Streetwise Professor

There has been a lot of hyperventilating over this Bloomberg story about the transfer of derivatives positions from Merrill Lynch to Bank of America.  Much of the commentary, most notably by Felix Salmon, has expressed outrage at dumping risk on the deposit insurance fund.

The Bloomberg story focuses on the fact that FDIC and the Fed are at odds over the transfer. This tells you a lot, and what it should tell you is not comforting.  Both sides are talking their book, and what the Fed is saying reveals its concerns about stresses in the market, and particularly on dealer firms.

FDIC is obviously and justifiably concerned about the contingent liability it assumes as a result of the transfer.  Presumably the Fed is not oblivious to this.  So why would it favor the transfer?

I think it speaks volumes about the Fed’s concerns over the condition of dealer firms.  In the current environment, the most worrisome ones would be Merrill, Morgan Stanley, and perhaps to a lesser degree Goldman.  All of these have seen their credit spreads widen recently.  Concerns about creditworthiness of these firms can lead to runs.

I don’t think that runs on derivatives per se are the issue: yes, counterparties can seek to novate, or find other ways to get cash out of their dealers with whom they have in-the-money positions (although that’s not as much of an issue with standard interdealer CSAs in which no credit is extended.)  But counterparties, customers, and lenders of/to dealer firms who are concerned about the derivatives exposure of a dealer of questionable creditworthiness have an incentive to reduce their exposure to the dodgy firm.

This, ironically, illustrates the systemic danger associated bankruptcy rules that give derivatives trades priority: it gives ostensibly junior claimants who can pull their money an incentive to get out first. You can’t evaluate the systemic risks of derivatives without considering capital structure more generally.

And there are reports that big non-dealer counterparties are getting nervous about dealer creditworthiness.  Novation inquiries are increasing as dealer credit spreads have gapped.

[Black humor moment in linked article:

“We’ve not experienced clients moving away from us. On the contrary, we’ve seen more clients come to us as a result of our strong positioning in the equity derivatives markets,” said a source close to one French bank.

Sure.  Remember that the French have claimed their banks have “no toxic assets.”  Which presumably explains why Sarkozy is running around like his head is on fire and his a** is catching it (h/t Charlie Daniels) trying to get the Germans to recapitalize French banks.]

Thus, my interpretation of the Fed’s action is this.  It sees the conditions are ripe for a customer and funder run on Merrill.  It wants to reduce the risk that customers and lenders perceive.  The less risk in ML, the lower the likelihood that customers and lenders will get the urge to go for a jog–or a sprint.  Reducing ML’s derivative exposure reduces its risk, and makes a destabilizing run less likely.  Not that BAC is in great shape, but it is less vulnerable to what the Fed fears than Merrill is, and less vulnerable to a depositor run precisely because of deposit insurance.

So that’s the real story here, IMO: the Fed’s encouragement of the move of ML’s derivatives to BAC reveals its nervousness about the vulnerability of ML, and some dealer firms generally, to a run.  From its perspective, moving the derivatives risk to BAC is the least bad option. If you believe that runs are an inefficient equilibrium outcome–and that is a reasonable belief–doing something to reduce the likelihood of a jump to that equilibrium makes sense.  And that’s what the Fed appears to be doing.

And no, that shouldn’t give you the warm and fuzzies.

During this week’s bus tour, Obama repeatedly asserted that it was necessary to pass the “jobs bill” in order to save the jobs of teachers, firemen, and the like.  Biden joined in, and predicted that failure to pass the jobs bill would lead to more rapes and murders, due to layoffs of police.  And it just ain’t Crazy Joe: Jay-the-most-aptly-named-man-in-DC-Carney said that Obama “absolutely” agrees with Biden.  Harry Reid weighed in, claiming that public employment was the priority, because “it’s very clear that private-sector jobs have been doing just fine.”

An aside. First: what planet is Reid living on?  (NB: not the first time I’ve asked this question to myself.)  Second: can you imagine the hue-and-cry, the gnashing of teeth, the rending of garments, had any Republican said anything remotely similar to what Reid did?  S/he would have been labeled the second coming of Marie Antoinette* for her/his callousness, insensitivity, lack of compassion, condescension, etc., etc.

But on to my substantive point.  Since when, in the nearly 225 years of this Republic, has the employment of firemen, policemen and teachers been the responsibility of the Federal government?  Indeed, the entire concept is a mockery of the idea of a “federal” system.

I know that the Constitution is a sad shadow of its former self, primarily the result of a relentless centralizing assault beginning in the Progressive era.  (The Progressives being arch-foes of many things in the Constitution, federalism among them.)  But the idea that it is somehow the responsibility of Washington to secure the employment of teachers, etc., represents a complete mockery of the most basic ideas of the Constitution.

Brought to you, ironically, by a former lecturer in Constitutional Law.  (Not professor.  Professors at least attempt to engage in original thought and scholarship.  Obama just lectured a few classes then: he lectures the world now.)

