Streetwise Professor

The recent controversies embroiling many corporations, notably Target, Disney, and Imbev (the owner of Anheuser-Busch) has brought the issue of stakeholder “capitalism”* to the center of American political discourse. These controversies demonstrate clearly why corporations and their executives should not indulge their own preferences or preferences of “stakeholders” other than shareholders, but should instead limit their efforts to what is already a very demanding task–maximizing shareholder value.

At its root, stakeholder capitalism represents a rejection–and usually an explicit one–of shareholder wealth maximization as the sole objective and duty of a corporation’s management. Instead, managers are empowered and encouraged to pursue a variety of agendas that do not promote and are usually inimical to maximizing value to shareholders. These agendas are usually broadly social in nature intended to benefit various non-shareholder groups, some of which may be very narrow (transsexuals) or others which may be all encompassing (all inhabitants of planet earth, human and non-human).

This system, such as it is, founders on two very fundamental problems: the Knowledge Problem and agency problems.

The Knowledge Problem is that no single agent possesses the information required to achieve any goal–even if universally accepted. For example, even if reducing the risk of global temperature increases was broadly agreed upon as a goal, the information required to determine how to do so efficiently is vast as to be unknowable. What are the benefits of a reduction in global temperature by X degrees? The whole panic about global warming stems from its alleged impact on every aspect of life on earth–who can possibly understand anything so complex? And there are trade-offs: reducing temperature involves cost. The cost varies by the mix of measures adopted–the number of components of the mix is also vast, and evaluating costs is again beyond the capabilities of any human, no matter how smart, how informed, and how lavishly equipped with computational power. (Daron Acemoğlu, take heed).

So what do climate-concerned executives do? Adopt simplistic goals–Net zero! Adopt simplistic solutions–deprive fossil fuel companies of capital!

Maximizing shareholder value is informationally taxing enough as it is. Pursuing “social justice” and saving the planet is vastly, vastly more so.

Meaning that even if corporate executives were benevolent–a dubious proposition, but put that aside for now–they would no more possess the information necessary to pursue their benevolence that does a benevolent social planner.

Instead, executives pursuing non-shareholder wealth objectives are almost certain to be Sorcerer’s Apprentices, believing they are doing right but creating havoc instead.

Agency problems exist when due to information asymmetries or other considerations, agents may act in their own interests and to the detriment of the interests of their principals. In a simple example, the owner of a QuickieMart may not be able to monitor whether his late-shift employee is sufficiently diligent in preventing shoplifting, or exerts appropriate effort in cleaning the restrooms and so on. In the corporate world, the agency problem is one of incentives. The executives of a corporation with myriad shareholders may have considerable freedom to pursue their own interests using the shareholders’ money because any individual shareholder has little incentive to monitor and police the manager: other shareholders benefit from, and thus can free ride on, any individual’s efforts. So managers can, and often do, get away with extravagant waste of the resources owned by others placed in their control.

This agency problem is one of the costs of public corporations with diffuse ownership: this form of organization survives because the benefits of diversification (i.e., better allocation of risk) outweigh these costs. But agency costs exist, and increasing the scope of managerial discretion to, say, saving the world or achieving social justice inevitably increases these costs: with such increased scope, executives have more ways to waste shareholder wealth–and may even get rewarded for it through, say, glowing publicity and other non-pecuniary rewards (like ego gratification–“Look! I’m saving the world! Aren’t I wonderful?”)

Indeed, we now have a highly leveraged agency problem, due to the ability of asset managers like Black Rock to vote the shares of their customers, thereby allowing the likes of Larry Fink to force not just one corporation to indulge his preferences, but hundreds if not thousands. Larry Fink and his ilk can influence the direction of sums of capital dwarfing anything in history to pursue their agendas.

The agency problem pervades stakeholder capitalism even when you dispense with the idea that the shareholders are the principals, and expand the set of principals to include non-shareholder interests (which is inherently what “stakeholder” capitalism means). And as discussed above, in stakeholder capitalism these interests conceivably encompass all life on earth.

The problem is that just as shareholders are diffuse and cannot prevent managers from acting in their interest, stakeholders are often diffuse too. And in the case of climate, All Life On Earth is about as diffuse as you can get. Furthermore, whereas at least in principle shareholders can largely agree that the firm should maximize their wealth, when one expands the set of interests, these interests will inevitably conflict.

So what happens? Just as in politics and regulation, small, cohesive minority groups who can organize at low cost will exert vastly disproportionate influence. It is not surprising, therefore, that companies like Target (to name just one) have responded to the interests of transsexuals–a decidedly narrow minority group–and given the finger to others who should be “stakeholders” as well, namely customers. Customers being a diffuse, dispersed, heterogeneous group that is costly to organize–precisely for the same reasons that it is costly for shareholders to organize.

(The Target and Bud Light episodes suggest that social media has reduced the costs of organizing diffuse groups, but even so, it is far costlier to do that than to organize ideological minorities.)

