Streetwise Professor

The Biden administration, courtesy of the delusionally titled Inflation Reduction Act, has made a huge spending commitment on alternative fuels, and in particular “clean” hydrogen, i.e., hydrogen not produced from fossil fuels (such as methane). Most of the “green” hydrogen stimulus involves supply-side subsidies (especially a $3/kg production tax credit, but also loans to be doled out by the administrative state). The Infrastructure Law sets aside funds for hydrogen electrolysis and hydrogen “hubs” (like that just announced for Germany). The administration is also attempting to make “the economic case for demand-side support,” such power purchase agreements (PPAs), contracts-for-differences (CFDs), advanced market commitments (made by whom?), and prizes (funded by whom?).

It’s hard to know where to begin in criticizing this mess. The biggest problem is that it attempts to address the climate issue (which I will take as a given, focusing on means not ends) by picking technologies. This almost never ends well. First, there is the knowledge problem–bureaucratic governments do not possess the information to make these technology choices. Second, there is the rent seeking/corruption problem–which exacerbates the knowledge problem, as interested parties exploit the ignorance of bureaucrats and funders, and their political connections, to induce investments based not on their economic virtues but instead on political influence.

There are also serious doubts about whether hydrogen qua hydrogen is the right alternative fuel given that it poses numerous problems and costs. The first is that using renewable energy to produce green hydrogen is extremely expensive. The second is that, well, hydrogen is highly explosive: I distinctly remember my 8th grade science teacher, Mr. Fisch, using electrolysis to fill a test tube with hydrogen, putting in a piece of chalk, then lighting a match to set off an explosion that sent the chalk flying across the room. You didn’t have Mr. Fisch as a teacher, but perhaps you’ve heard of the Hindenberg:

Explosiveness creates hazards, of course, and mitigation of them is expensive. Hydrogen is also extremely expensive to transport and store and requires a new and distinct transportation and storage system.

We are talking trillions of dollars to create “the hydrogen economy”–something even its boosters admit. Hell, they brag about it.

Hydrogen “carried” with carbon, in the form of ammonia or methanol, pose fewer problems (although ammonia in particular is nasty stuff). They are also costly, and it is clearly uncertain whether “green” forms of these hydrogen carriers are economical ways to reduce carbon emissions from fuels for transportation and power generation.

But the administration (and Europe too) have gone all in on hydrogen. Why? Maybe because their extreme antipathy towards carbon leads them to disdain fuels with any carbon in them.

Having chosen its technology, for better or more likely worse, now the administration is focused on how to force its adoption. The supply-side incentives are clear enough, so now there is a pivot to the demand-side, as expressed in the appallingly shoddy Council of Economic Advisors document linked above.

According to the CEA–and not just the CEA, as will be seen shortly–the problem is that “[r]eal or perceived risks around clean energy projects can raise the cost of accessing capital,  which could slow the rate at which projects like those in the hydrogen hubs program achieve commercialization..”

Well, I should hope so! That is, I should hope that risks are taken into account when allocating capital!

John Kerry flogged the risk issue on MSNBC (h/t Powerline):

“What’s preventing it is, to some degree, fear, uncertainty about the marketplace. People who manage very significant amounts of money have a fiduciary responsibility, an obligation to the people they manage it for not to lose the money, but to produce returns on that investment. Pension funds, many of them, are very careful about those investments in order to make certain they have the money to pay out to the pensioners who work for that money all their lives. So, there are tricky components of making sure that you have taken the risk away from these investments. And energy, which is what the climate crisis is all about, it’s about energy, it’s about how we fuel our homes, how we heat our homes, how we light our factories, how we drive and go from place to place.”

Damn those money managers for taking into account the risks and rewards of the money their investors entrust to them! Don’t they understand that John Effing Kerry knows what is right for humanity????? After all, he flies around the world in a private jet sharing his wisdom (and then dissembles about it before Congress).

I loved this part: “So, there are tricky components of making sure that you have taken the risk away from these investments.” Does John Kerry have a magic box into which he can make the risks disappear? Do tell!

Of course he doesn’t. What he means, clearly, is that the government must somehow absorb the risks inherent in the technology that they have already decided upon–apparently without analyzing those risks fully or carefully, or wondering whether maybe these damned investors might know something they don’t. (Of course they don’t wonder that! They are all knowing, right?)

At least the CEA attempts to put lipstick on the pig and raise some economic arguments to justify the need for demand-side support. There are market failures! Government never fails, but markets do, right?

In my experience the concept of market failure is most likely to be advanced when the market fails to do what someone thinks should be done, or wants to be done, based on their own vision. That is, when the market disagrees with someone, the market has failed! Especially when that someone is a member of what Thomas Sowell calls “The Anointed.”

The CEA basically cites to some theoretical possibilities. At the core of their argument is that learning by doing, including learning-by-doing that “spills over” among companies, can lead to inefficient investment. The CEA advances a couple of reasons.

One is a contracting failure. LBD–moving down the learning curve–reduces costs, meaning that prices are expected to fall. So, according the CEA, potential buyers are unwilling to enter into long term contracts for fear of agreeing to pay a price that will turn out to be too high: “if rapid declines in technology costs are expected, the willingness of private sector end-users to seek out such contracts with clean energy developers will be limited” (emphasis added). Without such contracts, hydrogen project developers can’t secure financing, so plants won’t get built, no learning takes place, and costs don’t fall. The Curly Equilibrium, in other words:

Really? If costs are expected to fall, market participants can enter contracts with de-escalator clauses, i.e., contractual prices that fall over time. Apparently the CEA only envisions contracts at a fixed price that extends through the life of the contract. But even then, given anticipated cost declines, the developer would be willing to sell at a price below the initial cost, basically, at the average cost expected over the life of the contract.

The CEA mentions the risks of of the magnitude of cost declines, but again, that should be a material consideration in any contracting and investment decision. Is the CEA arguing that the risk compensation demanded by borrowers will be excessive? They don’t say so explicitly, but that’s what you would need to argue that the prices in these contracts would be “too low” and thereby stymie investment.

I’d also note that indexed prices, widely used in a variety of commodity off-take agreements, eliminate the risk to buyers of locking in too high a price. They also address the asymmetric information problem that the CEA frets about. If the developer has better information about the likely trajectory of price declines, then yes, buyers looking at fixed price deals or deals with mechanical (non-market based) price de-escalators face a “winners’ curse” problem: the developer will agree to terms that overestimate his (better) forecast of future prices, and reject deals that underestimate.

