are less severe for price takers than price makers.

And as for alternatives to VaR, such as conditional expected loss measures, please.  They are just different ways of representing the same underlying information, and rely on the same assumptions. I guarantee that if Morgan’s VaR-esque new model underestimated risk, any other metric, such as conditional expected loss, would have done so too if it was based on the same underlying distributional assumptions and parameter estimates. Indeed, some of these estimates are more sensitive to distributional assumptions than VaR, because they depend on modeling of behavior of the tails.  They tend to go further beyond the available data than VaR models.

And could a regulator do any better? Yeah.  Right.  Get serious.

Can simple rules, such as “any trading position must be shown to reduce a specific transactional risk” uniformly lead to better results?   Not, in my opinion, when you are talking about complex financial institutions with diverse portfolios.  Indeed, although trades characterized as “portfolio hedges” can be used for “speculative” purposes (though again speculative trades can be justified if the return is sufficiently large), constraining the ability to manage risk can lead to riskier and less profitable banks, rather than safer ones.

In brief, the “hedge vs. speculation” distinction is simplistic. As a result, things like the Volcker Rule, which are predicated on that (and related) concepts, are not going to reduce systemic risk, and are in fact likely to increase it.

Jamie Dimon of course attacked the Volcker Rule vociferously.  Which is why the big loss is such a political issue.

Dimon is personally in a very bad spot.  Very bad.  He has already executed the vertical chop: those involved in the trade 3 levels down the org chart have resigned or been fired.  The fate of the entire London office is up in the air.

Dimon is between the devil and the deep blue sea.  If he admits that he had hands on involvement, he is directly culpable-and if his subordinates must go, why shouldn’t he?  Conversely, a claim of ignorance is hardly creditable to him.  But it is probably the best of the two alternatives, and it seems to be the one he is taking.

Along these lines, Dimon said something quite stunning on Sunday (h/t R):

He said he didn’t know if his firm broke any laws or U.S. Securities and Exchange Commission rule.

He didn’t know whether laws had been broken. A clear confession that he doesn’t really know what went on in London-or is pretending not to know.  Knowing what went on exactly in London is hard: knowing whether a crime was committed should be easier than that.

This is not a good position for a CEO to be in, especially one like like Dimon.  Given the intense scrutiny that he and Morgan will face, and the frenzied political environment in an election year, and the Occupy insanity, he is in a very vulnerable position.

Spain’s banks, especially the cajas, are in desperate trouble due to that country’s real estate boom and bust.  The banks hold large quantities of mortgages and loans to developers that are seriously underwater, a fact that the banks have been very slow in recognizing-as is almost always the case.  Don’t recognize the losses, you can perhaps benefit from a miracle turnaround in the market in the future.  Recognize them, you are out of business immediately.

Spain’s government has responded by forcing the banks to write down their mortgage assets, and to raise more capital.  The problem is that capital is a buffer against possible future losses; you can’t get anyone to contribute capital to pay for losses already realized.  So where is the money going to come from?  Because private capital is not going to fund past losses, the only real candidate is the Spanish government, but it has agreed to stump up only 15 billion Euros, far short of the 50 billion Euros that market participants deem necessary.  But Spain, with nearly 25 percent unemployment rate and an ongoing recession (with a forest decline in its economy of 1.8 percent this year) is unable to fund the amount necessary to bailout the banks.  Its bond yields already top 6 percent.

Which means that the money has to come from outside . . . the ECB or the European Stability Mechanism.  But the Germans have already made it clear they are not going to permit the use of ESM funds. Much more ECB support is also unlikely.

So how is this going to work, exactly?

Spain is also ordering the banks to dump their bad real estate loans into asset management companies (an expedient that the Chinese have used on multiple occasions).  But that can lead to fire sales (if the asset management companies dump the assets) which exacerbates the underlying problems.  And this just moves the losses around.  It doesn’t eliminate them.

So Spain is in deep trouble, and there is no obvious way out.

All this is happening, moreover, at a time when Greece is spinning out of control again, and quite predictably.  There was no way to commit the Greek electorate to adhering to any deal negotiated with Europe.  And they are quite clearly rebelling at the idea, confronting Europe with the choice between a Greek exit from the Euro and shoveling more money down the rat hole.  There are already reports that the Troika is willing to make concessions on the recently negotiated bailout deal, concessions that will almost certainly have to be followed by more concessions, and yet more.

This all resembles a disaster like Chernobyl,or a plane crash, where there are cascading failures.  Perhaps one of them would be containable, but multiple failures-especially those that feed back on one another-are far, far more difficult to manage. I keep looking for a way out.  Not seeing it.

