Streetwise Professor

The frantic sewing of parachutes in a plane that is 30,000 feet in the air continues apace. Last week the Office of Financial Research (a Son of Frankendodd) released its 2015 Annual Report. This tome received attention mainly because it raised alarm about potential systemic risks arising from central clearing mandates. An improvement, I guess, but like most official evaluations of the systemic risks of CCPs, it misses the real problems.

It gets off on the wrong foot by misstating the real benefits of CCPs. According to OFR, the top two benefits of clearing are related to the ability of CCPs, and via them regulators, to get more complete, accurate, and timely information on derivatives positions and trading prices. But these can be achieved by transaction reporting alone, without going the full monty to clearing, which also entails collateralization (including both initial and variation margining) and mutualization of default risk. (Trade reporting has turned into a nightmare, which I will write about further soon. But the point is that you don’t need clearing to get the benefits OFR touts.)

But the main problem, yet again, is that OFR focuses on the “single point of failure”/interconnectedness/default loss contagion channel for CCP systemic risk. This is not immaterial, but it is not the main thing. The main thing is that CCPs create potentially massive contingent demands for liquidity, where the liquidity contingency is likely to occur precisely at the worst time–when the system is undergoing a financial crisis.

Further, OFR gets it wrong when it states that CCPs “reduce the risk of counterparty default.” CCPs redistribute the risk of the insolvency or illiquidity of a large financial institution away from its derivatives counterparties towards its other creditors. It protects one group of creditors at the expense of others.

It is very much open to question whether this reallocation is systemically stabilizing, or is instead a means whereby one relatively concentrated group of market participants can advantage themselves at the expense of others.

Reading Izabella Kaminska’s excellent FT Alphaville post on Real Time Gross Settlement (RTGS) mechanisms makes plain that this phenomenon of substituting liquidity risk for credit risk, and redistributing credit risk away from core banks, is not limited to derivatives clearing. RTGS replaced deferred net settlement (DNS) because of banks’ and central banks’ concern that in the latter, interbank credit balances could accumulate, resulting in a default loss to settlement banks in the event that an net payer bank failed before the next netting cycle. RTGS eliminates interbank credit exposure.

But, of course, this doesn’t make credit exposure go away. It redistributes it to settlement banks’ other creditors. To a first approximation, the total losses from the inability of a bank to meet its obligations are the same under RTGS and DNS. The difference is who gets a chair when the music stops. Settlement banks–and crucially, the central banks–like RTGS because they almost always are going to get a chair.

Furthermore, as even its proponents acknowledge, RTGS is much more liquidity intensive. To be able to make every payment in real time, a settlement bank either has to have the cash on hand, or the ability to borrow it on demand intraday from the central bank. Liquidity needs scale with gross payments, which are substantially larger than net payments. Thus, like CCPs, RTGS substitutes liquidity risk for default risk.

This risk is exacerbated by the fact that a prisoner’s dilemma problem exists in RTGS. Participants concerned about the creditworthiness of other banks have an incentive to delay payments and hoard liquidity, since once a payment goes into the system, it is final and the payer is at risk to loss of the entire gross amount if a bank that owes it fails before it pays. This can lead to a seizing up of the liquidity supply mechanism, as the prisoner’s dilemma logic kicks in and everyone starts to hoard.

Since holding cash in sufficient amounts to meet all payment obligations is extremely expensive, RTGS has evolved to permit central banks to lend intraday on a collateralized basis. But as was seen in the 2008 crisis, collateralization poses its own risks, including ballooning haircuts that can set off price spirals due to collateral fire sales. Further, due to the potential for the breakdown of long and large collateral chains, this creates an interconnection risk, and represents a further coupling of the system. And it is coupling, remember, that is at the root of most catastrophic accidents. Secured lending can create a false sense of security.

Izabella’s post also points out another problem with RTGS, which is common to central clearing. It creates a much more tightly coupled system that is very vulnerable to operational risk. This risk crystalized in October, 2014, when a seemingly innocuous change to the system (deleting a member bank) caused the failure of the UK’s CHAPS  settlement system for a day. Ironically, this was the result of an interaction between one part of the system, and another part (the Liquidity Savings Mechanism) that was intended to economize on the liquidity demands of RTGS, and essentially created an RTGS-DNS hybrid. As in most “normal accidents”, unexpected interactions between seemingly unrelated parts of a complex system led to its failure.

There is another way to see all of this. Both central clearing and RTGS are intended to create “no credit” systems. That is true only in a very limited sense–a profoundly unsystemic sense. Yes, CCPs and RTGS are designed so that participants in those arrangements don’t have credit exposure to one another. But those participants aren’t the entire system, just a part of it: the exposure is pushed away from them to others. Further, the method for reducing credit exposure among the participants is to require extensive reliance on liquidity mechanisms that are prone to breakdown in stressed market conditions. Further, these liquidity mechanisms are based on credit: banks (or the CCP) borrow from other banks, or from central banks in order to obtain liquidity. Further, the credit moves into shadowier places.

Not to sound like a broken record, but things like CCPs and RTGS redistribute and transform risks, rather than eliminate them altogether. Unfortunately, these transformations do not necessarily reduce the risk of a systemic crisis, and arguably increase it in some cases. The failure of officialdom, and large swathes of the banking sector, to recognize or address this reflects in large part a failure to take a systemic perspective. Perhaps cynically, this can be explained by the fact that the central banks and banks that drive these reform efforts mistake their own interests for the interest of the system as a whole: le système, c’est nous. As a result, “Devil take the hindmost” could well be applied as the motto of RTGS and central clearing.

