The collapse in oil prices is completely understandable. The co-movement in equity and bond yields is harder to fathom.
As I noted in a previous post, the initial sell-off in oil was driven by corona-related demand declines. One thing interesting at the time was that equities did not respond similarly, which suggested that the prevailing view was that the situation would be contained in China. The last few weeks, equities and bond yields caught up, presumably due to the spread of the virus outside of China (especially in Italy).
The main oil-related news was a big supply shock–the prospect for higher Saudi and Russian output. But this should be positive for the economy overall, and thus for equities. There does not seem to be any new virus-related news that would lead to predictions of a sharp reduction in incomes and output. So, by itself, the oil supply shock should not cause a large sell-off in equities and big buying of bonds. But that is what we are seeing.
One can imagine other channels, e.g., losses on oil positions causing liquidation of equity positions. But the oil markets likely aren’t large enough to trigger such a reaction, and this channel would require those who are long equities to be long oil too–and in a big way in both.
Focusing on the oil supply shock in particular, I wonder if Putin and the Russians expected the furious Saudi reaction. The ruble is down 5+ percent today. Amusingly, Russian cat’s paw Zerohedge is claiming that Putin is all copacetic with this, saying that Russia can survive $25/bbl oil prices for a decade.
This is putting a brave face on things. And those with long memories will recall similar statements during the 2008-2009 collapse–statements that proved laughably false.
It is also interesting to note that Russian expressions of confidence relate to the state budget. Maybe the fiscal frugality has indeed positioned the government to live lean. The populace, not so much. But that’s very revealing about the mindset of the Russian ruling class: it is all about the state, utterly state-centric, and largely dismissive of the citizenry. And it has been so, as long as there has been a Russia.
As a coda to the post on the bloodbath in oil. I remember how many Smart People claimed that Putin’s alliance with MbS’s Saudi Arabia was an act of strategic genius! Genius I say! The move of a 4 dimensional chess grandmaster. A move that went a long way to achieving Russian dominance in the Middle East, at the expense of the US.
Er, no. Like almost all of Putin’s moves, it was an act of short term opportunism, and one that was built on a foundation of sand (appropriate, given the locale). MbS was being equally opportunistic, and his and Putin’s short-term interests aligned. But cartels–and this was little more than a cartel with a little geopolitical gloss–are inherently unstable, and the interests of the colluders are inherently in conflict. Inevitably such condominiums collapse.
Inevitably.
And so has this one. It was merely a matter of time, and what the proximate cause of the collapse would be.
There was no enduring alignment of interests that would provide the basis for a strategic realignment. There was a momentary alignment of interests between oil ticks. A market shock (extremely unexpected, no doubt) smashed the delicate structure to pieces.
The furious Saudi reaction to the Russian move demonstrates how fleeting Putin’s gains were. MbS is well and truly pissed, and looking to take revenge.
The only question that remains is: who will drink whose milkshake?
Oil is crashing, with WTI trading at a 33 handle, down 20+ percent since Friday.
The first leg down in oil prices was caused by the coronavirus demand shock in China. This most recent free-fall is a response to Russia’s refusal to agree with OPEC to extend the existing OPEC+ cuts, and deepen them in response to the demand decline; and the Saudis’ reaction to the Russians, specifically, to put the output pedal to the metal.
The Saudi reaction to the Russians is a classic cartel defector punishment strategy. The Russian demurral is more difficult to understand. One story circulating is that Putin wants to punish US shale. If so, he’s a fool. And worse, a fool who fails to learn from the foolishness of others, e.g., the Saudis whose predatory pricing strategy in 2014-2016 failed miserably.
Yes, cratering the price of oil will inflict pain on US shale producers. They will suffer financial losses, and will curtail drilling and output. But US pain does not equate to Russian gain. Russia will incur substantial losses from prices in the 30s–and more pain if prices go into the 20s, as is possible. But Russia will not recoup this pain with future gains. If and when they (and OPEC) decide they’ve had enough, and curtail output to raise prices, US output will respond accordingly.
US rocks can outwait Putin. Yes, reduced activity will damage the shale supply chain, and it will take some time to recover, but as the Saudis found out in 2016, the flexibility of the US oil sector allowed it to rebound extremely rapidly when prices rose. The resource remained. The human capital remained. When OPEC+ went into effect, US oil output soon exceeded the pre-2014 price crash levels, which sharply limited the upside for the Saudis and Russians.
I am currently putting finishing touches on a paper which, among other things, demonstrates the futility of the Saudi strategy in 2014–and the Russian strategy (if that’s what it is) today. I document learning-by-doing economies in the US shale sector. If these economies are big enough, lost output today due to predatory Saudi or Russian behavior translates into lower US productivity in the future. That means that Saudi/Russian price cutting today raises their rivals’ costs in the future, which could lead to higher future Saudi/Russian profits then.
But the empirical estimates show that the US productivity losses due to foregone learning are very small, and hardly allow the predators to recoup the huge costs they incur from their predatory strategies. Putting the Saudis and Russians together, $10/bbl price cuts today cost them on the order of $230 million/day: $20/bbl cuts cost them around $460 million/day. There is no way that the higher future cost of US oil production due to lost learning opportunities will allow the predators to recoup these losses in the future by raising the ceiling that US shale puts on world oil prices.
