Streetwise Professor

The Turkish lira is now about 12, a big recovery from its nadir on Monday. I expressed skepticism that Erdoğan’s announced policy of guaranteeing some Turkish bank deposits against an adverse move in the TRY was the cause. As we’ll see in a moment there is something to that. But even if the policy announcement caused all or some of the rebound, my skepticism about the viability of this mechanism remains.

As to the logic behind the policy. In essence, there was a run on the lira, and one way of running was to sell lira on deposit, and buy dollars. A typical bank run is to sell deposits for currency. One reason bank runs are far less frequent today in places like the US is deposit insurance, which is basically a mechanism to ensure that a dollar on deposit will always be worth a dollar of currency. That short-circuits the run dynamics, in which fear that a dollar of deposits will be worth less than a dollar of currency, which induces people to race to convert deposits into currency, which can cause banks to fail . . . leading to deposits being worth less than the equivalent amount of currency.

What Turkey has announced–and note, it has not announced the details so this isn’t really a plan but a sketch of a plan–is equivalent to a form of deposit insurance. Except that here the government is promising the TRY value of deposits will be worth at least a fixed amount of USD or Euros. But the idea is the same. If people are convinced that their deposits will remain pegged to the dollar, they have less incentive to run.

There is a key word in the prior sentence: “convinced.” It might work if people believe it will work. It won’t work if people don’t. So how can they have confidence? This confidence is necessary, but not sufficient, for success.

The confidence depends on the reliability and solvency of the guarantor. It’s not quite clear who that is in this situation. Is it the banks? The government? The former would be ludicrous, so let’s go with the latter.

So how is the government going to fund the guarantee? It’s likely hoping that the mere fact that people believe it can and it will will mean that the government is never on the hook for anything.

But that’s not realistic. The value of the TRY will fluctuate for the same reasons that currencies always fluctuate. Macro shocks. Balance of payment issues. Capital flows. Whatever. The Turkish government is short a put on the currency (that’s essentially what the guarantee is–a put on the TRY). Sometimes these factors are going to push the TRY down, obligating the government to make good on its promise.

So how is it going to pay for that? And note that it will have to pay a good fraction of the time. Roughly 50 percent of the time if the floor is set at the current exchange rate.

Print lira? LOL. So the lira declines, and the government prints more lira to pay off on its short put. Which will depress the lira further. Requiring more printing, etc. etc. etc.

Short put=short gamma. Short gamma can create an unstable positive feedback mechanism, and positive feedback mechanisms in economics very often have extremely negative consequences. Lira declines feed further declines. And again–as with any currency, lira declines are always a major risk. This is especially true with a country like Turkey. And resorting to this mechanism would likely destroy the trust that it depends on.

OK. The printing option seems pretty dumb–though don’t put it past Erdo! So, to meet its obligation to top up lira-denominated accounts to compensate for a decline in the TRY, instead of printing lira Turkey could sell dollars and Euros for lira which it then gives to depositors. At least this would potentially create a beneficial (negative/stabilizing) feedback mechanism, with the $ and € sales tending to increase the value of the lira.

But where is Turkey going to get the dollars and euros? That’s what I meant the other day when I said don’t trust a madman whose mouth writes checks his wallet can’t cash.

This second mechanism can be viewed another way: as a commitment device. Specifically, a device committing Turkey to defend the lira. Effectively, a way of committing to a peg: it has to buy lira/sell $ or € when the lira declines. And if Erdo’s other promise–not to raise interest rates–is believed, committing to a peg and foregoing the option to raise interest rates to defend the currency.

And if this is the real plan, it faces all the risks that pegging inevitably entail. Pegs are always at risk to speculative attack. Turkey is particularly so, given its paucity of foreign exchange reserves and its bizarre government policies. No doubt George Soros’ interest has been piqued.

This is why I am skeptical. Skeptical as to the announcement of this sketch of a plan leading to a 33 percent rally–FX traders no doubt have figured out what I just laid out. Skeptical as to the feasibility and stability of this mechanism, even if it did levitate the lira.

And as I alluded to at the outset, it may well be the case that the plan didn’t raise the lira on Monday and keep it there–traditional government intervention has. The FT reports that the central bank has spent billions of dollars in recent days to stabilize the TRY. This suggests that the plan is basically just propaganda to (a) conceal what is really going on behind the scenes, a traditional defense of the currency, and (b) allow Erdo to take credit for the rally without admitting that more dollars are going out the door.

Regardless of the mechanism, defending the lira puts strains on Turkey’s public finances. The fact that Turkish credit spreads have widened even as the currency has strengthened suggests that Mr. Market has figured that out.

Turkey, like all countries, faces the “impossible trinity.” A country cannot have a fixed exchange rate, an open capital account, and an independent monetary policy. But Erdoğan is promising all three. Fixing interest rates at low levels as he promises, because he’s on a mission from Allah=independent monetary policy. He has promised to maintain free movement of capital. And now, he is implicitly promising to fix the exchange rate.

We know with metaphysical certainty that this is impossible–the “impossible trinity” phrase came about for a reason. So it’s going to end badly. The only question is which part of the trinity is Erdoğan going to jettison. Based on form, I predict the lira.

The Turkish Lira has crashed, down over 50 percent since September, and now trading at less than a third of the value it had when I was in Turkey in 2018. It would be unfair to apply Jefferson Davis’ epitaph for the Confederacy: “Died of a Theory.” Instead, “Murdered by a Theory” would be more accurate.

And the murderer is readily identifiable: Turkish president Recep Tayyip Erdoğan. His theory is that high interest rates cause inflation, so as inflation accelerated and the Lira plummeted, rather than allowing the central bank to tighten monetary policy and raise interest rates, he pushed it to cut rates–which only accelerated the TRY’s crash.

Sunday, even Erdoğan apparently realized that his economic rationale was risible, so he switched gears, saying that this policy was dictated by Allah and the Koran:

“What is it? We are lowering interest rates. Don’t expect anything else from me,” Erdogan said Sunday in televised comments from Istanbul. “As a Muslim, I’ll continue to do what is required by nas,” he said, using an Arabic word used in Turkish to refer to Islamic teachings.

Meanwhile, Erdoğan has been telling his largely religious (and poor) political base (which is being devastated by inflation) that this is just a test from Allah. That the Koran says that Allah is seeing whether you can bear such trials in silence and faith, and that if they vote for him again in 2023 he will fix inflation. Whip Inflation Then (Insallah). Or something.

