Streetwise Professor

In his swan song at Glencore, the soon to retire Ivan Glasenberg doubled down on coal:

In what’s likely to be the final deal announced by outgoing Chief Executive Officer Ivan Glasenberg, Glencore agreed to buy stakes owned by BHP Group and Anglo American Plc in the Cerrejon thermal coal mine for about $588 million, subject to purchase price adjustments.

Glencore is filling a void left by two mining giants:

The sale completes Anglo’s retreat from thermal coal and extends similar efforts by BHP, amid investor pressure. However, Glencore has committed to run its coal mines for another 30 years, potentially allowing it to profit as rivals retreat. It’s already the biggest shipper of the fuel, and gaining full control of Cerrejon gives the company even more exposure just as prices trade at the highest level in years, buoyed by strong demand as the global economy rebounds.

In my opinion, this is a very canny contrarian bet. The panicked flight from coal by the Anglos and BHPs and others of the world is directly attributable to political and policy pressure. Hydrocarbons bad. Renewables good. Hydrocarbon companies are evil. You will be punished you carbon spewing bastards! Your CEOs will be snubbed by righteous people. Oh Noes!

But these policies are predicated on a collective delusion about renewables. Bloomberg can preach all it wants about how renewables are as efficient as conventional generation, but the fact is and will remain that dispatchable, reliable, continuous conventional generation, producing power from cheaply stored chemical energy, will remain much cheaper that non-dispatchable, intermittent, unreliable renewables that will have to rely on expensive battery storage. Bloomberg’s “levelized cost” metric is total bullshit because it leaves out all of the costs associated with reliability, transmission, and intermittency–details, details!

Renewables will never be able to handle current electricity demand at reasonable cost, but policymakers in the grip of the delusion are adding to electricity demand by forcing the electrification of other energy consumption, including transportation and home heating and cooking.

And it is almost certain that Glasenberg recognizes these delusions for what they are, and knows that in five to ten years time reality will rear its ugly head–recognition of reality can be postponed, but not forever. And Glasenberg recognizes when that reckoning comes, and electricity costs spike and reliability plunges, countries around the world will come begging for dependable electricity sources. And thus, they will come begging to Glencore for its coal.

The payoff will be all the bigger because Anglo, BHP, and others will not invest, leaving a capacity void. Price will rise to ration the limited supply.

Current government energy policies around the world are not time consistent. Political coercion to achieve a utopian outcome will result in more costly and less reliable energy that will not be politically sustainable. Ivan Glasenberg recognizes that time inconsistency, and as his parting gift to Glencore’s shareholders–and the world, frankly, when it comes to his senses–is an investment that will pay off handsomely when reality intrudes on renewables reveries.

Chairman of the Joint Chiefs of Staff, General Mark Milley, apparently studied Medieval fortification quite closely, as he implemented a classic motte-and-bailey stratagem in defense of the military’s program of Critical Race Theory indoctrination.

Expressing outrage, Milley dishonestly replied to Republican questioning about CRT thus:

I personally find it offensive that we are accusing the United States military general officers, our commissioned [and] noncommissioned officers, of being “woke” or something else because we’re studying some theories that are out there. I’ve read Karl Marx. I’ve read Lenin. That doesn’t make me a communist.

Why do I say dishonest? For an ambitious officer rising through the ranks during the Cold War, or shortly thereafter, studying Lenin, Marx, and Mao was a way to “know thine enemies.” To know how they thought. To know what motivated them. That is valuable knowledge in trying to counter them. Reading communists provides part of a good foundation for devising strategies to confound communists. As the movie Patton said while watching the Germans retreat at the Battle of El Gattar: “”Rommel, you magnificent bastard, I read your book.” 

Mandatory indoctrination in CRT at the academies, and in the ranks and officer corps, is nothing of the sort. It is not about educating servicemen and -women about a foreign enemy to be able to defeat them. It is about coercively reshaping the minds and hearts of those who have volunteered for armed service to force them to pay obeisance to beliefs most of them find inimical. Indeed, puts an official imprimatur on the view that the majority of those who serve are irredeemably racist, and in need of reeducation of the type that Marx, Mao, and Lenin enthusiastically advocated. (No word on whether Milley also studied Pol Pot.)

No, Milley didn’t read Marx to become a Marxist. He read Marx to understand Marxists to fight them better. By forcing CRT on the armed forces, he and others in the military establishment, e.g., CNO Admiral Gilday, are waging war on the values, beliefs, and characters of a large majority of those whom they command.