This illustrates a broader problem in public policy. Government is too often invoked as a deus ex machina that internalizes externalities. But the fact that most regulatory change efforts are driven by, or ultimately controlled by, a small subset of interested parties who have the most concentrated stake in an issue. Given the diffuseness of other impacted parties this is inevitable. But it means that in practical terms internalizing externalities via regulation of something as complex as the financial system is a chimerical goal. The externality hot potato gets tossed from one segment of the financial sector to another. Government regulation, as opposed to self-regulatory initiatives, mainly affect the makeup of the subset of participants who are involved in influencing the process, and the distribution of the bargaining power. This works through the entire process, from the crafting of legislation, to the writing of regulations, to their implementation. This is why we get things like RTGS or CCP mandates, which make a certain set of participants better off, but which it is heroic indeed to believe are truly welfare increasing.

The WSJ reports that the CME Group’s new Euro-Denominated cocoa futures contract is floundering, due to a pronounced lack of liquidity. (h/t @libertylynx) The incumbent ICE Futures Europe Sterling-denominated and ICE Futures US USD-denominated contracts dwarf the CME contract’s volume, even though European hedgers face some currency risks in using these contracts.

This is not a surprise, not by a long shot. It is always very difficult for upstart contract to make inroads, let alone dominate, in competition with an established incumbent. Liquidity is king, and the established contracts have a liquidity advantage that new entrants almost never overcome, even if the new contract is superior on some dimensions.

The only real example of the displacement of an incumbent is Eurex’s wresting of the Bund contract from LIFFE in 1997-1998. That story, which I analyze in a forthcoming paper in the Journal of Applied Corporate Finance, is the exception that proves the rule.

First, because it was supported by German banks who direct a lot of order flow to it, Eurex (and its predecessor, Deutsche Terminborse) had a base of liquidity on which to build.

Second, because it was electronic, it was possible for Eurex to offer faster and easier access to US users once the CFTC approved Eurex’s application to install terminals in the US.

Third, and most important, Eurex exploited LIFFE’s smug complacency. Eurex aggressively cut fees, and LIFFE did not match: it was convinced that its superior liquidity, and the inherent superiority of floor trading, would prevent its customers from defecting to Eurex to save a few DM per contract in fees.

Wrong! As I document in the JACF paper, the liquidity cost difference between the markets wasn’t that great by 1997 (due to the German bank support and the influx of US customers), and taking into account the lower trading fees it was actually cheaper to trade on Eurex. Volume started to leak to Eurex, and the leak turned into a flood. LIFFE belatedly cut fees, but by then it was too late. The market had tipped completely to Eurex, and LIFFE had a near-death experience.

I can speak first hand of LIFFE’s overconfidence. In 1992, I produced a study for DTB that showed that its electronic market’s liquidity was comparable to that of the floor-based LIFFE. The study was not intended for release: it was commissioned to determine whether it was advisable for DTB to add a new membership type analogous to locals in order to improve liquidity. But the results were so surprisingly favorable for DTB that they released the study, much to the derision of LIFFE and the futures trading community generally, which was truly in the grip of the Cult of the Floor.

The CEO of LIFFE was quoted in the FT and Risk Magazine to the effect that I was an ivory tower academic who had no idea the way the real world works, because everybody knows the floor is more liquid and always will be. Real bulletin board material. Literally, in my case.

He who laughs last. When Eurex launched its assault on LIFFE in 1997, it distributed my 1992 study broadly. I doubt that had much of an impact on the final outcome, but it couldn’t have hurt.

The LIFFE CEO ended up resigning after LIFFE capitulated, and voted to close the floor and go electronic. I was a good boy. I resisted the very strong temptation to send him clippings of the FT and Risk articles.

Every other exchange learned a lesson at LIFFE’s expense, and responded to a fee cutting entrant by cutting fees immediately. For instance, the CBT saw off Eurex’s attempt to compete in the Treasury market in short order by cutting fees to zero, raising them after Eurex capitulated.

So CME shouldn’t feel bad. It has plenty of company in launching a contract that fails to make headway against an established incumbent. Indeed, the experience should be comforting, because it is the dominant incumbent in USD STIRs, govvies, equity indexes, FX, grain, precious metal, livestock, and energy futures. It benefits massively from the liquidity entry barrier. Compared to that, the failure to penetrate ICE’s cocoa monopoly doesn’t amount to a hill of beans.

The Bank of England has received a lot of attention for its just-released study on the liquidity impact of swap execution facilities (SEFs). It finds that:

as a result of SEF trading, activity increases and liquidity improves across the swap market, with the improvement being largest for USD mandated contracts which are most affected by the mandate. The associated reduction in execution costs is economically significant. For example, execution costs in USD mandated contracts, where SEF penetration is highest, drop, for market end-users alone, by $3 million–$4 million daily relative to EUR mandated contracts and in total by about $7 million–$13 million daily.

The basic methodology is to use a difference-in-difference approach to compare measures of liquidity pre-and-post SEF mandate, and which exploits the fact that non-US banks can avoid the mandate by avoiding trading with US banks: this avoidance issue will is important, and I will discuss it later.

The study is carefully done, but I am not persuaded. For one thing, the measures of liquidity employed are driven by data availability (transactions prices), and are not the ideal measures of liquidity. The primary liquidity measures employed are really measures of price dispersion, rather than preferred measures of liquidity such as bid-ask spreads, depth, or price impact (although greater (lower) price dispersion could be associated with lower (greater) price impact).

There is also the issue that transaction characteristics are endogenous. For instance, it may be the case that it is cheaper to do large deals off-SEF than on-SEF. These deals will tend to be done at prices that are further away from the mean price (or the end-of-day midpoint price), and in the volume-weighted measures employed in the paper, these deals get a bigger weight in the liquidity measures. Thus, price dispersion may be greater pre-mandate, and in Europe, where the mandate can be avoided not because SEFs improve liquidity, but because it is prohibitively costly to transact large deals on SEFs. That is, the results could be symptomatic of a loss of liquidity on some dimensions, rather than proof that the mandate improves liquidity.

