Streetwise Professor

After languishing in the doldrums in the Covid era, and at times touching historic lows, the price of LNG delivered to Asia skyrocketed in recent weeks before plunging almost as precipitously:

As always happens with such big price moves, there has been an effort to round up suspects. Here, since the visible price increase occurred in the spot market, the leading culprit is the spot market–something that has been growing rapidly in recent years, after being largely non-existent prior to 2014 or so.

For example, Reuters’ Clyde Russell writes:

What is more likely is that some buyers misjudged the availability of spot cargoes, and when hit with a surge in demand found themselves unable to secure further supply, thus bidding up the prices massively for the few cargoes still available.

Frank Harris of Wood Mackenzie opines:

“Buyers are going to become aware that you may not always be physically able to source a cargo in the spot market regardless of price,” Mr Harris says. “The most likely outcome is it shatters some of the complacency that’s crept into the market over the last 12-18 months.”

It is incorrect to say that a shortage of spot cargoes per se is responsible for the price spike registered in the spot market. It is the supply of LNG in toto, relative to massive increase in demand due to frigid weather, that caused the price increase. How that supply was divided between spot and non-spot trades is a secondary issue, if that.

The total supply of LNG, and the spatial distribution of that supply, was largely fixed when the cold snap unexpectedly hit. So in the very short run relevant here (days or weeks), supply in Asia was extremely inelastic, and a demand increase would inevitably cause the value of the marginal molecule to rise dramatically. Price is determined at the margin, and the price of the marginal molecule would be determined in the spot market regardless of the fraction of supply traded in that market. Furthermore, the price of that marginal molecule would likely be the same regardless of whether 5 percent or 95 percent of volume traded spot.

If anything, the growing prevalence of spot contracting in recent years mitigated the magnitude of the price spike. Traditional long term contracts, especially those with destination clauses, limited the ability to reallocate supplies efficiently to meet regional demand shocks. The more LNG effectively unavailable to be reallocated to the buyers that experienced the biggest demand shocks, the less elastic supply in the spot market, and the bigger the price increase that occurs in response to a given demand shock. That is, having less gas contractually committed, especially under contracts that limited the ability of the buyers to sell on to those who value it more highly, mitigates price spikes.

That said, the fundamental factors that limit the total availability of physical gas, and constrain the ability to move it from low demand locations to high demand locations in the short time frames necessary to meet weather-driven demand changes (ships can’t magically and instantaneously move from the Atlantic Basin to the Far East), mean that regardless of the mix of spot vs. contract gas prices would have spiked.

Some have suggested that the price spike will lead to less spot contracting. Clyde Russell again:

The question is whether utilities, such as Japan’s JERA, continue with their long-term vision of moving more toward a spot and short-term market, or whether the old security blanket of oil-linked, but guaranteed, supplies regains some popularity.

It’s likely LNG buyers don’t want a repeat of the recent extreme volatility, but perhaps they also don’t want to return to the restrictive crude-linked contracts that largely favoured producers by guaranteeing volumes at relatively high prices.

The compromise may be the increasing popularity of short-term, flexible contracts, which can vary from a few months to a few years and be priced against different benchmarks.

Well, maybe, but color me skeptical. For one thing, contracts require a buyer and a seller. Yes, buyers who didn’t have long term contracts probably regretted paying high spot prices–but the sellers with uncommitted volumes really liked it. The spike may increase the appetite for buyers to enter long term contracts, but decrease the appetite of sellers to enter them. It’s not obvious how this will play out.

I note that the situation was reversed in 2020–buyers regretted long term contracts, but sellers were glad to have them. Ex post regret is likely to be experienced with equal frequency by buyers and sellers, so it’s hard to see how that tips contracting one way or the other.

This conjecture about the price spike leading to more long term contracting also presupposes that the only way of managing price risks is through fixed price contracts (or oil-indexed) contracts for physical supply. But that’s not true. Derivatives allow the separation of who bears price risk from the physical contracting decision. A firm buying spot (and who is hence short LNG) can hedge price risk by purchasing JKM swaps. This has the additional advantage of allowing the adjustment of the size of the hedge in response to more timely information regarding likely quantity requirements, price projections, and risk appetite than is possible with a long term contract. That is, derivatives permit unbundling of price risk from obtaining physical supplies, whereas long term contracts bundle those to a considerable degree. Moreover, derivatives plus short term/spot acquisition of physical supplies allows more flexible management of supply, and management of supply based on shorter term forecasts of need: these shorter term forecasts are inherently more accurate than forecasts over contracting horizons of years or even decades.

So rather than lead to more long term contracts, I predict that this recent price spike is more likely provide a fillip to the LNG derivatives market. Derivatives are a more flexible and cheaper way to manage price risk than long term contracts.

This is what happened in the pipe gas market in the US post-deregulation. Spot/short term volumes grew dramatically even though price spikes were a regular feature of the market: market participants used gas futures and swaps and options to manage these price risks, and benefited from the greater flexibility and precision of obtaining supplies on a shorter term basis. This shifted a lot of the price risk to the financial sector–which is the great benefit of the much bewailed “financialization” of commodity markets.