Put differently: you read Marx et al to learn about the enemy; you force Americans who have volunteered for military service to read Ibrahim X. Kendri (aka Ibram Henry Rogers) et al because you believe they (the American volunteers) are the enemy.

And Milley said so, in not so many words:

I want to understand white rage, and I’m white. So what is it that caused thousands of people to assault this building and try to overturn the Constitution of the United States of America? What caused that? I want to find that out. I want to maintain an open mind here, and I do want to analyze it.

Kendri and his CRT ilk identify white people and “whiteness” as the enemy. If you are reading Kendri to understand white people, and their alleged rage, you are doing so because you have already bought into the idea that they are the enemy.

And about this “white rage” thing. Is it really a thing? I don’t think so. It is basically a standard epithet that leftists drag out when their political opponents don’t conform like good sheep. My first recollection of a variant on this is when Peter Jennings said that voters had thrown a “temper tantrum” when they voted out the Democrats from control of Congress in 1994. The real rage here is expressed by leftists (ironically, largely white) who cannot countenance opposition: the charge is just another example of psychological projection. “Mommy! No Fair!!! Johnny hit me back!!!!”

And it’s interesting that when it comes from the left, rage is considered a sign of authenticity, of righteous reaction to injustice. (“Days of Rage” in Chicago in 1968 was a label the leftists chose, not one that was applied to them.) This is particularly true of “black rage.”

So apparently the virtuousness (or not) of rage is politically situational and ideologically contingent. Go figure.

Another element of the motte-and-bailey strategy regarding CRT in the military is to claim that there are racial tensions in the military, and that such tensions degrade morale and military effectiveness. Therefore, proactive measures to improve racial understanding are imperative.

Well, there are such tensions, and not for the first time. I guarantee things were infinitely worse in the late-Vietnam and early-post-Vietnam era. The Navy had severe racial problems: that’s one of the biggest challenges Elmo Zumwalt faced as CNO: as I recall there is a chapter in his autobiography where he discusses his struggles to deal with racial conflict in the service in detail. Things had come a long way a short handful of years later when I was at USNA: they have improved substantially in the decades since.

But CRT indoctrination will not ameliorate racial tensions–it will exacerbate them, and substantiallynso. Tell me how, exactly, preaching that one skin color is inherently evil and oppressive, and other skin colors are inherently saintly and oppressed is going to promote a sense of camaraderie among a racially diverse group of individuals. It does the exact opposite. R. Lee Ermey’s way was much more effective.

The motte-and-bailey response to criticism of CRT is not limited to Milley and the military. It is particularly pronounced in public schools, where it is (dishonestly) argued that preventing teaching CRT prevents teaching about slavery: as MSNBC’s Joy Reid put it, if you don’t teach Critical Race Theory you are teaching Confederate Race Theory. This is obviously illogical bollocks: CRT emphasizes the evils of slavery, but not all curriculum that deals honestly with slavery is CRT. Another motte is to deny that such a thing as Critical Race Theory even exists: it’s just a figment of fervid (raging?) right wing/white wing imaginations dontcha know.

Wrong. CRT is a thing. It is a dishonest, pseudoscientific, divisive, coercive thing, and essentially a mask for the will to power. Cancerous Race Theory is a more accurate description. And it is now a cancer in the military.

One last thing about Milley. The left is in a rage (more irony!) about criticism of Milley’s remarks before Congress. Tucker Carlson’s trenchant description of the general (“He’s not just a pig, he’s stupid!”) has brought down howls demanding his cancelation (yes, it was a day ending in “y”).

Leftists defending the military “leadership.” The world turned upside down. But this isn’t because the leftists have changed: it’s because the military “leadership” has become leftist. It will become only more so in the next three and a half years as the purges work through the ranks. The military was once the sole institution the leftists hadn’t marched through: but now they’re doing so, like Sherman marched through Georgia.

Virtually everyone in the Founding generation had one fear: Tyranny. They did not want to replace one tyrannical government with another. On this Federalists and Anti-Federalists agreed. The difference was that the Federalists believed that the Constitution had adequate safeguards against tyranny, but the Anti-Federalists did not.

