In March, 2020 the Federal Reserve injected massive amounts of liquidity into the markets in response to a blow-up in Treasury basis trades. I wrote about it here.
In recent weeks, the Fed, the BIS, and the BoE have raised red flags about the renaissance of this trade and the resulting potential for systemic risk a la 2020. Not all are convinced. Goldman Sachs in particular is in Alfred E. Neuman mode: What? Me worry?
We do not think the trade poses a major risk to Treasury markets in the near term . . . Leverage in the system is materially lower than it was in 2019/20 as a result of a series of [initial margin] increases (and price declines). The large increases in IM, which were in theory calibrated to the extremely elevated levels of Treasury market volatility of the past few years, should mean additional large increases may not be necessary — at least in the near term, we expect to migrate to a less volatile rate regime.
This assessment is based on a fundamental error that I went on about ad nauseam in the post-Great Financial Crisis clearing debate, specifically, concluding that if leverage goes down in one part of the system it goes down systemically. Wrong. Wrong. Wrong.
Yes, the ostensible purpose of higher margins is to reduce leverage in the margined trades. But especially for the hedge funds and other sophisticated entities who engage in the Treasury basis trade at scale, they can substitute one form of leverage for another.
As a first approximation, a fund has a leverage target or a level of debt capacity, it can fund the higher margin in the less leveraged futures trade by increasing leverage elsewhere. The funds will typically evaluate leverage holistically, not on a trade-by-trade basis.
It is therefore fundamentally logically flawed to conclude that “leverage in the system” (which is in fact source of systemic risk) has declined because it has gone down in one piece of it.
If there are constraints on funds’ ability to offset mandated leverage reductions in one type of trade by increasing leverage elsewhere, that would increase the cost of engaging in that type of trade and would impact the scale of that trade. But what has alarmed the central bankers is exactly that the scale of the trade has increased and now exceeds its 2020 level:
Note that leveraged funds’ Treasury futures shorts are currently substantially larger now than in 2020. Thus, despite higher margins, the scale of the trade is subsantially larger–and it is the scale–and the concentration–of the trade that poses systemic risks.
This bigger scale could be because raising margins doesn’t really constrain the ability of funds to lever up to engage in basis trades. Or it could be that even though the higher margins raise the cost of the trade, the spread has widened sufficiently to offset, or more than offset the higher cost. For example, constraints on dealer balance sheets that impair liquidity in the cash market could depress cash prices relative to futures prices.
Goldman’s errors don’t end there. One thing that could spark a margin spiral is an increase in initial margins that induces mass liquidations that lead to changes in the basis that lead to large variation margin obligations–something that Goldman doesn’t mention.
Alfred E. chimes in again here: “The large increases in IM, which were in theory calibrated to the extremely elevated levels of Treasury market volatility of the past few years, should mean additional large increases may not be necessary — at least in the near term, we expect to migrate to a less volatile rate regime.” That is, Goldman’s conclusion is essentially based on a very benign view on Treasury volatility.
There are myriad reasons to take a different view. The US’s acute fiscal situation and the accompanying periodic debt limit dramas. The constrained balance sheets of dealers that limit their ability to supply liquidity to the Treasury market. The prospect for an extremely chaotic election year. And geopolitics, with now two major disturbances ongoing (Ukraine and Israel/Gaza) with one continually on the boil in the background (China/Taiwan). And highly unsettled geopolitics with a feckless and befuddled administration at the tiller.
That is, it isn’t the level of margins that really matters. It is the possibility that margins may increase due to higher volatility. Goldman/Neuman isn’t worried. I think that’s unduly optimistic. Furthermore, an assessment of systemic risk must be based on the likelihood that Goldman’s don’t-worry-be-happy opinion is wrong.
And remind me: did Goldman predict the increase in Treasury volatility in 2019 or 2020? Stuff happens. Unknowns and unknowns and all that.
Furthermore, higher volatility->higher IM->liquidation of basis positions->margin spiral isn’t the only potential source of systemic risk. Other economic shocks can cause leveraged funds to slash positions and leverage, leading to liquidations of basis positions and the triggering of a margin cascade. That is, there is the possibility of fire sales.
These shocks can be systematic–a broad decline in stock or bond markets–or concentrated at a few funds, or even one, due to bad trades in other markets.
The 30 25 year anniversary last month of the LTCM collapse brings the latter to mind. Bad bets on convergence trades forced LTCM to liquidate and delever. Understandably, it attempted to unload its most liquid positions–including short Treasury futures. Treasuries had a massive rally on LTCM day that was not matched by a similar rally in the underlying, less risky Treasuries.
A squeeze–not unheard of in government debt futures markets–can also impose losses on basis trades, leading to liquidations that can exacerbate the price impact. Or a Treasury flash crash (in yields, and hence a flash spike in prices) like on 15 October 2014.
In sum, size does matter. Basis trades have become big again, and the factors that lead Goldman to parrot Alfred E. Neuman are hardly persuasive. From a systemic risk perspective, basis trades represent dry tinder that can explode into flame. Can does not mean will. But the possibility is there, and the effect if the right spark hits the tinder depends on the size of trade. The big scale and concentration of this trade thereby justify far more concern than Goldman expresses.
Michael Lewis is out with a book on Sam Bankman-Fried and FTX–just in time for SBF’s trial! What great timing!
I am sure that when Lewis started the project, he did not anticipate that he would have to use the trial of the person whom he had intended to be the hero of his story to turn the FTX lemon into marketing lemonade. But so he has.
Lewis was interviewed by 60 Minutes Last week, where he offered this gem:
This isn’t a Ponzi scheme. In this case, they actually had a great, real business. If no one had ever cast aspersions on the business, if there hadn’t been a run on customer deposits, they’d still be sitting there making tons of money.
Other than that, how was the play, Mrs. Lincoln? Or, if it wasn’t for that damned Russian winter Napoleon’s descendants would still be ruling France!
Where to begin? First, Ponzi schemes are not the only form of financial fraud so by rejecting that FTX was a Ponzi he does not prove it was not a fraud. Second, and more importantly, this begs the question of why there was a run. Did the customers just decide to run on a whim? Or maybe it was sunspots (a la last year’s Nobel winners Diamond and Dybvig)!
Yeah, sunspots, that’s it. Other than that, SBF would be sitting fat and happy. (Though mainly fat–he’s lost weight in the pokey.)
Uhm, no, actually, aberrations in the sunspot cycle didn’t spark a collective frenzy by depositors. The simple fact is that SBF was using customer monies for all sorts of purposes, ranging from funding a lavish lifestyle for himself (and his loathsome parents) to covering losses at the FTX-affiliated hedge fund (the very existence of which should have been the first red flag). The “aspersions” cast upon “the business” were basically factual revelations that “the business” was a financial disaster that used customer monies in violation of laws, duties, customs, and promises.
In other words, there was a run for the reason that there are usually runs: the customers of an entity operating on first-come, first-serve basis learned that said entity was financially suspect. Get your money, and let the devil take the hindmost.
And as for “great real business”–apparently not only did Michael Lewis drink deep from the crypto Kool Aid, he’s still binging on it. There were numerous reasons to be skeptical about crypto since it began (and I expressed skepticism from virtually the time of its emergence about a decade ago), and the dubiousness of the entire endeavor has only deepened. To claim that crypto exchanges were viable businesses that would make “tons of money” on an ongoing basis is utterly delusional.
The simple fact is that Michael Lewis is a deeply, deeply, deeply compromised narrator here. He was “embedded” in FTX for months. He had unparalleled access to the chubby wunderkind. And then the whole thing imploded in scandal.
Meaning that Michael Lewis has to–has to–make his would-be hero SBF a tragic one, wrongly and unjustly brought down by powers beyond his control. For consider the alternatives.
The first is that Michael Lewis had a front row seat to a massive fraud, and that he–the alleged eagle eyed chronicler of the corruption, shenanigans, misdeeds, and absurdities of mainstream finance (investment banks, the stock market, etc.)–missed what was going on in front of his very eyes.