Predatory pricing strategies are almost always futile. They are definitely futile with regards to the US shale sector. If Putin is indeed pursuing a predatory path, he is cutting off his own nose to spite his face.
In a reply to the Paul Romer post, ex-colleague and friend Scott points out the richness of Romer calling for a “new humility” among economists. But not all economists, mind you, just those who value freedom and express skepticism about regulation:
Among these pretend economists, the ones who prized supposed freedom (especially freedom from regulation) over all other concerns proved most useful—not to society at large but to companies that wanted the leeway to generate a profit even if they did pervasive harm in the process.
This brings to mind Hanna Arendt’s observation: “One of the greatest advantages of the totalitarian elites of the twenties and thirties was to turn any statement of fact into a question of motive.” This is exactly what Romer does. He ascribes venal motives to those who dare disagree with his eminence. He has precious few facts in his article, but casts many aspersions on motives of those with whom he disagrees.
Romer again refers to economists plural, but provides a single illustration–Alan Greenspan. To make him the Representative Agent for an entire swath of the economics profession is utterly ridiculous. He was the head of an economics consulting firm for decades before ascending to the Fed. He never held an academic appointment. He did not publish in peer-reviewed journals. He is an eminently bad person to serve as the epitome of regulation-skeptical economists.
Further, Romer has things exactly upside down. It was–and is–the pro-regulatory/pro-state/pro-government contingent of the economics profession (which has always represented a majority) that could have used, and could use, a dose of humility. Always dismissive of the knowledge problem, they believed that they could design regulatory and legislative schemes that would achieve superior outcomes, only to find out that unintended consequences are a bitch, and regulatory capture undermines the most well-intended schemes.
Indeed, in financial regulation in particular, major financial institutions play B’rer Rabbit, begging not to be thrown in the regulation briar patch, only to profit quite well from it.
In fact, it has long been government/regulation-skeptical economists who have counseled against hubris. In a book tellingly titled “The Fatal Conceit,” Hayek famously wrote: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”
The main issue I’ve always had with this quote is that it clearly expresses what Hayek thought economics should do, but did not accurately express the views of the profession at large. Those who view economies and markets as complex systems, as emergent orders, are very dubious of their ability–or the ability of anyone–to impose their designs. But they are, and always have been, a minority.
Another example of a great economist who was humble about attempts to control such complex systems via government was Adam Smith, who famously said:
The man of system, on the contrary, is apt to be very wise in his own conceit [there’s that word again]; and is often so enamoured with the supposed beauty of his own ideal plan of government, that he cannot suffer the smallest deviation from any part of it. He goes on to establish it completely and in all its parts, without any regard either to the great interests, or to the strong prejudices which may oppose it.
He seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board. He does not consider that the pieces upon the chess-board have no other principle of motion besides that which the hand impresses upon them; but that, in the great chess-board of human society, every single piece has a principle of motion of its own, altogether different from that which the legislature might chuse to impress upon it. If those two principles coincide and act in the same direction, the game of human society will go on easily and harmoniously, and is very likely to be happy and successful. If they are opposite or different, the game will go on miserably, and the society must be at all times in the highest degree of disorder.
In sum, Paul Romer is projecting. As Smith recognized centuries ago, and Hayek echoed many years later, it is the statists who need humility, and those who advocate a reliance on freedom often do so out of a humble conviction of the difficulty in even understanding the operation of complex systems, let alone controlling or regulating them.
I have to say his essay is unpersuasive, not to say incoherent. One way of framing the issue is to contrast the view of Keynes:
Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.
with that of Stigler (speaking of the passage of the Corn Laws):
economists exert a minor and scarcely detectable influence on the societies in which they live . . . if Cobden had spoken only Yiddish, and with a stammer, and Peel had been a narrow, stupid man, England would have moved toward free trade in grain as its agricultural classes declined and its manufacturing and commercial classes grew.
Romer is clearly in league with Keynes, rather than Stigler.
But he fails to make the case. This is true for many reasons. For one, he argues by anecdote, and hence his style is journalistic rather than rigorously scholarly. A few cherry-picked anecdotes–and Romer uses only three–are clearly insufficient to support Romer’s broader claim that the deregulation favored by many economists (not all) was on the whole baleful. There are entire areas of deregulation (e.g., transportation, telecommunications, restrictions on advertising) that he says nothing about, but which were the subject of massive scholarship in the 1970s and 1980s which demonstrated the inefficiency of the existing regulatory structure: the experience in these industries post-deregulation strongly supported the scholarship that criticized existing regulations.
One interesting example is pharmaceutical regulation, something that exercises Romer quite greatly. Sam Peltzman showed in the 1970s that efficacy regulation under the 1962 Drug Act amendments did not result in a reduction in the amount of inefficacious drugs introduced, but did reduce the rate of introduction of new, valuable therapies. All pain, no gain.
Romer has nothing to say about this.
With respect to pharma regulation, Romer blames the opioid crisis on “pliant pretend economist[s]” who “assume[d] the role of the philosopher-king—someone willing to protect the firm’s reckless behavior from government interference and to do so with a veneer of objectivity and scientific expertise.”