One manifestation of the dread of tyranny was a deep suspicion of standing armies, which were viewed as the enforcers of tyranny. Another was a veneration of an armed citizenry, not least because it was a check on tyranny, via the threat of armed resistance. Indeed, these two things went together: a large standing army could overawe even a well-armed citizenry.

Yesterday Gibbering Joe Biden expressed the sum of all the Founders’ fears:

BIDEN: "Those who say the blood of Patriots, you know, and all the stuff about how we’re gonna have to move against the government.”

"If you think you need to have weapons to take on the government, you need F-15s and maybe some nuclear weapons."pic.twitter.com/WVHUffpphP

— Breaking911 (@Breaking911) June 23, 2021

In other words, the armed citizenry is powerless against America’s massive standing military. Meaning that there is no check on tyranny. To which the Anti-Federalists would say: told you so.

Biden’s remarks, delivered in a drugged out way that wouldn’t be shocking if Hunter Biden had uttered them but is still disconcerting when Joe does, were revealing on many dimensions.

One of these–remarked upon by many–is his apparent willingness to use, or at least to threaten to use, nuclear weapons on Americans. Rather staggering, no?

Another is his apparent belief that F-15 pilots, and other members of the US military, would be willing to carry out orders to use massive force against Americans. I wouldn’t be so sure. Although an intent to ensure it may well explain the ideological offensive being waged against alleged “extremists” within the military at present.

Another, sickly ironic one, is the complete disconnect between this rhetoric and the rhetoric regarding January 6. The Babylon Bee says it better than I could:

'You'll Never Beat The Government With Just Guns,' Says Party That Also Believes Government Was Almost Toppled By Unarmed Mob On January 6https://t.co/NX4eJCfVe3

— The Babylon Bee (@TheBabylonBee) June 23, 2021

No, really, it is just too much. On the one hand, Biden and the Democrats say that armed resistance against the government is futile, but on the other hand, they say that unarmed resistance by a motley group at the Capitol was the greatest assault on American democracy since Pearl Harbor, and amounted to an insurrection that threatened “our democracy,” i.e., to overthrow the government.

Pick one. They both can’t be true.

There is a broader lesson here. The Founders and their 18th century vision–including their fear of state tyranny, their desire to center as much government as possible at the lowest level possible, and their belief that a revolutionary public is the last check against tyranny–is a 21st century Rorschach Test. A large number of Americans embrace it fervently. A large number of Americans loathe it. Indeed, that divide is a succinct way of summarizing the current American political fault line.

Clearly, most of the ruling class and the “elite” fall in the loathers camp. Most of the embracers are non-ruling-class “deplorables” whom the elite despises and wants to crush.

The ruling class and the “elite” sacralize the state, and especially the federal government. Unlike the Founders, who saw government as a necessary evil to be constrained, limited, and checked by a watchful–and if need be, revolutionary–citizenry, the ruling class and the “elite” have effectively adopted Mussolini’s credo: “Everything in the State, nothing outside the State, nothing against the State.”

And this is understandable, because l’etat, c’est eux. They control the state. They utilize the state to amass power and riches. A threat to the state is a threat to them. And as Biden indicates, they are willing to use all means necessary–including nuclear weapons, apparently–to defend that position.

This elite sacralization of the state is another way in which the US is converging to Putin’s Russia. The only difference–for now–is that Putin and the Russian elite explicitly express their veneration of the state above the people, and explicitly say that the people exist to serve the state. The American ruling class does not say this in so many words. But the idea is implicit in their rhetoric–like Biden’s rhetoric yesterday, and the unceasing rhetoric flogging January 6. More importantly, it is implicit in their deeds.

The 21st century ruling class has rejected the vision of the 18th century ruling class–which happens to be the vision of the 21st century ruled class. That is the real divide in today’s America, and why the country is in a pre-revolutionary condition. The visions of the ruling and the ruled are completely incompatible. That can only end in the submission of one side, or the failure to submit by either culminating in armed conflict.

And if it comes to conflict, the ruling class shouldn’t be so sure that military might is sufficient to prevail. Hasn’t worked magic in Iraq or Afghanistan, has it? Nor did it in Southeast Asia decades ago.

At the end of the Civil War, a great fear in the North was that Southerners would resort to guerrilla warfare. Some Confederates (e.g., Edward Porter Alexander) advocated it but Lee demurred. But if the current house divided does not stand, that’s exactly the kind of conflict that would occur. And although the military might not lose such a war (assuming it agrees to fight it), it has never proved able to win one.

