Streetwise Professor

The embarrassment of this administration is ballooning, as if one could have thought that possible as bloated as it was already. Apparently in a belief that “Trump did it!” is kryptonite to any criticism, some anonymous DoD person told reporters that Chinese balloons had transited continental United States airspace on at least three occasions when the Donald the Dreaded was POTUS.

Virtually everyone in Trump’s national security upper echelons–including people who hate him, like Bolton and Esper–immediately called BS. They all said they were never informed of this. So what are the possibilities?

First, it never happened and this is just somebody making shit up to clean up after Joe. Always a real possibility.

Second, it did happen, and the balloons were detected in real time, but the DoD decided to withhold this information from the commander in chief. That would be a scandal of major proportions. And sad to say, it is believable.

Third, the administration’s elaboration: the previous balloons weren’t detected in real time, but they were uncovered after the fact by the intelligence agencies through some undisclosed means. Although all of these explanations are disturbing in their own way, this would be the worst. It would imply a gaping hole existed in US detection technology. Although the administration claims that THIS TIME they detected the balloon as soon as it passed over the Aleutians, and this suggests that the vulnerability has been addressed, we can’t be sure whether it’s just that NORAD got lucky this time.

There must be a public investigation, by Congress, to determine which of these explanations is the correct one.

With regards to the first explanation. Why did the WaPo rely on a single source for a story like this? Why won’t the Pentagon reveal who made the statement to the reporter? Note that the story–if it was true–would have involved the leak of highly classified information: a crime. If it wasn’t true, a “senior” official is spreading–wait for it–disinformation, supposedly the greatest threat to “our democracy.” Either alternative is unacceptable, and should result in the investigation, termination, and perhaps prosecution of the perpetrator. And he should be identified immediately while these steps are proceeding.

Letting the balloon traipse from Alaska to South Carolina (apparently on a tour of US nuclear facilities) is bad enough for the reasons discussed in my earlier post. But this clumsy attempt to exonerate Biden through whataboutism (“whatabout Trump!!!”) makes things even worse. It reveals the US military and Department of Defense to be incompetent, mendacious, or both.

Biden didn’t say anything either at a shout or a whisper about the balloon in his State of the Union address. He obviously wants this to go away. It can not be allowed to go away. It is a national security embarrassment of the first order, and Austin, Milley, the head of NORAD, and the head(s) of the intelligence agency or agencies that allegedly discovered previous violations of US airspace ex post facto must be hauled in front of Congress for a public grilling.

And then, perhaps, keel hauled.

The carnival of the Chinese balloon transcontinental transit is bringing musical flashbacks, such as this from 1983:

Or going even further back–deep into my childhood:

Groovy, baby.

Seriously though, I am of mixed minds regarding the decision–the Pentagon’s according to Biden–to defer destroying it until it had traversed the US from sea to shining sea. On the one hand, I can perhaps see that there is intelligence value in observing it. On the other, it makes the United States look pathetic before a strutting China.

On balance, I believe the latter consideration substantially outweighs the former. The lame excuse given for not puncturing it with extreme prejudice earlier–that its fall would endanger people on the ground–belies an intelligence collection motive: if that was the reason, just say so! At least that sounds more boss:

And what are the odds of someone on the ground being hurt in Alaska, the Yukon, or even eastern Montana FFS?

And was the benefit to us of the intelligence we collected on the balloon greater than the value of the intelligence the balloon collected on us?

And perceptions are reality. It’s not like this is a new super weapon. Pretty sure we had figured out everything it was doing and capable of doing during the time it was flying over thousands of miles of trackless waste–if we didn’t already know before it breached US airspace over the Aleutians. But the image of a spy balloon flying with impunity over the fruited plain does convey the image of a “pitiful, helpless giant” (to quote Nixon, reading what the just-retired Patrick Buchanan wrote). This is especially true given that there is a pitiful, helpless mental midget holding the position of Commander in Chief.

This reinforces the image of fecklessness that hangs around this administration like a bad smell. And fecklessness encourages recklessness. That is, we have to think about how Xi interprets this, and believe me, he’s not going to believe “we were protecting people on the ground” line for one second.

He may laugh, though.

But after he’s done laughing, he’ll incorporate what he surely perceives as an image of weakness and indecision into his calculus regarding Taiwan and other points of potential conflict.

This raises the question of motive. After all, China has supposedly reined in its “wolf warriors” and was trying to present a more conciliatory face to the US, and the world. Blinken was supposed to meet with the Chinese to help reset relations. (Nod was to remain in the White House.)

One possibility is that this was a test–would the US still proceed with a rapprochement despite a provocation (humiliation, in fact)?

Another possibility–never to be dismissed in one party (but many faction) states–is that elements in the CCP (including, perhaps, aforesaid wolf warriors) wanted to derail any rapprochement, and figured that creating an incident like this was the way to achieve that objective.

Given the opacity of the CCP/Chinese government, it’s hard to say. But under either scenario, the return message should have been: don’t fuck with us. Instead, we sent the message that we are eminently fuckable.

For their part, the Chinese lost their shit when an F-22 FINALLY took down Chairman Xi’s Amazing Flying Machine.* To which we should have replied: fuck you and the balloon you rode in on, commies. Instead, we gave a mealy mouthed, diplomatic reply.