He doesn’t quote any economist, pretend, real or otherwise, playing the role of philosopher-king/academic scribbler whose frenzy regulators or legislators distilled into opioids. Instead, he says:
By the 1990s, such arguments were out of bounds, because the language and elaborate concepts of economists left no opening for more practically minded people to express their values plainly. And when the Drug Enforcement Administration finally tried to limit the distribution of these painkillers, pharmaceutical companies launched a massive lobbying effort in favor of a bill in Congress that would strip the DEA of the power to freeze suspicious narcotics shipments by drug companies. It is a safe bet that these lobbyists made their arguments to Congress in the language of growth, incentives, and the danger of innovation-killing regulations. The push succeeded, and the DEA lost one of its most powerful tools for saving lives.
Of course, during earlier eras, regulators allowed many industries to profit massively from products known to be harmful; Big Tobacco is the most obvious example. But until the 1980s, the overarching trend was toward restrictions that reined in these abuses. Progress was painfully slow, but it was progress nonetheless, and life expectancy increased. The difference today is that the United States is going backward, and in many cases, economists—even those acting in good faith—have provided the intellectual cover for this retreat.
So apparently, by highjacking the language economists prevented rational debate, thereby rendering legislators and regulators defenseless against predatory corporations.
Or something.
That is, not only does Romer fail to show that deregulation was on the whole detrimental, he also fails to show that economists had anything much to do with making it happen. He asserts the Keynesian line, but does not come close to proving it.
Indeed, the reverse is true. Romer’s argument actually supports Stigler’s claim, which can be “distilled” thus: money talks. Or to use Keynes’ term: vested interests talk. What economists said or didn’t say or how they said it or what language they said it in (English, Yiddish, Aramaic) was nothing, compared to the lobbying might of the pharma industry. So not only does Romer fail to identify any actual economist who advocated the policy that infuriates him, he fails to show that what any economist said meant squat for the outcome.
Indeed, this is precisely why a certain species of economists (Stigler, and well, yours truly) was/is so skeptical about regulation: it tends to favor the interests of the regulated. It always has, and it always will. Economic efficiency is a secondary consideration, and what economists have to say on the matter has little (if any) bearing on the outcome. If anything, Romer’s piece is a case for Public Choice economics. But that has implications that Romer would no doubt find inimical.
Romer’s other big anecdote is from the financial industry, namely the infamous Goldman Abacus transaction in which Goldman served as the middleman between John Paulson (who wanted to short US real estate) and a hapless German bank.
The stand in for all economists in this anecdote is one sorta economist: Alan Greenspan. Apparently, Greenspan was the Representative Agent for the economics profession. This is beyond simplistic. Insultingly so.
Another bogeyman in Romer’s telling is Michael Jensen:
Michael Jensen, an economist who helped reshape the U.S. financial sector in the late twentieth century. Jensen rightly worried about several problems that bedeviled the market, including how to keep corporate executives from promoting their own interests at the expense of shareholders. His proposed solutions—hostile takeovers, debt, and executive bonuses that tracked the share price of a firm, among other changes—were widely adopted.
Corporate shareholders saw their earnings skyrocket, but the main effect of the changes was to empower the financial sector, which Greenspan, for his part, worked doggedly to unfetter. As Lemann writes, Jensen’s ideas also helped chip away at the power of the traditional Corporate Man—the sort of executive whose pursuit of profit was tempered somewhat by a commitment to noneconomic norms, among them a belief in the need to foster trust and build long-term relationships across company lines. Taking his place was Transaction Man, who focused on little more than driving up share prices by any means necessary.
There is so much wild generalization here that I am at a loss of where to begin. For one thing, Jensen’s heyday was the 1980s LBO and hostile takeover boom, which had been largely stymied by regulation by the early-1990s, long before the Financial Crisis. (So much for the power of Jensen’s advocacy! Jensen’s hero, Michael Milken, was in jail, FFS.)
I am at a real loss to trace the connection between Jensen’s advocacy of measures to control managerial agency costs and, say, the real estate securitization boom of the mid-2000s. Romer certainly doesn’t lay out the road map. Here merely cites Jensen’s views and asserts some connection with those of Greenspan, and proclaims QED! The South Park Underwear Gnomes’ argumentation was tighter.
And again, what economists said was almost certainly irrelevant here. There were powerful forces–political as well as economic forces–behind the real estate boom and crash. Homeownership became a totem for politicians of both parties in the 1990s and 2000s. Wall Street was on board, because it realized this could be an engine for profit. Main Street financial institutions were on board for the same reason.
So what if Alan Greenspan was cool with this? If he hadn’t been, he wouldn’t have been around long. Economic and political interests found a convenient mouthpiece: the mouthpiece didn’t create the economic and political forces. At the end of the day, economists would not have mattered, and the financial sector would have gotten the mouthpiece it wanted.
This part made me roll my eyes:
the traditional Corporate Man—the sort of executive whose pursuit of profit was tempered somewhat by a commitment to noneconomic norms, among them a belief in the need to foster trust and build long-term relationships across company lines. Taking his place was Transaction Man, who focused on little more than driving up share prices by any means necessary.
Evidence for this “commitment to noneconomic norms, among them a belief in the need to foster trust and build long-term relationships across company lines” among 1960s-1970s corporate executives? None whatsoever. This is an ex cathedra pronouncement that bears no relationship to the reality of self-serving corporate management during this era–management that a 1970s Romer probably would have inveighed against as venal and self-serving (as many criticisms of managerial capitalism did).