Pray that it doesn’t come to that. But such an outcome cannot be precluded, given the ruling class’s sacralization of the state and its corollary: growing tyranny.

I grew up in the 70s. I never did acid then (or ever!), but man am I experiencing flashbacks. Feckless progressive Democrat presidents. (Though Carter, while an idiot, was at least compos mentis, which is more than can be said of Señor Senile Joe Biden.) Crime. (I’m betting on a comeback of the Charles Bronson revenge and Clint Eastwood Dirty Harry genres.) All in all, the 70s sucked, and I am not nostalgically hoping for a reprise–I’m dreading it actually.

One of the things that sucked worst was inflation. The 1970s were the inflation decade (although it peaked in 1980-1981). In recent months, the price level measured by the CPI, PPI, and GDP deflator has been up substantially. CPI, for example, is up about 4.5 percent on a year-on-year basis. This has raised concerns about a return of 70s-style inflation. Are these concerns justified?

The jury is out, but there is reason for concern.

First, it is important to distinguish between one time changes in the price level and inflation. Inflation is a long term upward trend in the price level, rather than a single stair-step jump in the price level.

The impact of the pandemic (or, more accurately, the draconian policy response to the pandemic) has created the conditions for a one-time step up in the price level. The economic recovery from the pandemic is a positive aggregate demand shock. Moreover, it has occurred against the backdrop of constrained supply conditions that resulted from the pandemic. Upward shifts in supply and demand lead to a higher price level, ceteris paribus.

One would think that these are effectively one-time shocks–hopefully the pandemic is a one-time thing, and therefore the recovery from it is too. Furthermore, supply conditions should ease. (We are already seeing that in some sectors, such as lumber, though not in others, such as semiconductors. Policy, namely paying people not to work in some states, may impede the easing of supply conditions). Thus, one would expect that this is one time, and at least partially transitory, jump in the price level rather than inflation qua inflation.

That said, there are reasons for concern. Most notably, the fiscal diarrhea in the US, and the willingness of the Fed to finance (i.e., monetize) that spending is freighted with inflationary potential.

In the post-Financial Crisis era, the Fed mitigated the inflationary impact of QE and other expansive monetary policies by paying interest on reserves. So the inflationary threat that I worried about in 2009 (and asked Ben Bernanke about) never materialized. But that’s no reason for complacency. We dodged a bullet once, but that doesn’t mean we will always do so. Massive deficit spending accommodated by the monetary authority is highly likely to result in inflation, sooner or later. (I am inclined to favor Thomas Sargent’s fiscal theory of the price level.).

Part of the reason that inflation didn’t occur post-2008 was that money velocity plunged. Part of this was due to the Fed paying interest on reserves, which led banks to hold them (lend them to the Fed in effect) rather than lend them to private individuals and firms. But expectations, and the self-fulfilling nature thereof with respect to inflation, likely played a role too. In the gloomy aftermath of 2008 people expected low inflation (or even deflation), which made them more willing to hold rather than spend money balances–which results in low inflation, thereby validating the expectations and perpetuating the equilibrium.

But expectations are fickle things, and as a result there can be multiple equilibria. Fed board members have strenuously argued that the recent spurt in prices is a one-time stair step phenomenon, not the harbinger of inflation. But if the spurt results in an upward shift in inflationary expectations by the hoi polloi, people will be less willing to hold money balances at the existing price level, so they will try to reduce (i.e., spend) them, which leads to inflation–thereby validating the expectations.

Thus, it’s not so much what the Fed believe that matters. It’s about what you and me and other individuals and firms believe. Combine a negative fiscal picture with a surge in prices and it’s quite possible that inflation expectations soon will no longer be “anchored” at low levels, but will surge to higher levels, which would result in inflation no longer being anchored at low levels.

So although I think that the recent surge in the price level is of the one-time variety, that doesn’t mean everyone will think the same way. And if everyone doesn’t think the same way we may see a 70s rerun. The dire fiscal picture contributes to such worries.

When the subject of inflation comes up, as Dr. Commodities I’m often asked whether commodities are a good hedge. Intuitively it makes sense that they should be, but historically, they have not been. Commodity prices are much more volatile than the price level, and not that highly correlated. That is, relative prices move around a lot even when the price level trends upwards.

