Streetwise Professor

In the very early days of this blog, I told the story about what Chief Economic Advisor Beryl Sprinkel said on Black Monday, 1987, when a panicked Treasury Secretary James Baker wanted to close the stock market: “We’ll close these markets when monkeys fly out of my ass.” No monkeys flew, and the markets stayed open, eventually stabilized, and then recovered.

But many monkeys are flying out of many asses in China. Although the authorities have not closed the stock markets, individual companies have halted trading in their stocks: trading in more than one-half of the listings in China is currently suspended.

Halting trading more than for a short interval in order to resolve information asymmetries and permit the flow of liquidity to stocks that have just experienced an information event (as during a temporary stock halt in the US) is in general a bad idea. (Post-87, Greenwald and Stein wrote a paper published in the JOB laying out this argument.) An uncoordinated and extended halt of many stocks is a really horrible idea, because of the negative externalities. That is, uncoordinated flying monkeys wreak even more havoc than coordinated ones.

Halting trading in a large number of stocks increases selling pressure on stocks that are still trading. This happens for at least a couple of reasons. First, individuals who need to raise cash (e.g., to meet margin calls) are forced to concentrate their sales in the stocks that keep trading. This tends to concentrate selling pressure, rather than diffuse it. Second, individuals who want to rebalance their portfolios away from equity into cash or bonds have to concentrate their sales in the stocks that continue to trade. Again, this concentrates selling pressure.

This creates a vicious feedback loop. A number of companies halt trading, which forces selling pressure to spill over with greater force on other stocks, which leads some of these companies to halt trading, which intensifies selling pressure on other companies, and so on. The ultimate likely outcome is a protracted lockdown of the entire market. Protracted because who is going to be the firm to restart trading first, and risk having everyone sell the hell out of them?

The vaunted Chinese economic managers (ha!) have well and truly bungled this one. They should have prevented open-ended trading halts, or had a coordinated stoppage and restarting of trading. The coordination failure at work now is manifest.

Again, I believe that the sharp selloff is more of a symptom of a deeper economic problem than a potential direct cause of such a problem. The main adverse spillover that the stock selloff could cause is through the margin debt channel. Margin calls could lead to fire sales of illiquid assets. Again, the more stocks that are not trading, the more severe these fire sales in non-equity assets will be: this is another adverse consequence of uncoordinated monkey launches. Moreover, failures to meet margin calls will saddle the lenders (themselves often highly leveraged) with losses. Both of these channels could have adverse consequences in the brokerage, banking and shadow banking sectors. Their balance sheets are not that hale and hearty to begin with, and this kind of shock could spark broader financial distress throughout the sector.*

In other words, the stock market decline is less of a crisis in itself, than a potential catalyst to a crisis via informational and fire sale channels. And perversely, uncoordinated trading halts in the stock market are more likely to intensify than mitigate any such catalytic effect.

But the Mandarins know everything, so I’m sure it will turn out swell.

In the meantime, the Mandarins have a message for all investors in China. Good luck with that!

* Perhaps one could argue, as Michael Brennan did when trying to explain price limits in futures markets in the JFE in 1986, that halting trading could ease pressure on margin credit. I am skeptical though. Even if stocks stop trading, margin lenders are likely to demand additional security in current conditions. Indeed, trading halts that reduce the informational content of stock prices create a source of uncertainty to margin lenders which they are likely to compensate for by demanding additional margin based on their estimate of the stock price once trading recommences, plus a premium to compensate for the uncertainty.

The People’s Bank of China is effectively funding an effort by a group of brokers to buy equity (to the tune of about $20 billion) in an attempt to stem the massive selloff in Chinese stocks. The news barely checked the relentless decline, which I will expect will resume with a vengeance.

In other words, China is panicking, and attempting to catch a falling knife, as the phrase goes. And that almost never works out well.

Actually, I don’t think that the equity market decline is China’s big problem, except to the extent that it is a harbinger of a dramatic slowing of the growth in the economy, or perhaps an absolute decline in the economy. Countries survive equity market meltdowns. It is the leveraged sector that is the concern. In China, that includes not just banks, but the plethora of shadow banks, trusts, and local government funding vehicles, all with murky interconnections with the banks.

There are pronounced signs of economic stagnation besides the shuddering equity market. The lack of growth in electricity generation is one. The sharp declines in China-sensitive commodities, notably oil, iron ore, and copper are another: oil was down 8 plus percent today. (Cheers, Vlad!) If it was oil alone, one could write it off to the market deciding that a generous Iran deal was imminent. The broad fall suggests that it is China, China, China.

The equity market, and the government’s response to it, is therefore a symptom of this broader economic problem. What the Chinese (and those long energy and metals production) need to be especially concerned about is if a decline in growth sets off a banking or shadow banking crisis. Then the Chinese central bank and government will be in the unenviable position of catching a barrage of plummeting arrows.