No, the issue here is not Corporate Man vs. Transaction Man. It is Straw Man (Romer’s, specifically) vs. Reality.
Romer gives economists both too much credit, and too little. By painting all economists who criticized regulation (based on empirical evidence and theory) as stooges, he gives them too little credit. By blaming them for massive public policy failures, he gives them too much. If only we had such influence.
Does economics matter? Yes. Do economists matter? Not really. And the reason for these answers is the same. Economic considerations–distributive considerations in particular, as they operate through the political and regulatory system–drive political and regulatory outcomes. Economists can comment on this, analyze it, and even advocate particular outcomes. But their participation has as much effect on the outcome as a sportscaster’s does on who wins the Super Bowl.
Like virtually all of the papers in this literature, it relies on crude before-after comparisons based on some magic year (2004? 2005? 2006?) during which commodity index investing became important. Even assuming that the rise in index investing was a sort of exogenous shock, this crude method of attributing causation has problems. After all, a lot of other stuff happened after, say, 2004. The rise of China as the predominate force in commodity markets, for instance.
Perhaps this problem would be less troublesome were commodities assigned randomly to “treatment” (part of an index) and “non-treatment” (non-index) groups. But this is definitely not the case. There are systematic differences between index and non-index commodities, so it is difficult to know whether the effects documented in Brogaard et al are due to a correlation between these systematic differences and the performance measures they utilize.
Ah. The performance measures. That raises yet more issues. The paper claims that firms with exposure to index commodities experienced lower returns on assets (i.e., operational income/assets) post-indexation than their non-index-exposed counterparts.
So what is the implicit model of the market in which these firms operate? If the presumption is that the markets are relatively competitive, why would you expect profit margins to change over a period of several years? Even assuming that indexation increased costs via the channels posited by the authors, in equilibrium this would lead to (a) an initial decline in profits, (b) exit (meaning fewer assets and lower output), and (c) a return of profits to the competitive level. Meaning that actually looking at assets or output would be a better measure of how indexation affects cost than profit margins.
If, conversely, the presumption is that these markets were imperfectly competitive prior to the indexation shock, the fall in profit rates could be a good thing, rather than a bad thing. It could indicate that indexation resulted in more intense competition/lower market power.
This is particularly interesting, given that this was a period in which measured profit rates were rising generally in the economy, a phenomenon which some (not I, but some) attribute to declining competition. Now, there are big problems with that literature (problems that the late great Harold Demsetz identified in the 1970s, but which modern scholars have forgotten), but take it at face value. Declining profits/margins could be interpreted as a signal of increased competitiveness and efficiency. A feature, not a bug.
And via a channel exactly contrary to that posited by Brogaard et al. They posit that indexation reduced the informational efficiency of commodity prices. But an increase in informational efficiency would tend to reduce market power–and reduce margins/profits. Note that many firms HATE the introduction of futures, or increased trading of futures, of their main inputs or outputs. Precisely because futures trading increases the informational content of prices which undermines an information asymmetry that generates profits for major producers and consumers.
Which brings me to that information channel. Brogaard et al measure informativeness using the autocorrelation in commodity returns.
Really?
They basically find that autocorrelations went up, which they interpret to mean that commodity futures markets became weak form inefficient (or further from weak form efficiency).
Again: really?
Taking their argument literally, it means that speculators were able to eliminate predictable movements in prices prior to indexation, but weren’t able to do so afterwards. This stretches credulity to its limits. After all, “financialization” of commodities also saw the entry of banks and hedge funds into commodity trading. We’re supposed to believe they left easy money on the table?
This purported reduction in price efficiency raises another issue. When I read about return autocorrelations I think time-varying expected returns. So the Brogaard et al result suggests that index commodity returns became more time-varying after indexation became a thing.
Arguably the primary impact of indexation was to integrate more closely commodity prices and stock and bond prices, and in particular, ensure that systematic risk was priced more consistently across commodities and financials. We know that equities and bonds have time varying returns. It is plausible that the documented increase in time variation in expected commodity returns reflects this integration, and is yet another feature rather than a bug.
If so, commodity prices that more accurately reflect the pricing of risk should lead to better investment decisions, not worse decisions. Further, these better investment decisions need not be associated, over several years, the operational performance measures they employ.
Indeed, along the lines of a paper that I wrote a few years back, indexation improves the allocation of risk and reduces the cost of commodity price risk to firms. In equilibrium, this would lead to lower rates of return. Which is exactly what Brogaard et al find.
Pursuing this further, I note that the authors do not use sensitivity to commodity prices as a means of determining whether firms are exposed to commodity prices, on the basis that hedging can reduce price exposure. Yes, but consider the following. Hedging is costly. Hedgers frequently pay a risk premium to speculators. This leads them to hedge less, which leads to high exposure. If indexation reduces hedging cost (as my paper implies), at the margin, firms will hedge more, and bear less risk. This reduces expected profits (which incorporate compensation for risk).
This has at least two implications. First, the average profit rate of firms exposed to hedgeable commodity prices (which are precisely the commodities that are included in indices) should decline post-indexation: this is consistent with the Brogaard et al finding. Second, firms should hedge more–leading to lower exposure to commodity prices. Brogaard et al do not test this latter implication. (Admittedly, this raises complications. Firms may limit commodity exposure in ways other than hedging, and a lower cost of hedging can lead to a substitution of hedging for these other means, leading to offsetting effects which reduce the commodity exposure impact of cheaper hedging.)