So now, the Lira is being murdered by theology instead of a theory.

The chaos became extreme on Friday, with Borsa Instanbul shutting down due to a crash in Turkish shares that triggered circuit breakers. The chaos continued on the open, with the USDTRY breaching 18 and the stock market shutting down again:

Note the big rally earlier today. Though it is rather sobering that 15 is, relatively speaking, good news.

The recovery was driven by an Erdoğan statement to the cabinet today in which he pledged to defend the currency and to protect Turkish depositors against currency declines. To be honest, I find it hard to take his announcement seriously, although the markets apparently have. He has made commitments, but their credibility is dubious at best, especially since he pledged to continue his Crazy Erdo interest rate policy.

To carry through on these promises, Erdo needs dollars and Euros. Which he doesn’t have.

So I would be short the TRY at 15. Relying on a madman’s mouth writing checks that his wallet can’t cash is foolish.

There are larger lessons here.

The first is that this demonstrates the extreme dangers of presidentialism and highly personalized political systems. A “leader” with no checks and balances can indulge in insane policies at a whim. Erdoğan has gutted every institution in Turkey that could counter his ambitions–and his flights of policy fantasy. The press is suppressed, with more journalists in jail in Turkey than anywhere in the world. Civil society figures (and ordinary people) are muzzled due to the threat of being arrested for “insulting the president.” (The friend of a friend, the head of the Ataturk Institute, has been convicted of this and has the sword of Damocles hanging over his head.) The courts are packed with his goons, and the military was neutered after the abortive coup of 2016 (which in retrospect looks more and more like a false flag operation, given how it has redounded to Erdo’s benefit).

(Erdoğan’s careening into megalomania actually makes Putin look good by comparison. Russian macroeconomic policy under Putin has actually been rather responsible. Perhaps because Putin is uninterested in the subject and willing to delegate, or because he realizes that he is not especially competent in the subject. Either way, his forbearance looks wise especially in contrast to Erdoğan.)

Another lesson is that fakakta economic policies can do incredible damage in short order, yet “leaders” may recklessly implement nonetheless. In the United States, the Biden administration’s continuing attempt to spend additional trillions in the face of the worst inflation of the last 40 years is economic insanity: here the United States is at risk of dying from ignoring a theory (the fiscal theory of the price level). Even non-righties like Larry Summers realize the danger

Fortunately, a semblance of checks and balances remains in the US, and Joe Manchin has played Horatio at the Bridge, holding off BBB for now. But for how long? The specter of presidentialism hangs over the US too: Manchin is being assailed viciously by the left as a threat to “our democracy” for his temerity in resisting the president’s will–even though said president’s mental incapacity is manifest.

The US should take heed of what is going on in Turkey, and not gut checks and balances, give carte blanche to presidents, and engage in reckless economic policies. Alas, given the sway that turkeys hold in politics and the media, this may be a vain hope.

One of the most disgusting tropes in the ongoing (and ongoing and ongoing and ongoing) controversy over COVID policy is the resort to ritual incantations of “science.” This is epitomized by Fauci’s recent declaration that “le science c’est moi.” If you disagree with him, you are anti-science, because he represents science.

This is a logical fallacy (appeal to authority) squared: you can’t challenge Fauci’s authority because he is cloaked in the authority of science. Fauci rivals Louis XIV in his grandiosity.

The science fetishists should read about the sociology of science, and in particular Thomas Kuhn’s The Structure of Scientific Revolutions. It is a dense work that makes many penetrating observations, but the crucial concept he identifies is “normal science.” That is, he emphasizes the institutional context of science, and the incentives facing those who identify as scientists, and are widely recognized as such.

The basic idea is that in the aftermath of scientific revolutions, a “paradigm” emerges that represents the conventional wisdom, and that most scientists are working within that paradigm. Moreover, they are heavily invested in it and would suffer a massive loss in their human capital if that paradigm were to be displaced. Thus, even as contradictory evidence accumulates, the science community resists. It does not act as the scientific methodology dictates, that is, by rejecting or revising theories that fail empirical test. Instead, the community attacks the apostates and repeatedly appeals to its authority to thwart attacks on the ruling paradigm even as contrary evidence accumulates. It doubles down on the paradigm whenever contrary evidence emerges.

This is why most scientific revolutions come from rank outsiders. People who are not invested in, and protected by the existing system. People who have little to lose by pointing out that emperor has no clothes.

My favorite example of this is ulcers. An obscure Australian doctor hypothesized that a common bacteria caused ulcers. The response of the scientific community–and the pharmaceutical industry that profited greatly from ulcer medications–was furious. He was ridiculed and marginalized. But eventually, in a triumph of true science, his hypothesis was confirmed by the data, and the normal science hypothesis was displaced.

Thus, rather than genuflecting to the scientific community (which arrogantly identifies itself with Science), one should always treat it with skepticism. Indeed, the more strident the insistence that someone or some group represents Science the more skeptical you should be. Their stridence reveals that they are afraid, very afraid, that their paradigm is under credible assault.

True scientists are open minded. Normal scientists are close minded. Arrogant defensiveness is symptomatic of normal science under credible threat. A reasonable inference to be drawn from haughty invocations of Science in response to questions is that the science is indeed questionable.

The Kuhnian institutional/sociological forces that warp scientific inquiry are made far, far worse when a scientific issue intersects politics. This is especially true given the gargantuan role of government funding of science: the guardians of the paradigm control who gets the grants. And this is especially especially true when there are strong commercial incentives for supporting the paradigm–such as medications that are justified by the paradigm.

All of these factors are at work in COVID. The illness has been hijacked by governments and shadow governments to justify imposition of measures that deprive billions of people basic liberties and to extend the power of those governments far beyond what would have been imaginable even two years ago:

Sadly, it has come to the point where invocations of Science are the hallmark of charlatans and governments and shadow governments that want to control you. This is especially true with respect to COVID “vaccines.” (I use quotation marks because what are being touted as vaccines are very different from traditional vaccines, a fact that is itself suggestive of propaganda and bait-and-switch tactics.).