Public education, and police and fire protection are quintessentially local activities.  Local communities internalize the benefits of these activities, and should bear the costs.  It is fundamentally defective as an economic matter, even ignoring Constitutional constraints, to shift the costs of providing these services to people who do not realize the benefits.  That just leads to waste and inefficiency.

But this isn’t about the Constitution, or economic efficiency.  This is about paying off Obama’s (and Reid’s, etc.) constituencies.

Sadly, I have looked in vain to find any relatively prominent person in politics object to the Obama-Biden-Reid efforts on principled Constitutional grounds–which in turn are based on a solid political and economic principle of delegating decision making authority to those who are directly impacted by said decisions.  Which suggests that disrespect or indifference to the most basic Constitutional tenets is a bi-partisan affair.

Not that this is news, but seldom is it so blatantly on display.

*Yes, I know Marie Antoinette’s “let them eat cake” is a fabrication, first found in Rousseau.  Just another reason to pay no attention to Rousseau.  But for worse or for worse, Marie is the poster girl for callous indifference to human suffering.  In contrast, Harry Reid’s comment is fully documented, yet he is getting a pass.  Particularly from the intellectual heirs of Rousseau.

This long Zero Hedge post recapitulates William Buiter’s analysis of the leveraged EFSF “bazooka.”  It is a very detailed exposition of why this mechanism is not credible.  As Buiter lays out, it is not credible primarily because it is laden with wrong way risk.  Good object lesson in what can go wrong with a CCP, by the way.

Over the weekend, the G-20 gave an ultimatum to Europe:  Fix your problems in eight days.  I guess the Euros should have been grateful: the G-20 gave them two more days than it took God to create the universe.  Presumably they were looking forward to a rest on the ninth day.

But no sooner speaketh the G-20, than Merkel and Schaeuble speaketh: In your dreams.  Today, Merkel said that talks are moving “by the millimeter.”

Not surprisingly, the hangup is distributive: who pays?

German officials have said in recent weeks that the eurozone needed to find a solution for Greece that makes the country able to repay its debts in the long-run.

France on the other hand has been reluctant to back bigger losses for banks, since French banks are among the biggest holders of Greek government bonds.

Its position is supported by the European Commission, the EU’s executive. Commission officials said last week that technical revisions to the July deal with the banks are necessary because changed market conditions had made the deal more expensive for Greece and the rest of the eurozone.

While that could imply an upward revision of the losses for banks, cuts would likely stay far below the 50 percent to 60 percent haircut pursued by the Germans.

That’s the fun of trying to negotiate an insurance (i.e., loss sharing) deal after the accident.

But the Franco-German dispute does point out a fundamental problem.  Any realistic plan would involve a big haircut.  In rough numbers Greek debt is about 170 of GDP, and it can probably afford to support 80-85 percent.  So, a 50-60 percent writedown is ballpark: the 21 percent number negotiated in July was wildly optimistic, and no longer operative.  But a 50 percent writedown will hit some banks hard: they will be undercapitalized, most likely.  So where is new capital going to come from?  If the French government injects capital into French banks, that will hit French national credit.  So the French want to Europeanize the solution–and since the Germans are the Europeans with the most money, that means “Germanize” the solution.  Which is hardly palatable to the Germans.

So statements about forcing the bondholders–which are disproportionately banks–pay sound great, but that just relocates the problem.

And remember folks.  This is Greece, which is just the opening act.  So don’t dream about a deal by October 23.  And even if a deal gets done in the relatively near term, it won’t be the last deal.  I’m not saying that the Europeans are checkmated, but it’s just very hard to see how they can actually prevail in this game.

This exchange between Wolfgang Munchau and Iain Begg provides an interesting counterpoint to my weekend analysis of the Euro sov debt crisis.  My post first discusses the theory behind “bazookas” as a means of preventing or deterring runs against sovereign debt (and a similar analysis holds with respect to banks too).  I then point out that the credibility of the bazooka/backstop is of crucial importance.

Begg’s reply to Munchau sets out the bazooka theory.  Munchau’s argument is that the EFSF bazooka is not credible.  It is not credible primarily because is based on the premise that countries like Italy will fund it, but countries like Italy are causing the problem too.  That is, the EFSF is beset with wrong way risk.  The Europeans are in effect aiming the bazooka at their own heads.  That isn’t the most credible deterrent against runs.

Indeed, the structure is highly unstable.  If, say, Italy can’t perform on its obligations because it is the one being bailed out, that increases the burden on France, which could put France into jeopardy.

I generally agree with Manchau.  Biggs has it right when it comes to how a backstop can prevent liquidity crises, but that backstop has to be credible: I agree with Manchau that the EFSF mechanism is not credible, given its wrong way risk problem.

Taking things to the next level, as I did in my post: what is the likelihood of negotiating a credible mechanism?  Here I am again skeptical, for political economy reasons, as expressed in the post.  On this issue, I was intrigued to see two posts touching on this issue in general.  Tyler Cowen dismisses IS-LM in part because it ignores altogether political economy issues, which he identifies as a first-order macroeconomic factor.  I agree completely.  Indeed, it is kind of bizarre to discuss sovereign debt crises, banking crises in which there was a strong regulatory dynamic, and fiscal crises (all components of Financial Crisis I and II) without discussing political economy.  Peter Boettke follows up on Tyler’s post, and emphasizes the centrality of political economy to macro problems, and in particular macro policies.