We are in a very fraught period with China. We are trying to recover from “locust years” (as Churchill called them) of military distraction and decay and recover at least a semblance of our former naval and air dominance over China. China is ruled by a megalomaniac with ambitions to crown his achievements by retaking Taiwan. The last thing do do under those circumstances is to convey weakness. And regardless of the true justification for allowing the balloon to traipse over American unhindered, that’s exactly what happened.

The phrase “the balloon went up” means that the situation is very serious. It dates from WWI, when the appearance of a reconnaissance balloon was a harbinger of an artillery barrage incoming. Well, the balloon went up, and to my mind, was brought down far too late.

*The F-22 took down the balloon with an AIM-9X Sidewinder. A testament to how sensitive the heat seeking infrared sensor on that weapon has become. In early versions of Sidewinder it was necessary to get right on the tail of an adversary for the guidance system to be able to pick up the heat signature of the engine. To be able to take down a balloon, which has far less of a heat signature than a MiG’s exhaust, is pretty impressive.

The F-22 pilots used the call signs Frank1 and Frank2, apparently an homage to WWI “Balloon Buster” ace Frank Luke (whom Eddie Rickenbacker called the best pilot in WWI). There is some irony here, though, because it is clear that the current Pentagon leadership is shall we say slightly less aggressive than Lt. Luke.

While working for an FCM in 1987 my main job was to assist S&L and mortgage banker clients manage their interest rate risk. Along with several colleagues I attended a banker’s conference in San Francisco where the firm had a booth and hosted a reception. One of the reception attendees was an S&L president, who happened to be a big bear of a man. During the cocktail chitchat somehow military backgrounds came up, and the S&L guy mentioned he had been a Marine in the Korean War. I asked him: “Were you at Chosin?” His eyes grew wide, and he threw his arms around me in an almost suffocating hug: he was surprised, and deeply grateful, that there was anyone my age who knew of that battle. For even then Korea was known as “the Forgotten War” (indeed Clay Blair’s book by that title came out in that very year).

He then started to talk about his experience. It was sobering listening. But it was evidently cathartic for him.

I write about this today because the epic Battle of the Chosin Reservoir began on 27 November 1950. On that day, the First Marine Division, along with a combat team of the 31st Infantry (US Army), were attacked by swarms of Chinese infantry who had infiltrated south of the Yalu River in the previous weeks. The Americans had moved far north into North Korea after the smashing US victory over the Norks at Inchon, and the subsequent routing of the North Korean Army. The US commander, Douglas MacArthur, had “victory disease”: he believed that the war was all but over, and promised his troops that they would be home by Christmas.

Giddy with success, MacArthur dismissed numerous intelligence reports of Chinese troops massing north of the Yalu, and infiltrating to the south of it. His soldiers and Marines around the Chosin Reservoir paid a huge price for his arrogant indifference when hordes of Chinese attacked in the dark on the night of the 27th, blowing horns and whistles, and beating gongs. The fighting was often at close range, and very often hand to hand.

The UN forces to the west were routed by the Chinese. Their “bugout” was probably the most humiliating experience in American military history. But the troops at Chosin grimly hung on.

The Marines and soldiers straddling the Chosin Reservoir in the east of NK barely withstood the assaults, outnumbered as they were by about 6-to-1. During the day the Chinese would melt into the forests to avoid US airpower, but at night, and for many nights, they resumed their attacks. For the Americans, it was a close run thing.

The Chinese had effectively surrounded the 1st Marines and 31st RCT, and attacked the division headquarters around Hagaru-ri. In the tradition of “every Marine a rifleman,” division commander O.P. Smith armed engineers, cooks, and clerks (“titless WACs,” in the slang of the time) and sent them to the hills overlooking Hagaru-ri to beat off the Chinese attacks. It was a close run thing, but they did.

American airpower was probably the difference. Navy and Marine F4U Corsairs and AD1 Skyraiders provided close air support, napalming, strafing, and rocketing the Chinese whenever the weather allowed.

Smith realized he could not hold out forever, and had to withdraw to the coast. Hence began an anabasis in a different direction, with the Marines and the few soldiers who survived beginning an epic march from the reservoir to Hangnam. An “anabasis” is a march from the coast to the interior, and the Americans did the reverse. Apropos this, when asked about how he felt about retreating, Smith said: “Retreat hell. We’re just attacking in a different direction.”

And indeed they were. Surrounded, they had to fight their way out against a Chinese enemy bent on their utter destruction. Every mile was contested, although as a result of exhaustion and casualties the Chinese resistance ebbed as the Americans trudged south.

But the Chinese were not the American’s only enemy: the weather was too. It was bitter cold, allegedly reaching -50F when the Americans consolidated for a few days around Kot’o-ri. Even when it wasn’t that cold, it was damned cold, with periodic blizzard conditions. So cold that wounds typically froze, which sometimes saved lives.

Even though enemy resistance had devolved mainly to sniping and ambushing, rather than screaming human wave assaults, the survival of the retreating Americans remained in doubt because the Chinese had blown a bridge at Funchilin Pass. Miraculously, Air Force C-119 “Flying Boxcar” transport aircraft dropped pieces of an M-2 “Treadway” mobile bridge which the Marine and Army engineers painstakingly assembled in the brutal weather to permit the breakout to continue. It took two days for the entire column to pass the chokepoint, but they all did.

