Streetwise Professor

July 24, 2018

Who Knew Igor Was a Deadhead?: Sechin Plays Shakedown Street

Filed under: Economics,Energy,Politics,Russia — cpirrong @ 6:14 pm

The Sechin business model is clearly not to generate profit through canny investment, careful stewardship of capital, and containing cost.  Rather, it could be called The Rent Seeking Variations.

One of Sechin’s favorite variations is to pump up a flagging bottom line by shaking down his erstwhile partners.  The classic in this genre is the takeover of Bashneft at a knockdown price extracted by putting its owner Sistema under extreme legal pressure, which Sechin followed by suing Sistema for alleged misappropriations, which were only vaguely pleaded, and which if anything suggested that Rosneft was delinquent in its due diligence.

Sechin is now replaying this gambit, this time with its partners is Sakhalin I–which include ExxonMobile.  Again, the allegation is lacking in specifics.  Rosneft accuses the partners of “unjust enrichment” in 2015 and 2016.  In a world-class, epic act of projection, Rosneft accuses Exxon Neftgaz and the others of “interest gained by using other people’s money.”

The case was filed on Sechin’s home court–the arbitrage court on Sakhalin.  I seriously doubt that Exxon would have put itself into a situation where it was at the mercy of a Russian kangaroo court, so no doubt the first battle will be jurisdictional.

Sechin succeeded against Bashneft and Sistema in large part because Russia put its main shareholder Vladimir Yevtushenkov in jail at one point, and clearly was in a position to do it again.  ExxonMobil and the others in the partnership are less vulnerable, and Exxon in particular is used to these sorts of bruising battles.  So Igor has his work cut out for him.

For a while–during the Tillerson years–Exxon and Rosneft were chummy.  Sanctions put a kaibosh on the relationship, and this is clearly a signal that they are sooooo over.  Which just leaves Rosneft even more isolated than before, and unlikely to attract technology, expertise, and money from a major foreign power anytime soon absent some exchange of hostages that will curb Sechin’s predatory instincts.

The fallout for Russia more broadly is also clearly negative.  This is just another indication of its opportunistic and predatory approach to foreign investment, which just will raise further barriers to such investment in the future.

Operating on Shakedown Street can be lucrative in the short run, but pretty soon you run out of suckers to shake down.

Perhaps counterintuitively to some, this is an indication of why freaking out over Russia is so overdone.  Its internal dysfunction has hampered, hampers, and will hamper in the future its economic performance, and hence its potential to build capability to challenge the US in a serious way.   Yes, it can be a pain, but the very aspects of its system that make it so objectionable also serve to undermine its ability to pose a serious threat to any major power.

July 19, 2018

Freakouts Cause Flashbacks–to Montenegro, of All Places

Filed under: History,Military,Politics — cpirrong @ 6:55 pm

The freakout du jour–Trump’s questioning whether it made any sense to have Montenegro in Nato–triggered a flashback (from inauguration day, in fact):

Another example of dysfunction is Montenegro’s impending bid to join Nato. Just what is the rationale for this? There is none: Montenegro brings no military capability, but just adds an additional obligation.

But it’s worse than than. Nato’s biggest weakness is its governance structure, which requires unanimity and consensus in major decisions. This is flagrantly at odds with one of the principles of war–unity of command–and makes Nato decision making cumbersome and driven by the least common denominator. Nato’s governance, in other words, makes it all too easy for an adversary to get inside its decision loop.

Coalitions are always militarily problematic: Napoleon allegedly rejoiced at the news that another nation had joined one of the coalitions against him. Nato’s everybody gets a vote and a trophy philosophy aggravates the inherent problems in military coalitions.

Put differently, decision making power in Nato bears no relationship to contribution and capability. This is a recipe for dysfunction.

So what is the point of adding yet another non-contributor (population 620K!) whose consent is required to undertake anything of importance? This is madness.

It is especially insane when one considers that Montenegro is a Slavic country with longstanding ties to Russia, and in which Russia has a paternalistic interest. Parliamentary elections last year were extremely contentious, with the pro-western incumbents barely hanging on. Post-election, there were allegations of an attempted coup engineered by the Russians. The country is extraordinarily corrupt. All of which means that if you are concerned about Russia undermining Nato, Montenegro is the last country you would want to admit. It is vulnerable to being suborned by Russia. Outside of Nato-who cares what Russia does there? Inside of Nato-that is a serious concern, especially given the nature of Nato governance.

But apparently current Nato members believe that it would be really cool to collect the entire set of European countries: frankly, I can think of no other justification. There is no better illustration of how Nato has lost its way, its strategic purpose, and its ability to think critically.

Now Trump’s particular objection (that Montenegrins are excitable types who might trigger WWIII) was typically Trumpian, in that it was a rather bizarre thought process/formulation that ultimately led to the right conclusion: it makes no sense to include Montenegro in Nato, and doing so can only cause trouble.  Arriving at the correct conclusion based on fractured reasoning–or a fractured articulation of the reasoning–usually occurs only by accident, but it happens enough with Trump that it is unlikely to be totally accidental.  But given that the establishment places undue emphasis on articulateness and verbal polish, the convoluted explanation completely prevents people from taking the conclusion seriously–in part because they are too busy freaking out.

Something that I pointed out in my post goes double–or triple–today.  Simultaneously freaking out about the existential threat posed by Russia and the outrage of objecting to including Montenegro in Nato is utterly illogical to the point of idiocy, and no amount of verbal acuity is going to change that fundamental fact.  That circle cannot be squared.

So here’s what we have on offer: articulate and invariably wildly wrong, or wildly inarticulate and sometimes right, especially on big issues.

July 17, 2018

In Helsinki, Trump Declares That This Is War to the Knife–Against His Domestic Enemies

Filed under: China,Politics,Russia — cpirrong @ 6:04 pm

Even by the standards of the last two years, the hysteria that erupted over Trump’s statements in the press conference with Putin in Helsinki were off the charts.  Benedict Arnold! Treason! Traitor! Impeachment! On CNN some supposed ex-Watergate lawyer compared it to Kristillnacht. I suppose if we wait a few hours it will become the latter-day equivalent of Auschwitz.  I’m only surprised that I haven’t seen it compared to the Hitler-Stalin Pact.  Give it time!