The paper documents that there is less dealer intermediation where the mandate is binding. This could also reflect changes in transactions characteristics. Dealers are more likely to be needed to intermediate big deals, or deals that are exceptional on some other dimension.

The paper doesn’t break down transaction characteristics by mandate-impacted and non-mandate-impacted subsamples, and in particular doesn’t include a measure of the dispersion of transactions sizes. As a result, it’s not possible to determine whether the mandate has altered the mix of transaction characteristics.

This relates to another finding of the study: namely, that the mandate has led to the fragmentation of the interest rate swap markets along geographic/currency lines, with SEFs gaining far lower penetration in Euro-denominated swaps that are dominated by European banks who can avoid the mandate by trading with one another, and by trading with European end-users. There is confirmation of this result from Tabb Group, which finds that “European derivatives market continues to resist electronic trading.”

Well, this raises the dog food question: If the dog food is as great as the ads say, why don’t the dogs eat it? if SEFs are so much more liquid, why don’t traders flock to them?

When given a choice between a statistical finding, and revealed preference, I go with the latter. Those who actually internalize the cost of trading largely avoid SEFs. This suggests that they are actually costlier to use, at least for some users, such as those who want to trade in large size, or have other idiosyncratic needs. The choices of those who have the choice strongly suggests that the statistical evidence purportedly showing lower execution costs on SEFs is flawed and misleading.

With this in mind, it was gratifying indeed to see CFTC Chairman Massad stating that he favors allowing market participants to decide whether they transact swaps electronically or using traditional voice execution. There was never a compelling case-or even a weak one-for forcing diverse market users with diverse transactional needs to use a one-size-fits-all execution method. Massad’s free-to-choose approach is therefore a vast and welcome improvement over his predecessor Gary Gensler’s monomaniacal determination to bash everybody over the head with a CLOB.

Update. Here’s a more detailed description of the Tabb Group study I linked to above. One important takeaway: European end users really hate electronic execution, and really love voice execution:

Despite the cost benefits of e-trading, institutional investors still prefer to interact with their dealers via phone. Nearly 80 [!] per cent of the more than 200 European investors interviewed as part of the Greenwich Associates 2015 European Fixed-Income Study confirmed their trading protocol of choice was the phone.

“These trades often require white-glove treatment, and clients work with dealers that are best at limiting market impact and providing the support needed to get the trade done,” says Greenwich Associates Managing Director Andrew Awad (pictured). “As a result, clients still place a high value on the support provided by swaps salespeople in executing complex and large trades.”

This strongly suggests that there are likely to be considerable differences between deals done on SEFs and those done the old fashioned way. Not particularly the point about “limiting market impact.” Those who want to do trades that are “complex and large” go to dealers to trade bilaterally to avoid price impact. If they are not able to do that, because of an electronic execution mandate, they will almost certainly trade differently. Fewer big, complex trades. If that is correct, then the Bank of England study is comparing grapes to grapefruit. If so, the difference in price dispersion documented in the study does not demonstrate greater liquidity on SEFs: it demonstrates worse liquidity, at least for some kinds of trades.

Mind you: end users were the supposed beneficiaries of the SEF mandate. According to GiGi et al, they were being shamelessly exploited by dealers, and SEFs would set them free. Apparently they like their chains just fine, thank you very much.

Again: revealed preference rules. Believe it over a stat every time.

Policies can be misguided, but coherent: that characterizes the Bush II Middle East policy for the most part. Then there are policies that are so bizarre and contradictory so as to be utterly incoherent. That’s the Obama Middle East policy.

On the one hand, for the past several years the administration has bent over backwards to make deals with Iran. In the months since the deal was sealed, it has made concession after concession to the mullahs, including obsequiously thanking the Iranians for releasing sailors whom they illegally seized and mistreated, and arguably paying $1.7 billion in ransom to secure the release of Americans held by Iran. The obsequious attitude to Iran is driving the Saudis into paroxysms of paranoia, which stokes proxy wars throughout the region, most notably in Yemen, Iraq . . . and Syria.

But in Syria, the US is on the side of the Saudis fighting Iran’s allies. Indeed, in Syria the Saudis pay for US covert support of anti-Assad forces fighting Iran’s puppet, the Assad regime. Just today John Kerry–who always has one more cheek to turn to the next Iranian insult–said: “The position of the United States is and hasn’t changed; that we are still supporting the [Syrian] opposition politically, financially and militarily.” You know, the opposition that is fighting Iranian forces on the ground in Syria.

But the US being on the side of the opposition may be old news. Now the rumors are rife that the US has backed away from its previous stance that Assad must step aside during the transition to a new government. This is setting off yet even more paroxysms of paranoia among the Gulf Sunni oil tick states. He said this, by the way, in the context of trying to arrange peace talks between the warring sides. How can you be a peace broker when you are “supporting the opposition politically, financially, and militarily”? That’s incoherence!

So maybe in its dying days the administration is groping for coherence, by going the full Monty on Iran. But I’m betting on continued incoherence.

More incoherence. Obama has been adamant about “no boots on the ground” (a phrases that triggers severe teeth-gnashing by yours truly) in the anti-ISIS campaign. Yet in the past few weeks Defense Secretary Ashton Carter has been going around saying yes, there will be American boots on the ground in Syria and Iraq to fight ISIS. Which is it? (Annoyingly, as of yet I have not heard anyone demand an explanation from Obama for this glaring contradiction. Is Carter off the reservation? Or is Obama merely dodging responsibility, and the press is eagerly enabling? Don’t bother answering. Rhetorical question.)

Then there’s US policy towards the Kurds, where Biden simultaneously supports the Turks in their war against the PKK and supports the PKK’s Syrian offshoot, the YPG, which the Turks hate as much as the PKK.