As I have noted before, the externality argument for these medications is rejected even by government authorities that advocate widespread, and indeed mandatory, vaccination. Even putting that aside, I dare you to name any other medical treatment in the FDA era that would be approved, let alone allowed to remain on the market, in the face of such dubious evidence of efficacy and such widespread indications of serious–and fatal–side effects. (The best proof of the lack of efficacy is the recent official insistence on “boosters.”).

There is no evidence that trade-offs are being evaluated rigorously–scientifically. Indeed, any suggestion that this be done is furiously attacked by government “scientists” and their government funded apparatchiks. This is most glaringly obvious in the case of children. The vast bulk of scientific evidence shows that children and young adults are at little risk of serious illness from COVID, and are not major vectors of spread. So the benefit of vaccinating them is approximately zero. There are plausibly risks of vaccinating them–this is especially true of young adults.

But governments around the world are currently proceeding to force giving children and young adults these shots.

And if you object, on scientific grounds, you are assailed as being an anti-science know nothing.

Science has been perverted in the name of fighting COVID. Sadly, the outcome of this will not be to improve the reputation of science, or to discredit “normal” politicized science: it will be to undermine the authority of true science. Those who proclaim most arrogantly in the name of science–Anthony Fauci most notable among them–are in fact science’s greatest enemies.

Due to the immovable object of price caps and the irresistible force of spiking natural gas and power costs, about 20 retail energy suppliers in the UK have gone toes up. Most of these have been addressed using what is called the Supplier of Last Resort (SoLR) mechanism, whereby customers of the failed firm are transferred to another supplier. (SoL sounds about right!) This mechanism effectively socializes losses:

Energy suppliers that rescue customers via the supplier of last resort can recoup their costs through an industry levy that is funded by bills.

Although the foregoing suggests that all UK energy consumers share in the costs, energy market regulator Ofgem suggests that the customers of failed firms may bear some of the costs:

Could bills go up?

When we appoint a new supplier using the Supplier of Last Resort process, we try to get the best possible deal for customers.

Suppliers we appoint will likely put you on a special ‘deemed’ contract when they take on your supply. This means a contract you haven’t chosen. A deemed contract could cost more than your old tariff, so your bills could go up. However, they are covered by the energy price cap Ofgem sets, which ensures you get a fair price if you are put on one. 

When contacted by the new supplier, it’s best to ask to be put on their cheapest tariff or shop around if you want to. You won’t be charged exit fees. This is a challenging time in the market and we know that there may not be many tariffs available when shopping around right now.

Deemed contracts can cost more because the supplier takes on more risk. For example, they might have to buy extra wholesale energy at short notice for new customers. So they charge more to cover these costs.

Up to last week, all the failures had been dealt with using this mechanism. But the failure of Bulb (Dim Bulb?) was evidently too big for Ofgem to deal with using the SoL mechanism. Instead, it resorted to a “Special Administration Regime” which basically nationalizes Bulb. This regime permits the government to “make grants and loans to the company in administration and may also give guarantees for any sum borrowed while it is in administration.”

That is, SAR is essentially a bailout/nationalization of losses and risk.

Ofgem notes:

The energy price cap, which sets a maximum price for customers on standard default tariffs, will remain in place to protect millions of people from the sudden increases in global gas prices. 

(Aside: It is impossible to protect millions of people from the sudden increase in global gas prices. It is only possible to determine–based on political mechanisms–which millions pay and how much. So this statement is typical government bullshit.)

Thus, given the price cap and the fact that Bulb is now owned by the UK government, Boris now has a big short position in natural gas. So how is he going to manage it?

I have heard that the government approached Vitol, which told them to fuck off. So . . . what next?

The company still has to procure energy at market prices and sell them at fixed prices. Since the government is now the residual claimant, it has a short exposure and can take this exposure on the balance sheet, as it were, and essentially run a naked short.

Or it can try to hedge by buying gas forward. But this is not a trivial problem. This is not a position of fixed size that faces only price risk that could be hedged using fixed quantities of swaps/forwards/futures. There is volumetric risk as well: cold weather increases both the price of gas and the amount of gas that must be supplied. A sophisticated hedge would involve both forward fixed price purchases and weather derivatives. Or through the purchase of a sophisticated structured product that has payoffs that depend on both volumetric and price variables.

I’m guessing that the government is not into sophistication, or frankly, capable of it. As a result, it is likely to be at a severe disadvantage in negotiating a price on a structured product or weather derivatives or long dated forwards.

It is also likely sweating out the hedger’s hindsight dilemma. If it doesn’t hedge and prices spike it will catch hell because of the large losses passed on to taxpayers. But if it hedges and prices don’t spike or in fact decline, it will catch hell too: you idiots overpaid!!!! Both of these judgments are based on hindsight, but even though hedging decisions should be evaluated ex ante on the basis of how they effect risk, inevitably they are evaluated ex post based on how they pan out.

Consider California in the aftermath of its 2000-2001 electricity crisis. It entered into long term contracts at what retrospectively was the height of the crisis, and thus paid higher prices than it would have had it procured on a short term basis. Of course, California attempted to recover by suing the contract sellers, claiming it was a nefarious manipulative scheme. Alas, it succeeded to some degree.

The best solution would be to do what clearinghouses do when a big member collapses–auction off the positions. This is what NYMEX did when the hedge fund Amaranth collapsed due to natural gas futures and swap losses in 2006: JP Morgan and Citadel assumed the positions in exchange for consideration. Similarly, when Lehman collapsed in 2008, the CME auctioned off its futures portfolio.

Even in these situations, however, there is always controversy about whether the price is right. Assertions that the buyers of Lehman’s futures positions received a windfall (i.e., bought on the cheap) led to litigation (filed by the Lehman bankruptcy trustee) and considerable controversy. (Here’s my take on the issue.)

Note that the factors mentioned above mean that the pricing in any putative auction of Bulb obligations is likely to be more discounted, and thus subject to more controversy, than the Lehman positions. As in the Lehman case, the positions will be auctioned in a stressed market. Moreover, as noted above, the exposures are far more complex and difficult to manage than Lehman’s rather vanilla (though large) futures positions. That complexity will bring a discount. Furthermore, apropos California circa 2001, the bidders realize that they are subject to government attempts to clawback any gains that result ex post due to favorable fundamentals (e.g., an unexpectedly warm winter). That is, the bidders may fear that the government will actually acquire a long option position, and hence they will be short an option: if prices spike, the auction “winner” will bear the brunt, but if they don’t the government will claim that it was exploited and over payed.