Soon afterwards, the Americans descended into the plain near the coast where they took off their coats to bask in the 32F warmth. They arrived to the safety of UN lines around Hangnam exactly 2 weeks after their ordeal had begun.

About 30,000 Americans, British, and South Koreans were involved in the battle. 18,000 were casualties, including around 2,500 dead, 5,000 wounded, 5,000 missing (disproportionately among the 31st RCT) and 7,400 non-battle casualties, mainly from frostbite. Chinese losses are unknown, but are widely estimated to number around 60,000–including Mao’s eldest son. Several Chinese corps were effectively destroyed.

The Americans brought off most of their wounded (although many wounded from the 31st RCT became POWs), and many of their dead, following the tradition of the United States Marines.

The survivors of the attack in the other direction were evacuated by sea–along with more than 10,000 North Korean refugees. Thus ended one of the most amazing feats in American military history, a true seizing of a sort of victory from the jaws of devastating defeat.

Those who survived were known as the Chosin Few. Almost all are gone now–the youngest would be around 90. I was fortunate to have met, albeit briefly, one of them. He was gratified by my remembering what he and what his comrades suffered, and what they achieved, and I write this to do what I can to keep that memory alive even though almost all of them have passed.

Semper Fi.

While writing the post on European electricity prices, I was wondering about the drivers. How much due to fuel prices? How much due to capacity constraints? Risk premia?

Spreads, specifically spark and dark spreads, are the best way to assess these issues. Spark spreads are the difference between the price of electricity and the cost of natural gas necessary to generate it. And no, dark spreads are not the odds that Europe will shiver in the dark this winter–though I’m sure that you can find a bookie that will quote that for you!: a dark spread is the difference between the price of power and the cost of coal required to generate it. In essence, spark and dark spreads tell you the gross margin of generators, and the value of generation capacity. High spreads indicate that capacity is highly utilized: low spreads that capacity constraints are not a maor issue.

Sparks and darks depend on the efficiency of generators, which can vary. Efficiency is measured by a “heat rate” which is the number of mmBTU necessary to generate a MWh of electricity. Efficiency can be converted into a percentage by dividing the BTU content of electricity (3,412,000).

Electricity is a highly “spatial” commodity, with variations across geographic locations due to the geographic distribution of generation and load, and the transmission system (and the potential for constraints thereon). Moreover, since electricity cannot be stored economically (although hydro does provide an element of storability) forward prices for delivery of power at different dates can differ dramatically.

Looking at sparks and darks in Europe reveals some very interesting patterns. For example, comparing the UK with Germany reveals that German day ahead “clean” sparks (which also adjust for carbon costs) are negative for relatively low efficiency (~45 percent) units, and modestly positive (~€35) for higher efficiency (~50 percent) generators. In contrast, UK day ahead sparks are much higher–around €200.

Another example of “identify the bottleneck.” The driver of high spot power prices in Germany is not limitations on generating capacity–it is the high fuel prices. (Presumably the lower efficiency units are offline in Germany now, as their gross margin is negative.) Conversely, generation capacity limits are evidently much more binding in the UK.

But if you look at forward prices, the story is different. Quarter ahead clean sparks in Germany are around €200, while in the UK they are over €300. Two quarter ahead (the depth of winter) are almost €600 in Germany and a mere €300 or so in the UK. (All figures for 50 percent efficiency units).

These suggests that capacity will be an issue in both countries, but especially Germany. Way to go, Germany! Relying on solar in a country with long nights ain’t looking so good, is it?

The wide sparks also undermine attempts to blame it all on Putin. Yes, high gas prices/gas scarcity courtesy of Vova is contributing to high power prices, but that’s not the entire story. Though to be fair, more gas generating capacity wouldn’t help that much if they become energy limited resources due to a lack of Russian gas.

The high forward prices may also reflect a high risk premium. My academic work from the 2000s showed that there is an “upward bias” in electricity forward prices. That is, forward prices are above–and often substantially above–expected future spot prices. My interpretation was that this reflects “spikeaphobia”: power prices can spike up, but they are supported by a floor. This means that being caught short is much riskier than being long. This creates an imbalance between long hedging (to protect against price spikes) and short hedging (to protect against price declines that are likely to be far smaller than upward spikes). This creates “hedging pressure” on the long side: if speculative capital to absorb this imbalance is constrained, this hedging pressure drives up forward prices relative to expected spot prices.

The imbalance is likely exacerbated by the fact that there are large fuel price spike risks too. Moreover, the price and liquidity risks that speculators absorbing the imbalances must shoulder is likely raising the cost of speculative capital in electricity trading, meaning that there is both a demand pull and cost push driving the risk premium. Thus, I conjecture that some portion–perhaps a hefty portion–of the large spark spreads for German and the UK is risk premium. (Back in the days I started to estimate the risk premium in the US markets in the late-90s, the risk premium was as much as 50 percent of the forward price. That decline substantially over the next decade to about 10 percent for summer peak as the electricity markets became more “financialized.” Financialization, by the way, is usually a pejorative, which drives me nuts. Financialization typically reduces the cost of hedging.).