Yet more incoherence. We frantically support peace efforts in the region (most of them futile) but attempt to appease Saudi and Qatari anger at our concessions to Iran by showering them with weapons . . . which the Saudis turn around and use to bomb the crap out of Iranian proxies in Yemen, which angers the Iranians. And around and around it goes.

In the region, this playing both sides is viewed with deep suspicion. Paranoia is part of the Middle Eastern DNA, and the slightest inconsistency is perceived as double dealing and backstabbing. As a result, we undo our attempts to mollify one element (e.g., the Iranians) by doing something to mollify their enemies (e.g., the Saudis) who are angry at our attempts to mollify the first element.

It’s a policy feedback loop from hell.

My grandfather had a wealth of colorful expressions, most of which were the product of his Appalachian upbringing. One, however, was a little different. Whenever it was too late to do something about a particular problem, he’d say: “Well, it’s a little late for herpicide.” In context, I understood what he meant, but the exact meaning escaped me. I asked him one time, and it turns out that Herpicide was a (quack) hair loss cure in the ’30s or ’40s. The company’s add campaign pictured a cue ball-bald man with the caption: “A Little Late for Herpicide.” I guess now it would be “A Little Late for Rogaine.”

This expression came to mind when I read in the FT that “Russia considers hedging part of its oil revenues.” It would have been a good idea when the price was $100, or $90, or even $50. At $30 (or below, as happened on Wednesday and Thursday), well, it’s a little late for hedgicide. Yes, oil could indeed go lower, but hedging today would lock in prices that are low by historical levels.

Hedging would make sense for Russia, just as it does for a highly-leveraged corporate. It clearly incurs financial distress costs when prices are very low. Hedging would reduce the expected costs of financial distress.

Presumably Russia would implement a program like Mexico’s, buying large quantities of out-of-the-money puts. This would allow it to capture the upside but obtain protection on the downside. It would also avoid a problem that it might face if it sold swaps/forwards: finding a counterparty. Selling a put to Russia doesn’t involve counterparty risk. Buying swaps from them would. Although this would be a right-way risk, one could readily see Russia balking on performance if oil prices were to spike, putting a short swap position well out of the money. It would have the cash to pay: the willingness to pay, not so much. Further, although Russia’s ability to pay is closely related to oil prices, it is exposed to other risks that could impair that ability, and these risks would create credit risks for anyone buying swaps from Russia.

Buying puts does create an issue, though: this would require Russia paying a rather hefty premium upfront, at a time when it is cash-strapped. As an illustration of its financial straits, note that it is attempting to avoid having to come up with cash to stabilize troubled megabank VEB. Borrowing to pay the premium is also problematic, given its dicey creditworthiness. Russia’s CDS spread is around 370bp (which, although it has turned up as oil prices took their latest plunge, is still below post-Crimea levels, and even below the levels seen in August). Current sanctions and the prospect of the crystallization of future political risks may also make lenders reluctant to front Russia the premium money.

One interesting thing to consider is how hedging would affect Russia’s output decisions going forward. Hedging, whether by buying puts or selling swaps, would reduce its incentive to cut output in low price environments. As I’ve written before, Russia doesn’t have a strong incentive to cut output anyways because  market share, market demand elasticity, and the cost of shutting down production in Siberia make it a losing prospect (as its refusal to cut output in 2009 and in the past 18 months clearly indicate). However, whatever weak incentives Russia has to cut (in cooperation with the Saudis for instance) would be even weaker if it was hedged. If cooperation on output between OPEC and Russia has proved hard up to now, it would be harder still if Russia was hedged.

A Russian hedging program, if big enough, could affect market pricing, but not the price of oil (at least not directly*): hedging is a transfer of risk, and a big Russian hedge would affect the price of oil risks. Its hedging pressure would tend to increase market risk premia (i.e., reduce forward prices relative to expected spot prices). If done using puts, it would also tend to steepen the put-wing volatility skew and increase volatility risk premium. Adding its hedging pressure to the market would also necessitate the entry of additional speculative capital into the market in order to mitigate these effects. Sechin has criticized speculators in the past: hedging Russian oil price risk would be prohibitively expensive without them.

Although Russia has mooted the possibility, I doubt it will follow through. I would imagine that the combination of the cash cost of options and criticism within the ruling clique of locking in low prices will cause them to pass. If and when oil prices rise substantially, I predict they will forego hedging because they will convince themselves that prices won’t fall again, just as they did post-2009.

In sum, this sounds like an idea that the technocrats have advanced that will die at the hands of the siloviki, like various privatization initiatives.

* The spot price of oil depends on output and demand. Hedging affects spot prices to the extent that it affects output. One way that could happen is that if it reduced Russia’s incentive to cut output. Another way it could happen is that hedging increases Russia’s capacity to finance investments in oil production by reducing capital costs. In this case, investment would be higher and output would be higher.

In each of these scenarios hedging reduces spot oil prices in some states of the world, not because of the direct effects of forward selling, but because the hedging provides incentives to increase output. This is a good thing.

The oil collapse continues apace, after a one day breather on Monday. As I write, WTI and Brent are off almost 8 percent. Equity indices around the world are going in the same direction.

This recent co-movement between crude (and other commodities, especially non-precious metals) has unleashed torrents of twaddle. One of the most egregious pieces thereof was a recent Krugman column:

When oil prices began their big plunge, it was widely assumed that the economic effects would be positive. Some of us were a bit skeptical. But maybe not skeptical enough: taking a global view, there’s a pretty good case that the oil plunge is having a distinctly negative impact. Why?

Well, think about why we used to believe that oil price declines were expansionary. Part of the answer was that they reduced inflation, freeing central banks to loosen monetary policy — not a relevant issue at a time when inflation is below target almost everywhere.