That is, unless the government can credibly commit to adhering scrupulously to the results of the auction, the auction may well fail to attract any bidders.

NB: credible commitment is not one of most modern governments’ strong suits. (This is likely one of the reasons Vitol told the government to bugger off. It realized that it was assuming a totally skewed position–heads they lose, tails they don’t win.).

According to the FT article linked above (amazingly factual and informative for a current day FT article, BTW) the government rejected two offers to assume the Bulb portfolio. I surmise that the bids were discounted heavily to reflect the factors mentioned above and Ofgem accordingly rejected them.

So I’m guessing the government will wear the risk. Perhaps it will try to manage it–and do it badly. Or more likely it will just let it ride. Maybe it will bet on Covid, thinking that the new variant or the new variant after that or the new variant after that will cause governments (stupidly) to lockdown again and crater economic activity and hence gas demand.

I note that Bulb might not be the end of the story. As noted above, the price caps remain in force, meaning that other suppliers may fail in the future–including those that have already gone through the SoL process. The government would be the ones SoL then. That is, the government not only has the Bulb liability–it has a big contingent liability that could dwarf Bulb.

Ofgem has already hinted at this:

In a letter to Kwarteng justifying the decision to pursue a special administration for Bulb, published on Wednesday, Ofgem’s chief executive Jonathan Brearley said the supplier of last resort mechanism was already “under considerable” strain from managing the failure of 20-plus other energy companies in recent months.

So Boris’s already big short could get bigger.

And perversely, it could influence government policy on COVID. Doing something (like lockdowns) that would crush energy demand would benefit its short energy position (existing and contingent). Talk about moral hazard.

Good luck with that Boris! Or should I say, good luck with that, Limeys?

For well over twenty years in my various energy pricing and policy classes I have pointed out that every energy price spike leads to accusations of manipulation and gouging and a call for an FTC investigation . . . which is always announced with great fanfare but never finds anything–something that is announced sotto voce, if announced at all.

And lo and behold, right on cue, due to the rise in energy prices in recent months Biden (or more likely, Howdy Joe’s ventriloquists) has asked the FTC to investigate rising gasoline prices:

President Biden called on the Federal Trade Commission to investigate whether oil-and-gas companies are participating in illegal conduct aimed at keeping gasoline prices high, in the latest effort by the White House to respond to public concerns about costs for everything from fuel to groceries.

Sisyphus would understand the drill. “Time to roll the price gouging rock up the hill again.”

And for the most idiotic, demented hot take, let’s turn to Lizzie Warren, speaking on Joy Reid’s show (talk about a singularity of stupid*):

Prices at the pump have gone up. Why? Because giant oil companies like @Chevron and @ExxonMobil enjoy doubling their profits. This isn't about inflation. This is about price gouging for these guys & we need to call them out. pic.twitter.com/kxiQkC2tYa

— Elizabeth Warren (@SenWarren) November 20, 2021

Recall, this is about a change in prices. So if the change in prices is due to gouging by oil companies, it would have to be due a change in gouging behavior. (I think even Joy and Lizzie should be able to follow this, it’s so basic: but maybe I’m too generous.)

But let’s follow that thread. It would imply that until recently, oil companies were not exploiting the opportunity to “double their profits” by price gouging.

So what happened? Did one day a few months ago the CEO’s of Chevron and ExxonMobil et al have a V8 moment, and slap themselves on the forehead and say “Wow! I could have doubled my profits by jacking up prices!”

So if they could screw consumers at a whim by jacking up prices why did they let oil prices go to single digits in 2020? Why does the urge to gouge seem to wax and wane?

This is so incandescently stupid. But I guess I should consider the sources, and remember that this sort of incandescent stupidity spikes every time oil prices do.

If the FTC exhibits the integrity it has in the past, this investigation will end the way all the others have, with a whisper not a bang, stating that fundamentals are the driver. But there is no guarantee that the current FTC will indeed exhibit such integrity, given how degraded government institutions have become (not that they were ever paragons, but everything is relative). Political imperatives and narratives, not realities, rule the day.

* Lizzie was dean of Harvard Law School, and a professor of law there. Joy Reid went to Harvard. God save us from Harvard.

Once upon a time Janet Yellen was a respected and respectable economist. That time is long past. She is now the lead singer for a Say Anything cover band. It’s sad to witness.

Janet is currently saying anything–and everything–to justify the monstrosity that is the Biden “reconciliation package,” AKA Build Back Better. Perhaps I should call it the Incredible Shrinking Reconciliation Package, because apparently it has shriveled from $3.5 trillion to a mere $1.75 trillion. But even at half the size, it is a monstrosity.

One indefensible thing that Yellen defended that has subsequently been modified, and may disappear, is the requirement that banks report to the IRS the gross annual flows on bank accounts when those flows exceed $600/annum. Yellen said oh no no no no–this is NOT aimed at the little guy. It’s to prevent billionaires from cheating on their taxes:

“There’s a lot of tax fraud and cheating that’s going on.” Treasury @SecYellen tells @NorahODonnell the proposed $600 IRS reporting requirement for banks is “absolutely not” a way for the government to peek into American’s pocketbooks but to hold billionaires accountable. pic.twitter.com/M3VKOhdtSu

— CBS Evening News (@CBSEveningNews) October 12, 2021

This is so patently ludicrous it requires little comment. Indeed, it is an insult to everyone’s intelligence because it so so outrageously and transparently false: everyone with a few functioning synapses understands reporting on the account of everybody with a bank account (and surely, a $600 filter would catch virtually every account holder) will do F-all to prevent billionaires from cheating on their taxes.

Yellen’s latest outrage is her claim that no no no no a massive increase in government spending will NOT add to the mounting inflationary pressures. Indeed, it will reduce these pressures. Yes, you read this right: she said that the reconciliation bill will reduce inflation, despite its size.

Why? Well, according to Yellen, it will shift out the aggregate supply curve. Why? The one specific thing that she said is that the child care subsidy in the bill will free up women to work. Well, even granting that–what about the rest of the huge bill?

Casey Mulligan has taken one for the team, and tortured himself by reading the entire bill. (God bless you, Casey.) He finds it chock full of disincentives to work. Here’s one of this posts that focuses on that, but I recommend that you scroll through all of Casey’s recent posts to get the full effect.