The second is that Lewis knew something was wrong, or at least suspected it, and remained silent.
The first alternative would be a major blow to Lewis’ credibility and reputation. The second would basically make him an accessory to a major crime.
To escape this dilemma, Lewis must insist–and demand that you believe him, and not your lyin’ eyes–that there was nothing wrong at FTX. Indeed, everything was right at FTX, except shit happened. Or something. Given his massive conflict of interest, Lewis’ arguments are utterly untrustworthy, and smacking of special pleading.
I have heard it said that SBF fooled a lot of people, so you need to cut Lewis some slack. Uhm, no. If your whole shtick is your financial gnosticism, your unique ability to perceive and interpret the greedy, grubby, self-interested behavior of financial market denizens, “I wuz fooled just like everybody else” doesn’t cut it when a greedy, grubby, self-interested shlub ran his scheme in front of your very nose.
It is quite clear what has happened here. Lewis’ well-worn–but quite lucrative–MO is to pick out some misfit hero or heroes fighting against the financial Man, and make him/her/them the protagonist of a just so story. Misfit David vs. Goliath.
SBF was to all appearances a gift to Lewis from the literary Gods. Crypto was the vanguard in a supposed revolution against the traditional financial system and institutions that Lewis had inveighed against for years. SBF fit the quirky misfit role to a “T.” He also talked in lofty phrases about his effective altruism, his lack of personal financial motivation, and his desire to use the wealth generated by his genius to make the world a better place.
It had the makings of the Michael Lewis book to top all Michael Lewis books, and SBF to be the hero of all Michael Lewis heroes.
And then it all went horribly, horribly wrong.
So what’s Michael Lewis to do? Since the elites (which includes Michael Lewis) don’t do mea culpas, let alone retire to a monastery, the only thing he could do–spin like a dreidel.
It is immensely amusing to me that Lewis clearly doesn’t understand the fundamental absurdity of his arguments. If you are really a crypto true believer, which Lewis clearly is, it is because you believe that a trust-based financial system is fundamentally flawed, and that trustless crypto is the answer. But Lewis also argues that FTX’s “great real [crypto] business” failed due to an irrational loss of trust. Both of those things cannot be true.
So Lewis has jumped the shark here. But due to his spinning, and his existing reputation, it is quite likely that’s a bad thing–but only because it means that the shark won’t eat him, as would be a just outcome.
I criticized Lewis’ Flash Boys when it came out 9+ years ago, so I have been a skeptic for a long time. But I have nothing on Scott Locklin, who wrote this in the immediate aftermath of the FTX implosion (and who also ridiculed Lewis’ Flash Boys). Locklin makes me look like a milquetoast. Definitely worth a read
Federal Trade Commission chair Lina Khan has had her undies in a bunch about Amazon since she wrote an overly long and overly praised Harvard Law Review article about it. Now as a capo in the administrative state, Khan has the power to execute her vendetta, here in the form of a massive antitrust lawsuit against the e-commerce giant.
The case is a farrago of economic ignorance and idiocy. It brings to mind Coase’s remark (which I paraphrase) to the effect that a certain kind of mind sees a non-textbook contracting practice and immediately concludes it is an evil monopolizing practice.
Quite the mystery! I mean, maybe it’s possible but the “somehow” part seems rather miraculous. Ask the 1970s-80s Big Three about how degrading quality raising prices usually works out, market share-wise.
This theory brings to mind the Underpants Gnomes:
So yeah I’d really like some explanation how that works, exactly. Neither Stoller or the FTC provide it.
The specifics of the FTC case are hardly more persuasive. I’ll look at the ones they highlight in their press release.
Leading with their best?
Anti-discounting measures that punish sellers and deter other online retailers from offering prices lower than Amazon, keeping prices higher for products across the internet. For example, if Amazon discovers that a seller is offering lower-priced goods elsewhere, Amazon can bury discounting sellers so far down in Amazon’s search results that they become effectively invisible.
If so, God save them.
As background, Amazon used to have a contractual term that precluded such differential pricing across platforms. The Euros no likey, so Amazon did it by algorithm (which twists Matt Stoller’s undies).
Contract, algo, whatever. However implemented, this is basically a form of resale price maintenance (RPM). My thesis advisor and mentor, the late, great Lester Telser, wrote the seminal article on the subject when I was one (so maybe the FTC should have caught up by now). Telser argued that RPM is efficient when some retailers provide costly “special services”–notably information–to their customers. This creates a potential free riding problem. Sellers can free ride off the information/special services provided by some retailers/platforms and sell at a discount at stores/platforms that don’t offer the costly service.
Amazon provides a lot of information on products, including product reviews. Offering a product on Amazon, a seller’s potential customers can learn about the product there, and in the absence of the restriction that the FTC is attacking, can then go and buy it from a platform that doesn’t incur these costs, thereby free riding on Amazon’s information provision.
Next up is a real doozy:
Conditioning sellers’ ability to obtain “Prime” eligibility for their products—a virtual necessity for doing business on Amazon—on sellers using Amazon’s costly fulfillment service, which has made it substantially more expensive for sellers on Amazon to also offer their products on other platforms. This unlawful coercion has in turn limited competitors’ ability to effectively compete against Amazon.
For one thing, I don’t see how requiring use of Amazon fulfillment on sales via Amazon raises the cost of selling on other platforms. But even putting that head-scratcher aside, where is the “coercion” here? Amazon offers a bundle. They don’t put a gun to your head forcing you to take it.
Further, there is a very good efficiency reason for this bundling. Amazon offers a delivery guarantee. If it vertically integrates into shipping, it has considerable control over whether it performs according to the guarantee. If a seller uses another shipper, Amazon has no such assurance.
Again, there is a free rider problem. Seller gets sales from customers expecting speedy delivery. Seller uses a cheap but less reliable carrier. Goods arrive late, or in bad condition. Whom is the customer mad at? To whom does the customer look for recourse? Amazon.
Vertically integrating into shipping reduces the cost of providing the guarantee that buyers like.
The FTC also apparently doesn’t understand the basic point that if alternative carriers are cheaper than doing it in house, by forcing customers to use a higher cost service Amazon reduces the derived demand for its services and its platform. Since–as the FTC also whines about–Amazon apparently prices to extract large sums from sellers, in the absence of efficiency benefits like those just described, it would be able to, and find it more profitable to let sellers choose their putatively cheaper carrier and charge the sellers a higher price to sell on Amazon.
Next!
Degrading the customer experience by replacing relevant, organic [but are they vegan????] search results with paid advertisements—and deliberately increasing junk ads that worsen search quality and frustrate both shoppers seeking products and sellers who are promised a return on their advertising purchase.
This is basically the Stoller argument. I’ve already discussed its facial absurdity. But it’s also absurd when you dig deeper.
Search ranking is a scarce resource, and an extremely valuable one. Scarce resources have to be allocated somehow. Usually best way to allocate a scarce resource is to price it. (This is done all the time with online advertising, by the way.) So what is the best way to price this resource?
An auction? Possible–Amazon has no doubt considered that. But maybe pricing through advertising is superior. I don’t know, but given that advertising can serve a reputational branding role, and can provide information, it may well be the case that for selling information-intensive goods, or goods of uncertain quality, advertising is better than auction to prioritize search results.
What I do know is that Amazon internalizes the costs and benefits here. Meaning that they have the incentive to choose the best alternative. Lina Khan–not so much.
And I can guarantee that if Amazon allocated search ranking by auction or some other pricing mechanism, that would cause the FTC to have a meltdown too. They apparently believe that “organic” rankings (WTF are those?) sans pricing of any form are best.
Fine. Start your own platform, Lina.
And next:
Biasing Amazon’s search results to preference Amazon’s own products over ones that Amazon knows are of better quality.