In other words, stakeholder capitalism inevitably creates a tyranny of minorities, and especially highly ideological minorities (because a shared ideology reduces the cost of organizing). Minority stakeholders will succeed in expropriating majority ones.

Minority tyranny is the big problem with democratic politics. Extending it to vast swathes of economic life is a nightmare.

So what is stakeholder capitalism, when you get down to it? A world of Sorcerer’s Apprentice executives (the Knowledge Problem) with bad incentives (the agency problem).

Other than that, it’s great!

Some libertarians have a peculiar take on this phenomenon. They view stakeholder capitalism as benign, because it is undertaken by private actors, rather than the government.

This take is gravely mistaken. It ignores fundamental principle, and commits at least two category errors.

The forgotten principle is that a liberal society should aim to minimize coercion.

The first category error is to believe that private actors cannot coerce–only governments can. In fact, private actors–including corporations and their managements–can clearly coerce. Come and see the violence inherent in the stakeholder capitalism system straight from the mouth of its primary exponent:

BlackRock CEO: “At BlackRock we are forcing behaviors… you have to force behaviors.” pic.twitter.com/2Q2H84GPC7

— Te?asLindsay™ (@TexasLindsay_) June 4, 2023

“We are forcing behaviors.” Coercive enough for you? Help, help, I’m being repressed:

That bit, by the way, concisely expresses the stakeholder capitalism movement, right down to the “shut up!” and “you bloody peasant!”

The second category error is to believe that there is some sort of clear boundary between private entities (corporations especially) and governments. In fact, the true picture is like the Escher Hands:

Corporations influence government. Government influences corporations (cf., Twitter Files, etc.–the examples are almost endless). Governments often outsource coercion to corporations. Corporations induce the government to coerce for their benefit–and to the detriment of alleged “stakeholders” like customers, labor, and competitors.

Furthermore, as the Arrow Impossibility Theorem teaches, any coherent social welfare function (i.e., any theory of social justice) is inherently dictatorial, and thus inherently coercive. Thus, to the extent that stakeholder capitalism is intended to implement any particular vision of social justice, it is necessarily dictatorial, and hence coercive. It is antithetical to a liberal system like that envisioned by Hayek, that is, one in which a set of general rules is established under which people can pursue their own, inevitably conflicting, aspirations. (Less formally than Arrow, Hayek also argued that any system of social justice is inherently coercive and dictatorial.)

Stakeholder capitalism is therefore a truly malign movement, and an anathema to liberal principles. We need to drive a stake through its heart, before it stakes us to the ant hill.

*I put “capitalism” in quotes because stakeholder capitalism is an oxymoron. Recall that capitalism is an epithet devised by Marx to describe a system ruled in the interests of capital, i.e., shareholders. Stakeholder capitalism is a system intended to be ruled in the interest of everyone but capital. Hence the oxymoron.

** Jeffrey Tucker has also eloquently and rightly excoriated the response of many libertarians to COVID. Here again, these libertarians forgot that limiting coercion is the bedrock libertarian principle.

*

Saudi Arabia is fussed at the low level of oil prices. So true to form with those unsatisfied with price, they are rounding up the usual suspects. Or in this case, suspect–speculators!

I’m sure you never saw that coming, right?

As the world’s biggest oil producers gather here Sunday to decide on a production plan, the spotlight is on the cartel kingpin’s fixation on Wall Street short sellers. Abdulaziz has lashed out repeatedly this year against traders whose bets can cause prices to fall. Last week he warned them to “watch out,” which some analysts saw as an indication that the Organization of the Petroleum Exporting Countries and its allies may reduce output at their June 4 meeting. A production cut of up to 1 million barrels a day is on the table, delegates said Saturday. 

Claude Rains is beaming, somewhere.

I’m so old that I remember when oil prices were beginning their upward spiral in 2007-8 (peaking in early-July), in an attempt to deflect attention from OPEC and Saudi Arabia, one of Abdulaziz’s predecessors blamed the price rise on speculators too.

Is there anything they can’t do?

Not that I’m conceding that speculators systematically or routinely cause the price of anything to be “too high” or “too low,” but if you do think that they influence price, they should be Abdulaziz’s best buddies. After all, they are net long now and almost always are. (Cf. CFTC Commitment of Traders Reports.)

If the Saudis (and other OPEC+ members) have a beef with anybody, it is with their supposed ally, Russia. Russia had supposedly agreed to cut output in order to maintain prices, but strangely enough, there is no evidence of reductions in Russian supplies reaching the world market, even despite price caps on Russian oil and the fact that they are selling it at a steep discount to non-Russian oil. Perhaps Russia has really cut output, but (a) that doesn’t really boost the world oil price if Russian exports haven’t been cut, and (b) it would mean that Russian domestic consumption is down, which would contradict Moscow’s narrative that the economy is hunky-dory, and relatively unscathed by sanctions.