I think in fact that the issue is that there is considerable uncertainty among all parties, developers and buyers alike, regarding what the future cost trajectory will look like. That is, there is a real risk here, and that risk should be taken into consideration when deciding whether hydrogen investments make sense. And market participants are far better at assessing the risks, and the pricing of those risks, than the government, which is clearly taking a “Damn the risks, full speed ahead!” Approach.

Sorry, but John Kerry et al don’t inspire confidence like Admiral Farragut at Mobile Bay.

One of the proposals under discussion is Contracts for Differences (“CFDs”) in which the government would (perhaps through a non-profit intermediary) provide a guaranteed revenue stream to a developer and absorb the price risk. To work, CFDs require indexing to some market price–and the market price for H2 hasn’t really been created. Further, they require some mechanism to set the guaranteed price, a non-trivial task given the very information asymmetries that the CEA worries about. The government-appointed third party (or the government for that matter) will certainly be the less informed party in any negotiations with developers, and will almost certainly overpay. (Not that they will mind–not their money!) Meaning that the asymmetric information problem the CEA frets about is present in spades in one of their preferred means of addressing it. Further, CFDs have already presented performance issues, with the sellers (those getting the guaranteed revenue stream) treating these contracts like options rather than forwards, and spurning their CFD commitments when market prices rise above the guaranteed price (as has happened with with generators in the UK when power prices spiked).

The CEA also invokes capital market imperfections also driven by asymmetric information that may impede financing if developers know more about the economics of projects than the financiers. This is a hoary old story that has been used to identify alleged market failures since time immemorial. So long ago, in fact, that when Stigler wrote “Imperfections in the Capital Market” (JPE) 56 years ago, he (in typical Stigler fashion) drolly started thus: “The adult economist, once the subject is called to his attention, will recall the frequency and variety of contexts in which he has encountered ‘imperfections-in-the-capital market.'” That is, “capital market imperfections” were an old joke decades ago.

Here’s another one, George! Based on long experience, George was a skeptic. Based on even longer experience, I am too, in this case in particular.

And let’s look at the empirical record. Learning by doing is a ubiquitous phenomenon. Dynamically declining costs in industries with potential information asymmetries abound. Yet industries have developed and thrived nonetheless.

Some examples.

I recently finished a piece describing extensive learning-by-doing in the shale industry, including evidence of learning spillovers and dynamic cost reductions. Yet, the shale sector has not faced problems getting capital or expanding rapidly. Hell, if anything, a common criticism is that shale drillers have obtained too much capital and drilled too much, not that they are starved for capital and drilled too little.

Does the CEA (or John Kerry!) believe the shale sector in the US is too small?

Insofar as spillovers is concerned, the fact that the costs of firm A decline when firm B produces more output is a necessary, but not a sufficient condition for an externality. One plausible outcome in oil (as identified in a paper on LBD in conventional drilling by Kellogg in the QJE) is that service firms are the ones that do the learning, and capture and internalize it.

LBD is well-documented for computer chips, which have seen relentless cost and price declines over the years. Yet computer chip factories have been built, and companies especially in the US and Asia have attracted the capital necessary to build these very expensive facilities and build new chip lines nonetheless. (In this industry too, there have been chronic complaints about overcapacity, rather than undercapacity. I am not commenting on the validity of those complaints, just noting that their existence contradicts the notion that dynamic scale economies and price declines due to LBD starve an industry of capital.)

The LNG industry has many of the characteristics that the CEA attributes to hydrogen. Yet this industry has expanded apace for well over 50 years now.

I viewed a presentation by DOE people today in which LNG was raised several times, and as an example not to be followed. DOE advisor Leslie Biddle (ex-Goldman) mentioned LNG several times (“I keep going back to the LNG analogy”), and in a negative way. LNG took 30 years to move to a traded market, dontcha know. And we don’t have that time! We need to create such a market in a year! (DOE’s Undersecretary for Infrastructure David Crane was more generous, giving us all of 5 years.) (Crane was also hyping the idea of hydrogen for everything, including home heating–apparently oblivious to the fact that even Net Zero fanatical Britain has just recently determined that H2 is too dangerous to heat homes.)

In the context of the discussion of a grand government plan to transform the energy system, I couldn’t help but think of Gosplan, or Stalin’s race to industrialization (e.g., the Magnitogorsk Steel Factory). We will inevitably–inevitably–meet the “Dizzy With Success” phase in hydrogen, mark my words.

I note that LNG production grew substantially before it became a traded market, which actually undercuts Biddle’s argument. Even though there was not a liquid traded market for LNG in the first decades of its growth and development, long term contracts, usually using crude (no pun intended) indexing features (like tying prices to Brent), contracts were agreed to, financing was obtained on the backs of these contracts, and liquefaction plants were built.

Oil refining faced many of the conditions that worries the CEA about hydrogen. Kerosene was a radical product early on, with a lot of uncertainty about market adoption. But Rockefeller dramatically expanded output and reduced costs: the cost of kerosene by 2/3rds in 10 years (1870-1880), in large part due to extensive learning and research on all aspects of the value chain. Standard Oil’s supposedly predatory acquisitions of were actually ways by which SO’s knowledge could be combined with physical assets to improve their efficiency.

The co-evolution of gasoline refining and the adoption of the automobile represents another example of investment and falling prices in a new market in a capital intensive industry.

I note that the early refining examples occurred when capital markets were far less developed than is currently the case. I further note that large energy firms (IOCs and NOCs like Aramco in particular) can potentially finance hydrogen (and other alternative energy projects) with cash flows generated by their legacy fossil fuel investments: this would largely eliminate any asymmetric information problem between developer and financier (because the developer is the financier) and developer and customer (because the developer could finance without securing a long term price commitment).

Another example. Electricity generation. Beginning with its inception in the early-1880s, electricity generation was highly technologically dynamic, with substantially declining costs. Yet in a few short years most urban areas in the US were electrified, with numerous private companies competing with government utilities. This was another industry in which overbuilding, rather than under-building, was widely discussed. The movement to price regulation occurred well after the industry developed, and was a reaction to intense price competition: regulation effectively cartelized electricity generation.