Preferencing in the absence of some other efficiency advantage is hard to rationalize–and certainly the FTC provides no such rationale. Again, since Amazon could extract the alleged quality advantage (and perhaps cost advantage) of the third party sellers by raising its prices to them, why offer lower quality products?
Here’s one reason: by offering its own products, and competing on price and perhaps visibility, Amazon is entering the market, creating competition, and inducing third party sellers to reduce prices. Which helps consumers and drives them to use Amazon. That is, by creating competition preferencing is pro consumer.
And finally:
Charging costly fees on the hundreds of thousands of sellers that currently have no choice but to rely on Amazon to stay in business. These fees range from a monthly fee sellers must pay for each item sold, to advertising fees that have become virtually necessary for sellers to do business. Combined, all of these fees force many sellers to pay close to 50% of their total revenues to Amazon. These fees harm not only sellers but also shoppers, who pay increased prices for thousands of products sold on or off Amazon.
Oi. Amazon charges fees. Who knew? Amazon has market power that allows it to charge high fees. Also hardly a revelation.
But this would apparently be a revelation to the FTC: it is not an antitrust violation to exercise market power gained by “superior skill, foresight and industry.” Only nefarious acts to monopolize fall afoul of the antitrust laws.
This one should be a slam dunk for Amazon’s lawyers.
One thing that jumped out at me in the complaint that isn’t in the press release: Amazon’s pricing and policies make it difficult for “single-category ecommerce companies to achieve the scale they need to succeed.”
So, who says they should succeed? Amazon’s success and the success of other platforms (e.g., Walmart) suggests that there are strong economies of scope here, which would make “single-category” platforms inefficient. We don’t want inefficient platforms to survive. If the FTC were to get its way, and somehow handicap Amazon so that inefficient single-category platforms that can’t exploit economies of scope survive, we are worse off.
One interpretation of the anti-Amazon arguments are that it is essentially using its scale and scope economies to price below the cost of alternative platforms, so those platforms don’t enter. This is analogous to Demsetz’s theory of natural monopoly, or the behavior of a dominant firm in a contestable industry (a la Baumol, Panzar, Willig). In these theories, there is no entry, but that’s a good thing because entry would be duplicative (given the scale and scope economies). Moreover, the potential for entry disciplines the incumbent’s pricing, mitigating traditional monopoly triangle losses.
The FTC’s lament about the high prices charged to sellers on Amazon’s platform highlights a major lacuna in its attack: the failure to take into account that Amazon is a two-sided platform. Pricing in two-sided platforms is quite complex, and it is impossible to evaluate Amazon’s pricing justly without taking these complexities into account.
One thing missing from the complaint is one of Khan’s law review criticisms–that Amazon uses the information generated from its operation of the platform to identify profitable entry opportunities, i.e., to identify products that Amazon can produce (or procure) and sell in competition with third party sellers.
Entry is pro-competitive, dontcha know. It tends to lower prices. I’m sure that’s news to you.
Companies perform market research all the time to identify which markets they can enter profitably because they can make products better or cheaper than incumbents. If Amazon can perform this research low cost due to the information it sweeps from the platform–great! Let them use it. (I note that an early theory of vertical integration advanced by Ken Arrow was that such integration produces information that the upstream firm can use to make better decisions.)
In sum, the FTC case against Amazon is pathetic. I would characterize it as economics free. Or maybe more accurately anti-economics.
It is also entirely untethered to any credible theory of how Amazon’s actions harm consumers, or more importantly, how eliminating the practices that the FTC decries would benefit consumers. And as my foregoing arguments show, consumers would almost certainly be harmed if the FTC gets its way.
But this is not a surprise. The Khan FTC has explicitly rejected the Consumer Welfare standard that has guided antitrust since Robert Bork first mooted it in the 1970s.
Now I have my issues with the way courts have interpreted the standard–which, alas, is largely due to how Bork framed it. A close reading suggests that Bork interpreted “consumer welfare” to mean efficiency-enhancing. The courts have typically read it to mean “lower prices to consumers.” Now in many contexts, the courts’ Cliff’s Note version leads to the right results–but not all.
That is only a reason to refine the standard, not to reject it altogether. But reject it the Biden FTC and DOJ have.
Which is why, as a general matter, and in the specifics of the Amazon case (and other cases Khan’s FTC has filed), it is more than fair to say that “FTC” really means “F the consumer.”
Now you might not think that a buck is a big deal, given that a T-note or crude oil contract has a nominal value of around $100 grand. But it is a big increment to the cost of executing a contract. For example, the bid-ask on a crude oil futures trade is usually about $10, and the brokerage commission adds on only a few bucks. So the tax would increase transactions costs on the order of 5 or 10 percent.
I note that the industry fought for years at efforts to impose a 15 cent futures transaction tax. What Johnson is proposing is substantially greater than that.
Now, if Johnson’s objective was actually to raise revenue, this would be an incredibly stupid idea. Rule one of taxation: tax what can’t move. Although in the floor days uprooting the exchange and taking it outside the city or the state would have been very difficult, that’s not the case in the electronic era.
Have servers, will travel. Yes, CME Group (and CBOE–which given recent developments might end up in CME) has corporate employees there, but if any city should understand that is no impediment to relocation, Chicago should given the exodus of several major corporate HQs from the Chicago area in recent years–Caterpillar, Boeing, and Tyson Foods being prominent examples.
Moreover, even before the CME says hasta la vista motherfuckers, it faces competition in some of its products from ICE, and a tax would shift business there.
Numerous trading firms (notably Citadel) have fled Chicago for reasons–namely the marked decay of the city. (And I do mean marked: even in the last two years the decline has accelerated dramatically.) The CME has certainly already put those factors on the scale when making its decision, and a sizable transaction tax would almost certainly tip the balance heavily in favor of joining the exodus.
Notice that I framed my analysis as a conditional statement: if Johnson’s objective was actually to raise revenue. One cannot be too sure these days. Mayors of city after city have taken actions, or failed to take actions, that seem designed to drive out all but the underclass and turn the polities they govern (I use the term loosely) into crime-ridden, drug infested wastelands. In fact, it’s hard to name a big city whose elected officials haven’t done that or aren’t doing it.
American Spectator writer Scott McKay calls it “weaponized government failure:” “deliberate refusal to perform the basic tasks of urban governance for a specific political purpose.” The “specific political purpose” being to drive out middle class voters who pose the main political threat to the Brandon Johnsons and their ilk.
Framed as a hypothesis, I’m hard pressed to come up with contrary evidence.
Whether that’s the true purpose behind Johnson’s transaction tax brainwave, if he moves forward with it it’s a near lock that CME will hit the road. An electronic exchange is footloose and fancy free and not beholden to any place. Where once there were “locals” whose physical presence was necessary to operate an exchange, there are now what may be called “globals” who can and do supply liquidity from anywhere.
And if it moves, Texas is a good place. No income tax for one thing. Reasonable housing costs. And as for the weather, as I told my late mom when she fought coming here: “Look, you spent four months a years indoors in Chicago. You’ll spend four months a year indoors in Houston. Just different months.”
So come on down, Terry Duffy. I’ll be here to greet you. With bells on.
Speaker of the House Kevin McCarthy has announced the initiation of an impeachment “inquiry” against Joe Biden.
On the substance, I’m ambivalent. Many crosscurrents here. Perhaps the most intriguing is that this might be turnabout: just as the indictments against Trump are plausibly a strategy to boost his popularity among the Republican base to ensure his nomination (in the belief he can’t win the general–though maybe they should ask Hillary about that), the House impeachment move is plausibly an effort to force the Democrats to stick with Biden (in the belief he can’t win the general–though maybe they should ask Trump about that).
The Democrats’ reaction is quite amusing, and telling in many ways. It also suggests that if this is a turnabout play, it’s working.