The same is likely to occur in LNG.

In what perhaps may become a new feature, in response to a Twitter request by @Esq_SD, here are my thoughts regarding (a) the new Woodward book, and (b) the Israel-UAE (and now Israel-UAE-Bahrain) peace deals.

With respect to the Woodward book, I wouldn’t read his has-been droning on a dare, a bet, or for a date with Gisele Bündchen. So all I can do is respond to the alleged bombshell in the book, namely that “Trump lied [about COVID] and people died!”:

“To be honest with you…I wanted to always play it down. I still want to play it down, because I don’t want to create a panic.”

This is a completely defensible, and indeed laudable, course to take. Panic makes bad situations worse. Panic kills. Always.

Historically, those in authority who have panicked, or more importantly through intemperate word or deed, caused those who they led or governed or ruled to panic, have created disaster. Those who contributed to maintaining calm even in dire straits have often proven instrumental in overcoming those circumstances.

I’m so old that I can remember being taught in school about a president who said “the only thing we have to fear, is fear itself”–and that he was admired for saying so.

But now, that president’s political heirs are saying in effect “the only thing we have to sell is fear.”

I am reminded of the first lines of Kipling’s If:

If you can keep your head when all about you   
    Are losing theirs and blaming it on you,

Kipling thought this was admirable. It’s now apparently worthy of contempt.

And ain’t it an accurate description of the situation Trump faces?

My criticism–more of a lament, actually–is that Trump did not succeed in stemming panic. Even before Trump spoke to Woodward on 19 March, I had started to call the policy response to COVID-19 a “panicdemic.”

And it only got worse from there. And in certain quarters, the panic continues unabated. This is particularly appalling, given that perhaps, given the ignorance of the early days, there were grounds for fear in March. But given all of the evidence amassed in the past six months, it is now beyond obvious that those fears were vastly overblown.

Yet the fear mongers keep mongering. Just look at the UK, where BoJo (whose erratic behavior makes Trump look like Seneca the Younger) has clamped down again. Or Victoria, in Australia (I’m being specific as an acknowledgement to Ex-Global Super-Regulator on Lunch Break’s admonition that there is more to Australia than Melbourne), or New Zealand, both of which have adopted the insane eliminate-the-virus strategy

The panicked policy responses have wreaked havoc, and inflicted far more damage than the virus itself. So would that Trump’s efforts to tamp down the panic been far more successful. But I certainly will not join the baying chorus attacking him for going against character, and choosing understatement over hyperbole.

As for the Mideast peace deals. What? You haven’t heard about them? Well, that’s understandable, because the media has been speaking sotto voce on the subject. And that tells you just how epochal the deals are.

They obviously can’t say the deals are a bad thing. They clearly are a good thing, but they can’t say that, because that would be a boon for Trump, and we can’t have that, can we? Especially with an election in 7 weeks. So the media silence (and the silence of the Democrats) is as ringing an endorsement as one could imagine.

You can bet your bottom dollar that if Obama had shepherded such a deal to completion, the media would be singing his praises from the rooftops. (As if Obama ever could have achieved this, given his inveterate hostility to Israel and his obsession in consummating a deal with Iran.) But since Trump’s fingerprints are on it, the most substantive diplomatic realignment in the Middle East in decades is all but ignored.

As is the deal in another allegedly intractable conflict, between Kosovo and Serbia. Richard Grenell’s scathing takedown of the press for its indifference to and palpable ignorance of the the importance of the rapprochement was fully justified. (Ironically, Grenell would check various intersectional boxes, but one box that he checks–Trump Republican–puts him beyond the pale of the pale.)

These two achievements also give the lie to the oft-repeated slander that the Trump administration is isolationist, withdrawing America from the world, and in particular, abandoning the Middle East.

Letting Syria go to shit–stay shit would be more accurate–is not abandoning the Middle East. It is prudent to avoid getting involved in . . . what’s the word that Democrats always used to throw around? . . . ah . . . quagmires, that’s it. Drawing down in Iraq–after largely vanquishing ISIS–is prudent. Economy of force and concentration on strategic priorities is prudent: getting involved and staying involved everywhere is strategic idiocy.

It is particularly ironic that Trump has been routinely savaged as a war monger, yet he–in the teeth of furious opposition from the Pentagon and the State Department apparatchiks other elements of the Deep State–has steadfastly–and patiently–whittled away at American military presence in fruitless conflicts, and used diplomacy to advance American interests and reduce conflicts, thereby avoiding additional military commitments.

We are well into a new era of great power rivalry, specifically with China. Prudent strategy focuses on those arguably existential conflicts, and avoids peripheral ones, or attempts to mitigate them through diplomacy. The peace deals, the drawdowns in Iraq and Afghanistan, and the waging of asymmetric conflict against China (cf., TikTok, Huawei, visas to Chinese students, prosecuting academics who whore for China) are all elements of such a prudent and foresightful strategy. Trump’s adoption thereof is more likely instinctual than intellectual, but his instincts are correct and he has had the fortitude to pursue them despite the inveterate opposition of the idiots in the Establishment. These policies do not represent an abandonment of American influence, but a concentration on The Objective.