But I think that the more likely story is that Russia is playing Lucy and the football with OPEC.

Which would be a return to form: see my posts from years ago. And I mean years ago. Apparently Won’t Get Fooled Again isn’t on Abdulaziz’s play list.

The other culprit behind lower oil prices is China: its tepid recovery is weighing on all commodity prices–not just oil. A fact that Abdulaziz should be able to understand.

But it’s much easier to shoot the messenger, and that’s what speculators are now–and almost always are. Venting at them probably makes Abdulaziz feel better, but even if he were to get his way that wouldn’t change the fundamental situation a whit.

Bashing speculators is what people who don’t like the price do. And since there’s always someone who doesn’t like the price (consumers when it’s high, producers when it’s low) bashing speculators has been and will continue to be the longest running show in finance and markets.

The Fed and the SEC have expressed concerns about Treasury “basis trades” wherein a firm purchases a cash Treasury security funded by repo-ing it out and sells Treasury futures. Their concern is somewhat justified. As mentioned in the linked article, and analyzed in detail in my paper in the Journal of Applied Corporate Finance (“Apocalypse Averted“) the spike in the cash-futures Treasury basis caused by COVID (or more accurately, the policy response to COVID) caused a liquidity crisis. The sharp basis change led to big margin calls (thereby creating a demand for liquidity) and also set off a feedback loop: the unwinding of positions exacerbated the basis shock, and thereby reinforced the liquidity shock.

This is just an example of the inherent systemic risk created by margining, collateralization, and leverage. The issue is not a particular trade per se–it is an inherent feature of a large swathe of trades and instruments. What made the basis trade a big issue in March 2020 was its magnitude. And per the article, it has become big again.

This is not a surprise. Treasuries are a big market, and leveraging a small arb pickup is what hedge funds and other speculators do. It is a picking-up-nickels-in-front-of-a-steamroller kind of trade. It’s usually modestly profitable, but when it goes bad, it goes really bad.

All that said, the article is full of typical harum-scarum. It says the trade is “opaque and risky.” I just discussed the risks, and its not particularly opaque. That is, the “shadowy” of the title is an exaggeration. It has been a well-known part of the Treasury market since Treasury futures were born. Hell, there’s a book about it: first edition in 1989.

Although GiGi is not wrong that basis trades can pose a systemic risk, he too engages in harum-scarum, and flogs his usual nostrums–which ironically could make the situation worse:

“There’s a risk in our capital markets today about the availability of relatively low margin — or even zero margin — funding to large, macro hedge funds,” said Gensler, in response to a Bloomberg News inquiry about the rise of the investing style.

Zero margin? Really? Is there anyone–especially a hedge fund–that can repo Treasuries with zero haircut? (A haircut–borrowing say $99 on $100 in collateral is effectively margin). And how exactly do you trade Treasury futures without a margin?

As for nostrums, “The SEC has been seeking to push more hedge-fund Treasury trades into central clearinghouses.” Er, that would exacerbate the problem, not mitigate it.

Recall that it was the increase in margins and variation margins on Treasury futures, and the increased haircuts on Treasuries, that generated the liquidity shock that the Fed addressed by a massive increase in liquidity supply–the overhang of which lasted beyond the immediate crisis and laid the groundwork for both the inflationary surge and the problems at banks like SVB.

Central clearing of cash Treasuries layers on another potential source of liquidity demand–and liquidity demand shocks. That increases the potential for systemic shocks, rather than reduces it.

In other words, even after all these years, GiGi hasn’t grasped the systemic risks inherent in clearing, and still sees it as a systemic risk panacea.

In other words, even though I agree with Gensler (and the Fed) that basis trades are a source of systemic risk that warrant watching, I disagree enough with GiGi on this issue that the apocalypse that could result from our complete agreement on anything will be averted–without the intervention of the Fed.

As the periodic debt ceiling game of chicken proceeds, you might read about the credit default swap (CDS) rate on US government debt. This is commonly (even by economists) used to quantify the market’s estimate of probability that the US government will default. Although it is related to this probability, it is not a direct measure of the “true” probability. So interpret with extreme care. Especially in the case of US government debt.

As a little background, a CDS is a contract that pays off if the underlying entity–in this case, the US government–defaults on its obligations. In that event, the purchaser of protection receives the face value of the debt minus the price of the defaulted security. If the defaulted security is worth 40 cents on the dollar at default, the “recovery rate” is 40 percent and the protection buyer receives 60 cents on the dollar.

If the protection currently costs X, you might reason that your expected payoff is p(1-R), where p is the probability of default and R is the recovery rate. Thus, you can estimate p=X/(1-R).

The problem with this logic is that p is not the real world–“physical measure” or “true”–probability of default. It is the probability of default in the so-called “equivalent measure.” Roughly speaking, this p includes a risk adjustment, a risk premium if you will. In theory the p estimated this way could be less than the actual probability of default, meaning that the premium is negative. But usually the p implied this way will be above the objective probability of default. Put simply, just like when you insure your car you will pay a premium that exceeds your expected claims, with CDS the protection purchaser will pay a premium that exceeds the expected payoff.