The main response is that this inquiry is totally unjustified, because there is no evidence that Biden is corrupt. For one thing, McCarthy announced an inquiry–which is a process to develop evidence. Justification of an inquiry faces a (much) lower hurdle than an actual impeachment, or a conviction and removal from office. Moreover, there is far, far more evidence in plain sight here than the predicates for the first Trump impeachment or the Mueller investigation. The former was based on allegations regarding a phone call between Trump and Zelensky which turned out not to be an accurate representation of the actual content of the call. The latter was based on the Steele Dossier and some extremely dubious hearsay (e.g., the alleged Papadopolous revelation). The Dossier was facially absurd–as I wrote immediately upon its release: the Putin gifted Trump 10 percent of Rosneft via Carter Page was obviously complete and utter bullshit.
With Biden there is: Hunter’s laptop; information from a trusted FBI source; undisputed and indisputable business dealings between Biden’s son and brother and corrupt companies (CEFC and Burisma) and oligarchs around the world; documented large flows of money through a labyrinth of shell companies; well over 100 suspicious activity reports related to Biden family members filed by US banks; testimony of Biden associates (Archer and Bobulinski in particular); contemporaneous US and European documents regarding the Ukrainian prosecutor Shokin whom Biden bragged about getting fired; Shokin’s statements; Biden’s bragging; and the now indisputable fact that Biden lied repeatedly about the absolute wall between him and Hunter’s business dealings; the fact that Hunter and Jim had nothing–zero, zip, nada–to offer Burisma or CEFC or corrupt Kazakh or Romanian oligarchs other than access to Joe Biden. And that’s just what pops immediately to mind. More than enough smoke to justify looking for a fire.
But but but . . . there’s no proof that Joe benefited personally from Hunter and brother Jim’s foreign dealings!!! the Democrats squeal. In unison.
Er, that’s the point of an inquiry, isn’t it? To determine whether Joe indeed realized a benefit. There is certainly more than enough evidence to create a reasonable suspicion of such a quid pro quo.
And ironically, one of Biden’s–and the Democrats’–primary justifications proves the existence of such a benefit. JOE LOVED HUNTER! Biden did what he did not out of greed for personal pecuniary gain, but because of his deep, abiding love for his troubled son. (Why is Hunter troubled if he had such a loving father? you might ask. And if Joe’s love is unconditional and without any strings or expectation of payback, why did Hunter sometimes express bitterness at what he had to give his father, e.g., half of his income?)
Well, let’s taken the deep, undying, unconditional love as given. That would imply that Joe benefited any time his son profited. Even if a single dime that rained on Hunter never touched Joe’s hands, all those dimes (100s of millions of them) would have given Joe immense pleasure.
Bribery involves performing an act in an official capacity in return for consideration. The showering of blessings on a son upon whom the sun supposedly rose and set in Joe’s world certainly counts as consideration for Joe.
Consider an analogy. Any corporate CEO that arranged or facilitated deals that benefited a family member would be fired, and perhaps prosecuted. Further, many government corruption allegations (I’m from Chicago, so I know!) involve actions by a government official that benefit a family member or members, without the necessity of showing that the official received any direct compensation.
Meaning that the no-direct-personal-benefit-and-he-did-it-all-for-love defense does not cut it. Even if it is true. Which is highly dubious (as the above litany of the supposedly non-existent evidence demonstrates), and which regardless is a fair subject of inquiry.
There is obviously some serious cognitive dissonance at work here. On the one hand, publicly Democrats are circling the wagons around Joe. On the other, there are clear signs of concern, and perhaps panic, in the Government Party about Biden’s electability, especially in light of his undeniable cognitive decline–from a not-too-high-to-start-with level.
As evidence of the latter, CIA sockpuppet moonlighting as WaPo columnist David Ignatius called upon Biden not to run in 2024. I also believe that the White House’s rather remarkable issuing of marching orders to the mainstream media to “ramp up scrutiny” of the House Republicans’ investigations reveals fear of an internal push–or putsch. It hardly screams confidence. Indeed, it betrays concern that the media may turn on Joe.
But the attitude of most Americans about the economy is decidedly sour even though the data is allegedly “surreally good.” What a strange disconnect, eh, Paul Krugman?
“The economic data have been just surreally good. Even optimists are just stunned,” says Nobel Prize-winning economist @paulkrugman. So why do polls show most Americans don’t think the economy is doing well? “There’s a really profound and peculiar disconnect going on.” pic.twitter.com/MNFhzZ2hh3
Who you gonna believe, Paul Krugman or your lying bank account? Median household income has fallen three straight years. Note: the decline has continued the last two years, after the COVID shock. This is mainly due to the “transitory” inflation that we were told we shouldn’t worry our little heads about.
Perhaps household income figures aren’t included in the data that Paul scrutinizes. If he did pay attention to it, or did and actually told the truth, he would realize that there is no “profound and peculiar disconnect.” Household income is what people care about, and what drives their evaluation of their economic circumstances. The connect is very, very clear.
I mean, duh.
But the whole-of-government (and government pilot fish e.g., Krugman and media) propaganda/gaslighting effort never stops. You are just too stupid to know whether you are living better this year, right? Pay attention to your betters, prole! They’ll tell you how you’re doing!
Thus, the “no evidence” gaslighting on Joe’s guilt is just a piece with a broader, and indeed ubiquitous, phenomenon. We are lied to 24/7. They have to know we know they are lying. But they continue to lie. And that is the essence of gaslighting. And there are many, many fronts in the gaslighting war, of which the Joe is the personification of innocence is just one.
In 2010, along with my UH colleagues Victor Flatt and Praveen Kumar, I taught what I believe was the first academic carbon trading course in the world. My lectures in the course related to the economic challenges of creating traded commodities, specifically the challenges of merely defining what the commodity is and monitoring adherence to the standards so established.
Now, this may seem trivial, but even something like “wheat” poses challenges due to heterogeneity related to quality (even within a given variety, such as soft red winter wheat) and monitoring whether the wheat traded under a contract adhered to the relevant terms agreed to by the parties. Indeed, as I noted in an early article of mine, the genesis and early development of commodity exchanges like the Chicago Board of Trade and the Liverpool Cotton Exchange was not driven by the desire to trade futures: these were cooperative, private efforts to define property rights and to create a mechanism to standardize commodities and to adjudicate contractual disputes primarily over quality. Only after these challenges were met was it possible to trade futures. Standards (and their enforcement) are obviously a necessary condition for trading standardized instruments like futures.
The major intended takeaway from my lectures in 2010-11 was that the problems of standard definition and especially standard enforcement were even more daunting in carbon than in traditional commodities like wheat or cotton, and that this was especially true with respect to carbon offsets–things like contracts to plant trees to capture carbon.
How do you define what is being bought and sold? How do you monitor whether the offset contracted for performs as agreed? How do you address contract performance failures? The Chicago Board of Trade struggled for years to overcome these issues in wheat and corn and oats in the post-Civil War era, even though the trade was relatively geographically concentrated, the contracts were of relatively short duration (typically for a single consignment), and the commodity was relatively simple.
All of these challenges are far greater for carbon, let alone for offsets. Sources of carbon emissions are numerous and diffuse and costly to monitor. With respect to offsets, they are highly heterogeneous; have very long lives; require continuous investment and upkeep; and have highly unpredictable performance (e.g., the forest that you plant may burn down, or be ravaged by insects). These contracts are far more complex than a deal to buy 10,000 bushels of SRW winter wheat for delivery in Chicago next month. Moreover, many offsets are located in countries with weak–and sometimes close to non-existent–legal systems.
Furthermore, the incentives of the parties to these agreements can be perverse, especially for “voluntary” offsets. A buyer who pumps its ESG score by purchasing offsets that turn out not to perform seldom suffers serious adverse consequences (although there is some backlash against “greenwashing”), and the seller has a strong incentive to collect the cash and not make the necessary expenditures to ensure that the offset performs as promised.
