Streetwise Professor

One of the themes of my writing on clearing mandates and other aspects of post-Crisis derivatives regulation has been that although these initiatives have been sold as ways of reducing risk in the financial markets, in reality, they shift many risks, transform others, and create new ones.  It is by no means clear that these new laws and regulations have reduced the overall vulnerability of the financial system.

For instance, clearing and collateral mandates are intended to reduce the amount of credit embedded in derivative trades.  But market participants can respond to this by substituting other forms of leverage.  The effects on credit risk and leverage overall are far more equivocal than the advocates of the mandates claim.  As another example, making derivatives more expensive means that some will eschew using them to manage risk.  Risk that was passed to others able to bear it at lower cost will remain with those who bear it at a high cost.  As yet another example-and the one that worries me most-is that clearing and collateral mandates have transformed credit risk to liquidity risk.  Since true crises are usually liquidity crises, this is highly disturbing.

The CFO of Rolls Royce made similar arguments forcefully at a conference a few days back:

European regulatory measures designed to make the financial system safer don’t actually eliminate risk, they simply move it to nonfinancial companies, warns Mark Morris, the finance chief for Rolls-Royce, the British aero-engine maker. And there could be a negative impact on the economy, he says.

Speaking at a conference organized by The Economist Group (a minority owner of CFO), Morris criticized European regulators for seeking to deal with over-the-counter derivatives risk in the financial sector by requiring some contracts to be centrally cleared or to have collateral posted.

The European market infrastructure regulation, known as EMIR, took effect last August but requires the European Commission to enact a series of technical standards before the rules can be fully implemented. Most are expected to be finalized by mid-2013.

“In essence, you can’t destroy risk,” Morris said. “It morphs into something else. If you take market risk and go into a foreign exchange [hedging] transaction with a bank, you’re replacing it with counterparty risk. If you try to replace the counterparty risk by using central clearing or some form of posting of collateral, what you’re doing is you’re replacing counterparty risk with liquidity risk.”

Morris makes some other good points in the article, so I recommend you read the whole thing.

It seems that the Europeans are more sensitive to these concerns than was the case in the US.  The European Parliament may demand changes in EMIR. Apparently they are aware of the legislate/regulate in haste, repent at leisure problem.  Unfortunately, with Frankendodd dismissed such concerns.  Methinks that the repentance stage will come soon.

It is bizarre to observe Obama’s burning desire to reproduce the European welfare state in the US (on full display in his inaugural address) at the same time that model is collapsing before our eyes.  But another element of Obama’s address reveals that his disconnect between a desire to reproduce European policies at the same time as those policies are lapsing into farce is not limited to the welfare state alone. On Monday, Obama pledged a renewed commitment to combating “climate change.”  (When has climate been static, by the way?)  Ironically, on Monday, the FT ran an article describing the near collapse of the EU’s emission trading (cap-and-trade) market:

Carbon prices have fallen to a record low of less than €5 a tonne, pushing the European Union’s eight-year-old emissions trading system into a crisis.

Benchmark EU carbon prices yesterday dropped to a session low of €4.79 a tonne – down nearly 20 per cent over the past week – after Germany’s failure on Friday to sell carbon permits triggered a crisis of confidence.

As the article notes, this follows hard on the collapse of the UN’s Clean Development Mechanism.  Kyoto is dead.  The regional/state markets in the US (REGGI and California) are wheezing, at best.

So why not a new Big Push (cue Douglas Haig) on climate change?  What could possibly go wrong?

Better yet, why bother with the pesky legislative branch when pursuing this endeavor in the face of a truly global record of failure?  After all, Congress might be subject to feedback, and we can’t have that.  Thus, according to Bloomberg, Obama plans to pursue his Quixotic venture (almost literally so, given the prominence of windmills in alternative energy efforts) via executive order and regulation, rather than legislation.  Again: what could possibly go wrong, putting what is arguably the worst, most dangerous government regulator, the EPA in charge of this?

Not to mention that these initiatives at the level of individual nations, or even large multinational blocks, will be costly, and have virtually no impact on global temperatures.  All pain, no gain.  It is utterly insane for California to attempt unilaterally to control emissions: it is only slightly less insane for the US to do so.  But that’s the way Obama wants to go, despite the collapse of similar initiatives around the world.