Beyond that, however, the usual view was that falling oil prices tended to redistribute income away from agents with low marginal propensities to spend toward agents with high marginal propensities to spend. Oil-rich Middle Eastern nations and Texas billionaires, so the story went, were sitting on huge piles of wealth, were therefore unlikely to face liquidity constraints, and could and would smooth out fluctuations in their income. Meanwhile, the benefits of lower oil prices would be spread widely, including to many consumers living paycheck to paycheck who would probably spend the windfall.

Now, part of the reason this logic doesn’t work the way it used to is that the rise of fracking means that there is a lot of investment spending closely tied to oil prices — investment spending that has relatively short lead times and will therefore fall quickly.

Where to begin? I guess the place to start is to note that Krugman commits a cardinal economic error (you’re shocked, I’m sure): he argues from a price change. What is frightening is that if you believe his characterization of the received wisdom in macroeconomics, this is the standard way of thinking about these things in macro.

Prices do not move exogenously. Prices can go down because of supply shocks. They can go down because of demand shocks. The price movement is the same direction, but the implications are very different. In particular, the implications for co-movements between oil prices and asset prices are very different. You cannot analyze based on the fact of the price change alone: your analysis must be predicated on what is driving that change.

A price decline because of a favorable supply shock is generally positive for the broader world economy. Yes it is bad for oil producers, but especially for advanced and most emerging economies who are oil/commodity shorts, a supply-driven price decline is beneficial and should be associated with higher stock prices, economic growth, etc. The production possibility frontier shifts out, leading to higher incomes overall although in a world with incomplete risk sharing there are distributive effects. But the adverse consequences for producers are almost always swamped by consumer gains.  In this scenario, growth and asset prices on the one hand, and commodity prices on the other, move in opposite directions.

Things are very different for demand shocks-driven price changes. A price decline because of an adverse demand shock is generally negative for the broader world economy, because it is a weakening world economy that is the major source of the demand decline. This is a matter of correlation, not causation. Causation runs from a weakening economy to lower demand for oil (and other commodities) to lower commodity prices and lower asset prices.  Oil price (and asset price) changes are an effect not a cause.

The current situation is much closer to the latter case than the former. Yes, there have been oil production increases in the last couple of years, but if world economic growth had continued on its pre-mid-2014 pace, demand would have grown sufficiently to absorb this increase. In fact, the decline in oil and other commodity prices starting around June 2014 occurred right about the time that world growth forecasts declined appreciably. Subsequent months have seen a litany of bad growth news from the main sources of commodity demand growth in the boom years, most notably, of course, China. And the news from China keeps getting worse. This is reflected in cratering stock prices there, and other indicia of economic activity. (Notably all of these indicia are pretty much non-official. Official Chinese statistics should be nominated for the next Nobel Prize in Fiction.)

But rather than go back to basics, Krugman assembles a Rube Goldberg contraption to explain what is going on. And of course, austerity and the liquidity trap play a starring role:

But there is, I believe, something else going on: there’s an important nonlinearity in the effects of oil fluctuations. A 10 or 20 percent decline in the price might work in the conventional way. But a 70 percent decline has really drastic effects on producers; they become more, not less, likely to be liquidity-constrained than consumers. Saudi Arabia is forced into drastic austerity policies; highly indebted fracking companies find themselves facing balance-sheet crises.

Or to put it differently: small oil price declines may be expansionary through usual channels, but really big declines set in motion a process of forced deleveraging among producers that can be a significant drag on the world economy, especially with the whole advanced world still in or near a liquidity trap.

Since because of his cardinal error Krugman does not identify what caused the price decline that begins his chain of “reasoning,” it’s hard to understand fully what he means. The most charitable interpretation is that there was a favorable supply shock that was so big that it caused such a large price decline in oil that this caused world “aggregate demand” to decline because of the severe adverse consequences on indebted and liquidity constrained producing countries and companies.

Inane. For one thing, these economies and sectors are very small in comparison to the world economy. Commodity producing countries have historically suffered major financial crises with little, if any, effect on growth world-wide, or on asset prices world-wide. The US oil and gas sector has also undergone some severe crises (e.g., 1986-1987) with limited fallout on US and world growth: the impacts tended to be concentrated regionally in the producing states, such as Texas. Not much fun there, but the rest of the country and the world didn’t much notice. In fact, they benefited from the favorable oil supply shock.

For another, even if there is some asymmetry between the “liquidity constraints” of producers and consumers, Krugman has been arguing strenuously that US and European consumers are liquidity constrained, hence his constant attacks on austerity. In Krugman’s argue-from-a-price-change story, that liquidity constraint has eased, and therefore one would expect to see improvement in consumption growth in places like the US, but the reverse is in fact true. The US economy is slowing rather noticeably.

No. The back-to-basics-trace-the-cause-of-the-price-change story is much more plausible. And here’s the irony. The epicenter of the commodity demand and world growth shock is China, which has binged on credit stimulus since 2009 in a way that Krugman should approve. But that cannot go on forever, and indeed, the main source of problems in China is the recognition that it can’t go on forever. China faces colossal balance-sheet issues that make deleveraging inevitable. When that happens, the commodity crisis will enter a new phase. How bad it is depends on how well the Chinese handle it. Given their mania for central control, I do not believe they will handle it well.

Macro panjandrums, like Oliver Blanchard, are puzzled, because official data do not yet reflect any large decline in growth. But that’s because official data are backward looking, and markets look forward relentlessly. They are signaling current and future problems, which official data will eventually validate. (And that’s when the data aren’t made up, as is notoriously the case in China.)

Commodity prices are particularly important, because commodities are consumed in the here and now. When demand declines, consumption declines, and prices decline contemporaneously. For all the talk about financialization, that can’t overcome the decisions of billions of commodity consumers around the world. Thus, at present, the high positive correlation between commodity prices and asset prices, like in 2008-2009, is a symptom and harbinger of broader economic problems. You don’t need Rube Krugman contraptions to explain that.