The upshot of all this is that the conclusions that the authors advance–namely, that indexation resulted in poorer real outcomes in terms of performance and investment–are not supported by their empirical findings. That is, there are alternative hypotheses that are consistent with the empirical findings that are diametrically opposed to their hypothesis.
This paper is well done within the analytical confines that its authors select. But that’s exactly the problem with this literature. The analytical confines exclude important channels of cause and effect. Most importantly, these confines make implicit assumptions about the degree and nature of competition that either make their results problematic, or mean that their results have diametrically opposed implications to those of the chosen analytical framework.
Meaning that the debate on the effects of indexation are still very much open, and that finance and economics scholars have largely failed to devise reliable tests to distinguish indexation-is-bad hypotheses from indexation-is-good hypotheses. Which is precisely why the debate is still open.
On Thursday, the CFTC voted along party lines to approve a proposal on position limits. The party line vote reveals a salient fact: the proposal represents a virtual abandonment of the Commission’s earlier proposals (2011, 2013, 2016). Indeed, virtually all of the features that I criticized in the earlier proposals are gone, and the current proposal largely mirrors the recommendations of the Energy and Environmental Markets Advisory Committee that I served on (before being uninvited by current EEMAC chair Dan Berkovitz). (More on EEMAC below.)
Most importantly, limits outside the “spot month” (which is actually just a few days for some commodities) for energy and metals commodities are gone. Good riddance. They remain for nine legacy ag futures contracts (corn, cotton, and the like), but the any-and-all limits have been expanded substantially.
The rule expands hedging exemptions beyond the prior proposals, and in doing so meets the objections of companies like Vitol. Interestingly, the proposal tidies up the definition of a “bona fide hedge” and makes explicit, rather than implicit, the principle that bona fide hedges are solely for the reduction of price risk.
The Commission did eliminate the “risk management” hedging exemption for swaps dealers, based on an interpretation of Congressional intent and a reading of statute that limits hedging to the management of risk of physical commodity positions. On principled grounds, I object to this. A swap dealer buying an oil swap from an E&P firm facilitates the hedging of a physical position, and hedging that swap via the futures markets serves a classical risk transfer function. A dealer selling an index swap to a pension fund isn’t hedging a physical risk, but it is still serving a risk transfer function and the distinction between physical commodity hedges and non-physical hedges is rather Talmudic.
The practical effect is unknown. In terms of index swaps, most swap dealers are out of the nearby contract when an index (e.g., GSCI) rolls, which is well before the spot month for energy and metals that make up the bulk of most indices. Hedges of the ag portion of these swaps could be affected by the any-and-all limits and the elimination of the risk management exemption, but the dramatic increase in the size of these limits may well greatly reduce any impact. A dealer hedging a swap with payments based on final settlement prices of say NYMEX crude or natural gas could be impacted by the elimination of the exemption, but the spot month limits may be large enough to cushion the impact here as well.
The most interesting feature of the proposal is its rather tortured attempt to address the “necessity” issue that derailed previous proposals in court.
The most important aspect of this is that it appears that the Commission has essentially conceded that a necessity finding is, well, necessary. That raises the issue of the criteria for establishing necessity.
One criterion could be that a limit is necessary only if the risk of speculation causing unwarranted price fluctuations is sufficiently great.
An alternative criterion is that a limit is necessary as long as the risk of unwarranted price fluctuations exists at all, if the contract is important enough.
The Commission took the latter approach, and limited its limits to commodities it deemed were sufficiently important (measured by volume and open interest) so that any unwarranted price fluctuation could lead to impairment of price discovery and risk transfer on a large scale. The closest that the Commission came to taking likelihood of disruption into account is its restriction of the limits to physical delivery contracts that could be cornered or squeezed. This is a logical problem (cash-settled contracts give rise to manipulation too) but this is of secondary importance. But it could be read to limit the Commission’s interpretation as to the source of unwarranted fluctuations to market power manipulation, which would be a good limitation indeed.
A sufficient statistic to infer that the Commission conceded much in its necessity finding is Dan Berkovitz’s freak out on the issue in his dissent.
As a manipulation-related aside, I will note that the spot month limits are justified by the notion that a position in excess of deliverable supply is necessary to execute a market power manipulation (i.e., a corner or squeeze). I have some recent research (which I’ll post and write about soon) showing that this may be a sufficient condition, but not a necessary one. Meaning that the limits will not be sufficient to eliminate market power manipulation.
As oil prices spiraled upwards in 2007 and 2008, I wrote more about the issue, and gained more notoriety. This resulted in my testifying before the House Ag Committee in July 2008 (a day or two before oil prices reached their all time high) and led to a WSJ oped.
Then the Financial Crisis happened, and I focused more on clearing issues, with periodic forays into the speculation debate. But Frankendodd included a provision on speculative position limits in commodities, and the CFTC rolled out a proposal in 2011.
I wrote a comment letter on the proposal. That letter (and others I wrote subsequently) were sufficiently important that in the final rulemaking and in later proposals it or other things I’ve written were cited dozens of times (my name gets 50 hits in the 2016 proposal).