Indeed, the risk premium embedded in Treasury CDS is likely to be quite large. The reason is that this type of CDS will pay off in bad states of the world–and likely very bad states of the world. That is, if the US government defaults, economic chaos and a recession (perhaps a severe one) is a likely outcome. The marginal utility of income (or wealth) is high when income (or wealth) is low, as during a large recession. Thus, protection sellers are required to perform on their contracts when the marginal utility of income/wealth is higher, so they are going to charge a high price in order to assume such an obligation. The worse the economic consequences of default, the higher the risk premium, and hence the price, that they will charge.

That is, the USG CDS price must exceed the expected payout, likely by a lot, because the payouts occur in bad economic times.

Corporate CDS spreads tend to be “upward biased” measures of default rates for companies, precisely because payoffs tend to be more likely during bad economic times because that’s when companies default. This bias is likely to be especially great for USD CDS precisely because a default will likely cause a severe economic contraction.

Another way to visualize this is to realize that there is considerable “systematic risk” in USG CDS. The risk in CDS payouts cannot be diversified away, and are highly correlated with the overall financial markets. Put differently, a US government default is not really an insurable risk. Classic insurance works by diversification and pooling of independent risks. That is not possible with USG CDS.

There’s another factor at play here–counterparty risk. How much would you pay for insurance from a financially shaky insurance company? Probably not much, because it may not be around to pay when you need it.

Since a US government default is likely to have severe consequences for the financial sector, there is a material probability that the seller of protection will be unable to perform in the event of a USG default.

This would tend to work in the opposite way as the risk adjustment described earlier, that is, it would tend to reduce the cost of protection. The protection is worth less because of the risk it would not be there when you need it. This reduces your willingness to pay for it.

These risk adjustment and counterparty risk issues are likely to be particularly acute for US Treasuries, given the potentially serious economic consequences of a government default. Meaning that USG CDS rates are very unreliable measures of the likelihood of a government default: they are impacted by both the probability of default and the economic consequences thereof.

Yes, a rising CDS spread–like we’ve seen recently–likely reflects a rising estimate of the true probability of a default. But you just can’t back out that probability from the rate.

In response to the liquidity crunch in the commodity trading sector (especially in energy trading) last year, the European Union is looking to regulate commodity traders more like banks:

For decades, Europe’s commodity traders have avoided being regulated on par with other financial firms. A new proposal currently working its way through the European Union legislative system could change that.

To close “loopholes,” dontcha know:

The loophole allows industrial companies like utilities and food processors — but also commodity trading houses — to take derivative positions without the scrutiny facing investment firms. Designed to reduce the burden of managing price risk, it also means that traders aren’t subject to rules on setting aside capital or limiting positions the same way banks and hedge funds are. 

2022 certainly saw unprecedented liquidity pressures in the commodity trading sector, as firms that had sold derivatives (especially on gas and power) to hedge their exposures from supplying the European market saw huge margin calls that greatly strained credit lines and led a coalition of traders to request ECB support (which the ECB declined).

The crucial part of the previous paragraph is “to hedge.” The danger of restricting or increasing the cost of such activities through regulation of the type that is apparently under consideration is that it will constrain hedging activities, thereby (a) making these firms more vulnerable to solvency, as opposed to liquidity problems, and (b) raising the costs of commodity intermediation.

Note that the companies that received state support that are mentioned in the article are not commodity traders qua commodity traders, e.g., Vitol or Trafigura or Gunvor. They are energy suppliers who were structurally short gas and did not hedge, and hence were facing serious solvency issues when gas prices exploded in late-2021 (before the Russian invasion) and winter and spring 2022 (when the invasion occurred). That is, firms that didn’t hedge were the ones that faced insolvency and received state support. (Curiously, Uniper is missing from the list of companies in the Bloomberg article, although Fortum Oyj was collateral damage from Uniper’s collapse.)

The relevant issue in determining whether commodity trading firms should be regulated like banks or hedge funds is not whether the traders can go bust: they can. It is whether (a) they are financially fragile like banks, and (b) whether they are systemically important.

These are exactly the same issue I addressed in my Trafigura white papers in 2013 and especially 2014. To summarize, commodity trading firms engage in completely different transformations than banks and many hedge funds. Commodity traders transform commodities in space, time, and form: banks engage in liquidity and maturity transformations. The difference is crucial.

Liquidity and maturity transformations are inherently fragile–they are the reasons that bank runs occur, as the recent failures of SVB, First Republic, and Signature Bank remind us. That is, the balance sheets of banks are fragile because they finance long term, illiquid assets with liquid short term liabilities.

Commodity traders’ balance sheets are completely different. The “pure” asset light traders especially: they fund short term (“self-liquidating”) relatively liquid assets (commodity inventories) with short term relatively liquid liabilities. Further, hedging is a crucial ingredient in this structure: banks are willing to finance the inventories because the price risks can be hedged.