Somewhat to my surprise, the Iranians released the 10 American sailors whose boats they had seized yesterday. This immediately set of a coordinated spasm of self-congratulation in the administration, and among its media enablers. The party line was laid down by Kerry, who gushed with gratitude for Iran’s gesture and generosity, and with self-praise, stating that the quick end to the situation was proof positive of the benefits of the Iran deal which he and Obama had so brilliantly brought to fruition. Without the deal, it wouldn’t have ended so quickly or smoothly, according to Kerry.

Excuse me, but if the Iran deal was so great, this incident would not have happened in the first place. If the Iran deal was so great, it would not have happened the way it did, with the US personnel being held at gunpoint, and photographed kneeling with their hands behind their heads while the IRGC went pawing through their equipment. If the Iran deal had been so great, they would not have been taken prisoner by the Iranians, and at one time held blindfolded (and again photographed): even if they were in Iranian waters, they would have been warned away and left to proceed. If the Iran deal was so great, the photographs of the humiliation of the American crews would not have been plastered all over the Internet and Iranian television.

But Kerry did not utter one peep of protest about the seizure of the vessels. He did not question whether the seizure was justified, or necessary. He did not slam the releasing of photographs and videos of American servicemen in submissive positions, a direct contravention of international law (of which Kerry claims to be so fond).

If anything Joe Biden (yeah, the guy Obama has tasked to cure cancer–wrap your head around that one) was even worse, saying that it is “standard nautical practice” to help boats in distress at sea.

I can tell you this: it is not standard nautical practice to assist distressed vessels by forcing their crews to kneel like drug runners on a cigarette boat chased down by the USCG.

And about that distress thing. I called BS on it yesterday, and today the Pentagon sidled away from that: they kinda had to, given that both boats motored away under their own power.

The entire episode remains cloaked in mystery, but I find the Pentagon’s claims of ignorance to be incredible. They continue to say they lost contact, and don’t know how that could have happened. I am pretty sure that the crews would have radioed the situation in as it was unfolding the only way I can conceive that their messages weren’t heard is if the Iranians jammed their communications, which would put a whole different  spin on things, wouldn’t it?

The Iranians have also claimed that US ships (including the USS Harry S. Truman) and helicopters made “unprofessional moves” for 40 minutes after the boats were captured. This suggests that the US was aware of the capture and made attempts to interfere. That would blow the entire Gilligan’s Island and “lost contact” narrative.

The US should have had more than enough situational awareness to realize something was up immediately. If they didn’t, some people have some explaining to do. If they did, they have some other kinds of explaining to do.

But it is clear that there will be a concerted effort to draw a curtain over the initiation of the incident in order to celebrate its end, so that little, if any ‘splaining will be going on.

Not. Good. Enough. There are serious issues here, and a full and public accounting of the episode is necessary.

It is particularly serious precisely because it raises grave issues about the Iran deal that Obama and his long-faced Sancho Panza are desperate to defend in spite of–or is it because of?–repeated Iranian provocations.

It is also serious because it raises issues about whether the military is being compromised in order to protect the deal at all costs.

Obviously a tick-tock detailing the exact sequence of events is imperative. But there are other questions (which a supine press has apparently not thought of, or has refused to ask).

For instance, what were the Rules of Engagement? Were the crews given the option of fight or flee, or were they expected to capitulate if confronted by the Iranians?

Did US units in the area find out about the seizure? How? How did they respond? Were they ordered to stand down?

I have to believe there is fury throughout the Navy at this episode. The sight of American sailors kneeling as prisoners on their own combatant vessel must rankle deeply.

Those feelings must be even worse because one of the sailors was shown on Iranian TV apologizing to, and thanking, his captors:

“It was a mistake that was our fault and we apologize for our mistake,” said the U.S sailor, who was identified by Iran’s Press TV as the commander. “It was a misunderstanding. We did not mean to go into Iranian territorial water. The Iranian behavior was fantastic while we were here. We thank you very much for your hospitality and your assistance.”

Not acceptable. At all.

I had the Code of Conduct of the United States Armed Forces drilled into my skull plebe year at Navy, and it has remained embedded ever since. And I can tell you that this behavior is clearly contrary to the Code.

One part of the Code is that you will not do anything that gives aid and comfort to the enemy in exchange for better treatment. It is clear that this statement benefited the Iranians: they are using this entire episode for propaganda value, but more importantly, to demonstrate their mastery over Obama: don’t believe for a moment that this isn’t having major repercussions throughout the region. Further, the only reasonable inference is that making such a statement was a precondition for release.

The sailor should not have made this statement. His only possible excuse is that he had been ordered to in order to seal the deal for the release, a possibility which I cannot discount. If anything, that possibility would be even worse, for it would mean that command authority would be ordering the violation of the Code, which was adopted to solve very serious problems with collaboration by POWs during the Korean War that (a) sapped morale, and (b) was used to wage a propaganda war against the US around the world.

This entire episode is disgraceful. A full and searching inquiry is necessary. But that is unlikely to happen: this event is destined for consignment to the memory hole. And that may be the biggest disgrace of all, not least because it will require the complicity of the military. In the past months have noted with dismay repeated examples of military dissembling and outright lying in order to protect Obama. This is contagious, and corrosive. It is also inimical to the effectiveness of the armed forces. This could be one of Obama’s most malign legacies, and that is saying something.

Lily Tomlin once said “We try to be cynical, but it’s hard to keep up.” She didn’t know the half of it, because she said this before the age of Obama.

Tonight Obama gives his last (thank God!) State of the Union Address. To guilt us all about the widespread reluctance to admit tens of thousands of Syrian refugees, Obama is trotting out a poor boy who lost his family–and his arms–to an bomb strike in Syria.