But the impact of the letter on my life went beyond that. Gene Scalia–son of Justice Antonin Scalia, and now Secretary of Labor–retained me to write a declaration criticizing the inadequate cost-benefit analysis in the proposal (it being something required under the law.)
Perhaps most importantly, Blythe Masters at J. P. Morgan liked it, and called to tell me so. She then proposed that I write an analysis of the systemic risk of commodity trading firms for SIFMA. I did–and came up with the wrong answer. So SIFMA spiked the report. But word leaked out, which prompted Trafigura to retain me to write a study (with a subsequent follow-on study) of the economics of commodity trading firms.
I don’t think I’m exaggerating to say that this study proved to be very influential, perhaps because of the lack of competition: writing on the sector was, and remains, very sparse. I have traveled, lectured, and taught around the world based on people wanting to hear what I wrote about in that piece.
The study was also the hook for the New York Times hit piece on me in December, 2013. See! I took money from evil speculators while writing in opposition to limits on speculation! Never mind that I had been consistently opposed to limits years before, and never mind that Trafigura (and other oil traders) are not speculators and use the futures markets mainly for hedging.
(As an aside, I am convinced, but cannot prove, that Gary Gensler was the moving force behind the piece. After all, why else would the NYT devote front page space to an obscure academic? And under the theory of there-are-no-coincidences-comrade, comments on the 2013 revised proposal were due in January, 2014. So December 2013 was the perfect time to kneecap a gadfly. By the way, Gary, how’s that gig as Treasury Secretary working out. Oh. Right. Well maybe you can chair Hillary’s legal defense fund.)
Asides aside, other than frightening my aged parents this article actually was all for the good. It validated me as an influential voice. It also got many very reputable people to rush to my defense, including Thomas Sowell, one of my long-time heroes.
The article raised its head a few years later when I was serving on EEMAC, and was asked to write the (Frankendodd-mandated) report on the committee’s deliberations. I was the dutiful scribe, and honestly recorded the committee’s adamant opposition to the then-outstanding proposal (which included all the bad features jettisoned in the new proposal).
This caused Elizabeth Warren to lose her [insert vulgar metaphor of your choosing here]. This article in particular cracked me up (and still cracks me up): Why Elizabeth Warren Is On the Warpath This Week.
Well, why was she on “the warpath”? Well–me, now that you ask:
The committee, which was established by Dodd-Frank, has nine members. Though it is supposed to express a “wide diversity of opinion” and “a broad spectrum of interests,” eight of the nine members represent companies or industries with a financial interest in killing the position limits rule, or have a personal financial interest themselves.
. . . .
The recent inclusion of Craig Pirrong on the committee is perhaps the most flagrant example. Pirrong, who co-wrote the first draft of the report with James Allison, is a professor of finance at the University of Houston, who has been paid by several industry participants and trade groups for his research into commodity speculation. He was also a paid research consultant for the International Swaps and Derivatives Association, the very group that got the initial rule overturned by the courts.
The CFTC report relies mostly on Pirrong’s research and a presentation he made to the committee last year, which did not include the opinion of anyone who believes in the dangers of excessive commodity speculation. In fact, 10 of the 13 witnesses at EEMAC meetings came from industry, two were representatives of CFTC, and the other was Pirrong. The meetings never mentioned that there would even be a final report. [Er, it’s in the law, you knobs.]
As Public Citizen’s Tyson Slocum, the only non-industry committee member and the only one to dissent from the recommendation, points out, Pirrong was not on the committee until after he co-authored the report. Pirrong “is so new to the EEMAC,” Slocum wrote in a minority dissent, “that I only learned he was a member when he was listed as a co-author.”
I’m so proud. One’s enemies are the best comment on one’s character.
What cracks me up is that it wasn’t a right-wing snarkmeister like me that included “Warpath” in the title of an article about Liz Warren. It was the (by then) far-left New Republic. Freudian slip? Whatever, it’s hilarious.
Alas, understandably but not commendably, Commissioner and EEMAC chair Christopher Giancarlo buckled under the political pressure and withdrew the report. But this was almost certainly a non-event: the proposal was dead in the water, and was only salvaged by saving major pieces overboard. And I’ve sailed on.
What a long strange trip it’s been. The speculation debate has had a first-order impact on the arc of my life for more than a decade. Although the Commission proposal will likely put an end to one chapter of that debate, as I wrote in my first piece in 2006, speculation controversy is a hardy perennial, and will no doubt recur the next time some major commodity price spikes or craters. And maybe I’ll be around to draw more fire–and deliver some–when that happens. And until then, I’ll keep Truckin’ on whatever fits my fancy.
Nota bene: I’m not a Dead Head by any means. But if the song fits . . . Well, not the drugs part!
Perhaps the best indicator is the palpable indication of nervousness at the highest echelons of the political (i.e., CCP) leadership. For example:
As China struggles to deal with the slowdown of the world’s second-largest economy, it has embarked on a new strategy of placing financial experts in provinces to manage risks and rebuild regional economies.
Since 2018, President Xi Jinping has put 12 former executives at state-run financial institutions or regulators in top posts across China’s 31 provinces，regions and municipalities, including some who have grappled with banking and debt difficulties that have raised fears of financial meltdown.