One more. Aircraft. LBD was first identified in the production of airframes. This phenomenon was first documented by Wright in 1936, and was subsequently observed in myriad other industries (e.g., Liberty Ship construction in WWII). LBD and the associated cost declines have continued in aircraft construction ever since. And aircraft have been built and aircraft manufacturers have been able to attract the capital to design and build new aircraft that benefit from these cost declines.

In the face of all these examples, the CEA and others making these market failure arguments should identify an industry that died aborning due to the alleged chicken-or-egg problem that makes demand side support of hydrogen investment necessary.

The CEA document has echoes of some rather common, but unpersuasive, arguments for government support of industry, such as the infant industry argument and the big push development literature. The latter has been demolished by practical experience: the list of its dismal failures is far too long. There are more than echoes of this discredited approach in the CEA document. It links to a paper that credulously recycles the old, bad, discredited theories.

What is amazing about the infant industry argument is how often it is invoked, and how little empirical evidence supports it. One of the few empirical papers, that of Krueger and Tuncer, rejects the argument in the case of Turkey.

A paper by Juhasz is often touted to support the theory. It shows that after the stimulus of the cotton spinning industry in France due to Napoleon’s Continental system, post-1815 the industry was competitive with the British, indicating that it had moved down the learning curve. Again, at most this identifies a necessary condition for protection–learning–but not a sufficient one. Even if LBD occurs, and even if there are spillovers, the cost of protection may exceed the benefits. A simple story demonstrates this. If the protected industry achieves cost parity with the first-mover (e.g., the UK in cotton), the protected firms merely displace firms in the first-mover country, leaving post-parity total costs unchanged. So in equilibrium, protection is costly but generates no benefits.

All in all, the CEA document reminds me of a rather conventional undergraduate econ paper, repeating textbook wisdom about externalities and market failures. It completely ignores the Coasean insight that market contracting methods are far more sophisticated than those in the textbooks, and that market participants have incentives to find clever ways to contract around what would be market failures if market transactions were limited to the forms considered in textbooks. It also ignores the historical record.

In other words, rather than writing off the difficulties of securing “bankable” contracts to secure funding for H2 developments to “market failures” or the excessive risk aversion of market participants, the government should step back and consider whether this alleged hesitation reflects a more sober and informed evaluation of risks than our betters in DC have undertaken.

I crack myself up sometimes.

In sum, the administration’s entire approach to hydrogen is utterly flawed. It attempts to pick technologies based on a pretense of knowledge it does not possess. It views flashing red lights warning of risks as signals to be suppressed rather than considered when making policy and investment choices. It engages in simplistic analyses of how real markets work, and how they have worked historically, to conclude that market failures requiring government intervention to fix abound in hydrogen.

All of these government failures could be eliminated by cutting the Gordion Knot, pricing carbon, and letting markets and private enterprise develop the technologies, products, contracting practices, and market mechanisms to trade off efficiently the benefits of reducing CO2 emissions. Decentralized mechanisms discover and utilize information, including information about new technologies, far more efficiently than governments. Decentralized mechanisms incentivize learning and innovation–including contracting and organizational innovations that can be instrumental in developing and adopting new technologies, products, and techniques.

In the case of hydrogen, pure or “contaminated” with carbon, priced carbon would address the problems that the CEA frets about, in particular the contracting problem. A carbon price would make it straightforward to index prices in contracts. A formula related to NG prices (because blue hydrogen is likely to drive the price of hydrogen at the margin, and because methane is likely to be the substitute at the margin for H2 in many applications) and the cost of carbon would send the appropriate signals and eliminate the need to fix prices in advance.

What the price of carbon should be and how it should be determined is a whole other question. But it would be far more productive, and not just in regards to hydrogen, to focus on that problem rather than leaving it to the John Kerrys of the world to pick technologies and then devise the coercive mechanisms necessary to force the adoption of those technologies.

Alas, we are on the latter path. And it will not take us to a good place. Probably figuratively, and perhaps literally, to the fate of the Hindenberg.

The Texas legislature meets every other year, meaning that 2023 is the first session in which legislation to address the issues that became apparent with the near death experience of the Texas power grid during Winter Storm Uri in February 2021 can be considered. The Texas Senate has passed two bills. Senate Bill 6 mandates the building of 10,000 MW of thermal generation (with on-site fuel storage), to be paid for via an “insurance” mechanism that guarantees a 10 percent rate of return to be funded by uplift charges to transportation and distribution utilities. Senate Bill 7 effectively creates an ancillary services market that allows dispatchable generation to sell reserves (e.g., spinning reserves) on a day ahead basis.

Opponents of the legislation state that it represents backsliding from the ideal of competitive energy markets:

Opponents immediately created the false narrative that the Texas bills are proof that Texas politicians “no longer have faith that competitive markets can adequately and economically satisfy the electricity need of Texas citizens,” said Beth Garza, a consultant for the think tank “R Street Institute.”

Well, the bills do represent major departures from Texas’ “energy only” market design. But this raises the question of what undermined the energy only market in the first place. And the answer to that is clear: subsidies for renewables. Past subsidies have wreaked havoc for years. Future subsidies, especially those in the Green New Deal in Drag, AKA the Inflation Reduction Act, threaten to wreak even more havoc in the future.

As I’ve written, this problem was evident years ago, in the mid-2000s. Even then, the penetration of renewables was undermining the economics of thermal generation, leading to exit of such capacity, thereby pressuring reserve margins and compromising–seriously–reliability. The process has continued inexorably in the past 15 years or so, leading to the precarious situation that culminated with Uri–and which has led to chronic concerns about blackouts during every cold snap and heat wave since.

The upshot of the process is an electricity system with a decidedly suboptimal generation mix. Too much intermittent, non-dispatchable renewables, too little dispatchable thermal. The Senate bills are attempts to address that distortion.

This is a great example of the “theory of the second best,” in which one policy that would be suboptimal in the absence of any distortions is welfare-improving in the presence of other distortions. The massive past, present, and prospective subsidies for renewables have distorted the operation of an energy only market. The past subsidies cannot be undone, and the future subsidies are also largely out of the control of Texas and ERCOT. So subsidies for thermal generation that would otherwise be objectionable can improve economic efficiency because they counterbalance the effects of these other subsidies.

It is clear that persisting with the EO market would be a recipe for future disaster. Subsidy to offset subsidy is a second best approach, but the first best is unattainable due to the renewable subsidy induced distortion.