But maybe that just reflects the fact that these endeavors are driven more by a religious and ideological belief than a commitment to tackle an issue an a practical way that wrestles with empirical and political realities, and weighs costs and benefits.  For people so driven, ostentatious sacrifice and adherence to ritual are valued in their own right, not for their practical consequences.  Incurring a cost signals the depth of commitment, and that’s what matters.  The pain is the gain.  For them, that is.  For the rest of us who are not wedded to such beliefs, not so much.

Obama delivered his Second Inaugural Address yesterday.  Despite paeans from the usual suspects (e.g., Chris Matthews, who should really get a freaking room) that compared Obama’s speech to the Gettysburg Address  or Lincoln’s Second Inaugural FFS, in reality it was just a predictably turgid pile of progressive platitudes.

The speech was chock-full of typical Obama tropes.  The most typical-and most despicable-of which was his old standby, the Straw Man.  Is Obama capable of giving a speech without one?  Speech, hell: is he capable of uttering 3 sentences without resorting to this most grating of rhetorical tricks?

To wit:

For the American people can no more meet the demands of today’s world by acting alone than American soldiers could have met the forces of fascism or communism with muskets and militias. No single person can train all the math and science teachers we’ll need to equip our children for the future, or build the roads and networks and research labs that will bring new jobs and businesses to our shores. Now, more than ever, we must do these things together, as one nation, and one people.

Pardon me, but WTF ever said “a single person” can achieve great things?  (And by the way, “training teachers” doesn’t come first in any list of Great Accomplishments, except at an NEA convention.)

Let’s consider Edmund Burke.  Did he assert such a thing? No, that great conservative spoke of “little platoons”-private cooperative endeavors.

What about De Toqueville?  Again-no.  He wrote about the American genius of private associations that citizens formed, spontaneously and independently of government, to achieve the benefits of cooperation.  Yeah.  Collective action. Without government.

The late, great James Buchanan? No.  He showed in his Theory of Clubs how private cooperation could produce (excludable) public goods.

Look.  Firms are cooperative enterprises that engage in collective action to produce things that people value.  Markets facilitate cooperation between diverse individuals who may not even know of each others’ existence, and who do not intend to cooperate, but end up doing so while pursuing their own self-interested objectives due to the way that price signals convey information about benefits and costs, and provide powerful incentives to act on that information.  The price system coordinates, and thereby permits multitudes to cooperate.

In other words, the market system is a mixture of cooperation and competition.

In contrast, in Obama’s cramped vision, government and government alone is the sole nexus of cooperation in society.  That it is coercive “cooperation”, rather than voluntary cooperation (a la Burke, de Toqueville, or firms operating in markets) escapes his attention, or at least doesn’t bother him one whit.  To him the alternatives are: cooperation mediated through government and government alone, or atomistic competition, red in tooth and claw.  A regurgitation of the Social Darwinian crap he heaved up a year or two ago.

I do not know whether Obama’s Straw Man is the product of extreme intellectual limitations or extreme intellectual dishonesty.  I’m voting “both” actually.  But regardless, it is embarrassing to witness such a display, and even more embarrassing to see it praised as some great oration.

The real Straw Man here is Obama.  Straw Man as in the Wizard of Oz.  Because he really needs a brain.

The extremely democratic, open access aspect of incorporation and limited liability in the modern US is hard to exaggerate. I set up an LLC yesterday.  It took less than an hour with a lawyer and a three figure sum to set it up.  Much of the time with the lawyer was spent yakking about UH and personal history and other chit-chat. I am sure I could have done it cheaper online, but the cost of doing it old school was so low I figured-why take the chance of making a mistake?  It was easier to set up an LLC than picking up a prescription.

It is easier and cheaper-by far-to incorporate than to become a fricking barber or beautician.  I defy you to identify anything that the state has erected fewer obstacles to obtain.  Anything.  There are few things that are so equally accessible to all Americans.

One should be suspicious of entry barriers, and embrace the things that are accessible to all.  The anarcho-libertarians who demonize corporations overlook this.  The open access corporation represents a triumph of open access and small-d democracy. Anyone can be an owner.  Anyone can be a CEO.  Do you anarcho-libertarians have any idea how rare that is? Do you really think that circumscribing or proscribing the ability to incorporate and limited liability will constrain elites and empower the ordinary?  If so-think again.

This is the funniest freaking thing I’ve read in a long time.  “No chance for Sochi 2014 corruption-Audit Chamber.”  “It is practically impossible.”  Seriously.  That’s what Sergei Stepashin says.

I’m dying here.  But it gets better.  Want to know why there’s no chance for corruption?