Clauswitz–and Sun Tzu–would understand, even if the DC Mandarins are clueless.

The Marine Corps credo is that every Marine is a rifleman. This credo reflects, and is reflected in, the Corps’ history of and excellence at close combat. From Belleau Wood to Guadalcanal to Tarawa to New Georgia to Peleliu to the Marianas to Iwo Jima to Okinawa to Inchon/Seoul to Chosin to I Corps (in Vietnam) to Kuwait and to Iraq and Afghanistan, the Marines have closed aggressively with the enemy and killed them, often at very high cost to themselves. Aggressive close quarter combat has been the Marine way of war for more than a century, and they think (with reason) that they do it better than anybody, ever.

The new commandant of the Marine Corps, General David Berger, has announced a radical new vision that is diametrically opposed to this historical tradition. Rather than close and kill, General Berger aims to reshape the force in order to permit it to operate in enemy held regions, and attrite the enemy’s air and naval forces with fires, primarily anti-ship and anti-aircraft missiles.

And for enemy number one, read “China.” Enemy number two? There is no enemy number two. This is all about China, and the South China Sea.

This would involve a dramatic change in Marine force structure. Fewer infantry battalions. Less tube artillery–but more missiles. No tanks. Zip. Zero. Nada.

Somewhat unaddressed in Berger’s vision document is how the “small Marine forces” that he envisions will “deploy” to islands “in close and confined seas in defiance of adversary long-range precision ‘stand-off capabilities.’” Presumably they will have to fight their way in–just like they did across the Pacific 1942-1945. How this is to be done remains very unclear, especially if close combat capability is reduced.

One of the most striking things about this document is the laser-like focus on China. In some respects, this is encouraging, because China is and will remain the primary threat to the US and US interests. And the Chinese anti-access/area denial plan of creating strategic depth by contesting a ring of island defenses (and indeed, even building the islands) bristling with missiles does require a major shift in US doctrine in response.

The document also demonstrates an admirable appreciation of the complementarity between air and naval forces, especially in the vast Pacific theater. Berger’s vision clearly entails close cooperation between the Navy and Marines to fight and dominate a powerful enemy in the western Pacific.

But one thing that history has demonstrated is that you often don’t get the war you plan for–in part because that’s not the war your enemy wants to fight precisely because that’s what you want him to do. Having a force specialized to execute a single operational concept provides little capability to fight other kinds of wars. And one thing that has helped the Marines survive the budget wars of the 20th and 21st centuries is its demonstrated flexibility in carrying out myriad different missions, from fighting furtive guerrillas in Central American jungles to digging out entrenched Japanese on Pacific islands to making hell-for-leather armor and infantry attacks across desert landscapes in the Middle East. Berger’s proposed force will not be able to perform such varied missions, or at least will have far less capability to do so. Is this a wise choice? Tough call.

One challenge Berger will face is in DC. I seriously doubt the appetite of the Pentagon, or especially the Congress, to embrace and fund such a dramatic transformation.

Another challenge will be from the Corps itself. This proposal is at odds with Marine tradition and self-image and culture. Closing with the enemy and killing him is what Marines do. More importantly, it’s what they believe they do better than anyone in the world, or anyone in history, for that matter. Remaking Marines from riflemen into missileers involves more than swapping out old weapons for new, or writing new operational manuals. It involves inculcating a whole new mindset. This is difficult to do in any organization, but is particularly difficult in one with such a deep commitment to and a well-justified pride in a traditional way of waging war.

Ex-Global Super-Regulator on Lunch Break asked me to opine on the relief of Captain Crozier from command of the USS Theodore Roosevelt, CVN-71. At present, I don’t have the information to make a firm judgment one way or the other. Depending on circumstances that I (and anyone else not in the Department of the Navy or Captain Crozier himself) cannot observe, I can see things going either way. (And I note, that even if I was a principal, the lessons of Rashomon should be kept in mind.)

Based on what is in the public record, the presumption must be that Captain Crozier’s actions in either leaking his letter, or disseminating it in a way that was almost certain to result in its leaking, were highly irregular, and prejudicial to good order and discipline.

But this is a rebuttable presumption. The problem is that the public does not have the information to rebut it, or to not do so. I can imagine realistic scenarios that cut either way.

I can imagine a scenario in which Captain Crozier had reasonable grounds to believe that the Navy Department (and the Pentagon generally) was insufficiently sensitive to the acute situation on the Roosevelt, and felt compelled to take extraordinary actions in order to make them aware. Bureaucracies frequently prefer to suppress information (cf. the CCP), or are so used to operating according to routine that they are incapable of handling the non-routine.