Only two top provincial officials had such financial background before the last big leadership reshuffle in 2012, according to Reuters research.
This is utterly futile. Although it reflects a realization by Xi and his minions that there is a problem, it also reflects that they have no idea what the cause of the problem is. Indeed, it shows that they are completely captured by their worldview, which believes that China will achieve wealth–and world domination–via the wise guidance of the Party and its enlightened leadership. (This worldview is not limited to Chinese Party cadres–the likes of Tom Friedman and Naomi Oreskes* and numerous other bon savants in the West share it.)
Their solution is a symptom of the problem. China’s current incipient crisis is a direct result of its economic model, which relies on state-directed investment to meet growth targets. No, there is not a granular, proscriptive investment program a la Stalin’s USSR. But provinces and local governments face strong incentives to meet growth targets that are most readily met via massive investment in infrastructure and housing: that these kinds of projects create corruption opportunities is just part of the incentive structure. Further, the financial system, with its repression of consumption and flip-side of subsidized credit, has provided further incentives to indulge the edifice complex.
This has resulted in massive malinvestment. The financial straits of these government entities, and the financial entities that have funded them, are merely a manifestation of the malinvestment: the investments have not generated returns sufficient to cover the costs of financing them. This is pretty amazing, given the magnitude of the direct and indirect subsidies.
Appointing managers with more “expertise” to exercise control at the sub-national level is not going to fix the fundamental fault in the system. The fundamental fault inheres in the socialist, centralized, Party-dominated, investment/credit-driven model.
The USSR showed that a centrally planned system can generate glittering results in terms of official statistics. For a while. But this largely reflects the flaws in national income accounting, especially in highly state-centric economies. Investment is a cost–a use of resources–but counts as contribution to national income. Pile up the costs at an insane rate for years, and you can show totally awesome GDP growth rates!
But eventually, the chickens come home to roost. If the investments are ill-advised, they do not generate a stream of consumption (and remember that consumption is the point of production, and investment) than can recoup the costs. Honest accounting would require writing down of these “investments,” causing a drop in measured national income. But this is never done.
The Soviet Union went through this “yeah we have problems but we just need better managers” phase. And it was a phase. The next phase was a slide into economic collapse. The phase after that was . . . outright economic collapse.
The Chinese and Soviet systems are not the same. But they share essential similarities, the most notable being that they are/were investment-driven and centrally directed, and horribly misprice credit. The means of direction are quite different, but the ultimate trajectories are quite similar. Investment-driven models that focus on achieving national income growth targets are prone to eventual collapse because of massively perverse incentives that lead to horrible misallocations of resources.
This has interesting short-run and long-run implications for the US (and the West generally). (“Interesting” being the most fraught word in the English language.) In the short run, it provides the US with considerable leverage over China with regards to trade: serendipitous developments, such as Asian swine flu increase this leverage. In the longer run, the fundamental flaws in the socialist model with Chinese characteristics will sharply reduce the Chinese geopolitical threat.
The problem is the interval between the short-run and the long-run. Big powers facing decline or economic crisis are inherently a source of instability. This problem is exacerbated in China, where the personalized, de-institutionalized nature of government under Xi also creates internal sources of instability. Xi is mortal, and has grandiose ambitions: as he sees the time to achieve those ambitions shrink, his incentive to take risk increases. Further, such systems are inherently unstable when the leader dies or becomes incapacitated because of succession crises–crises that are exacerbated by the fact that the ruler has a strong incentive to crush potential successors, rather than cultivate them.
Thus, there is likely to be a period of substantial internal turbulence in China, and this could have dire implications for the US and the world, especially given the changes that Xi has wrought in recent years.
In sum, China is entering the “we need better managers” phase of its development. This is a symptom of socialism, and a sign on the road to severe economic decline. A socialism syndrome, if you will. As an avowedly socialist country, China is not immune. Indeed, methinks it is particularly susceptible, especially given the neo-Maoism of Xi. This bodes well for no one.
*Oreskes is a Harvard “historian of science” who is primarily responsible for manufacturing the factoid (or should I say fiction?) that 97 percent of scientists believe in the threat of anthropomorphic climate change. Per the linked article: Oreskes believes in “change, owing perhaps to a sensible program of environmental regulation under Communism, and vindicating ‘the necessity of centralized government.'”
Sensible environmental regulation under Communism. LMFAO. Every Communist country is an environmental nightmare. I remember reading the official English-language Chinese paper when I was in China in the mid-2000s. It was a litany of environmental catastrophes. I truly shuddered when I thought that this was probably the sanitized view.
The BIS included a box on the September USD repo spike in a chapter to its Quarterly Review titled “Easing Trade Tensions Support Risky Assets.” The piece lays out many damning dots, but does not connect them. Let me give it a try.
In a nutshell, the BIS report says that as a result of the wind down of the extraordinary post-crisis monetary policy measures there has been a dramatic change in the funding structure in US markets. In particular, the “big four [US] banks” (which the BIS delicately–or is it cravenly?–doesn’t name) have flipped from being suppliers of repo collateral (and hence cash borrowers) to being suppliers of cash (and hence collateral borrowers). Further, other US banks are not viable competitors to the big four, nor are other potential cash suppliers such as money market funds because they have hit counterparty credit limits which have constrained their lending capacity. According to the BIS, these events has made The Big Four Banks Who Shall Not Be Named the “marginal lenders” in the repo market. And mark well: prices are set at the margin.