Are there other policies that might be preferable? The only real alternative I can see is a capacity market (another departure from energy only), with capacity obligations clearly directed at dispatchable resources. I am skeptical about the credibility of capacity commitments, and the ability to tailor them to address reliability concerns in particular. Furthermore, political economy considerations threaten capacity markets: renewables operators will lobby to qualify for capacity payments.

SB6 is focused on encouraging investment in dispatchable, reliable capacity. It is likely the MW will be forthcoming. The main challenge is whether the MWh will be there when needed, that is to ensure that the new generation is maintained so as to be able to supply surge demand with a high probability. To provide the incentive to make it so the EO market has to allow generators to earn high prices when supplies are tight. Political economy may again be the main obstacle to this. The new generation will earn high returns–perhaps well above 10 percent–during the periods they are most needed. This will create political pressure to claw back these profits: “windfall profits tax,” anyone? The prospect for clawback undermines the incentive of the new generation to be optimized to supply power in times of short supply.

In sum, renewable subsidies distorted the EO market. Some second best measure (the first best being no renewable subsidies) is necessary. These must effectively subsidize investment in reliable, dispatchable, thermal generation. Between the two main alternatives on offer–guaranteeing a return on investment on such generation, or a capacity market–the former seems superior. But regardless of which is chosen, it is essential to keep in mind what requires the choice: the distortion that compromised the reliability of the Texas grid in the first place, namely, renewables subsidies.

Progressivism is destroying the United States military and putting the nation’s security at a grave risk.

I could probably write a book on the subject–a long book–but two examples provide chilling illustrations of the general thesis.

The first is the military’s obsession with climate change:

Secretary of the Navy Carlos Del Toro said he sees fighting climate change as a top priority for the Navy as the Biden administration proposes shrinking the fleet by two ships and worries grow about how the U.S. Navy stacks up to China’s.

“As the Secretary of the Navy, I can tell you that I have made climate one of my top priorities since the first day I came into office,” Del Toro said March 1 in remarks at the University of the Bahamas.

And this:

“We view the climate crisis much the same way as damage control efforts on a stricken ship. This is an all-hands-on-deck moment,” he added.

An all-hands-on-deck moment? Well, that’s exactly the problem. At the rate of decline in the ship count in the United States Navy, there won’t be any decks for the hands to stand on.

The Navy’s job is not to save the world environment, let alone save it from a highly speculative (and arguably chimerical) danger–as if it can do anything about it anyways. The Navy’s job is to secure control of the seas, and deny that control to its enemies. That requires ships and trained sailors and officers and logistical support and munitions.

All of those things have been eroding relentlessly in recent years, and the Biden administration wants to accelerate the decline:

This year, the Biden budget called for the decommissioning of 11 ships and the construction of just nine ships, for a net loss of two vessels. That budget proposal was met with skepticism from members of Congress, which has acted in the last two years to spare the Navy from cuts to the fleet proposed by the Biden administration.

All hands should be on deck to stop and reverse those troubling and extremely dangerous trends.

But no, we have a gasbag SecNav blathering about greenhouse gasses:

“There is not a trade-off between addressing climate security and our core mission of being the most capable and ready Navy-Marine Corps team,” he said. “The exact opposite is true. Embracing climate-focused technologies and adopting a climate-informed posture strengthens our capability to stand by our partners and allies.”

Del Toro said worrying about climate change would lead to new technologies that the Navy can use to create a “virtuous cycle of energy efficiency, cost savings, maritime dominance and climate security.”

This are merely unsupported assertions–and wildly implausible ones to boot. Just how does “embracing climate-focused technologies and adopting a climate-informed posture strengthens our capability to stand by our partners and allies”? Just how will “embracing climate-focused technologies and adopting a climate-informed posture” improve our ability to win a naval conflict against China in the western Pacific?

And anyone who says “there is not a trade-off” is either a liar or an idiot–or more likely both. There is always a trade-off. Every dollar spent on climate unicorns is a dollar that doesn’t go to a ship or a sailor or a missile.

The other example is DEI in the military, especially at the academies.

It’s bad–really bad–at all the academies. When I attended the Superintendent’s call at my USNA reunion a few years ago it was diversity this and diversity that. That was clearly the Supe’s overriding concern (other than bragging about managing COVID, especially the issue of disposing of all the extra trash from packaging of the meals that Mids were forced to eat in their rooms–Bravo Zulu, dude!).

Navy is bad, but I think Air Force is the worst. USAFA has embraced CRT and is all in on the trans agenda.

A diversity and inclusion training by the United States Air Force Academy in Colorado instructs cadets to use words that “include all genders” and to refrain from saying things like “mom” and “dad.”

The slide presentation titled, “Diversity & Inclusion: What it is, why we care, & what we can do,” advises cadets to use “person-centered” and gender-neutral language when describing individuals.

“Some families are headed by single parents, grandparents, foster parents, two moms, two dads, etc.: consider ‘parent or caregiver’ instead of ‘mom and dad,'” the presentation states. “Use words that include all genders​: ‘Folks’ or ‘Y’all’ instead of ‘guys’; ‘partner’ vs. ‘boyfriend or girlfriend.’”

When confronted about this, Superintendent LG Richard Clark executed a classic motte-and-bailey maneuver:

“The recent briefing on diversity and inclusion is being taken out of context and misrepresented; the slide in question was not intended to stand alone,” Clark said. “First and foremost, the briefing centered on respect for others and the warfighting imperative of leveraging diverse perspectives to solve our nation’s most difficult national security problems. Our strategic competitors are doing the opposite. Our American diversity is a strategic advantage and opens the door to creative solutions, providing a competitive edge in air, space, and cyberspace.”

“The slide on ‘inclusive language’ was intended to demonstrate how respect for others should be used to build inclusive teams, producing more effective warfighting units,” Clark continued. “Understanding a person’s context shows respect. Until you know a person’s situation, we should not make assumptions about them.”

Clark smoothly retreats from the bailey (don’t say “mom or dad”) to take refuge in the motte of vacuous blather that asserts rather than proves the warfighting utility of these endeavors: “The slide on ‘inclusive language’ was intended to demonstrate how respect for others should be used to build inclusive teams, producing more effective warfighting units.”

These assertions–del Toro’s and Clark’s–unsupported by any evidence are characteristic of justifications of these progressive policies. Clark is especially prone to asserting things like “diversity is a strategic advantage and opens the door to creative solutions” but alas he is not alone. And saying it doesn’t make it true.