In the aftermath of the mooting of EU proposals to intervene massively in electricity markets, especially through price controls, forward power prices have plummeted: the above figures are from before the collapse. Price controls would impact both the expected spot price and the risk premium–because they take the spikes out of the price. However, as I noted in my prior post, this is not good news: if prices cannot clear the market, rationing will.

Dark sparks also tell a fascinating story. They are HUGE. The German dark spark for 2 quarters ahead (Jan-Mar) is over €1000, and the UK dark spread is over €600. In other words, it’s good to own a coal plant! By the way, these are clean darks, so they take into account the cost of carbon. Meaning that the market is sending a signal that the value of coal generation–even taking into account carbon–is very high. This no doubt explains why despite massive green and renewable rhetoric in China, the Chinese are building coal capacity hand over fist. It also points out the insanity of European policies to eliminate coal generation. Even if you believe in the dangers of carbon, the way to deal with that is to price it, rather than to dictate generation technology.

To give some perspective, the above figures imply that a 500MW coal plant in Germany was anticipated to produce €870 million in value in 23Q3 (24 hours/day x .80 operating rate x 91 days/quarter x 500 MW x €1000/MW). That’s more than the cost of a plant. Even if you cut that in half to take into account today’s power price collapse, it’s a huge number.

Think about that for a minute.

In sum, spreads tell fascinating stories about what is happening in the European electricity market, and in particular the roles of input prices and capacity constraints and risk premia in driving the historically high prices. But perhaps the most fascinating story they tell is the high price that Europe is paying to kill coal.

The “Inflation Reduction Act” became Joe Biden’s climate and health care bill.

The narrative pivots are truly amazing to watch.

The deeper you dig into the details, the worse it looks. The supersizing of the IRS is one example. And if you believe that the massive expansion in “enforcement” (representing fully half of the $87 billion in increased expenditure) won’t be directed at schlubs like you, well, you’re a schlub and a sucker. The IRS, like federal law enforcement generally, goes after the easy targets. The people without the resources to defend themselves. And given the rampant politicization of all federal bureaucracies with any enforcement powers, if you are an easy and leveraged target. Get some money, damage the deplorables.

As to the climate aspect, it is a massive boondoggle of subsidies of inefficient technologies. We are constantly told (just read Bloomberg, if you can stomach it) that renewables are becoming so so so efficient. OK. Then why do they need massive subsidies to displace putatively inefficient fossil fuels?

And is there any evidence that our Solons have contemplated the systemic impacts of their intervention? In particular, how encouraging electrification generally, and the supply of electricity with renewables, will affect the reliability and indeed the stability of the grid? Of energy supply generally?

Or as another example, have they thought a nanosecond about the environmental and geopolitical consequences of this intervention into the extremely complex energy supply system? I’ve gone on at length before about the environmentally destructive effects of allegedly “green” policies. In a nutshell: mining ain’t green.

I’ve also discussed the geopolitical aspects, specifically the inevitable conflict over mineral resources vital for batteries and electrification generally. This conflict will be with China in particular, and will occur primarily in Africa and South America.

When I originally raised this issue, I received a lot of pushback. Whatever. Just watch. The Scramble for Africa Part Deux is already underway (with Russia as well as China contending with the US).

This benign summary of US policy towards Sub-Saharan Africa conceals more than it reveals. It acknowledges that Africa has 30 percent of the “critical minerals that power our modern world.” It says “[t]he United States will assist African countries to more transparently [sic] leverage their natural resources, including energy resources and critical minerals, for sustainable development while helping to strengthen supply chains that are diverse, open, and predictable.”

Just how is that supposed to work, exactly, in competition with the Chinese (and Russians) who are all about “assisting” rather non-transparently (through bribery and force) African nations exploit their natural resources in ways that are anything but “sustainable,” “diverse,” or “open”? (They are altogether predictable though.)

The logic is inexorable. Western nations hell-bent on the “energy transition” will increase dramatically the demand for resources in poorly governed or ungoverned regions of the world. Given that property rights in these regions are weak (and often non-existent) the competition will not be mediated through markets, but through force and fraud.

Meaning that the unintended–but inevitable–consequence of the compelled transformation of energy supply will be conflict in wretchedly poor areas that will make 19th century British and French struggles in Africa look like child’s play.

Put differently, virtue signaling policies in the West will create massive rents in countries with weak institutions that are especially prone to the most vicious forms of rent seeking. That will work out swell!

Case in point: the looming battle in the Lithium Triangle:

Similar setbacks are occurring around the so-called Lithium Triangle, which overlaps parts of Chile, Bolivia and Argentina. Production has suffered at the hands of leftist governments angling for greater control over the mineral and a bigger share of profits, as well as from environmental concerns and greater activism by local Andean communities who fear being left out while outsiders get rich.

And it’s not just lithium. It’s copper too. And rare earths, and nickel, and on and on.

In other words, we are about to witness the “resource curse” on meth. Massive rent seeking struggles in weak polities, all due to the whims of western elites in the thrall of a theory–and divorced from reality.

And for what? Even if the theory is correct, the impact of things like the “Inflation Reduction Act” on global climate will be virtually immeasurable, in the 100ths of a degree F at most, and perhaps in the 10000s of a degree.