The most disgusting comparisons in my mind were to Pearl Harbor and 9/11, suggesting that what Trump did would have been analogous to sitting down with Tojo after Pearl Harbor or Osama after the Twin Towers went down.

Reality check.  Pearl Harbor death toll: 2403. 9/11 death toll: 2996. 11/8/16 death toll: zero.  1,117 American sailors were vaporized, drowned, or incinerated on the USS Arizona alone on 12/7/41.  Anyone comparing Russian hacking to those catastrophes is completing lacking in perspective, not to say mental balance, and is willing to make the most outlandish comparisons out of partisan spite.  Especially inasmuch as spy games have been going on since time immemorial, and between the US and Russia/USSR for decades.  What transpired in 2016 is par for the course. Where’s the outrage been all these years?

And is the US supposed to go to war with a nuclear power over hacking? For that is the implication of the Pearl Harbor and 9/11 analogies.  That is not just lacking in perspective–that is utterly deranged.

And what is the hysteria about, in the end?: mere words.  Nothing of substance transpired at the summit–as could have been expected.  The overwrought fears that Trump would totally capitulate on Syria, or recognize the Russian seizure of Crimea, or sell Ukraine down the river turned out to be imaginary.  There were just anodyne statements about working toward common goals, which will likely result in nothing.

How would things have been different, or be different today, or tomorrow, or next year, had Trump aggressively chastised Putin publicly about the alleged interference in the 2016 election?  No different at all, except that the hysterics would have had to find something to be hysterical about.   And I guarantee you: they would have.

What would Putin have done had Trump called him out?  First, he would have denied.  As he apparently did when Trump brought it up.  Second, he would have responded with a litany of sins that the US has committed against Russia, in which he would no doubt include the 2011 elections in Russia. After all, the man is the master of whataboutism and bald face denials of the obvious.  Why would you expect any different yesterday?

“Did so!”  “Uh-uh.” “Stay out of our politics!” “You did it first!”

That would have been edifying.

Which would leave us where, exactly? Right where we are today.

And if the failure to say sufficiently condemnatory words about Russian interference is treasonous, what is the failure to do anything about it when it was happening, in full knowledge that it was happening?  Which is exactly what the Obama administration did–by its own admission.  Would the hysterics have given Trump a pass if he had imitated Obama and told Putin to “cut it out”?  Yeah.  Right.  This also suggests an utter lack of seriousness.

What I find most deeply disturbing about this is that the Russia/Putin fetish is distracting attention from a real strategic threat.  By every measure–economic, military, geopolitical–China is a more dangerous power than Russia.  Indeed, even if you emphasize cyberattacks as the primary threat, China is likely far more dangerous than Russia, although amnesia about things like massive penetration of the F-35 program or the OPM hack (which compromised the personnel records of every federal employee) seems to be epidemic.  And it is not as if China does not, and has not, attempted to interfere in US elections.  (Johnny Chung, anybody? Maria Hsia? Buddhist Temples?)

Chairman Xi must be beside himself in glee that the US is tearing itself apart over Russia, a declining power, to the neglect of China, a rising one.

Perhaps Trump could have spared himself some of the attacks had he been more critical–though I am doubtful that he could have done anything short of killing Putin that would have placated the critics.  But no doubt Trump knew that.  No doubt he knew that having a summit at all would put him in a vulnerable situation.  Certainly he was aware that the indictment of the 12 Russian GRU personnel was a trap set by elements in his own Justice Department.

Yet Trump had the summit, and indeed pushed to have it, and said what he did at the press conference, knowing the likely fallout.  Why?

Of course the anti-Trump theory is that he is in Putin’s thrall, either because of genuine admiration or blackmail.  But this does not comport with much of his actual behavior in office, which includes killing hundreds of Russians in Syria, opening declaring an energy war, browbeating Nato to spend more on defense directed at Russia specifically, blasting the Germans about NordStream II, and on and on.  Further, what is the likelihood that there is some deep dark secret that only a few Russians know?

I think the more likely explanation is that Trump deliberately provoked his frenzy in full knowledge of the consequences, to prove that he will not back down, and that he will not validate his critics by acquiescing to their demands.  It was a typically Trumpian in-your-face-what-are-you-gonna-do-about-it moment.

The only other person I have seen with a similar take is James S. Robbins:

The easiest thing to do politically would be to avoid Russia. The president did not have to attend this summit meeting, especially with the midterm elections months away and Special Counsel Robert Mueller’s expected report looming. He could have simply avoided both the issue and the optics.

But Donald Trump did not become president by doing the easy or expected thing. His political M.O. is to disrupt the opposition by owning the downside. A summit with Vladimir Putin is the perfect Trumpian way to say to his frantic critics that he couldn’t care less what they think. And it may force some of the more thoughtful ones to begin to consider the possibility that President Trump is right, and the entire Russian collusion narrative has been a lie.

I seriously doubt the last sentence.  Or at least, I doubt that there are any critics who are both frantic and thoughtful (and the former greatly outnumber the latter).  But it is pretty clear that Trump has signaled that this is war to the knife–against his domestic political enemies–and he is not capitulating.


July 16, 2018

Oil Spreads Go Non-Linear (Due to Infrastructure Constraints), To the Chagrin of Many Traders: The Pirrong Commodity Catechism in Action

Filed under: Commodities,Economics,Energy,Exchanges — cpirrong @ 3:59 pm

When I wrote about the demise of GEM Trading a few weeks ago, I hypothesized that sharp movements in various spreads had been its undoing.  A story in Reuters says that GEM was not the only firm rocked by these changes.  Big boys–including BP, Vitol, Trafigura, and Gunvor–have also suffered, and the losses have caused traders their jobs at Gunvor and BP:

The world’s biggest oil traders are counting hefty losses after a surprise doubling in the price discount of U.S. light crude to benchmark Brent WTCLc1-LCOc1 in just a month, as surging U.S production upends the market.

Trading desks of oil major BP and merchants Vitol , Gunvor and Trafigura have recorded losses in the tens of millions of dollars each as a result of the “whipsaw” move when the spread reached more than $11.50 a barrel in June, insiders familiar with their performance told Reuters.

The sources did not give precise figures for the losses, but they said they were enough for Gunvor and BP to fire at least one trader each.