I taught the class in the immediate aftermath of the Global Financial Crisis, and I suggested that there were a lot of similarities between offsets and the kinds of deals that wreaked havoc in the banking system in 2008-2009, where bankers paid their bonuses upfront based on imagined profits predicted by highly speculative models to be realized over several years churned out garbage securities.
In 2010 I was therefore extremely skeptical about the viability of markets for offsets. And the defects that I talked about have been increasingly recognized in the last year or so.
I believe that the actions of Shell during the last week represent an authoritative recognition that these predictable–and predicted–problems have come to pass. Like other (especially European) energy firms. Shell made ambitious carbon reduction pledges that it intended to meet largely through the use of offsets. But reality has reared its ugly head, and Shell is all but abandoning this strategy. Other companies (e.g., Microsoft) say that they are still committed, but if they are even remotely interested in spending their shareholders’ money wisely, they will eventually have the same come to Jesus moment as Shell.
A Shell-funded mangrove restoration project in Senegal (Bloomberg).
This represents another grievous blow to the ambitions of the Net Zero fanatics. Offsets are a major component of Net Zero plans. Renewables are another part–and reality is catching up with that too (as the travails of Danish renewables developer Orsted and German turbine manufacturer Siemens demonstrate).
But will the fanatics be deterred? Alas, it appears not. Indeed, they appear to be doubling down, as illustrated by lunatics like Michael Gove:
Michael Gove has insisted the UK needs 'big, hairy, audacious' environmental goals such as the ban on the sale of new petrol and diesel cars from 2030, during a live debate at #ftweekendfestivalhttps://t.co/jD1bEkY8c0
Net Zero and the policies intended to bring it about–including extensive reliance on renewables and offsets–are a guaranteed recipe for an impoverished future. This was predictable–and predicted–more than a decade ago. But when will the madness end? I am guessing not before these policies cause economic catastrophe.
Something of a kerfuffle has broken out over the issue of China’s economic angst. On one side is Adam Posen, who in a Foreign Affairs article attributes China’s current predicament to the reluctance of private firms to invest, which he in turn attributes to their fears that an authoritarian regime like Xi’s will not respect their property rights and may expropriate them. On the other side, Adam Tooze (on Substack) and Michael Pettis (on X or Twitter or whatever it identifies as these days) claim no, China’s problems are the consequences of fundamental structural imbalances dating back years, and rooted in pre-Xi economic policies.
All of them are right in parts, and wrong in parts. I assert my post of the other day synthesizes the right parts 😉
It’s perhaps convenient to boil things down thus:
What mess does China find itself in?
How did it get into this mess?
What prospects does it have to get out of this mess?
Pettis and Tooze (and others, including me and not just the other day) attribute China’s current mess as the result of huge imbalances (over-investment, underconsumption) and secular demographic problems compounded by a very weak social safety net.
It got into this mess as the result of a development model and associated policies that heavily favored fixed investment (especially in infrastructure and housing financed by debt) and exports, and punished private consumption. The policies involved are myriad, but they can be summarized as central planning without complete government ownership. That is, the direction of even private enterprise was substantially guided by government policies that caused prices to encourage the types of economic activity that the government favored. The hand of the state was very visible indeed in China–something which fanboyz such as Thomas Friedman and too many western CEOs to count waxed rhapsodic about. (To which I should add the incentives faced by government employees at all levels who were rewarded for meeting certain aggregate growth targets that were most easily achieved by borrowing to make fixed investments–high powered incentives can be dangerous, my friends.).
But that model is played out, and was in fact always unsustainable: what’s amazing to me is how long they sustained it. But as Herb Stein said, if something can’t go on forever, it will stop. And that model couldn’t go on forever. It’s stopping time is about now. Hence China’s current distress.
So how to get out? The hydraulic economists who rely primarily on accounting identities (for all my admiration for Pettis’ diagnosis of structural imbalances, he fits that description to a large degree), the answer is: Correct the imbalances! Shift China from an investment focus to a consumption focus!
Well, how, exactly? And that’s where Posen’s critique of Xi-o-nomics–and mine–comes in. Achieving a new balance would require the CCP and the state to reduce their control over the economy. But the authoritarian Xi is hell-bent on increasing the Party’s–and his–control. For the reasons that Posen sets out, and many more besides, Xi’s kontrolle uber alles mentality is inimical to a fundamental structural shift in China’s economy, and especially a shift driven by private enterprise and private consumers, that is, a shift driven from below not from above. And below is the only place it can possibly come from.
So I would say that Pettis and Tooze prevail on the “how did China get into this mess?” issue, Posen on the “how does China get out of this mess (or not)?” issue, and all are largely in agreement in describing the just what the mess is.
The upshot of this synthesis is that China is shtupped. And the concern for those outside of China should be how a shtupped autocrat responds.
Evidence abounds that the Chinese economy is in the midst of a fundamental structural crisis. To which I respond: “It’s about time!”
I say this because I have written for over a decade that the Chinese development model is fundamentally flawed, and that signs of its distress have been emerging for years. My main surprise is that it has taken so long.
Signs abound of fundamental structural defects that cannot be addressed using the means that the CCP has used to extend and pretend for the past decade or so. The Chinese economy did not rebound robustly from the lockdown. Indeed, “flaccid” is a good descriptor of the economic performance in the last year. Despite reported growth estimates of 5 pct annually, it is virtually impossible to reconcile these official figures with more granular measures of economic performance (many of which are less subject to manipulation than top line growth numbers). For example, imports and exports have fallen–a troubling development for a trade-heavy economy.
Other indicators include widespread youth unemployment–especially among urban, educated young adults. A real estate collapse, with property development firms falling like dominoes and property turnover approaching zero. Accelerating debt-to-GDP ratios. Reduced marginal productivity of investment, as proxied by increasing debt per unit of GDP growth. Financial distress among local governments. This is another symptom of the real estate problem, as local revenues are significantly dependent on land sales. The local government troubles really represent a national fiscal crisis because local governments account for a disproportionate share of total government expenditure (and debt) in China. Banks are increasingly shaky due to a deterioration of the credit quality of their loan portfolios.
In the past China has responded to growth recessions with increased stimulus. But the government apparently increasingly realizes that the issues are structural, and that if anything increased stimulus will exacerbate rather than mitigate these problems.
Inside and outside China, there is a growing realization of the deep structural imbalances within China–something that has been obvious (and which I have written about for years) but which are now receiving attention. In particular, the investment intensity of Chinese economic activity, and the concomitant enervation of private consumption is the focus of most post-COVID analyses of the Chinese economy.
These diagnoses are fine as far as they go, but all too often those offering cures for the disease are slaves to economic aggregates and the hydraulic model of how economies work. Aggregate investment too high? Aggregate consumption too low? Well, just shut this valve and open that one and the economic shmoo will flow from investment to consumption. Problem solved! Easy peasy!
No, actually. The imbalances in the Chinese economy are the product of its very structure and most importantly its policy and political infrastructure. There are no valves to open or close, no dials to twiddle, that can alter these imbalances. Change would require a fundamental reordering of the entire Chinese system. Moreover, any fundamental adjustment in the allocation of resources would entail substantial adjustment costs, including the junking of much existing capital and widespread unemployment as people lose jobs in contracting sectors before they can find employment in new ones–not to mention that the human capital accumulated in the present structure is likely to be less than ideally suited for employment in the new consumer sector.
Low consumption and investment intensity are built into the existing system by design, and many of the problems that are metastasizing now are manifestations of this structure. The near absence of a social safety net encourages high savings and low consumption–a phenomenon that is deepened by the since discarded but still relevant One Child Policy that deprived the elderly of their traditional support, namely their children. Moreover, myriad policies have distorted relative prices to favor investment in infrastructure and state-owned enterprises (SOEs).