That said, if that was Captain Crozier’s belief, he should have resigned his command (and his commission) and stated forthrightly the reasons for doing so. Engineering a leak is unmilitary, and reeks of political calculation. I understand that is the way that DC plays the game, but that doesn’t make it honorable to play by corrupt rules.

I can also envision a scenario in which Captain Crozier’s understandable focus on his ship and his crew blinded him to measures that his superiors were taking to balance the interests of the crew and operational and strategic interests of the United States.

It is legendary that the first question that presidents ask during an international crisis is: “Where are the carriers?” They are the primary and most rapidly deployable asset in such crises. Making one unoperational is a weighty decision with major consequences, especially in fraught times: note China’s aggressiveness in the South China Sea at the very moment the world is gripped with the coronavirus panic.

Indeed, Captain Crozier alluded to this when he said in his letter that: “If required the USS Theodore Roosevelt would embark all assigned Sailors, set sail, and be ready to fight and beat any adversary that dares challenge the US or our allies.” If only it were that easy. It has taken days to disembark the crew and accommodate them in Guam. It would take that many days, or more, to reembark them and make the ship operational. Remember Kipling’s “unforgiving minute”? Patton did–and rightfully castigated his superiors for failing to do so.

Capt. Crozier then went on to say that conditions on the ship conflicted with CDC guidelines. But CDC (civilian) guidelines are created to address different situations with different trade-offs than the military must deal with.

And that is the fundamental tension (i.e., trade-off) here. Operational availability of one of the US’s most important military assets and a health risk to its crew. Captain Crozier understandably emphasized the latter. His superiors had to give much more weight to the former than did the Captain.

We don’t know what measures the Navy Department/Pentagon were taking to try to balance these very difficult considerations. Absent such information, I for one reserve judgment.

This episode implicates larger issues that I have mentioned several times.

The first is the shocking lack of data upon which decision makers have to act. What is the real health risk to the crew (which consists primarily of young, healthy individuals)? We don’t know. Why are we ignorant? In large part because of a failure to implement a random testing regime (which I outlined weeks ago) that would produce more reliable information. It is appalling that months after the risks began to crystalize that we still have to rely on data plagued with severe biases inherent in the method of collecting them.

The second is the grim calculus of trade-offs, never mind whether we have the information to make informed trade-offs. Of course we want to save lives–but not at infinite cost. To reprise a previous post, we don’t want to destroy the country to save it.

This is a grim calculus that wartime militaries must always face. They say there are no atheists in foxholes–but at the same time, there have to be utilitarians in headquarters.

Mind you that I do not write as someone who reflexively defers to command authority. The fact I chose not to remain in the Navy is the chief exhibit in that case: as I often say (including under oath in depositions) I left Navy because that’s where I learned I have issues with authority. Further, when a plebe at Navy, my final essay in the leadership course argued that disobedience of orders was justified in some circumstances: this did not go over well! (Which was a big part of my practical education that informed my decision to leave.) So I totally get that Captain Crozier may well be in the right. But I also get that he might not be. But what I get most is that I don’t know–nor do you–whether he is or not.

There is an ongoing outbreak of Covid-19 on the Nimitz class carrier, USS Roosevelt. The outbreak is severe, and today the CO, Capt. Brett Crozier, wrote an impassioned letter requesting onshore quarantine of the entire crew.

The first criticism that Captain Crozier raises is “Inappropriate focus on testing.” Crozier objects that tests provide little information: given the close proximity of those on board, they have presumptively been exposed, and should be isolated. Further, Crozier quantifies a relatively high rate of false negatives.

The captain is certainly correct regarding what is his primary responsibility–his ship and crew. But testing on the Roosevelt could provide invaluable information that could lead to far better policies in the United States, and the world at large. From a larger perspective, the opportunity for testing on the Roosevelt is something that cannot be allowed to slip away.

As I have noted repeatedly here, and on Twitter, policy is currently based on incredibly flawed data. In fact, the most useful piece of data is from a cruise ship Diamond Princess. The Roosevelt could provide a far bigger sample, and one that contains valuable information about the impact on non-elderly, relatively healthy individuals.

Even one of the things that Captain Crozier objects to–the presence of false negatives–is important. Quantifying that rate can provide information that greatly improves the inferences that can be drawn from other samples (apropos my earlier Bayes Rule post).

I understand that there are myriad competing considerations here. The health of the crew. The operational readiness of one of the most important combatants in the US Navy. Operational safety–e.g., who is going to operate the reactors and ensure that other systems are maintained properly even if the ship is not deployed? (You don’t leave a CVN parked in the driveway for a few weeks.)

Among those competing considerations, from Captain Crozier’s perspective, testing is indeed a near irrelevance. But it is extremely relevant for informing how we deal with the crisis around the world. The social value of this data is great indeed. I hope that those in the Pentagon, and in the administration, find a way to address Captain Crozier’s concerns while at the same time seizing on this opportunity to generate data that could save thousands of lives and trillions of dollars.