Hit Number 1. One of Krugman’s stock arguments to defend deficit spending and the accumulation of massive amounts of debt is “don’t worry!: we owe it to ourselves.” (I will pass over in silence at the Ricardian implications of that statement, which undermine Krugman’s argument that deficits are expansionary.) Krugman is also cheerleading for a Grexit.

It is therefore beyond ironic that a major reason that Greece faces Armageddon is the debt Greeks owe to themselves. The immediate source of Greece’s peril is the impending collapse of its banking system. The banks hold about €11 billion in Greek government bonds and about €14 billion in Greek Treasury Bills, money, per Krugman’s formulation, that Greeks owe to themselves. Greek banks are scraping by only because the ECB has agreed to fund these bonds. If Greece defaults, this funding goes away, and the banks will collapse. And it’s not just sovereign debt. The remainder of the nearly €400 billion on Greek bank balance sheets is loans to Greeks, i.e., money Greeks “owe themselves.” Many of those loans are underwater too.

In other words, money Greeks owe themselves will almost certainly bring down the banking system, and with it the Greek economy, once the ECB safety net goes away. But I’m sure Krugman will find a way to say that’s a good thing. Or that the problem was that they didn’t borrow enough from themselves. Or something.

Hit Number 2. The game theorist likely behind the let’s-play-crazy referendum and negotiating strategy, Finance Minister Yanis Varoufakis, has resigned. But don’t get excited. His replacement is a hardcore Marxist. But no worries. The FT assures us that he’s a pragmatist.  As if it really makes a difference whether a Menshevik or Bolshevik is in charge of economic policy.

Forget the debt issue. That will be resolved, for worse or for worser. The real reason that Greece is well and truly screwed is its statist, leftist, and frequently Marxist political culture. Greece needs to grow. Replacing one Marxist with another Marxist ensures that it won’t.

But look at the bright side. Now Venezuela has company.

The Greeks voted a resounding No! in today’s referendum, thereby rejecting a deal that had been taken off the table.

Figuring out the Syrzia plan is something of a puzzle. It reminds me of the old South Park Underwear Gnomes bit, hence the  title of this post. One can see the desired objective (a more prosperous future liberated from a crushing debt burden) and one can see the initial move (referendum), but the middle steps are a complete mystery.

At first blush-and second, and third-it appears that what the Greek government is doing is crazy and self-destructive. This suggests two alternatives:

1. The Greek government is crazy and self-destructive.
2. The Greek government is pretending to be crazy and self-destructive for tactical reasons.

I say crazy because the Greeks are claiming that they are willing to accept economic Armageddon instead of making far less costly concessions to the Europeans. But if there is even a small probability that people are of this type (i.e., they much prefer to die on their feet than live on their knees), pretending to be this way and getting a reputation for being this way can be an effective way of extracting concessions from an adversary. It is often rational to defer to craziness.

This gambit works best if a repeat player is matched against a series of one-shot players: the repeat player benefits from creating a reputation, the one-shot players don’t. That’s not the case here, though. The solvent Euros (e.g., the Germans and Dutch) also have an incentive to build a reputation for being tough in negotiations, because they are repeat players. They reason that if they concede to the Greeks, the Southern Euros (Spain, Portugal, Italy in particular) will try to extract concessions as well. So they have an incentive to play tough with the Greeks even though if this was a one-off situation it would make sense to make more concessions.

Which all means that I have no idea how this will play out.

Furthermore, this is primarily a game about redistribution rather than creating wealth. This maximizes the potential for conflict, and increases the incentives for rent seeking and rent dissipation. The exact outcome is difficult to predict, but the basic contours of this outcome are pretty predictable: everybody ends up poorer and miserable.

It is hard to have sympathy for either side. The Greeks have a corrupt and bloated state, and its people have a socialist, welfare/entitlement state mindset, and they borrowed lavishly to achieve a lifestyle that their productivity could not support. The Europeans gladly lent more to a corrupt and bloated state, and a people with a socialist-tinged, welfare/entitlement state mindset than they could afford to repay. They jointly made their bed, and now they have to lie in it. So be it.

The least likely outcome is that Greece makes fundamental changes and conjures up a growth miracle, like postwar Japan or Germany, or Taiwan or Korea. The socialist/statist/welfarist impulses are too deeply rooted, and its interlocutors-the Euros-are also too statist to compel or persuade the Greeks to change their ways.

A couple of years ago I said that Europe had a choice between amputation and gangrene in dealing with Greece. They chose not to amputate. They now have to live with the consequences.

Apologies for the light posting. Some travel (to Sweden, Denmark and London), work, and a need to decompress for a bit account for the absence.

I have kept a watch on things, though, and some Putinsanity has caught my eye.

For instance, VVP has accused cursed furriners of luring, Pied Piper-like, talented Russian youth away from the glorious Motherland:

A network of [foreign] organizations has ‘rummaged’ through the schools in the Russian Federation for many years under the guise of supporting talented young people. In reality, they simply hoover everything up like a vacuum

Note to Vlad: the reason that “talented young people” want to leave in droves is less that “foreign organizations” attract them, but that the state and society that you have constructed repel them.