In a nutshell, as in most welfare and subsidy programs, there are huge implicit marginal tax rates embedded in “Build Back Better.” Your benefits go away, or are reduced substantially, if you earn too much. That is a disincentive to work.

These various features shift back the supply curve, thereby exacerbating the inflationary effects of an increase in spending.

And as Mulligan notes, even the vaunted child care provisions are an economic nightmare, with many disincentives to work, and burdens on those who do work in childcare. This is a classic example of the government simultaneously stepping on the gas (subsidizing child care) and slamming the brakes (imposing mandates that dramatically increase the cost of child care). Among the costs are wage floors for child care workers and requirements that said workers obtain particular college degrees. Yeah, those are really great ways to juice productivity, right Janet?

There’s also how the bill is to be paid for, mainly with explicit or implicit taxes on capital. Those will–duh–discourage investment and capital accumulation, further reducing productivity growth. Another adverse shift in the supply curve.

But Yellen claims that the “investments” in Build Back Better will enhance productivity. Say Anything, indeed.

Yellen even defended the utterly insane idea to tax unrealized capital gains, something the desperate Dems seized on to replace the capital and wealth taxes that Krysten Sinema rejected. There aren’t enough hours in my day to explain all the ways in which this idea is insane, unworkable, inefficient, and a threat to freedom.

I’ll just say one thing: if you believe that this tax, if implemented, would be limited to billionaires in perpetuity, you have not been paying attention to the history of federal taxation since the passage of the 16th Amendment in 1913.

In sum, Yellen has not just defended, but advocated every bad idea in BBB. Shamelessly.

In 2009, Yellen was one of the Obama administration’s main justifiers of the stimulus bill. She did so on strictly Keynesian multiplier grounds. I disagreed with her on that, but that was a serious intellectual disagreement: I’m an anti-Keynesian, and she argued on traditional Keynesian grounds. At least there was a serious intellectual foundation for her view, although no doubt she was carrying administration water in advancing it.

Now, however, she is just spouting absolute garbage that has no foundation in any solid economic theory, and which is indeed contrary to good economics, but which happens to be propaganda for administration policy. She is as bad, or worse, than Jen Psaki. A flack and a hack.

I met Janet Yellen once, when I gave a presentation on clearing to the Board of Governors of the Fed when she was Vice Chair. She sat right next to me. She was very nice to me. She is quite small, and at this meeting she was dressed in a green velvet outfit with red trim. I couldn’t help thinking that she looked like an extra from Elf.

But alas, Janet Yellen is no longer an elf. She has become a clown, honking a horn to promote the clown show that is Biden administration economic policy.

As someone might say: Sad!

Coda. The subject of childcare reminded me of some work done by the late, great Sherwin Rosen on child care subsidies in Sweden. He drolly asked: ” If Swedish women take care of each other’s parents in exchange for taking care of each other’s children, how much additional real output comes of it?” More substantively, he said:

The most important finding is that the welfare state encourages excessive production of household goods and discourages production of material goods. Too many people provide paid household (family) services for other
people in the subsidized state sector and not enough are employed in the production of material goods.

Doesn’t sound like a shift out in the supply curve to me–especially for goods and non-household services.

No, this is not a post about baseball, with an outfielder running to the wall only to watch a home run soar over his head. It’s about the copper market, where backwardation (a positive difference between the price for immediate delivery–“cash”–and a futures price) has soared, and inventories have gone yard.

The peak of the frenzy was Tuesday of this week, when at one point the cash-threes backwardation on the London Metal Exchange (LME) soared to $1050/tonne (them’s metric tons, y’all).

LME COPPER FUTURES moved into a record backwardation on Oct 19 as available stocks in exchange-registered warehouses declined to the lowest level since 1974: pic.twitter.com/9IuO6r3jou

— John Kemp (@JKempEnergy) October 20, 2021

That was apparently an intraday price, because the official PM cash-threes back on that day was a mere $382.

The LME is unique in that it trades contracts for specific dates, and so there is a “tom-nex” spread too: the difference between the price for delivery tomorrow, and the price for delivery the day after that. Last Friday, this “daily back” reached $175/tonne–meaning copper delivered Monday was worth $175 more than copper delivered Tuesday. The tom-nex remained over $100 on Monday and Tuesday.

Backwardation on COMEX copper has also jumped recently. Here’s the October 21-January 22 spread(HGV1-HGF2).

Meanwhile, inventories have plummeted, declining to a mere 14,500 tonnes on Tuesday, down from around 250,000 MT in late-August:

So what’s going on? Let me first consider a fundamentals-based story.

The spreads between futures with different maturities for a storable commodity send signals on how to allocate resources over time. When demand is high/supply is low today relative to what is expected in the future, it is optimal to draw down inventories, and prices move away from “full carry” (i.e., spreads that cover the cost of carrying inventory) to incentivize this drawdown. With extreme (but expected to be fleeting) temporal imbalances, it can be optimal to consume all inventories and meet future demand out of future production (because future demand is expected to be lower or supply higher than at present). These extreme temporal imbalances lead to large backwardations to punish storage.

As an aside, that’s why this statement in a Reuters article is incorrect:

Backwardation is supposed to attract metal but this week’s deliveries into LME warehouses have so far amounted to a meagre 9,775 tonnes despite the biggest incentive in the market’s history.

No! Backwardation punishes stockholding–it’s an incentive to move stuff out to be consumed today rather than hold it into the future when it is anticipated to be more abundant.

In some respects, what is going on in copper is similar to what happened in lumber, which I wrote about some months ago. The lumber market went into a huge back due to tight fundamentals and inventories were low.

The good news here is that these price signals indicate that the extreme imbalance is expected to be temporary: copper is scarce today relative to what is expected to be the case some months from now. That’s pretty much what happened in lumber.

So why the temporary scarcity (relative to expected future scarcity)? One plausible explanation is energy prices, which are high now going into the high-demand winter season in the Northern Hemisphere. Due to supply responses that can occur in a period of months but also the seasonal decline in heating and power related energy demand, these prices are likely to fall. Metals refining is energy intensive, so such a rise in energy prices pushes up the metals supply curve today relative to what’s expected in the future: this can produce exactly what we’re seeing in copper, and is also becoming evident in zinc, nickel, and aluminum.