A salient example is “financial repression” which reduces returns to savings–and interest costs to borrowers, especially capital intensive industries, thereby channeling wealth to them. So what is a middle-aged Chinese person to do when he or she wants to save for old age, but can’t achieve high returns through traditional investments? Well, buy real estate for one–the massive overbuilding of apartments in China (illustrated by the many “ghost cities”) is emblematic of this malinvestment. The periodic proliferation of “wealth management” products offered by banks and other financial intermediaries desperate to secure funding for dodgy loan portfolios is another. I could go on.
These various policies are deeply embedded. They cannot be changed at a whim. And perhaps most crucially, they have created powerful political constituencies who are dependent upon their continuation: think of how many businesses (banks most notably) that would collapse during a fundamental rebalancing. And news flash: individual Chinese citizens/consumers are not a powerful political constituency.
Which brings us to the biggest bull in the China shop: supreme leader Xi Jinping. Xi is a devoted communist ideologue with a cult of personality. Basically Mao with a better haberdasher and hairline.
Xi’s overriding–not to say obsessive–ambition is extending, deepening, and strengthening the control of the CCP over every aspect of Chinese society. A fundamental reordering of the Chinese economy to correct the increasingly unsustainable structural imbalances would require massive decentralization, and a grant of considerable autonomy to Chinese individuals as consumers, investors, and entrepreneurs.
And that is an anathema to Xi.
Add to this Xi’s reading of the history of the Soviet Union. He–not wrongly–attributes the collapse of the USSR to Gorbachev’s attempt to loosen the grip of the state and the party over the economy. Xi is hell-bent on avoiding the same mistake. As a result he is consciously adopting an anti-Gorbachev strategy, and increasing centralization, and the power of the party over the economy. And since he has basically declared le Parti, c’est moi, increasing his power over the economy (not to mention virtually every other aspect of Chinese social life).
This foreshadows a fundamental conflict between economic and political realities. Xi’s political agenda will only exacerbate China’s current structural problems. His “solution” is a version-on-steroids of the source of the problems.
Unlike those who screech “OMG China’s slowdown will reduce world GDP growth,” in some respects (economic respects in particular) I don’t care much one way or the other: I don’t consume Chinese GDP growth (and especially not the official statistics on that growth), and the indirect effects on the US economy don’t trouble me that much.
The reason that I do care is the nexus between the Chinese economy and its foreign policy. I can see this cutting in at least a couple of ways.
On the one had, an economically hobbled and distracted China could turn inward and be more focused on foreign domestic issues than foreign adventurism and dreams of reordering the world to be subservient to Chinese domination and a desire to take revenge on centuries of alleged humiliation by foreigners.
On the other hand, intractable domestic problems can lead a personalist system–and China is clearly that now, in contrast to the more collectivist leadership of the post-Mao, pre-Xi era–to ramp up the foreign adventurism. This is particularly true when the personalist person is a seventy-something guy who wants to cement his place in history by, say, “liberating” Taiwan.
Prudence and an objective reading of Xi leads me to place greater weight on the latter possibility. Prudence, because it is the alternative that poses the greatest threat to the United States. Objective reading because of the Xi-as-anti-Gorbachev phenomenon discussed above. Gorbachev’s rapprochement to the United States was driven in large part by his recognition of the strategic and geopolitical ramifications of the USSR’s deep structural economic problems. A player of the Gorbachev Opposite Game–a fair characterization of Xi–would ramp up tension, rather than attempt to ameliorate it.
Xi is clearly ascendent in China now, but there are palimpsests that suggest discontent beneath the propaganda facade. What does an autocrat facing internal opposition do? He removes them. Note that the recently appointed Chinese foreign minister disappeared–and had much of the evidence of his existence erased: perhaps he’s exploring exciting new opportunities in organ donation! Further, commanders of the People Liberation Army’s strategic rocket forces were also recently replaced. Thus, these moves by Xi could be evidence of a dark star of opposition to Xi’s sun.
Intra-CCP politics were always highly factionalized. Xi has apparently triumphed over all of these factions. But short of Stalinist methods–which Xi has not employed–oppressed factions do not disappear, but take cover and can reemerge given the opportunity.
Alas, Chinese is the riddle, mystery, enigma on steroids–it puts even Russia in the shade in this regard. The United States, and the West generally, have very little insight on what is going on in China. Meaning that economic dislocation in a personalist system ruled by a Han exceptionalist, communism with Chinese characteristics autocrat creates extreme risks for the US and the rest of the non-Chinese world. But to compound the angst, the governing “elite” in the US and its allies is clearly not up to the challenge–and indeed may not even recognize its existence, and/or may be personally compromised in their ability to respond.
Meaning that economic tumult in the Middle Kingdom is fraught with risk for you and me. But China is where it is, and the tumult is inevitable.
When inflation reared its ugly head in 2021, the administration, and various running dog economists, pronounced that it was “transitory.” Then in a defeat for Team Transitory, it lasted for months and months, before beginning to abate in recent months. But now TT is declaring victory–“See! It was transitory after all! It just lasted a little longer than we expected.” (Redolent of “two weeks to flatten the curve”, no?)
No, actually. This reflects the sloppy thinking about and descriptions of inflation.
This is something of a pet peeve of mine, probably originating from a standard Chicago econ prelim exam question back in the day (when inflation was last a big deal) about the difference between a one-time increase in the price level and inflation.
The argument that the transitory people (read that how you wish!) made was that the spike in prices in 2021 was due to an adverse supply shock–a shift of the aggregate supply curve to the left, for you Keynesian types–due to COVID. Once the supply shock ended, they said, inflation would end.
Wrong! The end of the supposed supply shock should have caused the AS curve to shift back to the right, leading not just to an end of inflation, but an actual decrease in the price level, i.e., a deflationary period. That is, the supply shock should have led to a one time increase in the price level (smeared out over time due to price stickiness) followed by a one time decrease in the price level (smeared out over time due to price stickiness.) with the price level ending up roughly equal to its pre-shock level.
An increase in the price level, followed by an abatement in the rate of increase but no decline in the price level–which is what we have experience recently–is contrary to the predictions of the mental model that TT relied on. We have had a permanent increase in the price level.
The pattern we have observed is in fact much more in keeping with the predictions of the Fiscal Theory of the Price Level (developed initially by Thomas Sargent: advanced students can tackle John Cochrane’s recent excellent book on the subject–great timing, John!)–something that the administration and its acolytes are desperate to deny. In that theory, a large increase in government expenditure–like that which occurred during the COVID policy botch, and a whole-of-government botch it was–unaccompanied by a belief that the government would run larger surpluses in the future to pay for it, leads to a permanent increase in the price level. That is, government spending excess caused the large and permanent increases in prices.
In a model with completely flexible prices and one-period government debt, the price level jumps up at the time of the fiscal shock and stays there. In a more realistic model with sticky prices and long-term government debt, the increase in the price level is spread out over time, leading to a period of month-on-month inflation, with the rate of inflation damping out as the fiscal shock recedes further into the past and the price level reaches that consistent with the new level of government debt that results from the spending shock.
That’s pretty much what we’ve observed in the past couple of years.
So the good news is that the impact of past policy blunders on the price level is abating. The bad news is that the price level impact has not gone away and will not go away. The worse news is that the deflated thinking about inflation that pervades the conventional wisdom not only fails to understand what the policy error was, but aggressively denies it. Which means that it is all the more likely to be repeated.
The Biden administration, courtesy of the delusionally titled Inflation Reduction Act, has made a huge spending commitment on alternative fuels, and in particular “clean” hydrogen, i.e., hydrogen not produced from fossil fuels (such as methane). Most of the “green” hydrogen stimulus involves supply-side subsidies (especially a $3/kg production tax credit, but also loans to be doled out by the administrative state). The Infrastructure Law sets aside funds for hydrogen electrolysis and hydrogen “hubs” (like that just announced for Germany). The administration is also attempting to make “the economic case for demand-side support,” such power purchase agreements (PPAs), contracts-for-differences (CFDs), advanced market commitments (made by whom?), and prizes (funded by whom?).