In other words, the intended consequences of this act, and others like it, will be virtually nonexistent, while the unintended consequences will be dire. “Died of a theory” will be literally true–especially for those unfortunate enough to be living atop the resources the demand for which will be stimulated greatly by western elites mesmerized by that theory.

The optimal amount of any “bad” (e.g., crime, cancer) is very, very seldom zero.* This is because the marginal cost of reducing a harm increases (typically at an increasing, and often rapidly increasing, rate): eventually the cost of reducing the harm further exceeds the benefit, usually well before the harm is eliminated.

Unfortunately, a good fraction of the world is in the thrall of those with Zero obsessions who ignore this fundamental reality. COVID and climate are the two most telling examples.

Countries pursuing “zero COVID” strategies have subjected their citizens to draconian measures that have deprived them of the blessings of normal human interaction, and freedom of thought and movement. Children especially have been brutalized, losing two years of schooling, socialization, and even the ability to speak and understand and interpret the non-verbal due to absurd masking requirements.

This brutality has unsurprisingly reached its zenith (or nadir, if you prefer) in China, a nation of 1.3 billion governed by a despotic regime that has gone all in on Zero COVID. The outbreak of COVID in Shanghai after years of restrictions proves the futility of the objective. The CCP’s response to the proof of the futility shows its insanity.

In response to the outbreak, the regime has locked down a city of over 26 million people. And this ain’t your Aussie or Kiwi or American or Brit or Continental lockdown, boys and girls: this is a hardcore lockdown. Mandatory daily testing, with those testing positive sent right to hospital, symptomatic or no–despite the fact that this has overwhelmed the medical system and is depriving truly sick people of vital care. Children separated from parents. People locked in their abodes, often without adequate food. Pets slain.

It is draconian–and dystopian.

The other prominent example is “Net Zero” carbon emissions. This has become the idol which all the right thinking bow down before, especially in the West. Governments, financial institutions, and other businesses (especially in the energy industry) are judged based on a single criteria: do their actions contribute to achieving “net zero” emissions of greenhouse gases? And woe to those who do not pass this judgment.

It is absurd. And it is absurd because the monomaniacal focus on a single measure immediately banishes all considerations of trade-offs, of costs and benefits. The implicit belief is that the cost of carbon is infinite, and hence it is worth incurring any finite cost–no matter how huge–to achieve it.

And the costs are immense, have no doubt. In particular, the environmental costs–the production of battery metals involves massive environmental costs, for example–are huge. Yet they are ignored by people who preen over how green they are. Because to them, Only One Thing Matters.

This is beyond stupid. Those who will impose any cost, and force others to bear any burden, in order to achieve some Zero reveal that that number is a good approximation of their IQ.

Upon reflection, I believe that the worship of Zero is a mutation of the worship of central planning with dominated the pre-WWII era, and which was supposedly discredited by experience (e.g., the USSR) and intellectual argument (e.g., Hayek, von Mises). Central planning involved the determination by an elite of an objective to be achieved by a society, and the use of coercion–at whatever level necessary–to achieve that objective. Actually, compared to the Rule of the Zeroes, central planning was quite nuanced: it usually did involve some acknowledgement of trade-offs, whereas the Rule of the Zeros does not, with everything–literally everything–being subordinated to the One Zero.

But ultimately, central planning foundered on the reef of its internal contradictions. Attempting to impose a singular objective on a complex, emergent system consisting of myriad individuals pursuing their own idiosyncratic goals was doomed to failure. And it did. But only after inflicting tremendous costs in terms of human lives and human freedom, not to mention human prosperity.

The fundamental inconsistency between emergent and imposed orders meant that central planning required the application of massive coercion. The same is true in the Rule of Zeroes. This has been particularly evident in the case of COVID: what is going on in Shanghai proves this beyond cavil. But the same is inevitable for Net Zero. To impose a centrally dictated objective, and a unidimensional one to boot, on complex societies comprised of billions of individuals with extremely diverse preferences and capabilities is to wage war on human nature, and humanity. Sustaining it necessarily requires the application of massive, and massively increasing, coercion. Because it requires people to “choose” what they would not choose of their own volition.

The populism so scorned by the elite is a natural reaction to this fundamental inconsistency. Whether Le Pen prevails in France or no, the mere fact that it is a possibility reveals the seething discontent of large numbers of folks at the presumptions of their betters. And this is just the latest example of the disconnect between the Zeroes who presume rule, and those whom they presume to rule.

It is a disconnect born of a fundamental misunderstanding of the basic social reality that life involves trade-offs, and that different people value trade-offs differently. That supposedly Smart People have Zero understanding of this reality is a shocking commentary on our “progressive” age.

*Note that I do not say “is never zero.” That would be a paradox, no?

The LME restarted trading of nickel. Well, sort of. In the first five sessions prices were limit down, and trading stopped as soon as the limits were hit. The LME deemed two subsequent sessions “disrupted” and declared the trades in these sessions “null and void.”

In other words: more mulligans after the trade cancellations that followed the spike to $100K/tonne prices. The LME should change its name to the London Mulligan Exchange. Which is not a good look.