China is of paramount importance in metals refining, so the artificial shortage of power there (caused by price controls and high fuel prices) is exacerbating this problem. Power cutbacks to intensive energy consumers are exacerbating the short term supply disruption.

This points out how the world is hostage to Chinese policy–and Chinese policy mistakes. China has become so important in this area not because it sits atop large, cheap supplies of ores. Low labor costs made it cheaper to locate refining there, even taking into account transport costs. But also, Chinese subsidies of various sorts–financial suppression that makes capital cheap and subsidized power prices–have attracted arguably excessive amounts of capital to metals refining there. And add to that the relative indifference of China to pollution–and metals refining can pollute the air, the water, and the earth: lower environmental standards lead to lower costs and a great incentive to locate production in China.

The fallout from a concentration of metals refining capacity in China is reverberating around the world right now. Not just copper but a variety of metals are going haywire because of the energy-driven supply disruptions in China. Magnesium is just another example.

The former is a fundamentals-based story (albeit one in which central planning has distorted the fundamentals). Is this all that is going on?

Corners can also cause soaring backwardations. The LME was sufficiently concerned about the situation in the market to impose a limit on the amount of daily backwardation to .5 percent of the cash price (which is still a 180 percent annual rate boys and girls). The cash-threes backwardation has fallen by almost two-thirds (to $116/MT today) in the days since.

Fingers have been pointed at Trafigura for loading out large amounts of inventory, thereby exacerbating the tightness. Trafigura says it did so to meet obligations to customers. This would be consistent with the fundamentals story.

But . . .

It is not unknown for firms with large inventory holdings to remove them from the LME to create an “artificial” tightness, or to provide a cover story for a corner. Moreover, if a single firm owns enough inventory to be able to deplete stocks materially on its own, it doesn’t take too large a paper position for it to have a literal corner. Or even if one firm hasn’t cornered, a small number of firms with large physical and paper positions can have a nice little oligopoly that allows them to exercise market power, of which large backwardations are a symptom–and a source of profit. Think of how much money the holder of a large prompt position could make rolling that over at $100+ per day, day after day.

Put differently, fundamental tightness can create market power, and the exercise of this market power can greatly exacerbate backwardations.

The sharp drop in the cash-threes back after the LME intervened lends some plausibility to this explanation. However, a definitive diagnosis requires a deep dive into who was doing what that is not possible based on currently available public information. I am just laying out possibilities here.

Exercising market power in a tight market is sometimes referred to as a “natural corner” and has given some firms that have exercised market power a “get out of jail free” card in the United States.

I’ve just completed a paper on “natural squeezes” that critiques this flaw in US manipulation law. I’ll post it soon.

But when all is said and done, what is going on in copper now is possibly such a natural squeeze: a temporary tight supply and demand situation exploited to exercise market power. Maybe someday we’ll find out.

The United States is currently in the midst of a colossal game of chicken. The administration, state and local governments, and their CEO pilot fish at major corporations and hospitals are insisting on vaccinating all employees. Large numbers of nurses, pilots, flight attendants, ground crew, police, firemen, and other working stiffs are resisting. Notably, many in the military are resisting–including most notably special operators.

Who will blink? If neither side blinks, the crack up will be epic. There will be a severe loss of public protection services, and crime will spike. Ironically, given that the supposed justification for all of the various anti-COVID measures has been to protect the health care system, the loss of nurses will lead to a substantial overload on these systems: some hospitals are already cutting down on care, including emergency care. The already strained transportation will crack. Perhaps most ominously, the United States military will be seriously degraded, as the personnel loss is likely to be concentrated among the most highly trained, and disproportionately impact combat units.

Southwest Airlines was red pilled by what transpired over the Columbus Day weekend, and has relented on mandates. Alas, it is the exception, not the rule. (Delta is another exception. American and United are adamantly not.) Virtually all other mandate maniacs have their foot pushed to the floor.

It is beyond doubting that those resisting mandates are in the right, and those insisting are them are in the wrong.

I repeat: beyond doubt.

Even the administration’s politicized scientists at the CDC have acknowledged that vaccines do nothing–nothing–to prevent transmission. There is therefore no externality that can rationalize coercion. (And as I’ve noted before, even if such an externality existed, it does not necessarily support mandates: it is a necessary but not sufficient condition for them.)

Further, the efficacy of the vaccines is becoming more dubious by the day. The clinical trial results represent an extreme upper bound on efficacy, and real world experience is proving them far less robust than promised.

Moreover, although there is much controversy about this issue, the vaccines may have severe negative externalities: that is, they may supercharge the mutation process and lead to the the accelerated evolution of more virulent strains resistant to the existing vaccines. (Cynics will say that from the perspective of the vaccine makers, this is a feature, not a bug.) Here the science is not settled, but that in itself is reason not to proceed full speed with mandates.

Therefore, like virtually all government policy (and not just in the US), coercive vaccination is all pain, no gain.

Yet governments and their CEO collaborators proceed apace, undeterred by reality.

The administration blames everything–everything–currently ailing the country on the unvaccinated. They are the epitome of evil and the scapegoats for everything currently ailing America (the economy especially).

Example: Supply chain problems? THE UNVACCINATED!!! BLAME THEM!!!

And vaccinating everyone will fix everything, according to the “authorities.”

This is pure, 100 percent, unadulturated horseshit. Patent medicine barkers in the 19th century would be embarrassed at the abject dishonesty here.

So why are we here? Why are we in a situation in which government at all levels–with a mendacious administration in the lead–persisting hell bent on such a destructive and apparently irrational course?

Because from their perspective it is not irrational. Yes, it is irrational from a perspective of public health, economic health, and personal liberty. It is not irrational if your true objective is oppression for oppression’s sake. Then it makes perfect sense.

All of the non-pharmaceutical and pharmaceutical interventions make perfect sense if the objective is to compel submission to government authority. All of the unremitting attacks on therapeutic mitigation of COVID make sense if the objective is compulsion.

It’s about control, not health. Then the question arises what is the purpose of exerting such control?, but that’s the subject of future posts.

And governments are so obsessed with control that they appear dead set on steamrolling anyone who resists or objects, even though by doing so they will wreak great havoc on lives, and on the economy (which, of course, also impacts lives).