This is not to say that commodity traders cannot fail–they can. But they do not face the same kinds of fragility (vulnerability to runs) that entities that engage in maturity and liquidity transformations do. It is this fragility that provides the rationale for bank capital requirements and limitations on the scope of their activities. This rationale is lacking for commodity trading firms. They are intermediaries, but not all intermediaries are alike.

Further, as I also pointed out almost a decade ago, major financial firms dwarf even the largest commodity trading firms. Even a Trafigura, say, is not remotely as large or systemically important as, say, Credit Suisse. Yes, a bankruptcy of a big trader would inflict losses on its lenders, but these losses would tend to be spread widely throughout the global banking sector given that most loans and credit lines to commodity traders are widely syndicated. And the potential for these kinds of losses are exactly reason that banks hold capital and that it is prudent to impose capital requirements on banks.

As I noted in the 2014 study, virtually the entire merchant energy sector in the United States imploded in 2002-3. Lenders ate losses, but the broader economic effect was minimal, the assets of the failed firms continued to operate, and the lights stayed on.

In sum, analogizing commodity traders to banks is seriously intellectually flawed, and what’s good or justified for one is not necessarily for the other because of the huge differences between them.

Pace Bloomberg, the events of 2021-2022 did not “expose” some new, unknown risk. The liquidity risk inherent in hedging has long been known, and I analyzed it in the white papers. Indeed, it’s been a focus of my research for years, and is the underlying reason for my criticism of clearing and collateral mandates–including those embraced enthusiastically by the EU.

Thus, a more constructive approach for Europe would be not to apply mindlessly regulatory restrictions found in banking to commodity firms, but to investigate ways to facilitate liquidity supply to commodity traders under extreme situations. Direct access of commodity traders to central bank funding is inadvisable, but central bank facilitation of bank supply of margin funding to commodity traders during such extraordinary circumstances worthy of investigation.

Recall that the Federal Reserve’s response to a funding crisis originating in the Treasury futures markets was instrumental in containing the systemic risks arising from COVID in March 2020 (as described in my Journal of Applied Corporate Finance article, “Apocalypse Averted“). The Fed’s actions were extemporized (just as they were during the 1987 Crash). The EU and ECB would do well to use that experience, and that of 2021-2022, to devise contingency arrangements in advance of future shocks. That would be a more constructive approach to the risks inherent in commodity risk management than to impose regulations that could impede risk management.

It is important to note that making hedging costlier instead of making it cheaper increases the risk of extreme price disruptions. Constraining risk management means that commodity traders will supply less intermediation especially during high risk periods. This will swell margins and make commodity supply less elastic, both of which will tend to exaggerate price movements during periods of stress.

I always wonder about the political economy of such regulatory proposals. Yes, no doubt regulatory reflex is a driver: “We have to do something. Let’s take something off the shelf and make it fit!” But my experience in 2012-2014 also motivates a more cynical take.

The genesis of the Trafigura white papers was an abortive white paper I wrote for the Global Financial Markets Association, a banking industry group. The GFMA approached me to investigate the systemic riskiness of commodity trading firms, and I came up with the wrong answer, so they spiked the study. Somehow or another Trafigura got wind of this, and that was the genesis of the influential (if I do say so myself) papers I wrote for the firm.

The point being that in 2012 the banks were pushing to regulate commodity trading firms with capital requirements and the like in order to raise the costs of competitors, and were looking for intellectual cover for that endeavor–cover I did not provide after a deep dive into the commodity trading sector.

Hence, I wonder if this reprise of the ideas that were largely shelved in the mid-2010s is an example of “let no crisis go to waste,” i.e., whether there are interests in Europe pressing to regulate commodity firms for shall we say less than public spirited reasons.

The proposals are apparently very protean at this stage. But it will be interesting to see where they progress from here. And I’ll weigh in accordingly.

“Equity” is one of the three legs of the iniquitous DIE gallows. It is a driving force behind a variety of policy proposals, two of which have surfaced in recent weeks. They illustrate the fundamental depravity of such “equitable” policies generally.

The first is the Federal Housing Finance Agency’s policy to reduce rates and fees for homebuyers with low credit scores who put down relatively little on a house, and to raise them for those with higher scores, especially those who make a downpayment of between 15 and 20 percent of value. In other words, good credits are being forced to subsidize bad credits. In the words of the FHFA director, this is intended to “increase pricing support for purchase borrowers limited by income or by wealth.”

In other words, it is a purely redistributive policy. And excuse me, but where have I seen this movie before? Oh, that’s right. During the last financial crisis, which was in large part the consequence of policies designed to, well, “increase pricing support for purchase borrowers limited by income or by wealth.”