There is little new to report on the multi-billion JPM loss.  The big question is what position JPM has remaining, what it plans to do with it.  The bank probably has the staying power to hold on for awhile, and can avoid dumping it on the market a la Amaranth/Brian Hunter or LTCM.  But as Jamie Dimon admitted yesterday, this will expose the bank to considerable volatility going forward.

The exact transaction/transactions at issue is/are unknown, so it is impossible to make a definitive evaluation.  What is known does permit some conclusions, however.

The first is that whatever the position is, it is big.  And size is often a liability.  The bigger the position, the bigger a liability it becomes.  Market judo uses your size against you.  For if things don’t go your way, it is hard to exit a big position, and even attempting to do so can exacerbate your losses.

Reading this, I didn’t know whether to laugh or cry (h/t R):

Senior traders and dealers described Iksil as a “bright guy”, who was faithfully executing strategies demanded by the bank’s risk management model but who may have simply misjudged the amount of liquidity in the markets.

How many traders could have this as their epitaph: “He Simply Misjudged the Amount of Liquidity in the Markets”?

You can just imagine the Wily Coyote moment. You try to get out of a position and find out you have just run over the cliff and there is nothing to catch your fall, as liquidity disappears from beneath your feet just when you need it.

A couple of other points.

First, there is a lot of pixels being strewn about as to whether the Morgan trade was a prop trade or a hedge, and how this relates to the Volcker Rule.  Well, that’s a big part of the problem.  There is no hard and fast line.  As Holbrook Working pointed out long ago, what is conventionally called hedging is really speculation on the basis.  And if your basis position is big enough, and the basis is volatile enough, you can lose a lot of money.

The first member of the billion dollar club-Metallgesellschaft-was allegedly hedging.  It wasn’t doing basis trades, per se, but had a huge calendar spread position. Ditto Amaranth. LTCM’s “convergence trades” (that became divergence trades) were essentially basis trades that could be characterized as hedges.

It’s all about size and capital and correlation and volatility.  The right (or should I say wrong) combination of those factors-and particular a good dose of sh*t happens-can create a lot of risk, and result in big losses.

This is why much of the discussion of the Volcker Rule is quite beside the point.

Second, there is the question of when things went pear shaped, and when Jamie Dimon knew they were going pear shaped. He was very contrite about, and critical of, the trade yesterday.  He vigorously defended it in April.  If he got the bad news sometime between the defense and the criticism it’s one thing.  If he defended the trade in April knowing that it was already losing, or was substantially riskier than he let on, and that the firm was looking for the exits, it’s quite another.

If it was the latter, you can imagine his dilemma. If he failed to defend the trade vigorously, it would have no doubt resulted in a self-fulfilling disaster, as everyone would have anticipated the impending unloading of the position and traded against it.  But if in defending the trade he made misleading or knowingly inaccurate statements, he would face serious legal problems.

Again, right now there are only questions.  But no doubt there will be intense scrutiny that will lead to many uncomfortable political and legal moments for Dimon, and for JP Morgan as a whole.

Following a time-tested MO, Russians are insinuating that pilot error (or error by Indonesian air traffic controllers) caused the crash of the Sukhoi superjet.  After all, the pilot is dead, and can’t defend himself-but there is big money to be lost if it was a mechanical or design problem.

The man I usually refer to as Rogozin the Ridiculous was first out of the gate with this story.  Here he earns a new sobriquet: Dmitry the Disgusting:

A deputy Russian prime minister, Dmitry Rogozin, said the aircraft was working “impeccably” before the crash and suggested that “the human factor” — a reference to pilot error or a mistake by ground controllers — was likely to blame. Russian authorities often blame crashes on pilot error, even before the results of an investigation.

Interesting thing.  Planes that crash often work quite well-before they don’t.  Rogozin’s amazing forensic skills. demonstrated earlier in the year in his analysis of the Yekaterinburg sub fire, were on full display:

Rogozin said he had flown in a plane of this type in February in Novosibirsk and considered it a good, reliable, modern craft. “During the flight from Novosibirsk to Moscow I was in the cockpit and the pilots explained to me the advantages of the jet. The pilots had a high opinion of this plane. The aircraft has a great future, it is promising and competitive,” Rogozin said.

Wow. If that isn’t dispositive, what is? No need for any investigation.  Move along.  Nothing to see here.  Rogozin flew on the plane.