This is the most rank emotional manipulation I have ever seen in politics, and that is saying a lot. It is cynical beyond belief.

For one thing, as tragic as his story is, this boy is not representative of the refugees that will attempt to get in the US. It is well known that the refugees in Europe are disproportionately young adult males, not women and young wounded waifs.

You could get a more representative example of would-be refugees in front of the Cologne Cathedral on New Year’s Eve.

For another, Obama’s policies in Syria have been cynical beyond belief, and have dramatically worsened the humanitarian crisis in the country. As is his wont in such matters, he chose the worst option. He did not intervene decisively early in the crisis, thereby allowing it to spin out of control. That is defensible. But he also has supported the arming (via the CIA) of opposition groups in Syria, including Islamist groups. This has increased the intensity of, and extended, the war.

Don’t take my word for it. Walter Russell Mead, a very middle-of-the-road guy who started with high hopes for Obama, wrote a scathing article about Obama’s Syria cynicism back in November.

It hasn’t gotten better. Indeed, tonight’s farce shows that it’s gotten even worse.

All of this takes place against the background of the Iranian seizure of two US riverine patrol craft, two Swedish-built CB90 boats.

There is zero doubt-zero-that the Iranians did this to troll Obama’s SOTU. But the show must go on! So rather than make an issue out of this that might detract attention from Obama’s swan song star turn, the administration, with the appalling assistance of the Pentagon, is saying “no big deal! Just an accident!”

Here is one story puked up by the Pentagon:

Pentagon spokesman Peter Cook told The Associated Press that the boats were moving between Kuwait and Bahrain when the U.S. lost contact with them.

“We have been in contact with Iran and have received assurances that the crew and the vessels will be returned promptly,” Cook said.

U.S. officials said that the incident happened near Farsi Island, situated in the middle of the Persian Gulf. They say it stemmed from some type of mechanical trouble with one of the boats, causing them to run aground. The troops were picked up by Iran.

I have only two words in reply. Bull. Shit.

First, there is no way both boats had mechanical issues. If only one had problems, the other could tow it.

Second–and more outrageously–these are bleeping riverine boats intended to operate in very shallow waters. They draw .8 meters. That’s less than 3 feet, boys and girls. They wouldn’t go aground in your back yard after a heavy rain.

Third, in these days of GPS, a navigation error can be ruled out.

My conclusion: they were seized. Without a fight. Which tells you something about the Rules of Engagement vis a vis Iran that we operate under in the Gulf.

Josh Earnest actually had the audacity to say that it is incidents like this that make the Iran deal worthwhile.

I’d explain what he means, but I’m hopelessly trapped by archaic Western concepts like “logic,” so I can’t.

How many cheeks does Obama have to turn to domestic critics? Zero. How many to Iran? I can’t count that high.

Of course this will only stoke the Sunni freaks in the Gulf into even greater frenzies of paranoia about Obama’s Shia sympathies, thereby intensifying an already fraught situation.

So what’s the State of the Union? I’ll let you know when I get caught up on my cynicism. This may take a while.

The decline in oil prices is producing a predictable political outcome: attempts to prop up the domestic US industry. Some initiatives would make sense regardless of the financial distress of the US upstream sector: the Clinton and Obama administrations in particular have imposed a variety of inefficient regulations and restrictions on US hydrocarbon production, and it would be desirable to roll these back, as is being proposed:

Among the proposals under discussion: Expediting the process for exporting liquefied natural gas, and upgrading infrastructure to move energy to market more quickly and cheaply.

Another top priority for the two Republicans is loosening environmental and other regulations.

But then there’s just the plain stupid:

Some lawmakers are floating the possibility of taking retaliatory trade measures against Saudi Arabia, which has flooded the market with cheap oil in what some analysts see as a bid to drive America’s growing shale oil industry out of business.

. . . .

North Dakota Rep. Kevin Cramer (R) said lawmakers could begin to mull retaliatory tariffs against Saudi Arabia in the future but emphasized he is not advocating for that yet.

“I’m very hesitant to go down that path at this time but clearly that would be a possible option should the Saudis not play fair. Because as much as I advocate for free and open markets, I also advocate for fair markets,” he said.

Saudi Arabia, taking advantage of its low extraction costs, has refused to curb oil production in a bid to expand market share and undercut competitors. This has raised the prospect of the U.S. government taking action to level the playing field for domestic companies.

“I’m not prone to a lot of government intervention in terms of propping industry up, per se. What would be the most helpful is to roll back regulations that get in the way of further development and profitability,” said Cramer, who cited the Endangered Species Act as one burdensome regulation.

“Obviously they have access to our market and I suppose to some degree there is a role that can be played there. I’m not at the point where I’m ready to advocate tariffs or restricting their access necessarily,” he added.

Any tariff on Saudi imports would be special interest protectionism pure and simple, tarted up in the usual rhetoric (and whining) used to justify protectionist measures. “Fair markets” is a sure tell. Anyone who says “I’m for free markets but they should be fair markets” is a liar, and should drop the pretense. Any such person is all about protecting a favored industry or firm. When someone, regardless of party, says “fair markets”, I strongly advise you to check your wallet, because they are trying to rob you.

And why should Saudi Arabia “refuse to curb oil production”? Indeed, “curbing oil production” is the exercise of market power, for which the US (rightly) criticized OPEC and the Saudis in the past. What’s more, low cost producers are the ones who should sustain output in the face of a demand decline: high cost producers are the ones who should cut back.

Furthermore, although North Dakota is an oil long, the US as whole is an oil short, still producing only about 1/2 of its consumption, despite the spurt in oil production in the past 5-6 years. So low oil prices are still in the interests of the US.