It isn’t rocket science to figure out where this will go. More low credit quality households will buy houses they can’t afford. A loss of a job, or a downturn in the real estate market, or one of myriad of other things means that they won’t be able to repay the loan, resulting in default, foreclosure, and a credit loss to the lender. Most likely followed by class action law suits alleging predatory lending.

Wealth redistribution via housing policy and housing finance policy has always been a bad idea plagued by unintended–but totally predictable–consequences. But it’s like a bad drug, and one that the United States government just can’t quit for long.

The other policy, smaller in scale but similar in design comes from California. There the three major state regulated utilities have proposed implement two part tariffs, consisting of a fixed monthly fee and a per unit usage charge. The fixed fee will be based on income, with low income households paying $15/month and higher income households paying as much as seven times that amount. Further, the utilities will reduce the rate per kwh.

Now you can make an economic case for a two part pricing structure in an industry (like electricity) with high fixed costs, but that doesn’t appear to be the motive here: instead, it is an attempt to use electricity tariffs to redistribute income and wealth. It is also somewhat ironic that California, which faces chronic electricity shortages and constantly strives to reduce consumption because climate change is introducing a policy that encourages consumption. I am sure that will work out swell.

If you believe in redistribution, there are better and worse ways to achieve that objective. The better ways are through lump sum transfers or something like the negative income tax. The worse ways are through messing with prices. It’s fair to say that the worst ways are through messing with prices.

And that’s exactly what these two policies will do. The FHFA policy messes with the price of credit. The California electricity policy messes with the price of power.

Messing with prices distorts decisions on a variety of margins.

For example, distorting the price of credit (i.e., charging borrowers rates and fees that do not reflect default costs) encourages overborrowing by those with poor credit and underborrowing by those with better credit. As we saw in 2006-8, such policies can have systemic consequences. Even absent systemic consequences, they will lead to greater financial distress costs, deadweight bankruptcy costs, reduction in housing values due to the effects of foreclosure, etc.

Both policies also increase effective marginal tax rates, which distort labor supply decisions. In California’s case, the redistributive policies represent one more straw on the camel’s back of those debating where to locate, and due both to the direct effects and the signal sent regarding the extractive nature of California policies will add to the exodus of the middle class from the state.

The means by which these redistributive policies are being imposed is also pernicious. This is redistribution via regulatory fiat. The administrative state is already too large and too unaccountable. Giving it a license to redistribute income and wealth–or to engage in more such redistributive schemes–in the name of “equity” will result in a proliferation of such ghastly schemes, and the deadweight costs they entail due to their distortions of prices. Make elected politicians make the case for and take responsibility for redistributive schemes rather than delegating them to the unelected and the unaccountable. Especially those who can only implement redistributive policies through destructive distortions in the prices of the goods and services they regulate.

The United States desperately needs pro-growth policies, not redistributive ones–not least because growth is essential to prevent a debt crisis. These redistributive policies are decidedly anti-growth.

They are also divisive, and are being implemented at a time where social divisions are already acute.

I wish I could say that these two policies were outliers. They are not. They are representative of today’s strongest policy current: the Biden administration’s “whole of government” plan for “environmental justice” is another. Such policies are a recipe for stagnation, and taken collectively and together with lavish government spending bear the seeds of future economic crises. And not far into the future either.

Recently there have been quite a few articles declaring the death, or at least the senescence, of the shale boom. This from today’s Bloomberg, about the Permian specifically, is one of the more optimistic takes.

The gravamen of the argument of those digging shale’s grave is that the most promising prospects have been drilled already. This is no doubt true–and I’ll present some evidence of that shortly–but it’s hardly the entire story. When one looks more comprehensively at the shale boom, it becomes clear that it was driven by technological progress that has overwhelmed the traditional sources of declining productivity in natural resource extraction.

I recently completed a paper on the shale boom. It examines the sources of productivity growth in both oil and gas unconventional wells. In particular, it quantifies the impact of learning-by-doing on productivity growth on a well-by-well basis in all of the major production basins.

The empirical framework captures three potential sources of productivity growth. Firm specific learning, basin-wide learning, and exogenous technological change. As is conventional, I measure the former effect by the cumulative number of unconventional wells drilled in a basin by a given firm prior to drilling a particular well. The second effect is measured by the cumulative number of unconventional wells drilled by all firms in a basin prior to the drilling of a particular well. The last effect is captured by a time trend (again conventional in the learning-by-doing literature dating back decades).

I examine a variety of productivity measures. In what I consider the most novel and potentially interesting part I also look for evidence of cost-reducing innovation and learning effects.

Productivity measures include things like initial production, maximum production, production over the first 12 months, and decline rates. I find strong evidence of firm-specific learning effects in the first three variables, but not so much in decline rates. (Interestingly, learning does not appear to improve drilling speed, contrary to empirical findings in conventional wells.) I do not find strong evidence of industry-wide learning effects.

The last finding sheds light on the exploitation of most promising prospects first. The cumulative basin-wide experience variable is also impacted by this effect. More wells drilled means more industry experience, but it also means more of the good prospects have been drilled. Those two things offset, leading to coefficients that are small positives or actually negative.