“The Olympics are pretty expensive, this we know,” he said. “But the sports facilities cost about the same as in Europe. We conduct quarterly checks. … It’s practically impossible to simply steal just like that, I give you my honest word.”

“Rises in expenses are linked with infrastructure.”

Because of course, there is no corruption in the construction of infrastructure in Russia.  None.  The country where it costs about 6 times as much per mile to build roads than in the US.

For its next joke, the Audit Chamber will investigate Gazprom.  I can’t wait.  I can always use a laugh.

The good news: Gazprom is under increasing pressure from weak demand in its primary market-Europe-and growing gas production.  A couple of interesting data points.

First, in the first 9 months of 2012, Gazprom paid its European customers $4.4 billion in price adjustments as the result of contract renegotiations.  (h/t @NoGazprom).  Moreover, additional renegotiations are ongoing.  The customers demanded Gazprom refund some money because the oil-linked price in the contracts was well out of line with gas values (as indicated by spot prices).  Although Gazprom continues to cling to the oil linkage, the trend is clearly away from these traditional contracts due to burgeoning spot volumes.  This renders increasingly hollow Gazprom’s claims that spot markets are insufficiently liquid to make spot prices reliable benchmarks in sales contracts.

This is not a trival sum.  It represents about 7 percent of Gazprom’s 9M2012 revenues, and more than 15 percent of its 9M2012 profits.

Second, Norway is rapidly taking away market share from Gazprom.  (Could this have anything to do with Norway’s movement toward spot pricing?)

Norway, Russia’s closest rival in the European gas market, seems to overtaking Russia’s Gazprom. Norway boasted record high exports in 2012, while Gazprom suffered the worst numbers in 10 years.

Norway increased its exports 16% in 2012 to reach 107.6bn cubic metres, according to Europe’s key statistics office Eurostat. This is “a record level, close to the Russian gas exports to Europe,” Michael Korchyomkin, head of East European Gas Analysis, told Kommersant daily.

During the same period, Russia’s gas giant Gazprom cut sales to Europe and Turkey by 8%, according to the company’s head Aleksey Miller. That’s the lowest export level for the last decade, Korchyomkin said.

At the moment Norway is breathing down Russia’s neck in its key European market – Germany. In 2011 Gazprom supplied 30bln cubic meters out of the total 80bn cubic meters of gas Germany consumes annually. Norway sold just a bit less – 28bn cubic meters. Norway’s Statoil accounts for about 70% of the country’s exports and in 2012 signed a 10 year contract to supply gas to Germany’s Wintershall.

These are present pressures.  Future problems potentially loom even larger.  Most notably, the likelihood that world gas supplies will grow dramatically.  Initial hopes for rapid output increases in Poland and Ukraine appear to be overoptimistic, but eventually it is likely that these countries will start producing in commercial quantities.  If political obstacles can be surmounted in the US, large and increasing volumes of LNG exports will be looking for markets-including Gazprom’s current European markets, and the Asian markets it hopes to serve in the future.

One of the potentially most dangerous threats, though, is the huge offshore gas resources in the eastern Mediterranean, off Cyprus, Syria, and Israel.  Some analysts think that gas has the potential to turn Cyprus from financial basketcase into a prosperous and self-sufficient country.

The eastern Med gas is a particular threat to Gazprom because of its proximity to the company’s largest markets-Europe and Turkey.

Which is exactly why Gazprom and Russia have a tremendous incentive to make sure the underwater gas stays underwater.  Russia’s tentacles reach deep into every aspect of Cyprus’s economy and government.  Thus, not only does it have the motive, it has the means to impede Cypriot efforts to develop its gas resources.  Not to mention  that Russia has little incentive for Cyprus to escape basketcasedom.  A financially secure Cyprus would not need to provide a haven for dirty Russian money (but I repeat myself), which is about all that keeps the island afloat right now.  And oligarchs and corrupt  bureaucrats desperately want such a haven.

Given the instability and geopolitical fissures in that region Russia has other levers it can pull to stymie development of gas in Syrian and Israeli waters.  This article from the Economist gives just a few of the geopolitical obstacles in the way of commercializing the offshore gas.  It should be child’s play for Russia to get Turkey, Lebanon, Syria (or even an Alawite rump state conveniently located on the coast), and Israel embroiled in all kinds of squabbles that will delay considerably the development of the gas resources-perhaps forever.  There is plenty of animosity and mistrust to go around, which can easily be manipulated by an opportunistic Russia to ensure that not one molecule of Med methane makes it to mainland Europe.