The story goes on to say that binding infrastructure constraints are to blame, which is certainly the case.  But implicit in the article is a theme that I have emphasized for literally years (I recall incorporating this into my class lectures in about 2004).  Specifically, bottlenecks imply that marginal transformation costs (e.g., marginal costs of transporting oil between Cushing and the GOM) tend to rise very steeply when capacity constraints are reached.  That is, when you are operating at say 90 percent of capacity, variations in utilization have little impact on marginal transformation costs, but going from 95 to 96 can cause costs to explode, and basically go vertical as capacity is reached.

This has an implication for spreads.  Another part of the Pirrong Commodities Catechism is that spreads equal marginal transformation costs, and are essentially the shadow prices on constraints.  The behavior of marginal transformation costs therefore has implications for spreads: in particular, spreads can be very stable despite variations in the utilization of transformation assets, but as utilization nears capacity, the spreads become much more volatile.  Moreover, and relatedly, small changes in fundamentals can lead to big moves in spreads when constraints start to bind.  The relationship between fundamentals and spreads is non-linear as capacity constraints become binding, and well, here spreads have gone non-linear, to the chagrin of many traders.

Put differently, spread trades aren’t always “widowmakers” (as the article calls them)–sometimes they are quite safe and boring.  But when bottlenecks begin to bind, they can become deadly.

There is one odd statement in the article:

“As the exporter of U.S. crude, traders are naturally long WTI and hedge their bets by shorting Brent. When the spreads widen so wildly, you lose money,” said a top executive with one of the four trading firms.

Well, why would you hedge WTI risk with Brent?  You could hedge your WTI inventory by selling . . . WTI futures.  The choice to “hedge” WTI by selling Brent is effectively a choice to speculate on the spread.  That brings to mind the old Holbrook Working adage that hedging is speculation on the basis.  The difference here is that most, say, country grain elevators about which Working was mainly writing had no choice in hedging instrument (at least not in liquid ones), and perforce had to live with basis risk if they wanted to eliminate flat price risk.  Here, BP and Gunvor and the rest had the choice between two liquid instruments, and if the “top executive’s” statement is correct, deliberately chose the one that exposed them to greater spread (basis) risk.

So this isn’t an example of “sometimes stuff happens when you hedge.”  The firms chose to expose themselves to a particular risk.  They took a punt on the spread, which was effectively a punt that infrastructure constraints would ease.  They lost.

In my 2014 white paper on commodity trading firms (sponsored by Trafigura, ironically) I noted that to the extent that they speculate, commodity trading firms tend to speculate on the spreads, rather than flat prices, because that’s where they have something of an information advantage.  But as this episode shows, that advantage does not immunize them against risk.

This also makes me wonder about the risk models that the firms use, which in turn affect the sizes of positions traders can put on, and where they put them on.  I, er, speculate that these risk models don’t take into account the non-linearity of spread risk.  If that’s true, traders would have been able to put on bigger positions than they would have been had the risk models accurately reflected those risks, and further, that they were incentivized to do these trades because the risk was underpriced.

All in all, an interesting casebook study of commodity trading–what can go wrong, and why.

Correction: Andrew Gowers, head of corporate affairs at Trafigura says in the comments that (a) Trafigura did not suffer a loss, and (b) the company had told this to Reuters prior to the publication of the article.  I have contacted the editor of the story for an explanation.

July 13, 2018

Blockchain Wunderkinds: Solving Peripheral Problems, Missing the Big Picture

Filed under: Blockchain,Cryptocurrency,Economics,Exchanges — cpirrong @ 7:52 pm

Ethereum wunderkind Vitalik Buterin delivered a rant against centralized crypto exchanges:

“I definitely personally hope centralized exchanges burn in hell as much as possible,” Buterin said speaking to TechCrunch.

When bitcoin, the original cryptocurrency, was founded in 2008 by the anonymous Satoshi Nakomoto, the point was to create a decentralized financial future that renders middlemen useless. Nearly 10 years later, the centralized exchanges — those folks sitting in the middle of buyers and sellers — are among the most powerful players in the market for digital currencies such as ethereum and bitcoin.

Bloomberg News estimates they brought in $3 million a day last year. And exchanges such as Gemini and Coinbase are expanding at a clip, bringing on talent from Wall Street.

“It’s hard to ignore the irony that an asset created to allow decentralization is currently almost completely traded on centralized exchanges,” Peter Johnson, a vice president at Jump Ventures, said in an interview. Buterin, however, wants the crypto community to focus more on decentralization so that cryptos can more frequently trade peer-to-peer. Buterin’s remarks come as so-called decentralized exchange gain more attention.

Like many of his arrogant ilk, Buterin ignores the lesson of Chesterton’s fence: why does this thing you do not like and do not understand exist?

Yes, blockchain and cryptocurrencies allow peer-to-peer transactions.  They were largely designed to facilitate such transactions.  For some, the motivation is ideological: an anarchic belief in radical decentralization, and a deep distrust of centralized institutions.

But just because blockchain and related technologies reduce the costs of peer-to-peer transactions, doesn’t mean that such transactions are cheaper than centralized trading on exchanges.  Transacting requires finding a counterparty.  It requires negotiating a price (for a standardized thing, like a Bitcoin–negotiations of other terms for more complex things).  Negotiating a price is costly when information about value is diffuse, so in a decentralized setting not only is it necessary to search for counterparties, it is advantageous to search for information about prices to (a) find the best price, and (b) to be able to negotiate with better information about value .

Centralization reduces the cost of finding a counterparty.  It enhances competition, which tends to reduce bargaining costs.  It leads to better and more symmetric information about prices, which also tends to reduce bargaining costs.  Further, centralized markets can support specialized intermediaries–market makers–who specialize in smoothing out idiosyncratic temporal imbalances in buy and sell order flow, which further reduces trading costs.

Because of these features, centralized trading is frequently an emergent outcome of individual decisions, and one that economizes on transactions costs.  This is clearly what is happening in crypto world.  Indeed, the main puzzle at present is why there are so many exchanges.  The centripetal forces of liquidity will likely result in a huge consolidation in this space.