Coda: Another benefit here is that by the nature of the military, there would be excellent data at hand on virtually any interesting covariate you can think of–age, health conditions, socioeconomic background, etc. Combining BUPERS data with testing and clinical data from CVN-71 could provide a plethora of actionable insights.

I’ve expressed considerable skepticism about relying on test data to craft COVID-19 (AKA CCPVID-19) policy responses. This note formalizes the basis for my skepticism. Testing data would provide an accurate measure of the prevalence of severe infection if (a) the tests had low rates of false positives and false negatives, and (b) testing was random. Neither condition is remotely correct. Meaning that the test-based statistics are an extremely poor guide for policymakers, and a particularly dubious basis for driving the world economy into a depression, at the cost of trillions of dollars.

So what should we look at? If this is a particularly prevalent, virulent, and deadly respiratory disease, it will result in elevated levels of hospital admissions or physician visits for respiratory illness, and elevated levels of death from respiratory causes. That’s what we should be looking at. Or more to the point, what policymakers should be looking at. Is this a particularly deadly and widespread disease? If it is, it will have measurable effects on mortality and hospital admissions.

The CDC does collect data on influenza. Unfortunately, many of the statistics condition on a positive influenza test. For example, hospital admissions with a positive influenza test. That is not helpful, because we are focused on something other than the influenzas the CDC tracks. But the CDC does report deaths from influenza and pneumonia. That is more useful, as a deadly new respiratory illness should lead to higher pneumonia death rates.

Through last week, these data demonstrate little elevation on a national or regional basis. There was a spike in deaths above the “threshold” level early in 2020 (where the threshold basically is at the 5 percent significance level above the seasonally adjusted baseline), but subsequently it converged almost back to the baseline:

It is particularly interesting to compare 2019-20 with 2017-18. Heretofore, 2019-20 compares very favorably to that year, and even to less extreme years 2016-17 and 2018-19. Through now, in other words, 2019-20 does not look at all unusual.

The CDC also tracks data on those seeking medical treatment for flu-like symptoms: these data do not require a positive influenza test, and thus should reflect people suffering flu-like symptoms caused by something other than the flu. These data show somewhat higher levels for 2019-20 compared to previous years (except for 2017-18, which was much higher), but not extremely so. The main worrying aspect to the 2019-20 data is that they do not appear to be declining as rapidly with the approach of spring as in prior years. But the data do not exhibit a huge spike–they are just declining less rapidly than in prior years.

Yes, these data are backwards looking. I can imagine scenarios, such as the late introduction of CCPVID-19 into the US, which would mean that the wave of deaths/illness would not be manifest in the data, as it is still to come. But there are indications that the virus has been on the loose in the US at least since mid-January, and given its existence in China no later than mid-November, it could have been present in the US prior to mid-January. If it is indeed highly contagious and deadly, it should be leaving tracks in the mortality data.

It would be highly informative to have such data for other countries. I am not aware of it in as accessible a form as is provided by the CDC. If anyone can point me to it, that would be greatly appreciated.

You might argue that I am whistling past the graveyard. All I can say is that the data that alarmists point to is highly unreliable (and inherently so), and the reliable data as of yet demonstrate nothing out of the ordinary on the dimension that really matters–people dying from respiratory ailments.

What I can say with considerable confidence is that policymaking is driven by flawed data, and that there are types of data that would be more informative, and which are not infected by (deliberate choice of words) the problems inherent in the flawed data that dominates public discourse, and apparently dominates public policymaking. Produce that data. Disseminate that data. Make sure policymakers are aware of it, and are aware of the deficiencies of the data we hear about 24/7.

In 1968, journalist Peter Arnett claimed that a U.S. major had told him that a particular village in Vietnam, Ben Tre, had to be extirpated: “It became necessary to destroy the town to save it” (from the Vietcong), sayeth the major (according to Arnett). This has entered American discourse as “we had to destroy the village to save it.”

That phrase came to mind when contemplating the havoc wreaked by the CCP Virus. Europe is shutting down, country by country. Parts of the US have shut down. Others are on the verge of shutting down. The economic carnage is immense. Governments talk of spending trillions of dollars in various forms of relief: the loss of output/income will probably be measured in trillions.

Contra Hayek, it is the curious task of an economist to ask whether it’s worth it. That is, economics is predicated on the concept of scarcity, which in turn implies that every choice involves a trade-off. You want more of a good–or in the present instance, less of a bad–you have to give up something.

What price are you willing to pay? How much is saving 1000 lives worth? 10,000?

Orders of magnitude. Let’s say that shutting down the US economy through radical social distancing, quarantines, etc., saves 1000 lives, and costs $1 trillion. That works out to $1 billion per life. Moreover, the lives saved are most likely aged, infirm, sick individuals with short life expectancies and poor life quality.

Is that a price you are willing to pay? There is no right answer: the answer is subjective. Your answer may differ from mine. But when making decisions, it is a question we have to answer.

Increase the death toll by 10, and you are still at $100 million/life. This is far beyond any value of life estimate used in other regulatory and policy decisions.