Some of those interviewed (especially in the predictably egregious RT piece) called attention to the pilot’s request to fly at a lower altitude in a mountainous region.  Uhm, even a tyro would be unlikely to do this unless there was some compelling reason to do so.  And the man at the controls was no tyro:

Sukhoi’s chief civil test pilot, Alexander Yablontsev, and his co-pilot, Alexander Kochetkov, flew the plane, Superjet International, the Italian-led venture responsible for marketing the plane to the West, said in a statement on its website.

Yablontsev had accumulated 10,000 flight hours and commanded the Superjet on its maiden flight in 2008.

In other words, extremely experienced both overall and on this particular aircraft.  A man whom a Russian state corporation (Sukhoi is now part of the Putin-created monstrosity, I mean “national champion”, United Aircraft Corporation) deemed to be the most qualified to fly the plane on which it was staking its future as a commercial aircraft manufacturer.  But apparently someone who didn’t know enough to fly over mountains.

The Russians will no doubt attempt to cement this narrative, and influence the investigation.  And given the parties-and stakes-involved, “influence” can go well beyond a bullying phone call.

JP Morgan just announced a huge-$800 million $2 billion!-mark-to-market loss in the synthetic credit portfolio run out of its Chief Investment Office.  Bruno Iksil-“The Whale”-is almost certainly wearing the collar for this bloodbath (uhm, I think that’s a mixture of 3 metaphors-whatev).

Some immediate reactions.

1. Whales get harpooned.  No matter how big you are, the markets are bigger.
2. Traders can move prices by putting on big enough trades.  It’s not moving prices that is the trick: it is profitably closing big positions after you moved the price.  There has to be some asymmetry.  If your buying drives up prices, your selling to exit a position is almost certain to drive them down-and indeed, drive them down more due to market frictions.
3. That is, to be profitable, Whale Trades require an exit strategy.  Corners have an exit strategy-but even these are not foolproof, as many cornerers have found to their dismay.  Some other manipulative strategies, such as moving a price that affects the payoff to a related derivative, also have an exit strategy.  But just flexing, just moving a price by trading in huge size, is vanity and usually results in losses because there is no exit strategy. Like the Duke of York, you can march up the price hill by buying a lot, but you end up marching down the hill again when you try to sell.
4. Banks can kiss any weakening of the Volcker Rule adios! Indeed, the rule is likely to be tightened considerably.  I’m sure Jamie Dimon is getting lots of love from his fellow CEOs.  Lots.
5. Speaking of Dimon, I wonder if he can kiss his job good bye.

Russian aviation suffered another grievous blow yesterday with the crash of a new Sukhoi Superjet 100 on a demonstration flight in Indonesia.  The Superjet has been touted as the harbinger of the resurgence of Russian civil aviation.

No details about the cause of the crash have been released.  From the appearance of the gash in the vegetation and the lack of large pieces of debris on the mountainside in the photograph in the Bloomberg article, it looks that the aircraft plunged almost vertically into a ravine on the Indonesian volcano. The pilot had radioed to request permission to descend from 10,000 feet to 6,000 before contact was lost with the aircraft.  Perhaps this indicates a cabin compression problem, or an engine problem.  The pilot did not explain the reason for the request (at least I have not seen any such reason reported).

My condolences go out to all those who perished.

This has been a particularly bad year for Russian aviation, even by rather frightening Russian standards.  Those hardy enough or unlucky enough to fly Russian airlines have to brave a daunting array of dangers, from antiquated aircraft, to poor maintenance, to ill-trained and sometimes inebriated pilots, to bad fuel (potentially a cause of the crash of the plane carrying the Lokomotiv hockey club), to terrorism. The crash of a Sukhoi plane is particularly disconcerting, because whereas MiG military aircraft are notoriously dangerous to fly, Sukhoi military planes have a fairly good safety record.

And things could get worse. In an every-silver-lining-has-its-cloud sort of way, the growing number of commercial flights in Russia outpacing the ability of the country to produce pilots:

As passenger flights continue to increase, the number of students graduating from Russian aviation academies won’t be able to meet airlines’ staffing demands, an industry expert said. The burgeoning deficit is prompting airlines to cover their staffing needs by poaching pilots from other airlines and starting special recruitment programs, among other means. If this deficit is not successfully addressed, it could exacerbate the safety concerns about air travel in Russia, experts said.

“The most problematic segment, the deficit which could directly affect the level of flight safety in the future, is the shortage of graduates from educational institutions specializing in flight operations,” said Oleg Panteleyev, an analyst at the industry information agency Aviaport.