The crucial thing to note is that productivity increased from 2011-2020 (in oil) despite the impact of going to progressively less promising sites. This demonstrates the importance of learning and exogenous technological change.

The cost results are the most fascinating to me. I regress the number of wells drilled in a given month in a given basin against the learning variables, input cost variables, a time trend, and price (instrumented for gas to take into account endogeneity–the oil price is reasonably exogenous). I find strong industry-wide cost reducing effects of learning. Specifically, holding price and input costs constant, the number of wells drilled in a given month increases strongly with cumulative industry experience in a basin. That is, cumulative experience shifts out the supply curve. This is evidence of declining cost, and in particular declining fixed cost.

Here again you would expect that the exploitation of the low hanging fruit first should lead to higher costs as cumulative experience grows. But if that effect is there, it is overwhelmed by learning-driven cost reductions.

Based on this research, I am more bullish about the prospects for unconventional production growth in the United States than the conventional wisdom is. The conventional wisdom focuses on a single margin: the stock of potential drilling locations. That totally overlooks the real shale story: massive technological improvement, largely driven by learning effects. Those learning effects work on a variety of margins, including getting more out of a given well, and reducing the cost of drilling a well.

In essence the conventional wisdom is like neoclassical growth theory, in which diminishing returns are the depressing fact of life. But as modern growth theory emphasizes, technological progress has overcome diminishing returns. That’s why we are so rich–far richer than neoclassical growth theory can explain.

My interest in learning-by-doing dates back decades, to my amazing experience of taking bob Lucas’ undergraduate economic growth course at Chicago: Bob decided to teach the course as a way to master the growth literature, and so those fortunate few of us in the class were witnesses to the genesis of his research on growth, which is more important than his (still important) macro/money research for which he won the Nobel.

I wrote a few papers in grad school on LBD, for example showing how learning effects drove productivity growth in US gun manufacturing (at Springfield and Harpers Ferry Armories) in the 19th century. Researching learning in shale gave me an opportunity to dust off and update that previous research interest.

I would also note that shale pessimism is focused on oil. Gas has continued to go great guns–despite the fact that the same diminishing returns effect should be operating there as well. US gas production has continued to grow, especially in Marcellus and Permian. The latter is largely associated gas, but the former is not. This is a productivity story, and it’s not like diminishing returns don’t operate in Marcellus.

Indeed, gas supply growth has been so robust that prices are hovering around $2/MMBTU–back to the level prior to the spike in 2021-2.

Of course one cannot count on the rate of technological improvement continuing at the rate observed in 2010-2020 (for oil) and 2006-2020 (for gas). But one should certainly not discount it, and one should definitely not ignore it altogether and focus only on a source of diminishing returns.

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.

A brief follow-up on SVB (which kinds of sounds like a venereal disease, which is kind of apropos I guess).

During the GFC I wrote about how bank capital requirements were like price controls. A regulator can never set the “right” prices–in this case, the shadow costs of assets with different risks. It will underprice some risks, and overprice others. Banks will hold too many of the assets where risk is underpriced, and too little of the assets where the risk is overpriced.

Bank capital requirements focus primarily on credit risk, rather than interest rate risk. SVB incurred very little if any capital charge to hold Treasuries and agency debt, because they are viewed as “safe” from a credit risk perspective. But they did allow SVB (and other banks) to take on interest rate risk.

Very low or zero capital charges on Treasuries fall into the there-are-no-coincidences-comrade category. The government wants to encourage holding of Treasuries and agencies. Big deficits to finance, after all. As Niall Ferguson, Charlie Calomiris, and others have pointed out, governments regulate and structure banking systems first and foremost to facilitate government finance, not private capital markets.

Related to this is the issue of stress tests. The relaxation of regulation passed in 2018 meant that banks of SVB’s size no longer had to undergo stress tests. But the recent government stress tests would not have really stressed SVB: they only tested for a 200 basis point increase in interest rates, not the 400+ increase we have experienced. So SVB would have passed anyways.

In the immediate aftermath of the GFC I expressed skepticism about stress tests. I called the Tinker Bell Economics–“We believe! We believe!” That is, they are intended to assure everyone about the safety of the banking system, rather than to actually test the safety of the banking system.

The unstressful interest rate stress scenarios also plays into the idea that the Fed and Treasury don’t want to do anything to dampen banks’ appetite for government bonds.

One last comment. Many historical banking system crises are the result of yield chasing in low interest rate environments. Low yields (a) allows banks to borrow cheap, and (b) induces banks to chase yield by taking on more risk.

We obviously operated for years in a low rate environment, courtesy of the Fed. Yield chasing was an inevitable. SVB chased yield.

In sum, yes, SVB’s execs were rats. But the government designed the maze (capital requirements, low interest rates) and baited it with cheese. So when the government says that they are going to fix the problem, don’t believe them. But believe this: especially given the United States’ huge debt and deficits, any “fixes” will be rigged to protect the Treasury market, and the devil take the hindmost. Which would be you.