If the cost of an economic shutdown is $1 trillion, you would have to save on the order of 100,000 lives to approximate the value of a statistical life (around $10 million) the US government uses for other policy making purposes.

I know that most people recoil at such calculations. The idea of valuing lives in dollars violates most people’s moral intuitions.

So let’s focus on lives. A major recession–or depression, which is not inconceivable–costs lives. Suicide rates go up. Substance abuse goes up, which costs lives in the near term (overdoses, fatal vehicle accidents) and the long term (substance abuse shortens lives). Stress-related fatalities (heart attack, stroke) go up. Murder rates go up. Consumption of health care declines, leading to premature deaths.

And then we can start talking about quality of life.

Pretty soon it adds up. We are not just evaluating the trade-off of lives for money. We are evaluating the trade-off of lives for lives.

That is, always remember Bastiat: think of the unseen. There is an unseen public health cost associated with major economic dislocation. That unseen cost has to be weighed against the cost that is right in front of our faces at present, i.e., the death toll from CPCV-19/20.

It is of course difficult to estimate, or even approximate, the various costs. Our radical ignorance about the virus makes it difficult to assess what the death toll would be under various policies. Similarly, we are operating in completely unexplored territory in trying to estimate the economic cost, let alone the health cost, of more or less draconian restrictions on our lives and movement.

But we have to at least confront the trade-off. Acknowledge it. Grapple with it. My strong sense is that the monomaniacal focus on controlling spread of the virus, the costs be damned, is operating according to the logic of destroying society in order to save it. That logic was absurd in 1968. It is absurd in 2020.

One of the refrains we’ve heard repeatedly during the Panicdemic (which is arguably worse than the pandemic) is: “We Need More Tests! We Need More Tests!”

There is a Chicken Little vibe to these calls for testing. A sense that people are running around like the sky is falling, and not thinking through the right testing strategy.

What are tests for? One is for diagnostic purposes in specific cases. To be frank, the value of such tests is minimal. There is no unique therapy for acute Wuhan Virus sufferers. The protocol is to treat the symptoms of acute respiratory distress the same way as one would treat such distress from other causes. So knowing that someone’s acute distress is caused by agent X as opposed to agent Y is of limited therapeutic value.

Insofar as identifying someone expressing symptoms would help identify others so exposed, a much more efficient strategy is to presume that the symptomatic individual is suffering from WV, track his/her contacts, and monitor and quarantine said individuals accordingly. Yes, there will be Type I (false positive) errors, but the cost of such errors is likely to be relatively small if an individual is suffering from an acute condition, regardless of the exact pathogen that caused it. That pathogen is obviously capable of causing severe problems, so why not isolate those exposed to it, even if you don’t know exactly what it is?

Another purpose of testing is to collect information about the prevalence, virulence, contagiousness, and fatality of the disease. Such information can be used to optimize the policy response.

Testing those who are symptomatic and/or have been exposed is exactly the wrong way to go about that. Such a testing strategy is rife with sample selection bias.

For weeks (mainly on Twitter) I advocated construction of a random panel data set. Select people at random. Test them, and test them at regular intervals–including those who tested negative. This would provide an unbiased sample that would permit more reasoned assessments and judgments about the nature of the pathogen. We could see how many people had contracted the virus, how many people they infected, the mortality rate (and how the mortality rate varied with age, health status, etc.), and the trajectory of the virus.

If that had been done, say, in January when shit started to get real in China, perhaps we could have been able to condition policy on better information. (Not to mention if the CCP had done that in, say, December, when it knew it had a problem on its hands–but decided to suppress information rather than suppress the pathogen.)

Why didn’t our Technocrats figure this out? Yeah. We should put more of our lives in their hands.

But that opportunity to get unbiased data has passed. Now we are forced to respond based on the most sketchy and biased data. Chicken Little proposals about testing will generate . . . more biased data. Which is arguably worse than useless.

What a helluva few weeks it’s been, eh boys and girls? By way of post mortem (hopefully?) rather than prediction, here’s my take.

Under “normal” circumstances, two factors drive asset valuations: expectations of cash flows, and the rate at which investors discount those cash flows. COVID-19–Wuhan Virus, to call it by its proper name–has has profound influence on both.

WV has caused a major aggregate supply shock, and an aggregate demand shock, and these amplify one another. The aggregate supply shock stems from shutdown of productive capacity due to social distancing. And people who aren’t working aren’t earning and aren’t spending, hence the aggregate demand shock.

These developments obviously reduce the income streams from assets (e.g., corporate profits). That’s a negative for stocks.

As an aside, these factors defy traditional policy prescriptions. Monetary and fiscal policy are focused on addressing aggregate demand deficiencies, i.e., trying to move demand-deficient economies (where demand deficiencies arise from price rigidity and nominal shocks) back to the production possibilities frontier. Supply shocks shrink the PPF. Pushing the PPF back to its normal state in current circumstances is a function of public health policy, and even that is likely to be problematic given the huge uncertainties (that I discuss below) and the dubious competence of government authorities (which I discussed last week).