Departing LME CEO Matthew Chamberlain tried to shift blame last week, claiming that the problem was that the exchange did not have visibility into risk due to the fact that approximately 80 percent of Tsingshan’s nickel position was in the form of OTC trades with big banks, such as JP Morgan. This is weak excuse. It is highly likely that the banks hedged their Tsingshan exposure on the LME, so the exchange saw the positions, but just didn’t know for sure exactly who was behind them. But the LME has known for months (years actually) that Tsingshan was the elephant in the nickel ring, and that the banks who were short the LME were almost certainly hedging an OTC exposure. The LME should have been able to add two and two.

The price increases today and in the previous session suggest that the short covering is ongoing, and that the “I’m going to hang on to my position” rhetoric from Tsingshan, and the insinuations that the banks were allowing it to extend and pretend, are therefore not correct. It (and perhaps other shorts) are trying to reduce positions. Continued gyrations are therefore likely, and a default that would make recent “disruptions” look like child’s play is not out of the question. The fear of this is likely what is causing the LME to take actions (voiding trades) that only further blacken its already dusky reputation. To a fox caught in a trap, chewing off a leg is the best option.

If you use the official LME nickel and copper prices from Monday, before the exchange stopped trading of nickel, you can determine that the value of the metal in a US nickel coin is worth a dime. As the shutdown lingers, one wonders whether the LME is too.

The broad contours of the story are understood. A large Chinese nickel firm (Tsingshan Holdings, largest in the world) was short large amounts of LME nickel, allegedly as a hedge. But the quantity involved seems very outsized as a hedge, representing something like two years of output. And if the position was concentrated in nearby prompt dates (e.g., 3 months) it involved considerable curve risk.

The Russian invasion juiced the price of nickel, not surprising given Russia’s outsized presence in that market. That triggered a margin call (allegedly $1 billion) that the firm couldn’t meet–or chose not to. That led its brokers to try to liquidate its position in frenzied buying on Monday evening. This short covering drove the price from the close of around $48,000 to over $100,000.

That’s where things got really sick. The LME shut the nickel market. It was supposed to reopen today, but that’s been kicked down the road. But the LME didn’t stop there. It decided that these prices did not “[reflect] the the underlying physical market,” and canceled the trades. Tore them up. Poof! Gone!

Now in a Back to the Future moment echoing the 1985 Tin Crisis, the LME is trying to get the longs and shorts to set off their positions. “Can’t we all just get along?” Well likely not, because it obviously requires agreeing on a price. Which is obviously devilish hard, if not impossible given how much money changes hands with every change in price. (In my 1995 JLE paper on exchange self-regulation, I argued that exchanges historically did not want to intervene in this fashion even during obvious manipulations because of the rent seeking battles this would trigger.)

So the LME remains closed.

Some observations.

First, told ya. Seriously, in my role as Clearing Cassandra during the Frankendodd era, I said (a) clearing was not a panacea that would prevent defaults, and (b) the clearing mechanism was least reliable precisely during periods of major market stress, and that the rigid margining mechanism is what would threaten its ability to operate. That’s exactly what happened here.

Second, clearing is supposed to operate under a “loser pays/no credit” model. That’s really something of a misconception, because even though the clearinghouse does not extend credit, intermediaries (brokers/FCMs) routinely do to allow their clients to meet margin calls. But here we evidently have a situation in which the brokers (or Tsingshan’s banks) were unwilling or unable to do so, which led to the failure of the loser to pay.

Third, by closing the market, the LME is effectively extending credit (“you can pay me later”), and giving Tsingshan (and perhaps other shorts) some time to stump up some additional loans. Apparently JPM and the Chinese Construction Bank have agreed in principle to do so, but a deal has been hung up over what collateral Tsingshan will provide. So the market remains closed.

For its part, Tsingshan and its boss Xiang “Big Shot” Guangda are hanging tough. The company wants to maintain its short position. Arguably it has a strong bargaining position. To modify the old joke, if you owe the clearinghouse $1 million and can’t pay, you have a problem: if you owe the clearinghouse billions and can’t pay, the clearinghouse has a problem.

The closure of the market and the cancelation of the trades suggests that the LME has a very big problem. The exact amounts owed are unknown, but demanding all amounts owed now could well throw many brokers into default, and the kinds of numbers being discussed are as large or larger than the LME’s default fund of $1.2 billion (as of 3Q21 numbers which were the latest I could find).

So it is not implausible that a failure to intervene would have resulted in the insolvency of LME Clear.

The LME has taken a huge reputational hit. But it had to know it would when it acted as it did, implying that the alternative would have been even worse. The plausible worst alternative would have been a collapse of the clearinghouse and the exchange. Hence my quip about whether the exchange that trades nickel is worth a dime.

Among the reputational problems is the widespread belief that the Chinese-owned exchange intervened to bail out Chinese brokerage firms and a Chinese client. To be honest, this is hard to differentiate from intervening to save itself: the failure of the brokerages are exactly what would have brought the exchange into jeopardy.

I would say that one reason Xiang is hanging tough is that the CCP has his back. Not CCP as in central counterparty, but CCP as in Chinese Communist Party. That would give Tsingshan huge leverage in negotiations with banks, and the LME.