It’s hard to know where to begin in criticizing this mess. The biggest problem is that it attempts to address the climate issue (which I will take as a given, focusing on means not ends) by picking technologies. This almost never ends well. First, there is the knowledge problem–bureaucratic governments do not possess the information to make these technology choices. Second, there is the rent seeking/corruption problem–which exacerbates the knowledge problem, as interested parties exploit the ignorance of bureaucrats and funders, and their political connections, to induce investments based not on their economic virtues but instead on political influence.
There are also serious doubts about whether hydrogen qua hydrogen is the right alternative fuel given that it poses numerous problems and costs. The first is that using renewable energy to produce green hydrogen is extremely expensive. The second is that, well, hydrogen is highly explosive: I distinctly remember my 8th grade science teacher, Mr. Fisch, using electrolysis to fill a test tube with hydrogen, putting in a piece of chalk, then lighting a match to set off an explosion that sent the chalk flying across the room. You didn’t have Mr. Fisch as a teacher, but perhaps you’ve heard of the Hindenberg:
Explosiveness creates hazards, of course, and mitigation of them is expensive. Hydrogen is also extremely expensive to transport and store and requires a new and distinct transportation and storage system.
We are talking trillions of dollars to create “the hydrogen economy”–something even its boosters admit. Hell, they brag about it.
Hydrogen “carried” with carbon, in the form of ammonia or methanol, pose fewer problems (although ammonia in particular is nasty stuff). They are also costly, and it is clearly uncertain whether “green” forms of these hydrogen carriers are economical ways to reduce carbon emissions from fuels for transportation and power generation.
But the administration (and Europe too) have gone all in on hydrogen. Why? Maybe because their extreme antipathy towards carbon leads them to disdain fuels with any carbon in them.
Having chosen its technology, for better or more likely worse, now the administration is focused on how to force its adoption. The supply-side incentives are clear enough, so now there is a pivot to the demand-side, as expressed in the appallingly shoddy Council of Economic Advisors document linked above.
According to the CEA–and not just the CEA, as will be seen shortly–the problem is that “[r]eal or perceived risks around clean energy projects can raise the cost of accessing capital, which could slow the rate at which projects like those in the hydrogen hubs program achieve commercialization..”
Well, I should hope so! That is, I should hope that risks are taken into account when allocating capital!
John Kerry flogged the risk issue on MSNBC (h/t Powerline):
“What’s preventing it is, to some degree, fear, uncertainty about the marketplace. People who manage very significant amounts of money have a fiduciary responsibility, an obligation to the people they manage it for not to lose the money, but to produce returns on that investment. Pension funds, many of them, are very careful about those investments in order to make certain they have the money to pay out to the pensioners who work for that money all their lives. So, there are tricky components of making sure that you have taken the risk away from these investments. And energy, which is what the climate crisis is all about, it’s about energy, it’s about how we fuel our homes, how we heat our homes, how we light our factories, how we drive and go from place to place.”
Damn those money managers for taking into account the risks and rewards of the money their investors entrust to them! Don’t they understand that John Effing Kerry knows what is right for humanity????? After all, he flies around the world in a private jet sharing his wisdom (and then dissembles about it before Congress).
I loved this part: “So, there are tricky components of making sure that you have taken the risk away from these investments.” Does John Kerry have a magic box into which he can make the risks disappear? Do tell!
Of course he doesn’t. What he means, clearly, is that the government must somehow absorb the risks inherent in the technology that they have already decided upon–apparently without analyzing those risks fully or carefully, or wondering whether maybe these damned investors might know something they don’t. (Of course they don’t wonder that! They are all knowing, right?)
At least the CEA attempts to put lipstick on the pig and raise some economic arguments to justify the need for demand-side support. There are market failures! Government never fails, but markets do, right?
In my experience the concept of market failure is most likely to be advanced when the market fails to do what someone thinks should be done, or wants to be done, based on their own vision. That is, when the market disagrees with someone, the market has failed! Especially when that someone is a member of what Thomas Sowell calls “The Anointed.”
The CEA basically cites to some theoretical possibilities. At the core of their argument is that learning by doing, including learning-by-doing that “spills over” among companies, can lead to inefficient investment. The CEA advances a couple of reasons.
One is a contracting failure. LBD–moving down the learning curve–reduces costs, meaning that prices are expected to fall. So, according the CEA, potential buyers are unwilling to enter into long term contracts for fear of agreeing to pay a price that will turn out to be too high: “if rapid declines in technology costs are expected, the willingness of private sector end-users to seek out such contracts with clean energy developers will be limited” (emphasis added). Without such contracts, hydrogen project developers can’t secure financing, so plants won’t get built, no learning takes place, and costs don’t fall. The Curly Equilibrium, in other words:
Really? If costs are expected to fall, market participants can enter contracts with de-escalator clauses, i.e., contractual prices that fall over time. Apparently the CEA only envisions contracts at a fixed price that extends through the life of the contract. But even then, given anticipated cost declines, the developer would be willing to sell at a price below the initial cost, basically, at the average cost expected over the life of the contract.
The CEA mentions the risks of of the magnitude of cost declines, but again, that should be a material consideration in any contracting and investment decision. Is the CEA arguing that the risk compensation demanded by borrowers will be excessive? They don’t say so explicitly, but that’s what you would need to argue that the prices in these contracts would be “too low” and thereby stymie investment.
I’d also note that indexed prices, widely used in a variety of commodity off-take agreements, eliminate the risk to buyers of locking in too high a price. They also address the asymmetric information problem that the CEA frets about. If the developer has better information about the likely trajectory of price declines, then yes, buyers looking at fixed price deals or deals with mechanical (non-market based) price de-escalators face a “winners’ curse” problem: the developer will agree to terms that overestimate his (better) forecast of future prices, and reject deals that underestimate.
I think in fact that the issue is that there is considerable uncertainty among all parties, developers and buyers alike, regarding what the future cost trajectory will look like. That is, there is a real risk here, and that risk should be taken into consideration when deciding whether hydrogen investments make sense. And market participants are far better at assessing the risks, and the pricing of those risks, than the government, which is clearly taking a “Damn the risks, full speed ahead!” Approach.
Sorry, but John Kerry et al don’t inspire confidence like Admiral Farragut at Mobile Bay.
One of the proposals under discussion is Contracts for Differences (“CFDs”) in which the government would (perhaps through a non-profit intermediary) provide a guaranteed revenue stream to a developer and absorb the price risk. To work, CFDs require indexing to some market price–and the market price for H2 hasn’t really been created. Further, they require some mechanism to set the guaranteed price, a non-trivial task given the very information asymmetries that the CEA worries about. The government-appointed third party (or the government for that matter) will certainly be the less informed party in any negotiations with developers, and will almost certainly overpay. (Not that they will mind–not their money!) Meaning that the asymmetric information problem the CEA frets about is present in spades in one of their preferred means of addressing it. Further, CFDs have already presented performance issues, with the sellers (those getting the guaranteed revenue stream) treating these contracts like options rather than forwards, and spurning their CFD commitments when market prices rise above the guaranteed price (as has happened with with generators in the UK when power prices spiked).
The CEA also invokes capital market imperfections also driven by asymmetric information that may impede financing if developers know more about the economics of projects than the financiers. This is a hoary old story that has been used to identify alleged market failures since time immemorial. So long ago, in fact, that when Stigler wrote “Imperfections in the Capital Market” (JPE) 56 years ago, he (in typical Stigler fashion) drolly started thus: “The adult economist, once the subject is called to his attention, will recall the frequency and variety of contexts in which he has encountered ‘imperfections-in-the-capital market.'” That is, “capital market imperfections” were an old joke decades ago.
Here’s another one, George! Based on long experience, George was a skeptic. Based on even longer experience, I am too, in this case in particular.
And let’s look at the empirical record. Learning by doing is a ubiquitous phenomenon. Dynamically declining costs in industries with potential information asymmetries abound. Yet industries have developed and thrived nonetheless.