Buterin and others are attempting to find ways of mitigating some of the disadvantages of bilateral trading (bilateral just being another, more conventional, way of saying “peer-to-peer”).  Reducing the ways of finding people who want to take the other side of a transaction, for example.  But I am highly skeptical that these measures will overcome the inherent advantages of centralizing trading of homogeneous things that large numbers of people want to buy and sell pretty much 24/7, to the point that peer-to-peer will supplant centralized trading.  Buterin can rant all he wants, but centralization is here to stay, and if anything, this segment of the market will become more centralized.

Buterin’s error is seemingly the opposite of those who bewail the lack of centralization in some markets, e.g., those who want to make swaps trading more centralized and who rail against bilateral OTC transactions, but it is really the same mistake. Those who see too much centralization in some markets, and those who see too little in others, fail to recognize that trading mechanisms are emergent orders that develop diverse niches to accommodate the fact that transactors and transactions are heterogeneous.  Centralization is efficient for some transactors and transactions: bilateral/OTC for others.  That’s why we see both.

(This is a point I made at a Platts blockchain conference in November, BTW.  The theme of my talk was where decentralization can work, and where it is likely inefficient.  Trading of standardized instruments was one of the main cases I discussed.)

Alas, the ignorance of techno-geniuses is not limited to trading mechanisms.  One of the supposed benefits of blockchain that is that it allows the ownership of anything–a painting, a house, you name it–to be divided into shares, with the fractional interests recorded in an immutable register, and traded peer-to-peer.  That is, block chain facilitates equitization of assets.  A breakthrough!

Uhm, not really. The benefits of equitizing assets and risks has been long, long understood by economists.  In particular, it has long been understood that equitization facilitates more efficient risk sharing.

But long ago, economists also recognized that despite these apparent benefits, in fact very few assets and risks are equitized.  A vast literature has come up with explanations why.  Information and incentive problems–moral hazard and adverse selection–are notable among these.  A prosaic example: If I sell off shares in my car, what incentive do I have to maintain it properly and to economize on wear and tear and to reduce the probability of theft?  Who pays for maintenance? Who decides on what maintenance is needed?  When I sell the shares, I am likely to have better information about the value and condition of the vehicle, which would subject the buyers to an adverse selection problem, meaning that I am likely to get a low price for the shares–so why bother selling them?  There are other transactions cost problems associated with measurement (who verifies exactly what the asset is?) and opportunism and governance and control.   Related to the centralized trading point, if an asset is highly idiosyncratic/unstandardized, the desire to trade fractional shares will be small.

A potentially slightly cheaper way of recording and transferring fractional ownership does not address these far, far, far more fundamental impediments to equitizing (or should I say, “tokenizing”?) assets and risks.  But the coder geniuses miss the forest for the trees.  They see the issue that their technology can address, and think that it will be revolutionary, only because they do not understand the broader economic issues in play, and therefore think everyone born before them or who does not code must be an idiot.

No, not really.  They are looking at the capillaries, and missing the heart, veins, and arteries.

It reminds me of the Mark Twain quote: “When I was a boy of fourteen, my father was so ignorant I could hardly stand to have the old man around. But when I got to be twenty-one, I was astonished at how much he had learned in seven years.”  Except seven years haven’t passed for the Buterins of the world, and frankly, I seriously doubt that they will.  Instead, they inhabit a techno-Groundhog Day.

All of this is symptomatic of blockchain hype and froth.  There is an indication that we have reached peak hype.  R3, a bank-led blockchain consortium, is contemplating an IPO.  To me this is a signal that those on the inside of blockchain development, especially in the area where its benefits have been particularly hyped (finance/payments/settlement/fintech) understand that the reality will never match the hyperbole, so it’s best to sell out while hyperbole reigns supreme.  (Yes, they claim that they are being approached by those looking to buy the whole thing, but take that with a big grain of salt–I view it merely as part of the sales pitch.  “This is a hot little property right now.  Better get in before someone snatches it away.”)

In brief: don’t be the greater fool.

I think that blockchain and DLT will have some viable commercial applications.  But I am highly confident that they will not be nearly as revolutionary as the True Believers claim.  This is in large part due to the fact that it is clear that the True Believers have an extremely narrow, blinkered understanding of the broader economic issues associated with transacting, ownership, risk transfer, incentives, and governance.  Blockchain may address some issues, but many–if not most–of these issues are secondary or tertiary, not fundamental.  Some things are done more efficiently in a centralized fashion–the trading of standardized instruments being one.  Some things are not equitized/tokenized not because it is technically infeasible/prohibitively costly to issue and record fractional interests, but because fractional ownership entails substantial incentive and information problems.

So don’t believe the hype.  And take a pass on those R3 shares, if they do come to market.

Addendum: the dominance of crypto exchanges is even more remarkable, given how they, well, pretty much suck.  They are hardly comparable to modern futures or equities trading exchanges.  Yet people still strongly prefer to trade on rather clunky platforms with major potential security issues where you can’t easily convert digital into fiat currency and which are likely rife with manipulation than peer-to-peer.  That tells you something.

July 10, 2018

To Those Hysterical Over Trump’s Jacksonian Resurgence: Internationalist, Heal Thyself

Filed under: Politics,Russia — cpirrong @ 5:42 pm

As Trump wings his way east, first to a Nato summit, and then to a meeting with Putin in Helsinki, the commentariat and political class in the United States and Europe are on the brink of–another?–psychotic event.  The meeting with Putin in particular has triggered panic.

One recurrent theme is that Putin and Trump have similar views on the “rules based, institutions based, international order.”  Therefore, they are effectively allies and jointly a threat to the peace and stability of the world.  The title of one piece in Bloomberg summarizes the angst: Putin is Trump’s brother from another Motherland.

As a factual matter, it is true that both Putin and Trump challenge the existing post-Cold War consensus.  But since they reach that destination by very, very different routes, the similarities are far more superficial than the differences.  Furthermore, the consequences of this apparent convergence are likely to be far less dire for the United States than the angst-ridden claim.

It is only natural that Putin challenges the existing order.  After all, he presides over the main successor state to the Soviet Union, and much of the existing order was designed explicitly to contain and neuter the USSR.  Furthermore, the collapse of the USSR left Russia marginalized,  at best, which does not comport with Russia’s deeply held views that it is a great power–a view that Putin holds, clearly.  Russia also has a truly Westphalian mindset, which holds that the internal affairs of any nation are its business alone, and not subject to the meddling of others–or the “international community” at large.  Indeed, the one multilateral organization that Russia supports–the United Nations–receives its approbation precisely due to the fact that it can be used to derail international efforts to interfere in the internal affairs of states–including pariah states.  Putin’s revisionism is therefore readily understood.