So the LME is playing extend and pretend, in the hope that it can either strongarm market participants into closing out positions, or prices return to a level that reduce shorts’ losses and therefore the amounts of variation margin they need to pay.

I seriously wonder why anyone would trade on the open LME markets (e.g., copper) for reasons other than reducing positions–and therefore reducing their exposure to LME Clear. The creditworthiness of LME Clear is obvious very dodgy, and it is potentially insolvent.

Fourth, in an echo of the first point, this episode demonstrates that central clearing, with its rigid “no credit” margining system is hostage to market prices. This is usually presented as a virtue, but when markets go wild it is a vulnerability. Which is exactly why it is–and always was–vain to rely on clearing as a bulwark against systemic risk. It is most vulnerable precisely during periods of market stress.

All commodity markets are experiencing large price movements that are creating extraordinary variation margin flows, potential positive feedbacks, and the prospect for troubles at other clearers. Further, the broader economic fallout from the Ukraine war (which includes, for example, a large recession resulting from the commodity price shocks, or a Russian debt default) has the real potential to disrupt equity and bond markets. This would put further strains on the financial markets, and the clearing system in particular. Central Banks–notably the Fed–had to supply a lot of liquidity to address shocks during the Covid Panic of March 2020. Two years later, they may have to ride to the rescue again.

In January, 1950, Secretary of State Dean Acheson gave a speech outlining the US’s security perimeter–and conspicuously excluded South Korea. Within 5 months, with Stalin’s blessing, North Korea invaded. The opening stages of the Korean War were an absolute military disaster for the US. The rest of it wasn’t great shakes.

Yesterday Biden sent a similarly equivocal signal to Putin on Ukraine, insinuating that Russia had Biden’s blessing to invade Ukraine. As long as the invasion isn’t too big! Whatever that means. The administration then attempted to clean up this shocking statement by saying that any incursion would bring a strong US response. (Cleaning up after Biden is akin to cleaning up after a Barnum and Bailey Circus parade.)

There are war hawks in the US who want to confront Russia militarily if Putin does cross the border, bigly or otherwise–as Biden arguably just invited him to do. This is absolutely insane.

Look at the “correlation of forces.” It decidedly favors Russia. This is especially true in the air, where absent Nato intervention Russia will have not just air superiority but air dominance from the get go.

Yes, the one realistic way that Nato could materially contest a Russian invasion would be by pitting its air forces against Russia’s. (It’s capability on the ground is essentially nil.) It could probably do so decisively. But for what? And assuming it did achieve control of he air, would Nato use air power against Russian ground forces? Logistic resources within Russia? If not, could they change the result on the ground, other than make Russia’s task bloodier and harder? Almost certainly not. When it becomes evident that putative control of the air would not likely change the end result on the ground absent further action, wouldn’t the inexorable logic of conflict push the US/Nato to attack Russian troops and logistics from the air?

Any of these alternatives would bring the US and Nato into direct conflict with Russia where the potential for escalation in many dimensions is high. And again, for what? What American interest (or Nato interest for that matter) is advanced by contesting Russia for Ukraine? Is there any benefit remotely worth the risk of a war, let alone one between nuclear powers that could escalate? I cannot think of any, and those advocating a military response to a Russian invasion have certainly not advanced any.

And it must be emphasized that this would be the wrong war, in the wrong place, at the wrong time. The main beneficiary of which would be China. A futile attempt to save Ukraine would expose the US and its allies to risks of bigger losses in Asia.

Ukraine’s operational situation is dire, and becoming more so. In particular, as if the overmatch wasn’t already severe enough, recent Russian movements in Belarus pose a severe threat. A movement into Ukraine from Belarus would outflank the country’s one major geographic obstacle–the Dnieper (defending which would already concede loss of a third of the country). Ukraine’s only real chance is to hold the Dnieper–and even that would probably require US/Nato involvement. An attack from Belarus would eliminate even that chance.

A Korea outcome is probably the best the US could gain. And again for what? And at what cost, in blood, treasure, and strategic compromise in other theater?

The latest brilliant idea is for Ukraine to wage a guerrilla war against Russian invaders. There are stories circulating that the CIA is helping train organize such resistance, and Canadian special forces who could also do that are in country.

Yes, it took the USSR a decade to restore full control of Ukraine after WWII. And the Russian Civil War in Ukraine was brutal and multi-sided, with Reds v. Whites v. Greens. So it is possible that a Russian occupation could be bloody and costly. Would Putin be deterred by that? Is it worth running the risk of turning Ukraine into Syria or Libya to find out? Would that be better than Russian domination of Ukraine? Yes, Putin is an autocrat, but he isn’t Hitler or Stalin, and Russia isn’t the USSR.

And again, for what?

This is a completely unforced error. Regardless of whether you think Putin is genuinely fearful of Nato incorporating Ukraine, or whether that is just a convenient excuse for him to advance his imperial project, there was never any reason to bring Ukraine into Nato and thereby increase greatly the risk of confrontation. As I’ve said before, its inclusion raises the risk of conflict and detracts from rather than adds to Nato capability.