If diversity–as used by Clark and others–is so effective at creating “strategic advantages,” why was the really, really “diverse” Austro-Hungarian army the worst (by far) among major combatants in WWI, rather than the best? Why was the decidedly and almost uniformly pallid United States Navy able to wage the most stupendous and victorious naval campaign in history 1942-1945?

Given the demographics of the United States, the military will inherently be “diverse,” and especially after the tumult of Vietnam, it worked assiduously to address that diversity in the proper way: to find ways to create a cohesive fighting force. But the crucial thing about this effort was that it was avowedly meritocratic in nature, and focused on reversing the non-meritocratic elements of an explicitly and then implicitly segregated military.

The progressive version of diversity is inimical to this. CRT–which the USAFA, the other academies, and other elements within the military have embraced to one degree or another–creates division, not cohesion, and therefore poisons military culture: it segregates rather than unites, and drawing invidious distinctions between people based on race, caste, or class undermines the effectiveness of military units at every level. It is avowedly anti-meritocratic, viewing any “disparities” as the result of some “systemic racism” that only the gnostics who practice it can see it.

In short, one could not think of a better way to undermine the effectiveness and lethality of a combat organization–except its lethality to itself. Cf. the Austro-Hungarian army mentioned above.

The fact is the del Toro and Clark and far too many in the civilian and uniformed hierarchy are unduly focused on progressive political agendas that not only fail to contribute to America’s war fighting capability, but are positively antithetical to it. If del Toro is so intent on going to battle stations, how about doing so to fix, say, the Navy’s utterly dysfunctional procurement process? Or the serious recruiting issues the service faces? Instead he establishes as a priority something that the Navy can’t do jack shit about–except, perhaps, by devastating the world’s largest emitter of greenhouse gases. The capability to do so, alas, is eroding by the day.

The lapsing of the Soviet threat allowed the military and the civilians who control it to indulge their ideological fancies, and to use the military as a laboratory for social experimentation, in contravention of its real purpose. The post-Cold War reverie is clearly over. The military is insufficiently prepared for a return of peer competition, and the unmilitary priorities of the likes of del Toro and Clark will undermine the nation’s ability to restore the capabilities that have atrophied so dramatically over the past 30 years.

Churchill lamented the 1930s as the “locust years” when feckless politicians and military officials failed to recognize rising threats and consequently failed to prepare against Hitler’s Germany. Today the United States is experiencing something worse: termite years, where destructive ideologies are eating at the American military from the inside.

Gary Gensler has long lusted to get his regulatory hooks into cryptocurrency. To do so as head of the SEC, he has to find a way to transform crypto (e.g., Bitcoin, Ether, various tokens) into securities, as defined under laws dating from the 1930s. Although Gensler has stated that crypto regulation is a long way off–presumably because it is no mean feat to jam an innovation of the 2010s into a regulatory framework of the 1930s–he thinks that he may have found a way to get at the second largest crypto, Ether.

Gensler pictured here:

Sorry! Sorry! Understandable mistake! Here’s his actual image:

Ether just switched from a “proof of work” model–the model employed by Bitcoin–to a “proof of stake” model. Gensler recently said that Ether may therefore qualify as a security under the Howey test, established in a 1946 Supreme Court decision–handed down when computers filled large rooms, had no memory, and caused the lights to dim in entire cities when they were powered up.

Per Gensler:

Securities and Exchange Commission Chairman Gary Gensler said Thursday that cryptocurrencies and intermediaries that allow holders to “stake” their coins might pass a key test used by courts to determine whether an asset is a security. Known as the Howey test, it examines whether investors expect to earn a return from the work of third parties. 

“From the coin’s perspective…that’s another indicia that under the Howey test, the investing public is anticipating profits based on the efforts of others,” Mr. Gensler told reporters after a congressional hearing. He said he wasn’t referring to any specific cryptocurrency. 

To call that a stretch is an understatement. A huge one. Because the function of proof of stake is entirely different than the function of a security.

Proof of work and proof of stake are alternative ways of operating an anonymous, trustless crypto currency. As I’ve written in several pieces here and elsewhere, eliminating the need for trusted institutions to guarantee transactions does not come for free. Those tempted to defraud must incur a cost if they do in order to be deterred. A performance bond sacrificed on non-performance or deceit is a common way to do that. Proofs of stake and work both are effectively performance bonds. With proof of work, a “miner” incurs a cost (electricity, computing resources) to get the right to add blocks to the blockchain: if a majority of other miners don’t concur with the proposal, the block is not validated, the proposing miner gets no reward, and sacrifices the expenditure required to make the proposal. Proof of stake is a more traditional sort of bond: you lose your stake if your proposal is rejected.

A security is something totally different, and serves a completely different function. (NB. I favor the “functional model of regulation” proposed by Merton many years ago. Regulation should be based on function, not institution.). The function of a security is to raise capital with a marketable instrument that can be bought and sold by third parties at mutually agreed upon prices.

So with a lot of squinting, you can say that both securities and staking mechanism involve “the efforts of others,” but to effect completely different purposes and functions. The fundamental difference in function/purpose means that even if they have something in common, they are totally different and the regulatory framework for one is totally inappropriate to the regulation of the other.

This illustrates an issue that I often come across in my work on commodities, securities, and antitrust litigation: the common confusion of sufficient and necessary conditions. Arguably profiting from the efforts of others could be a necessary condition to be considered a security. It is not, however, a sufficient condition–as Gensler is essentially advocating.

But what’s logic when there’s a regulatory empire to build, right?

I’m also at a loss to explain how Gensler could think that proof of stake involves the “efforts” (i.e., work) of others, but proof of, you know, work doesn’t.

Gensler’s “logic” would probably even embarrass Sir Bedevere:

“What also floats in water?” “A security!”

Gensler might have more of a leg to stand on when it comes to tokens. But with Bitcoin, Ether, and other similar things, hammering the crypto peg into the securities law hole is idiotic.

But never let logic stand in the way of Gary’s pursuit of his precious:

GiGi is not solely focused on crypto of course. He has many preciouses. This week the SEC released a proposed rule to mandate clearing of many cash Treasury trades.

Clearing of course has always been a mania of Gary’s. His deep affection for me no doubt dates from my extensive writing on his Ahab-like pursuit of clearing mandates in derivatives more than a decade ago. Clearing is Gensler’s hammer, and he sees in every financial problem a nail to be driven.