It should also be noted that the “flooding the market with cheap oil” meme is vastly overstated. Saudi output in June, 2014, right before the price collapse began, was about 10mm bpd. It is now about 10.5 mm bpd. That difference represents a whopping .5 percent of world output. Even given an elasticity of 10 (which is probably too high) that could cause at most at 5 percent decline in prices. As I write, Brent just went below $33/bbl, and hence is down almost exactly 70 percent off its pre-collapse levels. So this collapse is not the result of the Saudis flooding the market.

Nor are the Saudis engaged in some predatory pricing strategy. At least I doubt that they are, because such a strategy would be irrational.

The price decline is the result of increased output in a variety of places (including the US), but mainly due to a steep decline in demand growth, especially from China.

Yes, the upstream sector in the US is suffering severe financial distress. So be it. That’s the nature of the business, and the nature of a market system generally. Resources should exit sectors that suffer demand declines. They should not be propped up through trade restrictions, especially trade restrictions that will impose far greater costs on the US economy as a whole than they will benefit one sector in that economy.

It is also perversely ironic that the very same Republicans (I am speaking of the individual legislators, like Murkowski and Cramer, not the party as a whole) who pushed for ending the idiotic export ban are now mooting an equally idiotic restriction in imports. This makes it plain that it’s not about principle, in the least. It’s all special interest politics. That’s not surprising, but it’s not admirable. And it’s not any better when Republicans push it than when Democrats and Obama do.

So yes, eliminate or cut back inefficient restrictions that a relentlessly anti-hydrocarbon administration has imposed, in order to eliminate unnecessary burdens on US oil and gas production that hurt both US producers and consumers in the US and around the world. But don’t impose large costs on American consumers of oil in order to prop up the US upstream sector. The sector should shrink if the demand for its product declines due to increased production elsewhere, or reduced demand. So be it.

There is no good guy and no bad guy in the conflict between Iran and Saudi Arabia (and its GCC allies). In its essentials, it is a struggle for regional dominance between two benighted and malign powers.

The theater of the conflict is Iraq and Syria. Iran has some advantages, most notably, it is allied with the government of Syria (now supported by Russia), and for sectarian and geographical reasons has advantages in Iraq. In Syria, Saudi Arabia and its allies must resort to funding and arming the opposition. Its options in Iraq are more limited, but it is likely objectively pro-ISIS.

Neither Iran nor Saudi Arabia can pose a conventional military threat to the other. Iran’s air force is a collection of museum pieces (F-4s, F-14s and F-5s!) seized from the Shah and kept together with bubble gum an duct tape, and some Russian aircraft gifted to them by a desperate Saddam 25 years ago. Iran’s ground forces have no power projection capability. Its units have struggled in Syria and Iraq, and were noted during the Iran-Iraq war mainly for their ability to absorb appalling casualties. Iran’s navy also lacks any power projection capability. Logistics would also render impossible any Iranian attack on KSA.

Saudi Arabia has a very well-equipped air force, with 70 F-15E strike aircraft, 86 F-15C and D air superiority fighters, 72 Eurofighter Typhoon multirole aircraft, and 80 Tornado ground attack planes. This is more than adequate to defend KSA against anything that Iran could throw against it on air, sea, and land. But KSA’s ground forces are, like most Arab armies, woefully ineffective, and mainly intended for regime protection. The Saudis are bogged down in neighboring Yemen, and could not hope to project any force into Iraq, let alone Iran.

Even if Iran develops a nuclear weapon, it will have little effect on the balance of power. The Saudis will almost certainly obtain one as well, and a nuclear weapon is more of a regime protection weapon than an instrument of power projection.

Iran’s main weapon is subversion, but this is difficult to employ against a police state like KSA. Indeed, the execution of Nimr Nimr that precipitated the latest crisis was no doubt a signal to Iran that the Saudis were willing to use extreme measures to crush any uprising in the Shia population in the eastern provinces. Also look at the brutal crackdown in Bahrain to see how the KSA and its allies deal with Iran-fomented Shia internal dissent.

So there will be an intensified shadow war between KSA and Iran, fought mainly in Syria and Iraq. Things have intensified now because the Iran deal and the Russian intervention in Syria disturbed the previous equilibrium in the region: this was one of the main reasons the Iran deal, and the administration’s subsequently fecklessness in responding to Iranian provocations, was so ill-advised. The most likely outcome is an intensified struggle resulting in a renewed stalemate.

In terms of oil, the most likely outcome is that the Saudis will figure that Iran suffers from lower oil prices more than they do, so they will not cut output. The Iranians have every incentive to produce as much as they can.

There are loud calls from some quarters that we intervene on behalf of our Saudi “allies.” With allies like this, we need no enemies, given lavish Saudi support for Islamism (and terrorist groups) around the world: indeed, I consider the Iranians’ in-your-face chants of “Death to America” more palatable than the Saudis’ two-faced duplicity. The relationship between the US and KSA is transactional, at best, and is unfortunately suborned by Saudi money which greases far too many palms in DC and Europe.

Stalemate is probably a good outcome from the US perspective. Getting in the middle means we will get it from both sides.

Our main interest is continued flow of oil through the Persian/Arab Gulf. A policy similar to that adopted by the Reagan Administration during the Iran-Iraq War, which largely took a hands-off approach to the conflict on the ground, and focused on assuring the free navigation of the Gulf, is a prudent one. If either side tries to escalate by attacking shipping or laying mines, like during the Tanker War, the US can intervene and smack them down as it did in Operation Praying Mantis.

We have no interest in a civilizational and sectarian war, and probably couldn’t intervene effectively even if we decided to. Neither country is capable of achieving a decisive victory over the other. The main stakes are who gets to rule (albeit indirectly) over a ruined Syria and a dysfunctional Iraq. So limit our involvement to keeping the oil flowing and deterring and preventing terrorist spillover. And definitely don’t take the side of Wahhabi freaks, or think that they are allies worthy of the name.