By dangling this as a possibility, the US and Nato predictably triggered a reaction that leaves them with the unpalatable choice of fighting a war over a country that is not vital to their interests or looking feckless and duplicitous by dangling the prospect of protection and then shrinking from providing it. It also provides Putin with a pretext to challenge all of Nato’s earlier eastern expansion. This juncture would never had been reached had the US and Nato not made promises that were never in its interest to keep. But they did, and that has put them in this dilemma.

My main fear at present is that Biden (or those who are actually making the decisions) will feel compelled to be butch and commit the US to a conflict involving such a huge asymmetry between gains and losses. Hell, even “winning” would involve more loss than walking away would.

How will it play out? I don’t know. Games of chicken are always hard to predict. Especially when one of the players is politically desperate and mentally compromised. And that, alas, is fair description of the president of the US in 2022.

Kazakhstan has been rocked by days of massive unrest, including attacks on government buildings (including the presidential palace), and large numbers of killed among both security forces and civilians.

The supposed catalyst for the uprising was a rise in liquid petroleum gas (LPG) prices–LPG being a fuel widely used for cooking, heating, and transportation.

This is plausible. Authoritarian regimes can persist despite a deeply unhappy populace because of coordination problems, exacerbated by preference falsification. A rise in the price of food and fuel hits the entire population, and can serve as a focal point on which masses can rally in coordinated opposition. Many rebellions and revolutions start for such reasons, but once they start they are difficult to contain even if the government reverses the initial catalyst, as Kazakh president Tokayev did with LPG. The opposition has coalesced. People know that many share their broader disgust with the rulers. And their is courage in numbers. So even though the spark has been extinguished, the fire can continue to burn.

But I suspect there is more to it than that. Intra-elite conflict is also likely an important driver. Tokayev had succeeded Nazarbayev, but the latter remained powerful, chairing the Security Council. Shortly after fighting erupted Tokayev fired Nazarbayev. Shortly after that, Nazarbayev and his family fled the country. Tokayev also restored the name of the capital (Astana) in lieu of Nur-Sultan (which was an homage to Nazarbayev). It is therefore likely that a conflict between factions is the real underlying cause of the uprising.

One striking thing is that the oppositionists appear to be fairly heavily armed. That would make sense if many of them are effectively militias for one of the elite factions.

Russia, using the beard of the Collective Security Treaty Organization (a poor simulacrum of the USSR), has intervened, sending paratroops to assist Tokayev in crushing the revolt. Apparently ground troops are also massing at the border, and units from the Far East are also being mobilized.

The speed with which Russia reacted is intriguing. It suggests considerable foreknowledge. Perhaps they had good intelligence, could see what was developing in the country, and were ready to act lickety-split if things went pear shaped–as they did.

Or perhaps the Russians knew because they were behind it. They have exploited unrest in Belarus to bring that country largely under Russian control. They are likely to do the same here. It wouldn’t be the first time a country stoked a revolution in another in order to provide a pretext to move in.

But regardless of whether gaining greater control over Khazakstan by intervening to stamp out a rebellion they stoked is part of a plan, or the uprising merely presents an opportunity to do so, there is little doubt that this will be yet another step in Putin’s ambition to put the band (i.e., the USSR) back together.

And Putin does believe he’s on a mission from God.

That’s the goal, surely. But it is easier said than done. Kazakhstan is an immense country. In point of comparison, it four times the size of Afghanistan. Unrest has already spread to all major cities. Yes, it looks like the capital of Astana (at least the government areas) is back under control, but securing many far flung cities and maintaining lines of communication would require far more troops than Russia has. (Recall how quickly it secured Kabul in 1979. Recall how securing Kabul did not translate to controlling the country.) And securing the countryside–forget about it.

Indeed, the immensity of the task is one reason to believe Russia did not foment the uprising, but is instead extemporizing.

Further, this presents a great opportunity for the United States to wage asymmetric warfare against Russia. You know that will be alleged–hell, the government has already blamed it on foreigners. In this case, it is likely to be true. Which will increase the cost of Russian intervention.

Another couple of points. First, although Russia has garnered all the attention, the elephant in the room is China. China borders Kazakhstan. Crucially, Xinjiang borders Kazakhstan, and China is neuralgic about that Muslim province. Moreover, China has extensive economic interests in Kazakhstan. Even though Putin and Xi have been lovey-dovey of late, that’s only been where their interests aligned. There is some alignment of interests in Kazakhstan–neither wants to see it descend into chaos or worse yet assert its independence–but Xi also has no interest in seeing Russia become dominant there and muscle out China. Russia attempting to dominate Kazakhstan will create friction in China.

Second, Ukraine may catch a break for once. The paratroops that Putin dispatched to Astana would be the spearhead of any invasion of Ukraine. Moreover, Russian military capacity (manpower, logistics) is likely insufficient to execute two large operations over such vast spaces (and on two different axes to boot). As noted above, Kazakhstan’s vastness can easily gobble up large numbers. If the Russian involvement in Kazakhstan proves more than fleeting, and especially if it absorbs tens of thousands of troops (not to mention the logistical resources necessary to operate in such a huge country), its ability to attack Ukraine will be reduced commensurately.

Sometimes revolutionary fervor dies out almost as quickly as it starts. But sometimes it doesn’t. Geography alone makes crushing the revolution difficult. And those difficulties may make Kazakhstan Putin’s Ulcer.