Bank failures tend to come in waves, and we are experiencing at least a mini-wave now.

Banks fail for three basic reasons: 1. Credit transformation: deterioration in borrower creditworthiness, usually due to an adverse economic shock (e.g., a real estate bust). 2. Maturity transformation: borrowing short, lending long, and then getting hammered when interest rates rise. 3. Liquidity transformation combined with an exogenous liquidity shock, a la Diamond-Dybvig, where idiosyncratic depositor needs for cash lead to withdrawals that exceed liquid assets and therefore trigger fire sales of illiquid assets.

The two most notable failures of late–Silicon Valley Bank and Silvergate–are examples of 2 and 3 respectively.

In some respects, SVB is the most astounding. Not because a bank failed in the old fashioned way, but because it was funded primarily by the deposits of supposed financial sophisticates–and because of the disgusting policy response of the Treasury and the Fed.

SVB took in oodles of cash, especially in the past couple of years. The cashcade was so immense that SVB could not find enough traditional banking business (loans) to soak it up, so they bought lots of Treasuries. And long duration Treasuries to boot.

And then Powell and the Fed applied the boot, jacking up rates. Bonds have cratered in the last year, and took SVB’s balance sheet with it.

Again, an old story. And hardly a harbinger of systemic risk–unless such reckless maturity mismatches are systemic.

SVB was the Banker to the Silicon Valley Stars, notably VCs and tech firms. These firms are the ones who deposited immense sums in exchange for a pittance of return. Case in point, Roku, put almost $500 million–yes, you read that right, 9 figures led with a 5–into SVB!!!

I mean: WTFF? Was the Treasurer a moron? For who other than a moron would hold that much in cash in a single institution? (Roku claims its devices “make your home a smarter.” Maybe they should have hired a smarter treasurer and CFO, or replaced them with one of its devices). Hell, why is a company holding that much in cash period?

A few of these alleged masters of the universe (like Palantir) saw the writing on the wall and yanked their deposits: deposits fell by a quarter on Friday alone, sealing the bank’s doom. Those who were slow to run howled to the high heavens over the weekend that if there was not a bailout there would be a holocaust in the tech sector.

Even though the systemic risk posed by SVB’s failure is nil (or if not, then every bank is systemically important), the Treasury Department and the Fed responded to these howls and guaranteed all the deposits–even though the FDIC’s formal deposit insurance limit is $250,000. You know, .05 percent of Roku’s deposit.

When evaluating this, one cannot ignore the reality that the Democratic Party is completely beholden to Silicon Valley. This is beyond scandalous.

Occupy Silicon Valley, anyone?

Treasury Secretary Janet Yellen insulted our intelligence by assuring us this is not a bailout. Well, it’s not a taxpayer bailout, strictly speaking, because the Treasury is not providing the backstop. Instead, it is being funded by a “special assessment” on solvent banks. Which are owned and funded by people who also pay taxes. And such an “assessment” is a tax in everything but name–because it is a contribution by private entities compelled by the government.

The policy implications of this are disastrous. The whole problem with such bailouts is moral hazard. What is to stop banks from engaging in such reckless behavior as SVB did if they can obtain seemingly unlimited funding from those who know that they will be bailed out if things go pear-shaped?

And the regulatory failure here demonstrates that bank regulation–despite the supposed “reforms” of Frankendodd–can’t even catch or constrain the oldest bet-the-bank strategy in the book. Free banking–no deposit insurance, no bailing out of depositors–couldn’t do worse, and would likely do better.

No, the failure of SVB is not the scandal here. The scandal is the political response to it. This reveals yet again how captured the government is. This time not by Wall Street, but by tech companies and oligarchs that are currently the primary source of Democratic political funding.

A couple of weeks ago the Silvergate story looked juicy, but SVB has put it in the shade. Silvergate also grew dramatically, but on the back of crypto rather than SV tech. It became the main banker for many crypto firms and entrepreneurs. The crypto meltdown did not affect Silvergate directly, but it did crush its depositors, the aforesaid crypto firms and entrepreneurs. They withdrew a lot of funding, and an old fashioned liquidity mismatch did it in.

In traditional banks, deposit funding is “sticky.” Banks that rely on wholesale funding (“hot money”) are more vulnerable to runs. Silvergate’s funding was not traditional sticky deposit funding, nor was it hot money per se. It was money that was pretty cool as long as crypto was cool, and became hot once crypto melted down.

A run started, but the run was precipitated by a liquidity shock. Simple story, really.

Silvergate’s failure was not a scandal. SVB’s failure per se was not a scandal (except to the extent that our vaunted banking regulators failed to prevent the most prosaic type of failure).

Again–the scandal is the politically tainted response that will have baleful consequences in the future, as the response virtually guarantees that there will be more SVBs in the future.