I think that availability bias is a big reason why people focus on commodity prices–they are readily observable, on a second-by-second basis, because they are actively traded on liquid markets. Other goods and services, not so much. But just because we can see them easily doesn’t mean that they are reliable beacons for the price level overall, or changes therein.

This brings to mind why we should really fear a return of 70s-style inflation (or worse, heaven forfend).

When sitting in (the great) Sherwin Rosen’s Econ 302 course at Chicago on a cold morning in February, 1982, I was startled when Sherwin’s normal rather droning delivery was interrupted by him shouting and pounding his right fist into his left palm: “And that’s the problem with inflation. IT FUCKS UP RELATIVE PRICES!!!!”

Some prices are stickier than others, meaning that inflation pressures can impact some goods and services more and sooner than others–thereby causing changes in relative prices.

This is a bad thing–and why Sherwin dropped the F-bomb about it–because relative prices guide resource allocation. If you fuck up relative prices, as inflation does, you interfere with resource allocation, leading to lower incomes and growth. Inflation has adverse real consequences.

So we should definitely fear an acid flashback to 70s inflation. And although I do not believe the recent surge in prices is a harbinger thereof, I think that there is a material risk that we may all experience such a flashback–even if you didn’t grow up in the 70s.

There has been something of a kerfuffle recently over the large scale purchases of single family homes by the likes of BlackRock and other institutional investors like pension funds. The criticism is somewhat redolent of the Occupy days, because it unites many on the left with some on the populist right, like J.D. Vance:

Blackrock is pursuing an investment strategy that will make it harder for young Americans to own homes. The Left will ignore this, because Blackrock has committed to "racial audits" and other diversity BS. https://t.co/lgtb3xSlO9

— J.D. Vance (@JDVance1) June 9, 2021

Understanding should come before judgment. So let’s try to figure out what is going on here. I don’t have a definitive answer, but my strong sense is that this phenomenon is ultimately a consequence of the 2008-2009 Financial Crisis, and the various policy responses to it.

One thing is clear is that the initial foray of institutional investors was a response to the Crisis. And no wonder. Massive amounts of single family homes were in foreclosure, and the biggest fire sale in American real estate history was underway. And in fire sales, those with “dry powder”–cash rich investors relatively undamaged by the crisis that sparks the sales–go bargain hunting. In 2009-2010, the bargains were in residential real estate, especially single family houses. And the “real money” investors like BlackRock and pension funds were best positioned to grab those bargains.

Here it is almost certain that the activities of BlackRock et al did elevate real estate prices. And a good thing, too, for the problem at the time was not that housing prices were too high, but too low. Without bargain hunters (or vultures, if you wish) housing prices would have been even lower, more homeowners would have been underwater, more of them would have been foreclosed, etc. Of course BlackRock et al were not doing this out of charity, but to make a buck. But they were responding to price signals and their actions almost certainly mitigated a horrible situation.

But as the WSJ article linked above notes, institutional investment in the housing sector has persisted after the fire sales ended–especially in places like Houston, Atlanta, and Nashville. This is characterized as a reach for yield strategy on the part of the institutional investors. The yield on rental property is apparently attractive relative to alternative investments. And no surprise: have you looked at bond yields recently? Like in the last 12 years? Is it any wonder that investors like pension funds (especially government funds that are hugely under water) are desperate for assets that generate a stream of cash flows at attractive rates?

But high yield suggests that prices are low in some sense, rather than high. (Price is in the denominator of the return calculation.) “Bubble” real estate markets are characterized by extremely low rental yields, not high ones.

Look at this another way. People are choosing to pay rent, rather than buy and make mortgage payments and forego income on the investment of a down payment amount. Why? Why are they paying rents that generate a high return for the housing owner, rather than buying homes and capturing that return themselves?

My answers will be somewhat speculative, but now the question is the important thing. Many individuals are choosing not to buy, and to pay rent instead. The rents that they are willing to pay are driven by the stream of benefits that they get from living in a single family home. Why don’t they outbid BlackRock or some state pension fund and pay a price that capitalizes that stream of benefits?

Note that there are clear advantages to occupiers owning. The Atlantic article linked earlier discusses the frictions associated with renting. Well, renter-landlord relations have been fraught always and everywhere. Rental contracts are not “complete”–they leave a lot of grey areas that give rise to conflict between owner and renter, and to opportunism by both. Those wasteful activities can be eliminated by having those who live in a home own it. That in and of itself should give individuals a bidding advantage over institutions when buying homes. Cut out the middleman and you cut out the transaction costs inherent in the landlord-tenant relationship.