Note the rampant insecurity here. I think that Putin knows that Russia has little to offer. But he can’t admit that, so he rages agains the West.

Item two: Surprise, surprise, surprise. The Russia-Turkey gas pipeline project is stalled because of a failure to communicate on price. Don’t say I didn’t tell you so:

Russia’s plan to build a new $15 billion pipeline to Turkey is at risk of delay because of a fight over gas prices, according to people with knowledge of the matter.

State-run OAO Gazprom and its Turkish counterpart Botas had a six-month period to agree on prices for gas supplies between the two countries, which expired on Monday. The Ankara-based company now has the right to take the matter to international arbitration, three of the people said, asking not to be named because the information is private.

The dispute over prices means there’s no immediate prospect of signing a binding pact for the new pipeline, the second between Russia and Turkey. An agreement could now be delayed until at least October, two more people said, also asking not to be identified.

The Russians think that you are stupid enough to believe that this is due to Erdogan’s defeat in the recent parliamentary elections, but that’s just a face saving cover story. Truth be told, the Russians are masters of vapor agreements. By my rough estimate, two of the last 100 announced gas deals have come to completion. And I’m being generous.

Anyone who believes anything Russia/Gazprom say about any pipeline project, deal, contract, etc., please contact me! Have I got a deal for you!

(As an aside, Erdogan and Putin are doppelgängers in a competition for the coveted titled of Most Insane Wannabe Autocrat Obsessed With Restoring Lost Imperial Greatness. May the best nut win!)

Next comedic moment: the Russia-Greece pipeline vapor deal, which is effectively contingent on a (non-existent) Russia-Turkey pipeline vapor deal. (BTW: Why is everybody freaking out about Russia courting Greece? Let Putin have them! Just what he needs. Another economic basket case, to join Abkhazia, Transnistria, South Ossetia, Donetsk, Luhansk. May the Orthodox nations enjoy every happiness! They deserve one another!)

Item three: Russia blasts the new US defense doctrine, which (realistically) identifies Russia as a threat to the sovereignty of its neighbors due to its willingness to use force as “confrontational.”

This is a perfect illustration of Pirrong’s Principle of Putinist Psychological Projection. Whatever the Russians say about the US is a pitch-perfect description of what the Russians are doing. They are the masters of projection.

This leads to my last observation: what will Putin do in Ukraine? He can’t go back: that would be a humiliating climbdown which he is psychologically incapable of, and which could actually threaten his power. Maintaining the status quo is the lowest risk, but offers the least potential for gain, and creates the real potential for a creeping collapse as the economic drain of sanctions and militarization saps the economy. Going forward and attacking Ukraine presents serious risks. Ukraine might be able to deny him a quick victory and impose serious losses. Even if he prevails operationally, the costs of occupation will be steep. These include the direct costs, which will be especially high if Ukrainians resort to historical precedent and wage a grueling guerrilla war (remember the Greens?). They also include the indirect costs of almost certainly escalated sanctions.

He’s in a fine mess, and I don’t know how he will react. Time is running out for a summer offensive, but time is not on his side generally. My fear is that he will follow Eisenhower’s dictum: “If a problem cannot be solved, enlarge it.” The question is: where? The Baltic-Finland, Sweden, Denmark, as well as the Baltic States-is a real possibility. Putinsanity is hard to predict, but nothing is beyond the realm of possibility.

Here’s a first. I appear in a comic strip history of the CME-ICE rivalry in Bloomberg Markets Magazine. Quite the likeness!

Other than the fact that I appeared at all, the most amusing part of the, er, article, is the panel depicting CME’s Terry Duffy getting the news that ICE was making a rival bid for CBOT via a note slipped under his hotel room door at the FIA at Boca at 0600. I had eaten dinner with Duffy and CME CEO Craig Donohue the night before. They were in a little better mood then than they were the next day.

Bloomberg’s Matt Leising called me at about 0630 to ask me about the development. That led to an appearance on Bloomberg TV, where I was interviewed right before Jeff Sprecher. He watched me give the interview, and was not pleased with my prediction that CME would eventually prevail, but have to pay a lot more: I saw him say to the woman next to him (who I later found out was his wife, Kelly Loeffler) “who is this guy?” That was exactly how it worked out though, and apparently there were no hard feelings because Sprecher spoke at a conference I organized at UH a couple of years later. Either that, or he didn’t connect me with “this guy.”

Evenhanded guy that I am, I invited Craig Donohue to speak at a conference a year or two after that. His speech was interrupted by some Occupy types (remember them?), whom my tiger of an assistant Avani and I bodily shoved out of the room while the rest of the audience sat in stunned silence (not knowing what was going on).

So yeah. My involvement with CME and ICE sometimes does sound like something out of the funny pages. Now it’s official.