The problem at issue here is the periodic episodes of large price moves and illiquidity in the Treasury market in recent years, most notably in March 2020 (the subject of a JACF article by me).

Clearing is a mechanism to mitigate counterparty credit risk. There is no evidence, nor reasonable basis to believe, that counterparty credit risk precipitated these episodes, or that these episodes (whatever their cause) raised the risk of a chain reaction via a counterparty credit risk channel in cash Treasuries.

Moreover, as I have said ad nauseum, clearing and the associated margining mechanism is a major potential source of financial instability.

Indeed, as I point out in the JACF article, clearing and margin in Treasury futures and other fixed income securities markets is what threatened to turn the price (and basis) movement sparked by Covid (and policy responses to Covid) into a systemic event that required Fed intervention to prevent.

I note that as I discussed at the time, margining also contributed greatly to the instability surrounding the GameStop fiasco.

Meaning that in the name of promoting financial market stability Gensler and the SEC (the vote on the proposal was unanimous) are in fact expanding the use of the very mechanism that exacerbated the problem they are allegedly addressing.

Like the Bourbons, Gensler has learned nothing, and forgotten nothing. He has not forgotten his misbegotten notions of the consequences of clearing, and hasn’t learned what the real consequences are.

Of course these two issues do not exhaust the catalog of Gensler’s regulatory imperium. Another big one is his climate change reporting initiative. I’ll turn to that another day, but in the meantime definitely check out John Cochrane’s dismantling of that piece of GiGi’s handiwork.

As Gideon John Tucker said famously 156 years ago: “No man’s life, liberty or property are safe while the Legislature is in session.” Nor are they when Gary Gensler heads a regulatory agency.

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.

European power prices are going hyperbolic, with day ahead prices in swathes of the continent varying between €660 and €750/MWh.

For those who want to play at home–spot the congestion!

Even more remarkably, Cal 2023 power prices are around €1000/MWh in German and France:

That’s for baseload, folks. 24/7/365. Peak Cal 2023 French power is currently at €1425. Ooh la la!

This has of course set of a flurry of policy proposals.

None of these proposals will mitigate the fundamental problem–energy supply is extremely scarce. Most of these proposals will actually exacerbate the underlying scarcity.

Instead, these proposals are all about how to distribute the cost of scarcity. They are fundamentally redistributive in nature.

The proposals include price controls (natch), windfall profits taxes, and nationalization.

Price controls always exacerbate the scarcity and create actual shortages by encouraging consumption and discouraging production. They will necessitate rationing schemes. In electricity, rationing often involves brownouts and blackouts. Planned blackouts, such as no power availability at all for some hours of the day.

WIndfall profits taxes attempt to capture the surplus of inframarginal (i.e., low cost) suppliers, and redistribute that surplus (somehow) to consumers. Redistributing through subsidized prices exacerbates scarcity because it increases demand.

Windfall profits taxes may otherwise have few distorting effects in the short run, given that supply from the inframarginal firms is likely to be highly inelastic (they basically operate at capacity). (Ironically, the scheme to hit Russia by capping the prices it receives on oil is predicated on a belief that supply is highly inelastic.). However, windfall profits taxes have very deleterious long run incentives. They deprive those who invest in production capacity of the value of those investments precisely when they are greatest (which really distorts investment incentives). Even the risk that windfall taxes will be imposed in the future depresses investment today. Meaning that although such taxes may not do too much damage in the present, they increase the likelihood of future scarcity.

The reach of windfall profits taxes is also limited. Many of the rents resulting from the current world energy situation accrue to input suppliers (e.g., owners of LNG liquefaction capacity, coal miners that export to Europe) who are beyond the reach of grasping European hands via windfall profits taxes. (And are the Norwegians going to transfer wealth to Europe by imposing windfall taxes on their gas production and writing a check to Brussels? As if: the Norwegians are already talking about limiting energy exports to Europe.)

Nationalization can be a crude form of windfall profits tax: nationalizing low cost producers basically seizes their surplus. Nationalization can also be a form of subsidization: seize unprofitable firms, or firms that can only survive by charging very high prices, and sell the output below cost. Losses from below cost sales are socialized via taxpayer support of loss-making nationalized enterprises (which creates deadweight costs through taxation present and future).

Nationalization of course generates future operational and investment inefficiencies due to low power incentives, corruption, etc. Moreover, to the extent that nationalized entities subsidize prices, they will encourage overconsumption, and thereby create true shortages and necessitate rationing.

All of these policies aim to mitigate the pain that power consumers incur by shifting the costs to others–and in the forms of subsidies funded by general taxation, the overlap between those who receive the subsidies and those who pay them is pretty large. But even this transforms a very visible cost into a much less visible one, and thus has its own political benefit.

The Germans–at least the Green Party ministers in the government–are advocating a fundamental change in the market mechanism, specifically, eliminating marginal cost pricing:

“The fact that the highest price is always setting the prices for all other energy forms could be changed,” Economy Minister Robert Habeck, who is also the vice chancellor in the ruling coalition in Berlin, said in an interview with Bloomberg.

“We are working hard to find a new market model,” he said, adding that the government must be mindful not to intervene too much. “We need functioning markets and, at the same time, we need to set the right rules so that positions in the market are not abused.”

Marginal cost pricing is a fundamental economic tenet: price equal to marginal cost gives the right incentives to produce and consume. Below marginal cost pricing (the cost of the most expensive resource sets the price) encourages overconsumption. Further, unless marginal units are compensated there will be underproduction. Both of these create inefficiencies, exacerbate scarcity, and can lead to actual shortages and the necessity of rationing.

On a whiteboard you could draw up a pricing mechanism that perfectly price discriminates by paying each resource its marginal cost. This effectively appropriates all of the producer surplus which can be redistributed to favored political constituencies. But this doesn’t cover fixed costs and a return on capital, which discourages future investment.

Further, classroom whiteboard exercises are usually impossible even to approximate in reality. Knowing what marginal cost is for each resource in a complicated system is a major problem, especially when you take transmission into consideration. The likely outcome would be some sort of kludge with roughly average cost pricing combined with some Rube Goldberg scheme to compensate producers. This whole system would involve massive redistribution and all of the politicking and corruption attendant to it.