Many of those resisting mandates appear to be quite strong in their convictions. (When a football coach chooses to forego a $3 million payday rather than submit, he is definitely putting money where his mouth is. So are all the others who are jeopardizing careers and pensions with their refusal.) Governments and companies appear similarly committed. Given that neither appears to be likely to swerve or jump, the outcome is therefore likely to be ugly indeed.

Back oh-so-long ago, during the California electricity crisis and its aftermath, I would say that California wanted to deregulate its power market in the worst way, and succeeded. (Wanting to keep up my ESG score, I recycled this line to describe Gibbering Joe’s Afghanistan exit.)

The main design failure of California’s restructuring (a more accurate description than deregulation) of its power market was that it capped retail prices for the two largest utilities in the state (SoCal Edison and PG&E) while requiring them to acquire power at market-determined wholesale spot prices. (San Diego Gas and Electric had met criteria to allow it to enter into long term forward purchase contracts and as I recall was not subject to the same retail price cap.). Thus, SCE and PG&E were massively short wholesale (spot) power. When those prices spiked, due mainly to fundamental factors, the utilities hemorrhaged cash and hurtled towards bankruptcy. Their financial distress led to further dislocations in the California market (and the western US power markets generally).

The world is currently undergoing what is being called an “energy crisis,” focused on power markets, and their inputs, mainly natural gas and coal. There are two parts to this “crisis,” one fundamentally driven, the other driven by ill-conceived regulatory and political factors redolent of California circa 1999-2001.

The most pronounced indicator of the fundamental-driven stress is the price of liquified natural gas (LNG), which has reached dizzying heights.

That price spike is in early “shoulder” months, boys and girls. Lord knows what the peak demand months have in store.

And that’s the nub of the problem: storage.

Historically, natural gas has been a “spikey” commodity. The shale boom mitigated spikeness in US natural gas prices, but periodic price spikes are an inherent feature of storable commodities. The truly motivated can read about it in my book, but the CliffsNotes version is this. It is optimal for inventories to run out periodically: if inventories were never exhausted, some of the commodity would never be consumed, which makes no sense. So “stockouts” will occur periodically. When they do, it is impossible to accommodate demand increases or supply declines by drawing down on inventory. Instead, prices bear the entire burden of adjusting to a demand shock (for example). Thus, periodically stocks will be tight, and when they are, a demand increase causes prices to rise dramatically (because inventories can’t cushion the blow).

The cover illustration in my book, based on a purely theoretical model of a storable commodity market, illustrates the point. Note the periodic spikes.

That is, price spikes are inherent in storable commodities.

The magnitude of the price spikes is amplified by the nature of natural gas production and consumption. Both demand and supply are extremely inelastic. The inelasticity effects optimal storage decisions, but when natty inventory constraints bind, inelasticity means that price impacts of shocks are extreme.

This is why going short natural gas (or shorting the calendar spread especially in the winter) is referred to as a “widow maker” trade.

There are lots of widows out there today. In essence, a hard winter of 2020/2021 depleted stocks. The 2020 COVID demand collapse and subsequent price crash (JKM traded at $2.20/mmBTU in May 2020) cratered drilling, constraining current supply (as wells drilled then would have been producing now) making it difficult to build stocks. Warm summer weather in 2021 drained stocks and impeded stock build. Outages in Norwegian production, and a wind drought in the UK (which required greater utilization of gas generation) stoked demand. Stocks are now at historically low levels, setting the stage for even bigger spikes this winter.

The gas market–due to LNG–is now international, meaning that shocks in any region impact prices around the world. Asia (especially China) and Europe are now playing tug of war for gas, and prices are spiking in both places.

Since gas and coal are substitutes, the price spike in gas is resulting in a price spike in coal:

Oil can also be used to generate power, although this has become relatively rare in recent years. However, the spikes in gas and coal are making fuel switching to oil more attractive, and additional gas/coal price spikes in the winter will likely result in more use of oil in electricity generation, which will put upward pressure on oil prices too.

This is all fundamentals driven, and exactly what occurs periodically in storable commodities. There’s nothing really that can be done about it, policy wise. But that won’t stop governments from trying.

You’ve no doubt read of energy “shortages” in recent days and weeks. Well, low supplies and high prices are not a “shortage” per se. A true shortage is a failure for a market to clear, resulting in queueing for the good. That is, a shortage occurs when the price is kept to low, leading to a gap between the quantity demanded and the quantity supplied.

Think gasoline lines in the US in the 1970s.

That’s where regulation comes in. Various regulations, adopted for political economy reasons, create shortages and the other dysfunctions currently observed in world energy markets.

Take China. The authorities have implemented power rationing. The reason commonly given is a “coal shortage.” Yes, coal prices are high in China (and the world), but that doesn’t create a true shortage. What has? Power prices are capped. The big increase in input costs (both coal and LNG) mean that Chinese generators can’t sell profitably, so they restrict output, leading to a true shortage.

What this means is that the shadow price of power–the price that market participants would be willing to pay for an additional megawatt–is (a) above the regulated price, and (b) above the market clearing price. Consumption would be higher in the absence of the price cap.

High coal prices do not reflect a “shortage”, properly defined. Yes, they represent constrained supplies, but that is not a shortage.

And do not forget that China’s coal supply constraints (and high prices) are in large part a result of their brilliant central planners. China imposed quotas on coal production some years back. The reason was–wait for it–coal prices were too low. Now the government is winking at the quotas in order to encourage production–because prices are too high.

India is another country where the Californiaesque capped power price/uncapped input price problem is rearing its ugly head.

France is going to cap gas and power retail prices, but make suppliers whole (though how it will do so remains unstated as of now). Compensating suppliers (effectively having the government pay the difference between marginal cost and the capped price) will prevent true shortages, but will have the perverse effect of exacerbating the spikes in gas and coal prices because at the capped price consumers will not internalize the true scarcity of fuel, and will overconsume.

The UK is experiencing another echo of California. Several of its retail gas suppliers have imploded because they are required to sell at a capped price and chose to cover their sales commitments by purchasing wholesale spot. The price cap made no sense: competition among retail suppliers would have kept prices in line. Adding the price cap just put the competitive retailers at risk of bankruptcy. (Admittedly, such can occur when retail prices are not capped if retailers offer fixed prices to consumers and don’t hedge, as occurred in Texas this last winter. But price caps make that outcome more likely.)