Further, “leveraged players (eg hedge funds) were increasing their demand for Treasury repos to fund arbitrage trades between cash bonds and derivatives.”
So here are the dots. Recent structural changes have given the Big Four Banks Who Shall Not Be Named a dominant position in the repo market. Their main potential competitors as suppliers of funds are constrained by size or regulation. There has been a large increase in demand for repo funding.
Not even being willing to name the banks (as if their identities are unknown), the BIS does not even draw the blindingly obvious implication of its analysis–that the Four Repo Horsemen have market power. A lot of market power. Are we supposed to believe that (out of the goodness of their hearts, perhaps) they did not exercise it? I didn’t just fall off the turnip truck.
Even the euphemism Big Four is deceptive, for in reality this group is dominated by one bank–Morgan. And of course Morgan has been loudest in its protestations that it really wanted to lend more, but just couldn’t, dammit, because of those cursed liquidity regulations.
The BIS attempts to run cover, and provide some rather lame excuses for the failure to lend more despite the high rates:
Besides these shifts in market structure and balance sheet composition, other factors may help to explain why banks did not lend into the repo market, despite attractive profit opportunities. A reduction in money market activity is a natural by-product of central bank balance sheet expansion. If it persists for a prolonged period, it may result in hysteresis effects that hamper market functioning. For instance, the internal processes and knowledge that banks need to ensure prompt and smooth market operations may start to decay. This could take the form of staff inexperience and fewer market-makers, slowing internal processes. Moreover, for regulatory requirements – the liquidity coverage ratio – reserves and Treasuries are high-quality liquid assets (HQLA) of equivalent standing. But in practice, especially when managing internal intraday liquidity needs, banks prefer to keep reserves for their superior availability.
Hysterisis? Decaying internal processes and knowledge? Staff inexperience? Complete and utter argle bargle. We’re talking overnight secured lending here, not rocket science structured finance. It’s about as vanilla a banking transaction one could imagine. And LCR provides convenient cover.
The BIS lays out a compelling case that four major institutions have market power in repo. September events in particular are consistent with the exercise of market power, and the alternative explanations are beyond lame. Yet none dare speak its name, or even raise it as a possibility. Not the BIS. Not the Fed. Not the Treasury. Despite the systemic risks this poses.
The Financial Crisis supposedly changed everything. It apparently changed nothing.
It’s impossible to turn around these days without being beset by control freaks.
Exhibit 1. Michael Bloomberg, who is running for president. Bloomberg is infamous for his desire to control everything, from what you eat to what you drive to how you defend yourself. Bloomberg thinks taxing “sugary drinks” (among other things) is a great thing, despite the regressivity of this tax, because it’s good for the poor:
And if you buy a gun do defend yourself, you’re pretty stupid–so he will take them away:
“And if you want to have a gun in your house, I think you’re pretty stupid…” – Michael Bloomberg, 2014 https://t.co/XWmcPjP4V6
Pretty sure his security detail is heavily armed. But that’s the credo of his ilk: for me, but not for thee.
Bloomberg also sucks up to the world’s leading control freaks, the Chinese Communist Party. When (amazingly) confronted about this by (amazingly) a PBS interviewer, Mikey totally flacked for them:
.@MikeBloomberg tells @FiringLineShow that China's leader is addressing pollution to satisfy constituents & secure his political future. "The Communist Party wants to stay in power in China and they listen to the public," he says. pic.twitter.com/B9SoAXJwrM
And behold the stunning dishonesty here–the lengths to which he goes to avoid criticizing the CCP. Bloomberg wants to control the entire energy system in order to reduce the emissions of global greenhouse gases (GHG). The Chinese are building coal plants at a frenzied pace, yet when confronted on this, Bloomberg treats the Chinese coal plants as merely an issue of local particulate pollution in places like Beijing.
As an aside on this issue: the silence of the Davos Douches (control freaks all) who sucked up to Xi on this issue, and so many others involving China, is deafening.
Exhibit 2. Elizabeth Warren, reprising her “you didn’t earn that” bullshit:
It's a point I've made since my very first campaign: Nobody in this country got rich on their own. They relied on infrastructure we all paid for, employees we all paid to educate. So if you're successful, good for you—now pay it forward so everyone has a chance at success. pic.twitter.com/FAuZhggAGk
What pretzel logic. Because you might have benefited from some public goods, you are obligated to let Lizzie decide what she will take from you in order to pay for all the non-public goods that she wants.
I have a better idea: I’ll gladly pay taxes for public goods that earn a return in excess of the cost of capital, and Lizzie can STFU.
Exhibit 3. Angela Merkel. Zere vill be NO free speech for you!:
The irony of this is that those so wise in the ways of science
are obviously lecturing the developed world, which in their wisdom they apparently haven’t recognized is depopulating. Population growth is overwhelmingly concentrated in very low income Africa, the Middle East, Asia, and the Subcontinent, whose peoples (a) will never hear what these scientists are demanding, and (b) would ignore it in any event.
So what are these scientists proposing? What coercive powers will they deploy against brown people in order to achieve their vision?
No doubt Bloomberg has the answer: if they don’t submit voluntarily, kill them. You know, for their own good.