The real problem the Europeans have is that they want to kill the market messenger. The market is signaling scarcity. The scarcity is real, and acute, but they no likey! And by the nature of energy production–capital intensive, with moderate to long lead times to enhance capacity–the scarcity will continue for some time, with little the Europeans can do about it.

In other words, they can’t fix their real problem (scarcity), which is the harvest of their previous policy follies. So they are left to find redistributive schemes to allocate the costs in a politically satisfactory way. These redistributive schemes–price ceilings, windfall profits taxes, nationalization, fundamental restructuring of the market mechanism–all tend to exacerbate scarcity in both the short and longer runs.

The fact is, when you’re screwed, you’re screwed. And Europe is well and truly screwed. What is going on in policy circles in Europe right now is figuring out who is going to get screwed hardest, and who is going to get screwed not so much. And there will be substantial costs, both in the short but especially the longer term, as whatever Frankenstein “market” emerges from these frantic policy stopgaps will wreak havoc in the future, and will be very hard to put down.

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 latest hysteria in DC and the media revolves on whether the United States is currently in a recession, given that real GDP has contracted in consecutive quarters. That has always been the good-enough-for-government-work definition of a recession, but the administration and its media mina birds are saying “ackshually that’s NOT the technical definition of a recession NBER blah blah blah low unemployment blah blah blah.”

So what is it? Well, the dimwitted press secretary and the only slightly more witted head of the National Economic Council, the appalling apparatchik Brian Deese, inform us that the economy is “in transition.” From what to what, they don’t say. Just . . . in transition. So I guess the economy is on puberty blockers or something. Because you know those are a thing now.

This obsessing over terminology brings to mind Jimmy Carter’s Chairman of the Council of Economic Advisors, Alfred E. Kahn. In 1980 Kahn made the mistake of referring to the economy being in depression or recession and he was promptly taken to the woodshed by the political types in the White House. Koch then announced he was foregoing use of those words, and would instead say that the economy was in a banana. After Chiquita (if memory serves) complained, he changed “banana” to “kumquat.”

Kahn was a real economist with a real sense of humor. In other words, totally different that the current crowd of humorless lilliputians.

The parallel with Carter demonstrates one thing though: when an administration freaks out about terminology, it means that they are frantic and desperate and have no substantive case to make. But calling a turd ice cream doesn’t improve the taste.

In fact, the economy’s performance is actually worse than the GDP figures alone would suggest. Instead of underperforming for two quarters, the economy has actually underperformed for three quarters. That’s illustrated in this chart of the shortfall of GDP from potential (as measured by the Fed):

Note that prior to the fourth quarter of 2021, the economy was rebounding sharply from the COVID policy-created collapse. (Not the COVID-created collapse: the COVID policy-created collapse.). The rate of convergence of GDP to potential slowed in the quarter Biden took office, then speeded up for a quarter. By 3Q21, the gap had narrowed to $108 billion, and actual GDP was 99.5 percent of potential. But in the fourth quarter, the gap widened by $169 billion. It widened again by $144 billion in 1Q22, and a further $155 billion in 2Q22.

Based on the trend prior to the fourth quarter of last year, it would have been reasonable to expect that the gap would have been closed by the end of 2021. That would have meant about $108 billion in convergence in the fourth quarter. Adding that $108 billion “shoulda” convergence to the actual divergence of $467 billion gets you to $575 billion in underperformance in the last three quarters.

You can say that this isn’t akshually evidence of a recession, and I really don’t care if you do (because it makes you look like an idiot). You CAN’T say that this doesn’t mean the economy has sucked for 9 months. Nine. Not six.

Oh, and of course, inflation has been raging over that period of time.

How’s that Phillips Curve working out guys? Can you say “stagflation”? Well, you probably won’t say that either, but it’s accurate.

And what is our wonderful government doing in these stagflationary times? Well, experiencing another bout of fiscal diarrhea that resembles a colitis sufferer binging on ExLax.

For starters there is the $52 billion CHIPS act, which is a subsidy boodoggle. There is no economic case whatsoever for it. If computer chips are scarce and prices are high, that provides the right incentive to invest. But the chip industry realizes that Uncle Sucker will crank up the printing machine if they whine loud enough. So they whine “supply chain yadda yadda”, and Uncle Sucker turns the crank.

On deck is the odds-on-favorite for most Orwellian named thing of 2022: “The Inflation Reduction Act of 2022.” More government spending (almost $1 trillion) allegedly paid for with higher taxes (which we know never materialize). Since fiscal excess is the main driver of the recent inflation, this Inflation Reduction Act will increase inflation.

It actually might be better if the government dropped the trillion from helicopters and let us decide where to spend it–then we’d just have the inflationary consequences.

But nooooo. The bill ladles out billions in subsidies for “renewable energy” boondoggles which will raise the true cost of energy because “renewables” are notoriously inefficient. (I put “renewables” in quotes because copper, lithium, cobalt, etc., are not renewable.) And it imposes new levies on efficient fossil fuels like natural gas and coal. Which will raise the cost of energy further.

So deciding where to spend what it shouldn’t be spending at all will harm the economy further.

There’s also some health care fuckery included but I can only take so much so you’re on your own to learn about that.

And of course many Retardicans in Congress, especially in the Senate, are totally on board.

Meaning that Congress and the administration are hell bent on fueling stagflation and making energy more expensive and less efficicient, while arguing over the esoteric meaning of a word pretty much everybody understood just fine before, oh, Monday.

Fiddling while the dollar burns. And you’re the one who will get burned the worst.

It is indeed gratifying to see Dutch police beating, tear gassing, and even shooting at farmers (including 16 year olds) protesting the Fourth Reich’s righteous diktats on nitrogen. Serves them right!

Actually, the EU and its Dutch gauleiters are targeting nitrous oxide, another malign greenhouse gas, like carbon dioxide and dihydrogen monoxide (i.e, water, in vapor form). And of course sulfur dioxide is another horrible pollutant.

Do you see the problem here, ladies and gentlemen, ladygentlemen, and [insert your narcissistic self-identification here]? The common element–literally?

Of course you do. Oxygen! Oxygen is at the root of our existential climate crisis. Why should we attack the greenhouse gasses individually? Why not attack the root of the problem? Target its schwerpunkt? Yes, cut off well, the oxygen to the oxides. Problem solved!

We must therefore wage total war against this horrible gateway gas.

It’s up to you to do your part: don’t hold your breath waiting for politicians or polizei to do it for you.