Which means that the strains on Gazprom have more than economic relevance for Russia.  They have geopolitical ramifications as well. And those ramifications are not good. Russia has a vital economic stake in keeping the Levant in turmoil-and in keeping a client in power there.  It has shown no compunctions in the past about fomenting trouble, or interfering with attempts to solve it, when its economic interests are at stake.  Given the huge dependence of Russia-and the Putin model in particular-on the Gazprom rent stream this is a matter of survival to the Putin regime.  And that’s the bad news: Gazprom’s troubles give it and Russia a strong incentive to make trouble in the Levant.

One of the most ambiguous, and often damning, phrases in a school or performance review is “works to his potential.”  Left unsaid is just what that potential is, and the comparison of performance to personal potential, rather than to the performance of peers, is often a polite way of communicating that that potential is rather low.  The quintessential way to damn with faint praise.

This came to mind when reading about a spat between Medvedev and a high ranking official at the Russian central bank.  Medvedev is pushing for 5 percent growth:

“The government’s main aim is to reach steady economic growth of at least 5% [a year], and achieve stable growth of Russian citizens’ wellbeing,” Mr. Medvedev said

But Central Bank first deputy chairman Alexei Ulyukayev rained on that parade, and delivered the devastating “works to potential” performance review:

We at the central bank of the Russian Federation assume that in Russia… economic growth roughly matches its potential.

That growth, mind you, is in the 3.5 percent range.  4 pct would be a major achievement.

This is rather pathetic for a country at Russia’s stage of development, and is a far cry from the pre-crisis growth rate.  In part, this reflects moribund world economic performance.  Europe is continuing to stall. China is on another sugar high, but the pressing need to transition from an investment-and-export-driven model will result in a decline in growth rates there as well.  The US is bumping along, and the impending Health Care Cliff and continued fiscal policy uncertainty will serve as drags on growth.

But it also reflects Russia-specific factors, and is in fact a damning verdict on Putinism.  Two other speakers at the conference where Medvedev and Ulyukayev spoke, Alexi Kudrin and my friend Sergei Guriev, pointedly said that Russia’s institutional deficit were the major drivers of its mediocre potential:

But Sergei Guriev, an influential economist and government adviser, warned in an op-ed Wednesday in the Vedomosti daily newspaper that the Kremlin is in danger of falling short of its targets for improving the investment environment because of slow progress on privatization and other moves to liberalize the economy.

Former Finance Minister Alexei Kudrin, who was also at the conference, warned that lack of reforms means “there are no grounds to achieve economic growth of more than 4% for the next five to seven years.”

Mr. Kudrin, who lost his job September 2011 over a disagreement with Mr. Medvedev over a sharp rise in social and military spending, blamed the lack of reforms on the government, which prefers “to throw in money to resolve problems and rely on oil prices,” he said.

Putin’s purgatory, indeed.  The mania for stability, the fear of change, the vested interest of the elites in the existing system, and the stasis that inevitably occurs with an aging leadership will conspire to throttle any “moves to liberalize the economy” and to encourage throwing oil money at problems.

Meaning that Russia’s potential for growth is nowhere near 5 percent.

One of the first Russia-related posts I wrote on SWP was titled “The New Oprichnina“?*  This article, written more than 6 years later, argues that the analogy holds in Year XIII of the Age of Putin.

The article discusses the travails that Russian businesses suffer at the hands of the new Oprichniki.

I was talking with a forensic specialist who conducts investigations for companies who suspect violations of the Foreign Corrupt Practices Act.  This regularly takes him to what he calls “seven shot [inoculation] countries,” hardly the world’s garden spots, or the paragons of economic and legal institutions.  I asked him if he did work in Russia.  “Not if I can possibly avoid it.”  I asked why: “It’s not a country. It’s a criminal enterprise. The only places that compare are the worst places in west Africa.”  He described the host of official parasites that descend on everyone who attempts to set up a business-and the fearsome intimidation visited on anyone who pushes back.  Once upon a time it was mouth breathers in track suits.  Now it is “officials”.

So no.  Calling it the New Oprichnina is not too far fetched.

*Apologies.  The SWP archives got corrupted somewhere along the line, and the Russian/Cyrillic version of the title appears as gibberish.  Hopefully that’s not true of the rest of the post 😛

Further my last.  Europe may be out of sight for now, but that’s only because it’s not out of the woods.