The pandemic nature of WV also makes it the systematic shock par excellence. It hits everyone and every asset class, and cannot be diversified away. A big increase in systematic risk results in a big increase in risk premia, meaning that the already depressed expected cash flows on risky assets get discounted at a higher rate, leading to lower valuations.

A lot higher rate, evidently. Why? Most likely because of the extreme uncertainty about the virus. Data on how infectious it is, how many people have been infected, the fatality rate, how it will be affected by warmer weather, etc., are extremely unreliable. In other words, we know almost nothing about the salient considerations.

This is in part due to lack of testing, and to inherent defects in the testing: those who get tested are disproportionately likely to be symptomatic, exposed, or hypochondriacal, leading to extreme sample selection biases. The tests are apparently unreliable, with high rates of false positives and false negatives. The RNA tests cannot detect past infections. It is in part due to the novelty of the virus. Is it like influenza, and will hence burn out when temperatures warm? Or not?

Another major source of uncertainty is due to the fact that the initial outbreak in China was covered up by the evil CCP regime. (Which now, in an Orwellian twistedness that only totalitarian regimes can muster, is boasting that it will save the world. And which is blaming the United States for its own abject failures. Which is why I insist on calling it the Wuhan Virus–so go ahead, call me a racist. IDGAF.) Thus, data from Ground Zero is lacking, or wildly unreliable. (Ground One–Iran–is equally duplicitous, and equally malign.)

This huge uncertainty regarding a major systematic factor leads to even greater discount rates–and hence to lower stock prices.

And then there is the truly disturbing factor. These textbook causal channels (lower expected cash flows, higher discount rates) have in turn caused changes in asset prices that force portfolio adjustments that move us into the realm of positive feedback mechanisms (which usually have negative effects!) and non-linearities. This represents a shift from “normal” times to decidedly abnormal ones.

When some investors engage in leveraged trading strategies, big price moves can force them to unwind/liquidate these strategies because they can no longer fund their large losses. These unwinds move asset prices yet more (as those who placed a lower valuation on these assets must absorb them from the levered, high-value owners who are forced to sell them). Which can force further unwinds, in perhaps completely unrelated assets.

Not knowing the extent or nature of these trading strategies, or the degree of leverage, it is virtually impossible to understand how these effects may cascade through the markets.

The most evident indicators of these stresses are in the funding markets. And we are seeing such stresses. The FRA-OIS spread (known in a previous incarnation–e.g., 2008–as the LIBOR-OIS spread) has blown out. Dollar swap rates are blowing out. The most vanilla of spreads–the basis net of carry between Treasury futures and the cheapest-to-deliver Treasury–have blown out. Further, the Fed has pumped in huge amounts liquidity into the system, and these alarming spread movements have not reversed. (One shudders to think they would have been worse absent such intervention.)

One thing to keep an eye on is derivatives clearing. As I warned repeatedly during the drive to mandate clearing, the true test of this mechanism is during periods of market disruption when large price moves trigger large margin calls.

Heretofore the clearing system seems to have operated without disruption. I note, however, that the strains in the funding markets likely reflect in part the need for liquidity to make margin calls. Big margin calls that must be met in near real-time contribute to stresses in the funding markets. Clearinghouses themselves may survive, but at the cost of imposing huge costs elsewhere in the financial system. (In my earlier writing on the systemic impacts of clearing mandates, I referred to this as the Levee Effect.)

The totally unnecessary side-show in the oil markets, where Putin and Mohammed bin Salman are waging an insane grudge match, is only contributing to these margin call-related strains. (Noticing a theme here? Authoritarian governments obsessed with control and “stability” have a preternatural disposition to creating chaos.)

Perhaps the only saving grace now, as opposed to 2008, is that the shock did not arise originally from the credit and liquidity supply sector, i.e., banks and shadow banks. But the credit/liquidity supply sector is clearly under strain, and if parts of it break under that strain yet another round of extremely disruptive knock-on effects will occur. Fortunately, this is one area where central banks can palliate, if not eliminate, the strains. (I say can, because being run by humans, there is no guarantee they will.)

Viruses operate according to their own imperatives, and the imperatives of one virus can differ dramatically from those of others. Pandemic shocks are inherently systematic risks, and the nature of the current risk is only dimly understood because we do not understand the imperatives of this particular virus. Indeed, it might be fair to put it in the category of Knightian Uncertainty, rather than risk. The shock is big enough to trigger non-linear feedbacks, which are themselves virtually impossible to predict.

In other words. We’ve been on a helluva ride. We’re in for a helluva right. Strap it tight, folks.

China’s economy exhibits numerous symptoms of severe weakness that even its most world-class product–economic statistic manipulation–cannot conceal. One indicator of this is an increasing number of bond defaults (more on this in a bit). But there are others. Such as imposing the death penalty on the CEO of a large bank, pour encourager les autres, presumably.