Well, actually, holding your breath is your part: your turning oxygen into carbon dioxide is part of the problem. So save the planet: stop breathing. This will also solve the Dutch farmer problem: if you don’t breathe, you don’t eat–hence, no farmers and their nasty nitrogen!

You know your duty. Just do it.

So today inflation as measured by the Consumer Price Index checked in at 8.6 percent annualized. Which is an uptick in the rate rather than the promised easing.

Sic transit transitory.

The Queen of Transitory, Janet Yellen (Jerome Powell being the King) acknowledged as much earlier this week in Congressional testimony, admitting that her prediction had been wrong. Whoopsie!

One wonders about her (and Powell’s and the rest of the herd’s) mental model of inflation, especially under current circumstances. The usual explanation is some version of the Phillips Curve inflation-unemployment tradeoff. Which is stupid because it is just a correlation, and a worthless one at that since it is about as stable as Amber Heard.

But even that idiocy obviously won’t fly here, so Yellen mumbled about COVID and supply chains and Putin and blah blah blah (as well as holding forth on gun control and abortion, which are OBVIOUSLY primary responsibilities of the Treasury Secretary). These explanations are also inadequate.

Insofar as COVID is concerned, arguably the policy response to it (not COVID itself) shifted back supply curves as stores were closed and people stayed home from work. But those restrictions peaked in early-2021 and have been easing then, so can’t explain by themselves accelerating inflation in the subsequent months.

Yes, COVID has had lingering effects on certain sectors that have constrained supply while demand has rebounded. For example, a lot of truckers that left the industry in 2020-2021 haven’t come back. Interestingly, trucking schools shut down during the pandemic, which has constrained the flow of new labor to the market. In industries such as lumber and oil refining, the largely policy-driven collapse in demand in 2020 led to actual disinvestment and a loss of capacity. We saw the impacts of that in the lumber market a year ago, and are seeing it in the markets for refined products now.

But those factors alone cannot explain the recent spikes: demand has to be part of the equation as well.

Also, supply constraints (and supply chain bottlenecks) cannot explain increases in the general price level, especially as measured by broader measures such as the Producer Price Index and the GDP Deflator. Here’s a straightforward example.

Consider computer chips, inadequate supplies of which hit the auto industry hard, and which are blamed as a major culprit for inflation. Yes, the chip supply constraint limited the production of new automobiles, raising the prices of both new and used cars (which are substitutes for new ones). But, the limitation on the output of automobiles reduced the derived demand for other automobile inputs, such as aluminum, steel, rubber, labor, and capital goods. Ceteris paribus, that should have put downward pressure on the prices of those inputs.

Put differently, bottlenecks increase prices on one side of the bottleneck relative to the prices on the other side. One cannot attribute a rise in the price level (in which the prices of most if not all goods and services are rising, albeit some more than others) to bottlenecks, at least not directly. Bottlenecks can cause prices to fall too. You can’t just look at the impact on the downstream side.

A more indirect story is that by limiting output (and therefore income) bottlenecks cause real income to be lower, thereby reducing the demand for real money balances. Given the nominal supply of money, the only way to equilibrate the now lower demand for real balances with a given nominal supply is to reduce the real value of the money stock by increasing the price level.

Color me skeptical that this can explain the magnitude of the inflation we’ve seen. (The Fed juicing base money by almost 50 percent in 2021 could have added to this impact.)

I therefore am deeply skeptical that supply constraints, attributable to COVID or otherwise, explain the broad rise in prices that has been accelerating over the past year plus.

What about Putin, Biden’s favorite scapegoat? Well, the Ukraine War doesn’t really explain the timing. Consider diesel prices.

There was a spike in the crack spread right at the time of the invasion in late-February, but that subsided quickly. The subsequent runup, especially the ramp-up in mid-April, is harder to ascribe to the war and almost certainly reflects some demand side factors.

Furthermore, it usually takes some time for upstream shocks to translate into higher prices at the consumer level (e.g., a wheat price shock impacting retail food prices). Meaning that a lot of the impact of a disruption first occurring in March is yet to have been fully felt. Good news all around, eh?

No, I think that the stock explanations that the likes of Yellen, Biden and the media fall back on to explain the accelerating inflation are woefully inadequate. Supply chain (and the effects of COVID thereon) in particular.

The most plausible explanation to me is the fiscal theory of the price level, developed formally some years ago by Thomas Sargent and recently studied deeply by John Cochrane. In a nutshell, the theory posits that the price level adjusts to equate the real value of government debt to the discounted real value of government primary surplus. Holding primary surplus constant, an increase in government obligations requires a price level rise to reduce the real value of outstanding debt by the amount of the new debt. Similarly, given the level of government debt, any reduction in expected future surpluses requires a rise in the price level. (The theory is obviously a lot more complicated: that’s a Cliffs’ Notes version of the Cliffs’ Notes of John’s book.)

The massive COVID-driven fiscal stimuluses of both Trump and Biden dramatically increased the nominal value of US government debt. Moreover, the clear preference of this administration and Congress is to expand government spending (and debt) further (e.g., student debt forgiveness, among other things). (It will be interesting to see what happens to inflation if there is a big shift in Congress in 2022.)

I would also suggest that the big regulation plus big “green” agenda pursued by this administration and Congress are also inimical to growth, and expectations about growth. (I put “green” in quotes because as I’ve written before, a monomaniacal focus on CO2 is not a balanced environmental policy, and is indeed inimical to the environment in many ways.)

The green agenda is particularly pernicious. BIden and others (not just in the US) keep yammering away about the wonderful transition to green energy that will occur. What this really means is a transition to more expensive energy and lower incomes. Sic transit transition? I wish.

Less growth means lower future GDP means less future government revenue means smaller primary surpluses.

Meaning that both from the debt side and the growth/surplus side the COVID and post-COVID years are, according to the fiscal theory of the price level, a recipe for large increases in the price level. We’ve seen just such an increase. The timing works out. The fact that the increase in prices is broad works out.

This administration–of which Yellen is unfortunately an accurate avatar–not only does not believe in the fiscal theory, but finds it an anathema because its implications regarding the need to restrain government spending and to jettison onerous regulations and its cherished CO2 agenda require it to become, well, Reaganites. So what is likely the right model of the current inflation will never be their mental model.

Which means we will not be able to say sic transit inflation anytime soon.