According to Panteleyev, about 330 new pilots graduated from Russian flight schools in 2011. Although the state flight schools plan to graduate 480 pilots in 2012 and to increase that number in future years, the number of graduates will be less than the number required by airlines. The industry’s staffing needs will include an estimated 800 to 1,000 pilots annually over the next few years, he said.

Meanwhile, passenger travel continues to grow in Russia. Sixty-four million people flew on Russian airlines in 2011, and the number of passenger flights increased 12.6 percent compared with 2010, RIA-Novosti reported in March. The number of passengers grew 18 percent in the first two months of 2012 as compared with the same period last year, according to the news service.

The margins along which carriers can adjust to meet the shortage are readily foreseen, and all involve a compromise in safety.  Airlines can work their pilots longer hours, leading to more fatigue. They can schedule more tightly in order to utilize human and mechanical resources more intensely.  They can hire less capable, less well-trained, and less-experienced pilots.  All of these alternatives increase risk, particularly in Russia given the challenging weather conditions, and the fact that aircraft are more aged (and hence have fewer advanced computers and avionics that can substitute for pilot skill, and which are are more vulnerable to mechanical problems that less-skilled pilots are more capable of handling), and less-well maintained.  The Sukhoi crash only exacerbates these problems as it reduces the likelihood that the rapid introduction of new, more capable and forgiving aircraft will offset the decline in average pilot skill.

In other words, Russian civil aviation is already precarious, and is only likely to get worse as the demand for air transit increases.  It is plagued by both hardware and software problems that are becoming more acute, and will continue to worsen as the industry attempts to expand the scale of its operations.

In “honor” of Karl Marx’s birthday, the Christian Science Monitor ran a feature of “10 Great Marx Quotes.”  Google has made this an Editor’s Pick.  Ugh. (H/t R-again!)

Today is the birthday of a truly great scholar and far better human being than Karl Marx-Frederich Hayek .  The CSM should be running a feature  of Great Hayek Quotes.* Google Editors should be making it one of their featured choices.

But here on earth, we know that’s not happening.  So I’d like the SWP community to do the job for them.  I encourage comments including great Hayek quotes.  The more the better-we can beat 10, easy.

I’ll start it out:

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.

Even the striving for equality by means of a directed economy can result only in an officially enforced inequality – an authoritarian determination of the status of each individual in the new hierarchical order

Jump in, folks!

PS. Coordination Problem often names a Hayek offering as its Quote of the Day.

Much has been written about Putin’s resumption of the Russian presidency. Much of it relates to economics. Much of it is silly.

This article from the FT’s Beyond Brics blog summarizes a lot of the silliness that is spun by those making the “bullish” case for a Putin return:

The bulls can put together a persuasive story: Putin 2.0 cannot run the economy as he did in his first two presidential terms in 2000-8 or as prime minister in 2008-12 because he can no longer rely on rapidly rising oil prices.

. . . .

Therefore, so the bull argument goes, Putin must pursue economic reform, including market liberalisation, privatisation, reducing red tape and fighting corruption. Otherwise Russia cannot generate the economic growth needed to transform itself into a fully-functioning modern society. Finance minister Anton Siluanov said on Monday Russia required growth of 5.6 per cent annually, (not the 3.4 per cent forecast by the government for 2012).

. . . .

So, say the bulls, Putin will change because he must. At the age of 59, he will be thinking of his legacy, and he won’t want to be remembered as the man who created a historic opportunity to modernise his country – only to waste it.

Most of that is nonsense on stilts.  Or, more accurately it is projection on stilts: it accurately summarizes what Putin should do if his objective was to create a modern Russian economy with self-sustaining growth, which is what the bulls think a “normal” country and a “normal” leader would do.

But that totally misses the way the Russian system works, and what Putinism is about.  It misses that Russia is a natural state, and that the system is structured to benefit the elites and uses control of resources to keep a balance among the elites in order to maintain political stability.  Creating a dynamic system, a modern system, would fatally undermine this equilibrium.  Moreover, in this system, corruption is a feature, not a bug.

As I noted yesterday, Putin is already signaling clearly that he will brook no opposition, and will bring down the batons on anyone with the audacity to raise his head.  This is one aspect of maintaining political control.  Maintaining control of the economic levers is another.   Putin may talk modernism, but he walks traditionalism, meaning a traditional, natural, authoritarian state where economic policy is all about distributing rents and maintaining control of economic resources in order to protect the elite and their property.

And although Putin may talk about moving beyond oil and gas, he’s not walking away from it.  To the contrary.  He is avidly pursuing energy deals with western companies (h/t R), and touting these deals to anyone who will listen.  Steve LeVine argues Putin is “good for business” but the businesses LeVine mentions are notably the big western energy companies.