The UK is also suffering a true shortage of gasoline–excuse me, petrol–a la the US in the 1970s. A true shortage, because there are lines:

Man heads to the petrol station with his horse to 'stir up' some laughs pic.twitter.com/NsPiW8Ijcg

— The Sun (@TheSun) September 29, 2021

Scarcity of truck drivers to distribute fuel is at the root of the problem. But that can’t lead to a true shortage–lower supplies and higher prices yes, but not a shortage with people waiting in line. So what gives?

Apparently there was an information cascade about impending shortages, which led to a panicked run for gas stations. This evidently started with a leak (probably politically motivated) of cabinet deliberations.

A sudden demand increase of this magnitude can lead to true shortages–queueing–if prices do not rise to clear the market. This raises the question of why petrol sellers didn’t increase prices. I’m not aware of formal caps, but I surmise that fear of allegations of “gouging” led retailers to choose to allow customers to pay the high price implicitly (through the time cost of sitting in line) rather than raise price to reflect the sudden (and perhaps contrived) scarcity.

For storable commodities like natural gas, coal, and refined petroleum products, price spikes can last for some time. That’s what we are experiencing today: it’s just one of those spikes like on the cover of my book that happen in commodity markets. Given that we are going into a peak demand season with constrained supplies, the prospect for a continuing spike–and indeed, a higher spike–is very real indeed.

Governments can’t change this fundamental reality. Market prices are sending a signal about underlying conditions. Governments don’t like the message the prices are sending, and will try to do something about it. Alas, their knee-jerk response–to shoot the messenger by capping prices–will make things worse, not better. But because governments can’t help themselves, look for many 1970s energy market flashbacks in the coming months.

Joe Biden and the Congressional Democrats are scrambling madly to pass a $1.5 trillion “infrastructure” bill, and a $3.5 trillion “Build Back Better” monstrosity. Both are execrable, but the latter is beyond grotesque.

Do you know what’s in them? No? Well, then you are almost certainly as informed as most of those who are supposed to vote on them.

These bills are being sold with lies, starting with the Liar in Chief, who claims that his build back bullshit (BBB) costs nothing, zero, zip, nada. How can a $3.5 trillion spending bill cost nothing? Because it includes $3.5 trillion in taxes, silly!

This line is being regurgitated ad nauseum by assorted Congressional idiots (e.g., Nancy Palsy, I mean Pelosi), the White House, and assorted journalistic slugs like the WaPo’s Glenn Kessler.

I should actually write this lie is being regurgitated ad nauseum because it is outrageously false as a matter of economics. The cost of something is the value of the resources used to produce it. In the present instance, the resources used to produce it are extracted by taxes. The cost is real, and the taxpayers bear the cost.

Put differently, the entire administration propaganda effort is asserting that the No Free Lunch Fallacy is in fact no longer operative. Free lunches for all!

Much of the bill consists of massive transfer payments that have resource allocation implications, e.g., a gargantuan expansion of child care tax credit, two years of free community college. The additional resources used to provide child care and community college are real costs. The same can be said of virtually everything in the bill.

There is no free lunch, but the entire ruling class is attempting to gaslight you that there is in order to gain your support, or at least your acquiesance.

But that doesn’t end the gaslighting. The administration and Democrats in Congress claim that you won’t be paying higher taxes. It will be corporations and billionaires. Nobody earning under $400K will pay higher taxes!

Yeah, right.

First, taxes on capital (including corporate taxes, capital gains taxes, inheritance taxes, which are the main sources of revenue in BBB) are borne predominately by wage earners. Reduce after tax returns on capital means less investment means a lower capital stock means lower wages. A reasonable estimate is that virtually all taxes on capital are paid by labor, not capital. So if you look at tax incidence, working schmucks will pay the bulk of the cost. But the incidence of the cost is concealed from those who bear it, which represents yet another lie being used to smuggle these bills to passage.

Second, a billion is 3 orders of magnitude smaller than a trillion. It would be necessary to expropriate around 70 percent of the the entire wealth of billionaires in order to cover $3.5 trillion: their entire wealth would not pay for the two bills together.

And as if that could be accomplished anyways.

There are also stealth features of the bill that are very disturbing. There is a “pilot program” to study mileage taxes. That camel’s nose is therefore under the tent, and any such tax will be highly regressive and impact people who live in rural areas particularly hard. (But they’re Republicans, so fuck ’em, right?) There is also a provision to require the reporting of the IRS all–all–transactions over a certain dollar amount. Biden (or, more accurately, his puppeteers) proposed a $600 floor. $600. Which would mean pretty much every mortgage payment, a lot of credit card payments, etc. This has apparently been raised to $10,000, but don’t be surprised if that gets lowered to a level that will impact millions of Americans.

Most Americans do not really experience the tender mercies of the IRS (because most income tax revenue is generated from high earners who draw the greatest IRS attention). They really don’t understand how draconian (and Kafkaesque) it is. Subjecting American’s ordinary banking transactions to IRS scrutiny will be a shock.

BBB also increases IRS funding by $80 billion, and would double-yes, double-the staffing of the IRS. Doubling the size of the most oppressive part of the US government is another leap and bound down the road to serfdom.

I could go on. But you get the idea. These bills are a monstrosity.

The Democrats are hell bent on getting these bills done, and are therefore resorting to exceptional procedural measures, namely reconciliation, to pass BBB. They are also trying to condition passage of the infrastructure bill on passage of BBB, because the former is more palatable to the mushy middle, e.g, Manchin and many Senate Republicans.

They are doing so precisely because they feel that they have a very short window to implement their agenda, most of which is embodied in BBB. Their margin in Congress is razor thin–and basically non-existent in the Senate. Further, they realize that it is very likely to disappear altogether in the aftermath of next November’s election: ironically, the less popular Biden is, the more crazed the Democrats are in their pursuit of the bill. It’s now or never.

Such massive endeavors should never be passed on a purely partisan basis, especially when the legislature and the country are so closely divided. Doing so only exacerbates division and political conflict. But progressives are in a hurry precisely because they see their window of opportunity closing. So expect the lies to get even more grotesque, and the political strong arming to become even more thuggish.

If these bills fail, the Republic may have a chance. If they pass, they are likely to seal its doom, for they represent a point of fiscal no return.