Trump’s is more complicated, and reflects a longstanding divide in the United States.  Much of the criticism of Trump from the American establishment–including the part of the establishment that considers itself conservative, and indeed the sole legitimate voice of conservativism–is therefore a manifestation of longstanding divisions in American politics, which (a) caused his election, and (b) is why it is becoming less hyperbolic to talk of a new American civil war.

The best template to explain and understand this is Walter Russell Mead’s division of American foreign policy thought into Hamiltonian, Wilsonian, Jeffersonian and Jacksonian schools.  The establishment is decidedly Hamiltonian and Wilsonian.  As Mead–and I–noted from the onset of Trump’s emergence–he is the avatar of the long marginalized, and indeed scorned, Jacksonian America.  The establishment thought that this component of the American polity had long since been condemned to obscurity, and views its resurgence with the fright of a horror movie character seeing The Mummy or Jason Voorhees come back from the dead.

Jacksonians challenge virtually every aspect of the Hamiltonian-Wilsonian consensus.  The foreign policy establishment–whether Neocon or liberal internationalist–believes that America has some grand mission abroad, to bring democracy, peace, equality, freedom, or economic progress, or some combination thereof, to the rest of the world.  Jacksonians (and Jeffersonians) do not believe in such missionary work, and indeed are quite skeptical of it.  In the words of John Quincy Adams (ironically Jackson’s political foe and bête noire) “she [the US] goes not abroad, in search of monsters to destroy. She is the well-wisher to the freedom and independence of all. She is the champion and vindicator only of her own.” Jacksonians are deeply patriotic, and believe that theirs is the greatest nation in the world, but that it should lead by example and not attempt to impose by force or more subtle forms of coercion or blandishments its views, beliefs, or mores on others.

This leads them to be deeply skeptical of international engagements, let alone conflicts, when US interests are not directly threatened.  And unlike internationalists, they define American interests narrowly.

On this score, recent history is strongly supportive of Jacksonian skepticism.  As in so many aspects of life, the past quarter century–or perhaps to date it more precisely, since the fall of the USSR in 1991–has demonstrated the incompetence of the architects of internationalist policies, the infeasibility of these policies, or both.  This period has been marked by a litany of bloody, expensive failures, of which Iraq and Libya are the most conspicuous (but not only) examples.  Interestingly, these failures were the responsibility of different parties, different administrations, and different mindsets (Neocons on the one hand, “responsibility to protect” on the other), and differing degrees of international buy-in, but these different parts of the establishment shared a belief that the exercise of American power could make the world a better place by destroying monsters abroad.  The experiences strongly suggest that these beliefs were utterly mistaken.

(A confession: I supported the war in Iraq.  In retrospect, it was the worst misjudgment of my life. One of the main challenges of writing this post is to not overlearn from that mistake.)

Putin was adamantly opposed to US/European action in Libya, but he was prime minister at the time and Medvedev acquiesced to American and European pressure.  Give the devil his due: regardless of his motivations, Putin’s (and Lavrov’s) diagnosis of the consequences of that intervention were far more accurate than, say, Hillary’s, or pretty much any member of the US or European foreign policy “elite.”

Given this woeful record, what person in his right mind would NOT be skeptical of a deeper intervention in Syria, say, with the objective of regime change?  Syria makes Game of Thrones look simple by comparison.  Yet few things attract the foreign policy establishment’s ire like Trump’s oft-expressed desire to withdraw from Syria, or at least sharply limit American involvement there to destroying ISIS.

And given this woeful record, deep skepticism about the competence of the establishment, and the desirability of messianic interventions even if guided by a competent establishment, is well-justified.

Which leads me to reiterate a theme that I have written about for going on three years now: if the established elite hates Trump, and the Jacksonian resurgence that he personifies, they have no one–no one–to blame but themselves.  No one has brought more discredit to the beliefs of the establishment than that self-same establishment.  Internationalist, heal thyself.

Jacksonians also prize sovereignty and independence, and bridle at attempts to subordinate the US to international bodies, or tie it down in alliances with nations whose interests are less than fully aligned with America’s–especially when the US pays a disproportionate share of the expense.  And especially when the alleged allies repay the effort and expense with endless ankle biting and carping criticism.

Here is where Trump’s criticism of Nato resonates.  That Nato nations free ride on US defense expenditure is beyond dispute.  Trump calls the Europeans out on this, and they squeal like stuck hogs–and the US foreign policy establishment squeals right along with them.

More implicit in Trump’s criticism is a question about the purpose of Nato in 2018.  It had a purpose in 1949.  It had a purpose in 1990.  What is its purpose now?  Trump is effectively daring it to find one.

The UN and many other international bodies are often opposed to the US, and even the alliances (especially with Europe) seem to consist of Lilliputians intent on tying down the American Gulliver.  This also rankles independent and sovereignty-minded Jacksonians.  Global progressives think that the US is a malign force that needs to be suppressed and controlled by international bodies.  That also grates intensely on patriotic Jacksonians.

Jacksonians—and many Hamiltonians—are also justifiably critical of an omnipresent nanny state that regulates every aspect of human existence.  This is why his criticism of the EU is justified, and why many Americans nod in agreement.  And why many Europeans also agree, even though intense social pressure forces them to mute their criticism.  Jacksonians also value democracy, and hence are not enamored with the profoundly anti-democratic EU (whose motto appears to be: “you will vote until you get it right”).  So European outrage at criticism of the EU is music to my ears.

The Trump—Jacksonian—critique of the foreign policy establishment in the US and abroad therefore has much merit.  And again, the very reason that Trump is in a position to challenge the elite consensus is that the elite has failed time and again to deliver on its promises.  It is a legend in its own mind.  In reality, not so much.

The Hamiltonian side of me is most disturbed by Trump’s stance on trade.  But even here one can see his point.  It is farcical to characterize the current world system as one of free trade.  Real free trade would not involve byzantine agreements that only a mandarinate can interpret.  China is profoundly protectionist.