Draghi be damned: Spain still in a debt death loop.  And that doesn’t even take into account the fact that 90 percent of the Spanish state pension fund is invested in Spanish government debt.  Or that Spain has long leaned on its banks to buy its debt, meaning that Spanish banks buy the bonds of the government that is supposed to bail them out if they get in trouble.  There’s a financial Escher etching for you.

So what does Spain do? It begs Germany to increase growth. As if it’s like turning on a faucet.

And if there is such a faucet, the handle has come off in Germany’s hand: the economy contracted more in 4Q12 than at any time since the depths of the financial crisis.

Meanwhile, France is getting deeper into Mali.  IMO, best outcome: something like the American Punitive Expedition to Mexico in 1915, which futiley chased Pancho Villa around the deserts of northern Mexico for a year. Worst case: British army in Afghanistan, 1842, or Islawanda.

US support-per the linked FT article-is lukewarm at best.  We (and the Brits) are supplying airlift.  A telling illustration of the lack of sustained expeditionary capability in NATO outside of the US.  Given the extreme logistical challenges of operating in the Texas-size wilds of northern Mail it is hard to imagine a force of a few thousand frenchies doing anything but getting swallowed up in the vast, desolate expanses.

And as I noted yesterday, France is approaching economic zombiedom.

So yeah. Everything is just hunky dory. Maybe as long as Draghi’s paper lasts.  Or more accurately: as long as the bond markets believe in the magic of paper.

Europe seems to be challenging Alfred E. Newman-“What, us worry?” Draghi and the EU have papered over-I am tempted to say “literally”-the immediate financial issues pressing on Spain and Italy.  Given the respite from panic, the Europhoria seems to have taken over.

But the fundamentals are still abysmal.  European unemployment hit all time highs-over 11 percent across the Eurozone, 20+ percent in some countries, and 50+ percent in some demographics-notably younger working age individuals-in countries like Spain and Greece.  Greeks are reenacting a Mediterranean version of post-WWI Vienna, venturing into the forests to collect firewood.  Spain has stuffed its banks and pension funds with government debt-they have no capacity to absorb any more. Given the parlous state of the banks (Bankia is apparently billions of euros underwater), and the dire straits of the Spanish economy, it’s hard to see all of Draghi’s paper keeping out the gales of reality for long.  Add to that the continuing move of Catalonia towards independence, or at least greater autonomy, it is evident that the downside risks are huge.

Meanwhile, France is sputtering-to put it generously-under Hollande’s socialist government.  Growth is moribund-French economists have opined the the government’s point 8 percent growth forecast is overly optimistic.  Capital is fleeing.  The tax-and-spend approach is almost certainly going to condemn the country to stagnation, at best.

Meanwhile, with all going so well at home, France is intervening aggressively in Mali, with mixed results at best.  I shall pass over in silence French hypocrisy regarding foreign intervention.  The initial French air attacks apparently halted the Islamist rebels’ momentum, but not for long.  Within 24 hours the rebels had regrouped and recommenced their advance.  On the opposite end of the continent, in Somalia, a French commando raid to free a hostage-an intelligence operative who had been half for several years-turned out badly, resulting in the death of the hostage and one French soldier, and the capture of another.  Today the Somali Islamists announced the death of the captive, but boasted they had obtained much information from him.  Draw your own conclusions.

In the UK, Cameron is walking a tightrope, threatening to renegotiate Britain’s relationship with the EU, but refusing to put Britain’s membership to a vote.  His position is infuriating the French (go figure) and threatens his position atop the government in the UK, as splitting the difference just serves to get both the Europhiles and the Europhobes furious at him.  And Obama has told Cameron to get his mind right, and get on with the EU program-or risk the special relationship with the US.

And Germany?  Germany is being strangely quiet.

In sum, I think Europe is living in a fool’s paradise.  The ECB has staved off the imminent crisis, but the fundamental economic weakness remains, especially in Greece and Spain.  Moreover, France is in a dicey situation-at best-and socialist nostrums can only make things worse. Military action-and in particular, a protracted military engagement in a place as wild and sprawling as Mali-can only stress the French polity.

Yields are down, and there is a sense that the crisis has passed.  But the ECB can only levitate things for so long, especially if France struggles-or worse.  Greece and Spain are in extremis. In my opinion, it is only a matter of time before the bond markets get a serious case of the yips again.   So enjoy the what-me-worry? moment while it lasts.  I don’t think it will last long.