Some examples.
I recently finished a piece describing extensive learning-by-doing in the shale industry, including evidence of learning spillovers and dynamic cost reductions. Yet, the shale sector has not faced problems getting capital or expanding rapidly. Hell, if anything, a common criticism is that shale drillers have obtained too much capital and drilled too much, not that they are starved for capital and drilled too little.
Does the CEA (or John Kerry!) believe the shale sector in the US is too small?
Insofar as spillovers is concerned, the fact that the costs of firm A decline when firm B produces more output is a necessary, but not a sufficient condition for an externality. One plausible outcome in oil (as identified in a paper on LBD in conventional drilling by Kellogg in the QJE) is that service firms are the ones that do the learning, and capture and internalize it.
LBD is well-documented for computer chips, which have seen relentless cost and price declines over the years. Yet computer chip factories have been built, and companies especially in the US and Asia have attracted the capital necessary to build these very expensive facilities and build new chip lines nonetheless. (In this industry too, there have been chronic complaints about overcapacity, rather than undercapacity. I am not commenting on the validity of those complaints, just noting that their existence contradicts the notion that dynamic scale economies and price declines due to LBD starve an industry of capital.)
The LNG industry has many of the characteristics that the CEA attributes to hydrogen. Yet this industry has expanded apace for well over 50 years now.
I viewed a presentation by DOE people today in which LNG was raised several times, and as an example not to be followed. DOE advisor Leslie Biddle (ex-Goldman) mentioned LNG several times (“I keep going back to the LNG analogy”), and in a negative way. LNG took 30 years to move to a traded market, dontcha know. And we don’t have that time! We need to create such a market in a year! (DOE’s Undersecretary for Infrastructure David Crane was more generous, giving us all of 5 years.) (Crane was also hyping the idea of hydrogen for everything, including home heating–apparently oblivious to the fact that even Net Zero fanatical Britain has just recently determined that H2 is too dangerous to heat homes.)
In the context of the discussion of a grand government plan to transform the energy system, I couldn’t help but think of Gosplan, or Stalin’s race to industrialization (e.g., the Magnitogorsk Steel Factory). We will inevitably–inevitably–meet the “Dizzy With Success” phase in hydrogen, mark my words.
I note that LNG production grew substantially before it became a traded market, which actually undercuts Biddle’s argument. Even though there was not a liquid traded market for LNG in the first decades of its growth and development, long term contracts, usually using crude (no pun intended) indexing features (like tying prices to Brent), contracts were agreed to, financing was obtained on the backs of these contracts, and liquefaction plants were built.
Oil refining faced many of the conditions that worries the CEA about hydrogen. Kerosene was a radical product early on, with a lot of uncertainty about market adoption. But Rockefeller dramatically expanded output and reduced costs: the cost of kerosene by 2/3rds in 10 years (1870-1880), in large part due to extensive learning and research on all aspects of the value chain. Standard Oil’s supposedly predatory acquisitions of were actually ways by which SO’s knowledge could be combined with physical assets to improve their efficiency.
The co-evolution of gasoline refining and the adoption of the automobile represents another example of investment and falling prices in a new market in a capital intensive industry.
I note that the early refining examples occurred when capital markets were far less developed than is currently the case. I further note that large energy firms (IOCs and NOCs like Aramco in particular) can potentially finance hydrogen (and other alternative energy projects) with cash flows generated by their legacy fossil fuel investments: this would largely eliminate any asymmetric information problem between developer and financier (because the developer is the financier) and developer and customer (because the developer could finance without securing a long term price commitment).
Another example. Electricity generation. Beginning with its inception in the early-1880s, electricity generation was highly technologically dynamic, with substantially declining costs. Yet in a few short years most urban areas in the US were electrified, with numerous private companies competing with government utilities. This was another industry in which overbuilding, rather than under-building, was widely discussed. The movement to price regulation occurred well after the industry developed, and was a reaction to intense price competition: regulation effectively cartelized electricity generation.
One more. Aircraft. LBD was first identified in the production of airframes. This phenomenon was first documented by Wright in 1936, and was subsequently observed in myriad other industries (e.g., Liberty Ship construction in WWII). LBD and the associated cost declines have continued in aircraft construction ever since. And aircraft have been built and aircraft manufacturers have been able to attract the capital to design and build new aircraft that benefit from these cost declines.
In the face of all these examples, the CEA and others making these market failure arguments should identify an industry that died aborning due to the alleged chicken-or-egg problem that makes demand side support of hydrogen investment necessary.
The CEA document has echoes of some rather common, but unpersuasive, arguments for government support of industry, such as the infant industry argument and the big push development literature. The latter has been demolished by practical experience: the list of its dismal failures is far too long. There are more than echoes of this discredited approach in the CEA document. It links to a paper that credulously recycles the old, bad, discredited theories.
What is amazing about the infant industry argument is how often it is invoked, and how little empirical evidence supports it. One of the few empirical papers, that of Krueger and Tuncer, rejects the argument in the case of Turkey.
A paper by Juhasz is often touted to support the theory. It shows that after the stimulus of the cotton spinning industry in France due to Napoleon’s Continental system, post-1815 the industry was competitive with the British, indicating that it had moved down the learning curve. Again, at most this identifies a necessary condition for protection–learning–but not a sufficient one. Even if LBD occurs, and even if there are spillovers, the cost of protection may exceed the benefits. A simple story demonstrates this. If the protected industry achieves cost parity with the first-mover (e.g., the UK in cotton), the protected firms merely displace firms in the first-mover country, leaving post-parity total costs unchanged. So in equilibrium, protection is costly but generates no benefits.
All in all, the CEA document reminds me of a rather conventional undergraduate econ paper, repeating textbook wisdom about externalities and market failures. It completely ignores the Coasean insight that market contracting methods are far more sophisticated than those in the textbooks, and that market participants have incentives to find clever ways to contract around what would be market failures if market transactions were limited to the forms considered in textbooks. It also ignores the historical record.
In other words, rather than writing off the difficulties of securing “bankable” contracts to secure funding for H2 developments to “market failures” or the excessive risk aversion of market participants, the government should step back and consider whether this alleged hesitation reflects a more sober and informed evaluation of risks than our betters in DC have undertaken.
I crack myself up sometimes.
In sum, the administration’s entire approach to hydrogen is utterly flawed. It attempts to pick technologies based on a pretense of knowledge it does not possess. It views flashing red lights warning of risks as signals to be suppressed rather than considered when making policy and investment choices. It engages in simplistic analyses of how real markets work, and how they have worked historically, to conclude that market failures requiring government intervention to fix abound in hydrogen.
All of these government failures could be eliminated by cutting the Gordion Knot, pricing carbon, and letting markets and private enterprise develop the technologies, products, contracting practices, and market mechanisms to trade off efficiently the benefits of reducing CO2 emissions. Decentralized mechanisms discover and utilize information, including information about new technologies, far more efficiently than governments. Decentralized mechanisms incentivize learning and innovation–including contracting and organizational innovations that can be instrumental in developing and adopting new technologies, products, and techniques.
In the case of hydrogen, pure or “contaminated” with carbon, priced carbon would address the problems that the CEA frets about, in particular the contracting problem. A carbon price would make it straightforward to index prices in contracts. A formula related to NG prices (because blue hydrogen is likely to drive the price of hydrogen at the margin, and because methane is likely to be the substitute at the margin for H2 in many applications) and the cost of carbon would send the appropriate signals and eliminate the need to fix prices in advance.
What the price of carbon should be and how it should be determined is a whole other question. But it would be far more productive, and not just in regards to hydrogen, to focus on that problem rather than leaving it to the John Kerrys of the world to pick technologies and then devise the coercive mechanisms necessary to force the adoption of those technologies.
Alas, we are on the latter path. And it will not take us to a good place. Probably figuratively, and perhaps literally, to the fate of the Hindenberg.