I think that Trump is a mercantilist, and that represents a deep intellectual error.  But many of his critiques of China in particular, and to a lesser degree the Europeans, have some basis in fact.  Whether trade wars are the best way to redress what Trump criticizes is anther matter.

Given all this, I discount the shrieks of the establishment—heavily.  One can object to some of Trump’s specific criticisms.  You can criticize his methods.  But if he is a barbarian at the gates, the city that fears he is about to sack it is vulnerable because of its own profound internal failings.

Which brings me back to Putin.  One of the standard attacks against Trump is that by sharing a distrust of the current international system with Putin, Trump is strengthening Putin and weakening the United States.

I am of course no Putin booster (as 12 years of posts amply demonstrate), and think it is desirable to contain Russian influence.  But to believe that Trump’s challenge to the prevailing consensus empowers Putin and disempowers the United States is to engage in the same kind of zero sum thinking that I have criticized Putin for in the past.

Indeed, Putin should be careful what he asks for.  A replacement of the multilateralist international system with a more independent, unilateralist—and Jacksonian–United States will not necessarily redound to Putin’s benefit, and may be his worst nightmare.  The increase in American defense spending, and the aggressive promotion of US energy, are antithetical to Putin’s interests.

At best, the reorientation of US policy may give Putin more freedom of action in places like Syria—to which I say, good luck with that, and welcome to it.  It may also empower Russia to some degree in the near abroad, but even there Russia’s fundamental—and increasing—weaknesses (economic, demographic) will limit the damage it can do.

But fundamentally the US shares few interests with Russia, and has many opposing interests.  America unbound, more unilaterally assertive where it views its true interests to lie, and not distracted or enervated by efforts in peripheral areas, is more threatening to Russian interests in the long run than a Clinton administration would have been.

Further, Trump’s more benign view of Russia may reflect an assessment that Russia is not truly a great power, given its economic, demographic, institutional, and social limitations.  In terms of capability, and arguably intentions, China represents a more pressing challenge to the US, and focusing on Russia represents a foolish diversion of resources and division of efforts.  That is, Trump may be less cultivating Putin than patronizing him.

In sum, the post-Cold War world order has been vastly oversold.  The encomiums heaped upon it reflect intentions—and self-congratulation–far more than results.  Putin challenges it for his reasons.  Trump challenges it for very different reasons.  Arguably both are acting in their national interests.  A meeting between these two challengers to the existing order could not have occurred unless that order had failed, fundamentally.  The hysteria surrounding it is a testament to the failure of the hysterics, not the success of what they are defending.



July 8, 2018

The CFTC Intervenes to Prevent Moral Hazard in the CDS Market–But Why the CFTC?

Filed under: Derivatives,Economics,Politics,Regulation — cpirrong @ 8:36 pm

The WSJ reports that the CFTC engaged in extraordinary efforts to prevent manipulation of the CDS market by Blackstone Group.  Blackstone had bought about $333 million in protection on homebuilder Hovnanian, and then extended a low-interest loan to the company to induce it to make a technical default on debt the company itself owned (having bought it back).  The CFTC caught wind of this, and put on the full court press and eventually, uhm, persuaded (by intimating that it considered such behavior manipulative) Blackstone to negotiate an exit from the CDS with its counterparties.

In the Allen-Gale taxonomy, this would be best characterized as an “action-based” manipulation, as opposed to trading-based, or information-based.  It is clearly not a market power manipulation.

The conduct at issue is clearly a form of rent seeking–a set of transactions engineered for the purpose of obtaining a wealth transfer.  Unlike a market power manipulation, the direct welfare costs of this activity were probably small, and limited to the costs of negotiating with Hovnanian, and executing the CDS transactions.  However, as in most manipulations, the big costs here were indirect.  Blackstone’s scheme undermines the CDS market as a risk transfer mechanism.  In effect, Blackstone’s stratagem was a form of moral hazard, in that the insured could affect the probability of loss.  Moral hazard raises the cost of insurance, and leads to suboptimal risk transfer.  (Yes, I know that CDS market participants shudder at the use of the word “insurance” to describe CDS, in part because they want to avoid insurance regulation.  I am not using the word in its legal sense, but in an informal way to describe a risk transfer mechanism.)

CDS are particularly prone to moral hazard because individuals (notably, the managers of corporations) can do things to trigger defaults, and CDS can provide them directly or indirectly with an economic incentive to do so.  Further, CDS contracts are incomplete (i.e., not all possible contingencies can be specified) and often as a result contain ambiguities that clever rent seekers can exploit to win a payoff.

The CFTC’s actions are therefore laudable.  What’s particularly curious about this, however, is precisely the fact that it was the CFTC that intervened here.  Under Title VII of Frankendodd, the SEC has jurisdiction “over ‘security-based swaps,’ which are defined as swaps based on a single security or loan or a narrow-based group or index of securities (including any interest therein or the value thereof), or events relating to a single issuer or issuers of securities in a narrow-based security index”–the CFTC has jurisdiction over everything else.

The Hovnanian CDS are clearly in the SEC’s ambit, and not in the CFTC’s.  But in the case of the Hovnanian CDS, the SEC has been conspicuously absent. IIt is not mentioned at all in the WSJ piece.)  Curious, that.  Even more curious given the jealousy with which the SEC (like most government agencies) defends its turf against perceived incursions–especially the CFTC.   Why did the SEC let the CFTC take the lead on this, without a peep of protest?  And why did the CFTC apparently overstep its authority?

Things could have become interesting had Blackstone persisted with its scheme, and the CFTC filed an action against it.  In the event, an obvious legal response by Blackstone would have been to claim that the CFTC had no legal authority to take enforcement action.

Given this legal issue, the CFTC’s intervention may have less of a deterrent effect on future manipulations than an SEC intervention would have.

The SEC does not have the reputation of being a shrinking violet by any means, but it has been noticeably shy in some high profile events, the Hovnanian CDS story being one, and Tesla being another.  Makes me wonder . . .

July 7, 2018

No, Putin is Not a Genghis Wannabe Pinin’ for the Hordes. это Россия.

Filed under: Politics,Russia — cpirrong @ 9:42 pm

The WSJ embarrasses itself with this silly Yarosov Trofimov “think piece”  titled “Russia’s Turn to Its Asian Past.”  I say “think piece” in quotes because that’s what it pretends to be, but there really isn’t a lot of thought in it.  It is a farrago of random quotes and facts about Russian history that actually betrays little actual knowledge of Russian history.