Perhaps the best indicator is the palpable indication of nervousness at the highest echelons of the political (i.e., CCP) leadership. For example:

As China struggles to deal with the slowdown of the world’s second-largest economy, it has embarked on a new strategy of placing financial experts in provinces to manage risks and rebuild regional economies.

Since 2018, President Xi Jinping has put 12 former executives at state-run financial institutions or regulators in top posts across China’s 31 provinces，regions and municipalities, including some who have grappled with banking and debt difficulties that have raised fears of financial meltdown.

Only two top provincial officials had such financial background before the last big leadership reshuffle in 2012, according to Reuters research.

This is utterly futile. Although it reflects a realization by Xi and his minions that there is a problem, it also reflects that they have no idea what the cause of the problem is. Indeed, it shows that they are completely captured by their worldview, which believes that China will achieve wealth–and world domination–via the wise guidance of the Party and its enlightened leadership. (This worldview is not limited to Chinese Party cadres–the likes of Tom Friedman and Naomi Oreskes* and numerous other bon savants in the West share it.)

Their solution is a symptom of the problem. China’s current incipient crisis is a direct result of its economic model, which relies on state-directed investment to meet growth targets. No, there is not a granular, proscriptive investment program a la Stalin’s USSR. But provinces and local governments face strong incentives to meet growth targets that are most readily met via massive investment in infrastructure and housing: that these kinds of projects create corruption opportunities is just part of the incentive structure. Further, the financial system, with its repression of consumption and flip-side of subsidized credit, has provided further incentives to indulge the edifice complex.

This has resulted in massive malinvestment. The financial straits of these government entities, and the financial entities that have funded them, are merely a manifestation of the malinvestment: the investments have not generated returns sufficient to cover the costs of financing them. This is pretty amazing, given the magnitude of the direct and indirect subsidies.

Appointing managers with more “expertise” to exercise control at the sub-national level is not going to fix the fundamental fault in the system. The fundamental fault inheres in the socialist, centralized, Party-dominated, investment/credit-driven model.

The USSR showed that a centrally planned system can generate glittering results in terms of official statistics. For a while. But this largely reflects the flaws in national income accounting, especially in highly state-centric economies. Investment is a cost–a use of resources–but counts as contribution to national income. Pile up the costs at an insane rate for years, and you can show totally awesome GDP growth rates!

But eventually, the chickens come home to roost. If the investments are ill-advised, they do not generate a stream of consumption (and remember that consumption is the point of production, and investment) than can recoup the costs. Honest accounting would require writing down of these “investments,” causing a drop in measured national income. But this is never done.

The Soviet Union went through this “yeah we have problems but we just need better managers” phase. And it was a phase. The next phase was a slide into economic collapse. The phase after that was . . . outright economic collapse.

The Chinese and Soviet systems are not the same. But they share essential similarities, the most notable being that they are/were investment-driven and centrally directed, and horribly misprice credit. The means of direction are quite different, but the ultimate trajectories are quite similar. Investment-driven models that focus on achieving national income growth targets are prone to eventual collapse because of massively perverse incentives that lead to horrible misallocations of resources.

This has interesting short-run and long-run implications for the US (and the West generally). (“Interesting” being the most fraught word in the English language.) In the short run, it provides the US with considerable leverage over China with regards to trade: serendipitous developments, such as Asian swine flu increase this leverage. In the longer run, the fundamental flaws in the socialist model with Chinese characteristics will sharply reduce the Chinese geopolitical threat.

The problem is the interval between the short-run and the long-run. Big powers facing decline or economic crisis are inherently a source of instability. This problem is exacerbated in China, where the personalized, de-institutionalized nature of government under Xi also creates internal sources of instability. Xi is mortal, and has grandiose ambitions: as he sees the time to achieve those ambitions shrink, his incentive to take risk increases. Further, such systems are inherently unstable when the leader dies or becomes incapacitated because of succession crises–crises that are exacerbated by the fact that the ruler has a strong incentive to crush potential successors, rather than cultivate them.

Thus, there is likely to be a period of substantial internal turbulence in China, and this could have dire implications for the US and the world, especially given the changes that Xi has wrought in recent years.

In sum, China is entering the “we need better managers” phase of its development. This is a symptom of socialism, and a sign on the road to severe economic decline. A socialism syndrome, if you will. As an avowedly socialist country, China is not immune. Indeed, methinks it is particularly susceptible, especially given the neo-Maoism of Xi. This bodes well for no one.

*Oreskes is a Harvard “historian of science” who is primarily responsible for manufacturing the factoid (or should I say fiction?) that 97 percent of scientists believe in the threat of anthropomorphic climate change. Per the linked article: Oreskes believes in “change, owing perhaps to a sensible program of environmental regulation under Communism, and vindicating ‘the necessity of centralized government.'”

Sensible environmental regulation under Communism. LMFAO. Every Communist country is an environmental nightmare. I remember reading the official English-language Chinese paper when I was in China in the mid-2000s. It was a litany of environmental catastrophes. I truly shuddered when I thought that this was probably the sanitized view.

And has Naomi been to Beijing in January?

These are our better thans, people. FFS.