Some (including LeVine, it appears) rationalize this as a means of funding and pivoting to a more modern economy.  Such beliefs are truly a triumph of hope over experience.  Sergei Guriev has written often and powerfully about this.

Further note that although Putin announced privatizations, energy was clearly off the table:

In the decrees, Putin said he wanted the government to sell its stakes in firms which do not belong to natural resources or defence sectors and are not natural monopolies. That would require a change to the state’s privatisation programme when he wanted in place by Nov. 1, he added.

This strongly suggests that Sechin has prevailed, and that what is old is new again.

Other aspects of Putin’s newly announced programs are purely aspirational, decrees to achieve wonderful economic outcomes, but with no concrete policies that could actually achieve them:

Putin ordered the government to take measures to raise capital investment to no less than 25 percent of GDP in 2015, from the current level of 20 percent, and to create 25 million high productivity jobs by 2020.

He also called for a 50 percent increase in labour productivity by 2018 and a 30 percent increase in the share of high tech products in GDP in order to lessen Russia’s dependency on natural resources.

Uhm, just how, exactly?  This is redolent of Soviet planning, with the center setting ambitious targets.  The difference being that it’s easier to do that with something like steel production, especially when you can shoot people who don’t perform, and dragoon peasants from the farms to the factories and dragoon the peasants who stay behind into feeding those who left.  Not so easy to do in a modern economy.

Putin seems to recognize this (h/t R again):

In characteristically colorful language, Putin struck back by blaming the economic difficulties on the Communists who ruled the Soviet Union until 1991. The Soviet economy was based on heavy industry and produced shoddy consumer goods.

“Yes, my dears, there’s no need to discuss this,” Putin said. “The point is that what we produced — and no need to wave your arms — no one needed. No one bought our galoshes except for Africans who had to walk on hot sand.”

That’s great that he recognizes the obvious, but it’s a long way from that to understanding how to create a system that generates 25 million high productivity jobs and increases the role of high tech in the country.  It’s further still from such an understanding to a willingness to take the measures necessary-measures that would undermine his power, his wealth, the wealth of the elite, and the stability of the political system.

And he’s all about stability.  When analyzing the actual policies he pursues, rather than the pie-in-the-sky rhetoric, you have to start from that fact, rather than projecting western political “it’s the economy stupid” attitudes onto him.  Putin understands Soviet failures, and will not repeat them.  But he also understands the mortal dangers that a rule based, competitive system would pose to him and the elites.  He will steer a middle course, a natural state course.  He will continue on, pretty much as before.

Another “bull” point (with “bull” being accurate in more ways than one) in the Beyond Brics article is that Putin will change to ensure his legacy.   I think that’s farcical for the reasons just discussed, but it is completely unrealistic for other reasons as well.  First, although it is not historically unprecedented, it is extremely rare for aging leaders to change dramatically.  Hell, it’s extremely rare for aging people period to change dramatically.  Indeed, habits and tendencies tend to become progressively more defined and rigid as one ages.   For someone as arrogant as Putin, in particular, it is delusional to think he will conclude that he has to change dramatically.  Second, change requires receiving realistic feedback.  Authoritarian systems generally, and Putin’s in particular, have disconnected most of the feedback mechanisms: elections, a free media.  The crackdown on the opposition (including today’s lovely threats to smear their livers on the sidewalk) may succeed in its object, but in so doing will short circuit another source of feedback.  The natural authoritarian tendency for leaders to surround themselves with sycophants, and for sycophants to rise to the top because sycophancy is the primary fitness trait in such regimes, further isolates the leader from reality.

Some of Putin’s other decrees are particularly idiotic:

Putin bound the government to reduce mortgage loan rates to 2.2 percent by 2018.

He also pushed for state measures to increase real wages 1.4-1.5-fold by 2018. The average lifespan in Russia must reach at least 74 year Putin said in a decree.

2.2 percent? Really? What’s he doing? Trying to create a real estate bubble? That always ends so well!

And just what state measures can increase wages 50 percent in 6 years?  Why hasn’t any other state figured out how to do that?  And how is lifespan to be increased by decree? He might as well order the tides to stop: Canute knew better than this, but pace the sycophancy point, who in Russia is going to tell him so?  And would Putin play Canute to chide the sycophants around him? Please.

No.  There will be no modernization to speak of.  Putin’s Purgatory will continue, and become more stagnant and corrupt.  The hamster wheel from hell will keep on spinning, until it falls apart or is knocked over by some shock that turns off the tap of resource rents that is essential to its operation.