Trofimov’s basic thesis is that spurned by the West, Russia is increasingly looking east, and moreover, “some Russians” (how many, out of a population of ~140 million he doesn’t say) look favorably on the Golden Horde.  Indeed, the piece is illustrated with a drawing of Putin as Genghis Khan–and even though Trofimov didn’t choose the illustration, he did speak approvingly of it on Twitter.

Trofimov’s “evidence”?  Well, Putin laments Russia’s lost empire, for one thing.  This is hardly a new phenomenon: Gaidar wrote a book about a decade ago titled “Collapse of Empire” which starts out discussing the lost empire syndrome and how it has haunted Russian consciousness since 1991, and which argues that Russia won’t progress until it gets over that loss.  Gaidar noted that this was accompanied by widespread resentment of the West, and ambivalence–or worse–about where Russia fit in.

For another, “Now Russia is increasingly looking East, toward an uneasy alliance with an illiberal and much more powerful China, and—in recognition of the country’s increasingly Muslim makeup—with nations such as Turkey and Iran.”  This is just great power politics.  In what represents continuity, rather than change, a leadership that believes in multipolarity, rejects globalism, has a decidedly Westphalian worldview, and views the US as its primary rival is looking for like-minded allies, who happen not to be in the West.  Go figure.  This doesn’t make Putin a Genghis wannabe pinin’ for the Hordes.

Trofimov assembles quotes from assorted people who claim Russia is rejecting the West due to various slights, real and perceived.  Again, in a nation of 140+ million people, you can find people–even well-known ones–who can express all sorts of views.  Moreover, again, it’s a long way from saying that Russians generally think that they’ve been making a huge mistake for the past, oh, several centuries blaming Russia’s relative backwardness on the “Mongol (or Tatar) Yoke.”

Trofimov’s lack of seriousness is best illustrated by his treating seriously one person in particular–Aleksandr Dugin, whom Trofimov describes as “the leading voice of this Eurasianist movement in Russia today.”  OK: I dare you to name the second leading voice.  One would probably be very hard-pressed to do so, which indicates just how marginal this movement is.

Dugin is a fringe figure to whom Putin paid some attention years ago, but his fifteen minutes of fame is long over.  He is now basically an outcast, having been fired from Moscow State University in 2014 for saying “kill them all” when asked what should be done with Ukrainians.  Giving Dugin any credence would be akin to emphasizing the importance to American contemporary thought of some Neoconfederate who once was a professor until he was driven from the academy for his lunatic ravings.

And oh, it’s not like Eurasianism is a new thing.  The current strain is sometimes referred to as “Neo-Eurasianism”, to distinguish it from the earlier version that flourished for a time in the emigre community after the Revolution (of which Nikolai Trubetzkoy was probably the most well-known advocate).  There are differences, of course, but the key commonality is that Eurasianism old and new emphasize Russia’s apartness from the West, and attribute it largely to its unique geographic position.

Having seen Dugin portrayed as some Svengali-like figure to Putin by those who view the Russian president as a bogey man, I have learned that anyone who gives him any importance whatsoever is unlikely to have anything insightful, or even interesting, to say.

The most amusing piece of “evidence” Trofimov presents is “a small theme park reconstruction of Sarai Batu”, “the Horde’s razed 15th century capital.” Whatever!

The most annoying thing about Trofimov’s article is its utter lack of historical perspective.  He acts as if Russian ambivalence and hostility towards the West is a new thing.  As if Russian questioning of its relationship to the West is something that has developed in the second half of the Putin era.  As if it is a novelty for some parts of the Russian intelligentsia and political class to reject the West and insist that Russia carve out a distinct place in the world and develop its distinct–and superior–society.

Hardly.  It is in fact a very old thing, and represents a major theme in Russian history.  Trofimov says that what is happening now is “an attempt to undo the westernizing approach that has dominated the Russian state going back all the way to Czar Peter the Great, three centuries ago.”  In fact, there have been such attempts ever since, well, the time of Peter the Great (e.g., the Old Believers who rejected Peter’s changes to bring the Russian Orthodox Church’s rituals in line with those of the Greek).  The subsequent centuries have seen see-sawing debates between Slavophiles and Westernizers.  Virtually everything that Trofimov cites as indicating some great new reversal of Russia’s progressive arc to the West in fact has echoes in the writings of the Slavophiles in the mid-19th century, and in those of their successors over the years.  They have never gone away.

Indeed, a Russian much admired in the West for his stand against the Soviet Union, Aleksandr Solzhenitsyn, was essentially a Slavophile who was hardly a lover of the West.  Ironically, one of the criticisms leveled against Solzhenitsyn when he returned from exile in 1994 is that he had nothing new to say about Russia, but was merely recycling old Slavophile thinking:

WHEN Alexander Solzhenitsyn set foot on Moscow soil July 21 after 20 years of forced exile, the influential Russian literary journal, Novy Mir, was already preparing to publish his programmatic tract, “The Russian Question at the End of the 20th Century.”

The lengthy article, which examines Russian history since the 17th century and sums up the writer’s historio-philosophical views, is “as significant as his celebrated 1990 essay ‘How to Rebuild Russia,’ ” Novy Mir editor Sergei Zalygin excitedly told the Rossiiskaya Gazeta.

But what new ideas does Mr. Solzhenitsyn truly bring to his Russian brethren? Surprisingly few. In fact, the man acclaimed as Russia’s greatest living writer presents almost nothing that hasn’t been heard before, either from him or the host of Russian nationalist Slavophiles dating back to the 19th century. Indeed, the 40-page essay is permeated with familiar principles such as “healthy isolationism,” antidemocratism, nationalism, and xenophobia.

Thus, to the extent that there are anti-Western intellectual currents in Russia, and that some in Russia (particularly among the intelligentsia) are advocating Russia turn its back on the West, this represents historical continuity, rather than discontinuity.

And it is particularly important to emphasize that this is now, and has always been, much more of a parlor game for intellectuals than something that has affected Russian government, policy, or statecraft.  Indeed, if anything–now and in the past–the direction of causation has been from international setbacks to intellectual ferment, than it has been from intellectuals’ ideas to Russian policy, whether under tsars, commissars, or presidents.