So then what gives? Now for the speculation, which again revolves around the fallout from the Financial Crisis.

First, the leading diagnosis of the cause of the Financial Crisis was that it was too easy to get a mortgage. In response to this, post-Crisis legislation and regulation tightened up the home financing market. A lot. You can argue that the tightening was justified. You can argue that it went too far. But regardless, restrictions on the ability of individuals to finance a home purchase, or regulations that made it more expensive to do this, shifted the balance away from purchasing towards renting.

Indeed, if the likes of Elizabeth Warren were intellectually consistent (yeah I’m a comedian, I know), they should see the increased presence of Wall Street on Elm Street as a good thing, because it means that their endeavors to prevent another housing “bubble” have worked.

Second, the Financial Crisis took a severe toll on the balance sheets and creditworthiness of many individuals. Although these problems have dissipated, they haven’t disappeared. Combined with the more restrictive access to credit, these creditworthiness/balance sheet effects impede the ability of individuals to capture the high returns of home ownership, and they cannot compete on price with institutional investors who do not face such impediments.

Third–and this is perhaps the most speculative point of all–the Financial Crisis and the follow on Foreclosure Crisis arguably had an impact on the preferences of individuals, especially Millennials and Gen-Zs. Post-Crisis home ownership seemed less like a dream–it had a potential dark side. So many in those cohorts prefer to pay rent and give a high return to institutional investors and deal with the hassles of a landlord rather than buy and face the risk of financial ruin.

Fed policy may also play a role. It clearly has depressed returns on conventional fixed income investments–and has done so by design. That has made institutional investors look at non-traditional investments. But Fed policy alone can’t explain why yields on housing investments apparently haven’t fallen to the level of the low yields on bonds. There must be some other factor impeding the rise of housing prices to reduce the yields that the institutional investors are apparently capturing by buying and renting out single family homes. That brings us back to a search for factors (like those just discussed) that prevent individuals from outbidding institutional investors to capture the stream of returns from housing ownership (and to eliminate the costs that arise when the home occupier is not the owner).

In turn, this means that inquiry into this issue should focus on whether post-Crisis, there are excessive restrictions and costs imposed on individuals looking to finance home purchases. That is, are the post-2008 laws and regulations designed to prevent a recurrence of the housing boom too restrictive?

I don’t have an answer to that question, but again, posing the right question is where you have to start.

My provisional conclusion now is that institutional investors are doing what they do: responding to price signals in order to maximize risk adjusted returns. They are responding to incentives. To evaluate what is going on, it is necessary to evaluate whether those incentives have been distorted by ill-conceived policies.

Of course, these policies were not created in a vacuum. They are the result of a political process that includes lobbying and rent seeking by institutional investors, among others. They have an incentive to harm potential competitors in the housing market. So any inquiry should also focus on whether these institutional investors have helped rig the game against individuals by pressing for the imposition of unwarranted restrictions on home financing. If so, censorious judgment would be warranted.

So is burgeoning institutional ownership of single family housing a 2020s version of Bad Day at Black Rock? A 2020s film noir? I don’t know. But I have the questions and some provisional answers.

One of the few compensations I get from a Biden administration is that I have an opportunity to kick around Gary Gensler–“GiGi” to those in the know–again. Apparently feeling his way in his first few months as Chairman of the SEC, Gensler has been relatively quiet, but today he unburdened himself with deep thoughts about stock market structure. If you didn’t notice, “deep” was sarcasm. His opinions are actually trite and shallow, and betray a failure to ask penetrating questions. Plus ça change, plus c’est la même chose.

Not that he doesn’t have questions. About payment for order flow (“PFOF”) for instance:

Payment for order flow raises a number of important questions. Do broker-dealers have inherent conflicts of interest? If so, are customers getting best execution in the context of that conflict? Are broker-dealers incentivized to encourage customers to trade more frequently than is in those customers’ best interest?

But he misses the big question: why is payment for order flow such a big deal in the first place?

Relatedly, Gensler expresses concern about what traders do in the dark:

First, as evidenced in January, nearly half of the trading interest in the equity market either is in dark pools or is internalized by wholesalers. Dark pools and wholesalers are not reflected in the NBBO. Moreover, the NBBO is also only as good as the market itself. Thus, under the segmentation of the current market, nearly half of trading along with a significant portion of retail market orders happens away from the lit markets. I believe this may affect the width of the bid-ask spread.