Trofimov actually acknowledges this, but then throws it aside:

It’s not clear to what extent the Kremlin believes its own propaganda. While resentment over Russia’s diminished stature is a key motivator of Mr. Putin’s behavior, so far Russia’s decision-making has been driven largely by opportunism rather than by a grandiose civilizational shift. “I don’t think Putin is thinking in terms of historical mythologies,” said Mr. Kortunov of the Russian International Affairs Council. “I don’t think he needs an ideological grounding for his policies.”

Actually, it’s quite clear: it doesn’t believe it at all.

In sum, all this chin pulling over “who lost Russia?” or “is Putin a new Stalin/Genghis?” is vapid.  It is an offshoot of the End of History fantasies that accompanied the end of the Cold War, and which posited that the entire world would converge to the liberal Western model, particularly that epitomized by the US.  The competing Clash of Civilizations view made much more sense at the time and has certainly stood the test of events much better.  No one lost Russia because Russia was never the West’s to lose.  It has always been a self-consciously distinct civilization that has constantly struggled to define its relationship to the West.  The current intellectual debates within Russia, and the nature of Russian policy towards the West and the rest of the world, are continuations, not departures.  History rhyming, as it were.

The current obsession with Putin in the West obscures that fundamental fact.  Putin could get killed by a falling house tomorrow and very little would change.  It wouldn’t be like the death of the Wicked Witch of the East leading to the liberation of the Munchkins. Russia would be Russia.  The changes in Russian policy and mindset would be superficial, at best.  Russia would continue its centuries-long attractive-repulsive relationship with the West.  Russia would continue to have strong authoritarian tendencies and an abiding suspicion of its neighbors.

Unfortunately, the Trofimov piece, like so many others, completely lacks this historical context, and leaves one with the impression that what is happening now in Russia is something extraordinary.  It’s not: it’s very ordinary, in the Russian scheme of things.  But by giving the opposite impression, articles like this create false perceptions about current events, and false expectations about how things may change in the future, or how American or European policies could materially impact how things evolve.

There’s an old expression: это Россия.  That’s Russia.  Often said with a shrug, indicating resignation about things that have always been so, and are unlikely to change.  Yaroslav Trofimov hasn’t identified something new.  He’s basically described something quite old: это Россия.  Would more people understand that was the case.

July 6, 2018

Tesla Will Become a Real Car Company When Elon Becomes a Real Boy

Filed under: Economics — cpirrong @ 6:51 pm

Last week Tesla achieved Elon Musk’s stated milestone of building 5000 Model 3’s in a week.  After an initial burst of enthusiasm which saw the stock price jump upwards, the market was unimpressed: the stock turned down on the day, and is now down $41.3 since 29 June (that’s almost 12 percent).

The company only hit the target (well, in actual fact it missed by a few hours) by making  extreme–and I mean extreme–efforts.  Putting a new assembly line in a tent.  Cannibalizing spare parts.  Cutting production on higher margin Model S vehicles.  Jettisoning quality tests.  Dragooning people into overtime without warning contrary to previous company policy.

Thus, the market’s reaction is not surprising.  Tesla didn’t prove that it could meet a production target under normal conditions: it proved absolutely that it couldn’t.  That is, it proved exactly the opposite of what Musk had intended.

After the “achievement,” Elon Musk tweeted that Tesla had proved that it was finally a real car company.  No, it hadn’t: a normal car company would never been in the situation of behaving like some Soviet enterprise in the 1930s rushing and cutting corners to meet The Plan, lest everyone wind up in The Gulag.

Which is perhaps an especially apt analogy, given Elon’s behavior during this period, and the cult of personality that he has cultivated.

When Musk tweeted about “a real car company” the thought that came to mind was Pinocchio, who wanted to be a real boy.  Given Elon’s propensity to stretch the truth–well, lie, actually–in a way that would shame Pinocchio, that’s an apt analogy too.

There will no doubt be a serious hangover as a result of the rush to meet Musk’s self-imposed target.  Labor relations at Tesla were already poor–they are no doubt awful now.  The company also has had serious build quality and service issues.  I shudder to think of the build quality of the cars thrown together in that last minute frenzy.  Musk’s already crumbling credibility has taken a hit.

For the last, Elon has no one to blame but himself.  His repeated failures to achieve any of the lofty predictions he has made  (failures that would have brought the SEC down on pretty much anyone else) meant that failure to meet the 5000 cars or bust pledge would have been devastating.  So Elon had to pull out all the stops, even though by doing so he in fact revealed the emptiness of his boastful prediction, and could well have produced 5000 busted cars.

For Tesla to become a real car company, Elon will have to become a real boy–or at least a real CEO, rather than a cult leader impersonating a CEO.  Alas, I doubt that will happen, because of one difference between Elon and Pinocchio: Pinocchio realized he wasn’t real, but I don’t think Elon has the same self-awareness.

Chinese Oil Futures: Performing As Predicted

Filed under: China,Commodities,Derivatives,Economics,Energy — cpirrong @ 6:27 pm

The recent introduction of Shanghai oil futures has resulted in a lot of churn in the front month, and very little activity in even the 1st and 2nd nearby:

China’s new oil futures are a hit with investors but they’re facing commitment issues.

While daily volume in the yuan-denominated contract has increased five-fold since its debut in late-March amid steady growth in open interest, almost all trading is focused in front-month, September futures.

. . . .

It suggests that, for now, traders are using the futures principally to speculate on short-term price fluctuations, as opposed to hedge long-term consumption or production, according to Jia Zheng, a portfolio manager at Shanghai Minghong Investment Co.

Which is pretty much what I predicted on the day of the launch:

Will it succeed?  Well, that depends on how you measure success.  No doubt it will generate heavy volume.  Speculative enthusiasm runs deep in China, and retail traders trade a lot.  They would probably make a guano futures contract a success, if it were launched: they will no doubt be attracted to crude.

. . . .

If you are looking for a metric of success as a commercial tool (rather than of its success as a money making venture for the exchange) look at open interest, not volume.  And look in particular in open interest in the back months.  This will take some time to build, and in the meantime I imagine that there will be a lot of awed commentary about trading volume.  But that’s not the main indicator of the utility of a contract as a commercial risk management and price discovery tool.


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