Which begs the question: why is “nearly half of the trading interest in the equity market either is in dark pools or is internalized by wholesalers”?

Until you answer these big questions, studying the ancillary ones like his regarding PFOF an NBBO is a waste of time.

The economics are actually very straightforward. In competitive markets, customers who impose different costs on suppliers will pay different prices. This is “price discrimination” of a sort, but not price discrimination based on an exploitation of market power and differences in customer demand elasticities: it is price differentiation based on differences is cost.

Retail order flow is cheaper to intermediate than institutional order flow. Some institutional order flow is cheaper to intermediate than other such flows. Competitive pressures will find ways to ensure flows that are cheaper to intermediate pay lower prices. PFOF, dark pools, etc., are all means of segmenting order flow based on cost.

Trying to restrict cost-based price differences by banning or restricting certain practices will lead clever intermediaries to find other ways to differentiate based on cost. This has always been so, since time immemorial.

In essence, Gensler and many other critics of US market structure want to impose uniform pricing that doesn’t reflect cost differences. This would be, in essence, a massive scheme of cross subsidies. Ironically, the retail traders for whom Gensler exhibits such touching concern would actually be the losers here.

Cross subsidy schemes are inherently unstable. There are tremendous competitive pressures to circumvent them. As the history of virtually every regulated sector (e.g., transportation, communications) has demonstrated for decades, and even centuries.

From a positive political economy perspective, the appeal of such cross subsidy schemes to regulators is great. As Sam Peltzman pointed out in his amazing 1976 JLE piece “Toward a More General Theory of Regulation,” regulators systematically attempt to suppress cost-based price differences in order to redistribute rents to gain political support. The main impetus for deregulation is innovation that exploits gains from trade from circumventing cross subsidy schemes–deregulation in banking (Regulation Q) and telecoms are great examples of this.

So who would the beneficiaries of this cross-subsidization scheme be? Two major SEC constituencies–exchanges, and large institutional traders.

In other words, all this chin pulling about PFOF and dark markets is politics as usual. Furthermore, it is politics as usual in the cynical sense that the supposed beneficiaries of regulatory concern (retail traders) are the ones who will be shtupped.

Gensler also expressed dismay at the concentration in the PFOF market: yeah, he’s looking at you, Kenneth. Getting the frequency?

Although Gensler’s systemic risk concern might have some justification, he still fails to ask the foundational question: why is it concentrated? He doesn’t ask, so he doesn’t answer, instead saying: “Market concentration can deter healthy competition and limit innovation.”

Well, concentration can also be the result of healthy competition and innovation (h/t the great Harold Demsetz). Until we understand the existing concentration we can’t understand whether it’s a bug or feature, and hence what the appropriate policy response is.

Gensler implicitly analogizes say Citadel to Facebook or Google, which harvest customer data and can exploit network effects which drives concentration. The analogy seems very strained here. Retail order flow is cheap to service because it is uninformed. Citadel (or other purchasers of order flow) isn’t learning something about consumers that it can use to target ads at them or the like. The main thing it is learning is what sources of order flow are uninformed, and which are informed–so it can avoid paying to service the latter.

Again, before plunging ahead, it’s best to understand what are the potential agglomeration economies of servicing order flow.

Gensler returns to one of his favorite subjects–clearing–at the end of his talk. He advocates reducing settlement time from T+2: “I believe shortening the standard settlement cycle could reduce costs and risks in our markets.”

This is a conventional–and superficial–view that suggests that when it comes to clearing, Gensler is like the Bourbons: he’s learned nothing, and forgotten nothing.

As I wrote at the peak of the GameStop frenzy (which may repeat with AMC or some other meme stock), shortening the settlement cycle involves serious trade-offs. Moreover, it is by no means clear that it would reduce costs or reduce risks. The main impact would be to shift costs, and transform risks in ways that are not necessarily beneficial. Again, shortening the settlement cycle involves a substitution of liquidity risk for credit risk–just as central clearing does generally, a point which Gensler was clueless about in 2010 and is evidently equally clueless about a decade later.

So GiGi hasn’t really changed. He is sill offering nostrums based on superficial diagnoses. He fails to ask the most fundamental questions–the Chesterton’s Fence questions. That is, understand why things are they way they are before proposing to change them.