I agree that political economy is the linchpin, and not just in macro policy but all of the regulatory issues that are currently of pressing importance.  The reason that I am quite concerned about Europe is precisely because  political economy issues there make it very difficult to devise a mechanism for allocating sovereign debt losses (and potential banking losses connected thereto).  It is always hard to devise such sharing mechanisms, particularly after a chunk of the losses has already been realized.  It is even harder given the institutional structure of the EU, which by design makes it difficult (and arguably illegal) to shift losses on one state’s debt to other member states.

You will hear many plans of bazookas in coming weeks.  All will differ in details.  What you should focus on is whether these mechanisms are in fact credible, and politically feasible.  The things we’ve seen so far, not so much–as Manchau emphasizes.  Incredible political creativity–and perhaps, duplicity–will be required to create a credible mechanism.   The economic destination is pretty well understood, but the political road to get there is unmapped, and indeed, is likely yet to be built.

Several articles in today’s news pertain to predictions or recommendations I’ve made over the last couple of years.

One relates to Europe’s handling of its sov debt crisis.  Walter Russell Mead writes today that:

Chancellor Merkel has, I think, turned an important corner — or realized that German public opinion has now turned one.  Public concern about the German banking sector is now acute enough that it is politically easier for her to arrange to bail out German banks than to drum up support for new funding for the PIIGS.  Flinty German taxpayers hate to throw money away, but if throw they must, better to save the German banks in which the taxpayers keep their savings.

Rather than pushing hugely unpopular bailouts of lazy Latin and Mediterranean foreigners through a restive Bundestag, Merkel thinks it is better to dedicate any new bailout spending to rescues of innocent German banks. Instead of using taxpayer money to prevent defaults in Greece and elsewhere, use taxpayer money to insulate German banks (and their depositors) from the consequences of the defaults and “haircuts” when they come.

This is the good news underlying last week’s market rallies: the German political establishment seems to have figured out a way to pry much more money out of German taxpayers to prevent a total European meltdown.  Germany can and, it now looks like, will, put any amount that is necessary into the banks to make sure the German banking system doesn’t do a Titanic impression.

Let defaults happen, make the banks take large haircuts when they do, and then bailout the banks.  From a German point of view, this is a workable and sensible plan.  Defaulting will allow Greeks and perhaps others to shorten the painful austerity and begin to escape recession while staying in the euro; the”haircuts” satisfy the German urge to punish the wicked and discipline the private sector; the bank bailouts will prevent the consequences of Club Med defaults from destroying the European financial system.  At the same time, this approach limits the need to rely on politically toxic country bailouts; Germans do not want to send their hard earned money to bail out “thieving, lazy” Greeks.  The EFSF does not have to be increased, but Europe can still be saved.  Merkel and her colleagues have found a creative way to match the preferences of German voters with the needs of the European financial system.  Well done, but now comes the hard part.

I remember making that suggestion in several SWP blog posts.  In March, 2010.  (I distinctly remember talking about it in a class right before heading to a DKM show in that month.)  Europe–and the world–would be in much better shape if it had come to that realization then.  But no, they chose to live with the gangrene.  Methinks its now too late.

Mead also observes something that was highlighted in my Sunday post on the Euro sovdebt crisis: the difficulty of crafting an agreement to share burdens.  This is always difficult when there are serious distributive effects, as there are here.  In particular, the two euroheavyweights, France and Germany, have very different interests.  Sarko is, as I suggested, trying to buy insurance from the Germans after getting the cancer diagnosis:

Underneath all this is the ugly reality that the French are not sure that they can get through this crisis without money from Germany — and that the Germans think they have their hands full already.  The Germans have come up with a plan that substitutes domestic bailouts of troubled banks for international bailouts of troubled governments; the French are looking for a plan that substitutes international bank bailouts for domestic ones.

This is not a good match and the very different priorities of the two plans suggest that the French and the Germans will have a hard time coming up with a common approach.  But that isn’t the biggest problem Europe is facing.  The biggest problem is the possibility that the crisis is moving north to France.  The need to fling tens of billions of euros into the banking system could cut France’s credit rating, increasing the size of the interest payments it must make on its large national debt.  That in turn would cut France’s creditworthiness even farther, driving the interest rates up yet again.  This is the same disabling spiral that has thrown one euro country after another into crisis; if France goes, there is nothing left to defend.

Is the European financial crisis so severe that France can’t ride out the storm without help from Germany?  The French are behaving in ways that suggest that they are worried; if this is true, then politically and economically this crisis is just getting started.  Germany can protect itself from meltdowns in Greece, Portugal, Spain and even Italy; France is something else again.

The other articles relate to China.  Here, going back to 2009, I have been a China bear.  I have believed, and continue to believe, that a system that is still largely government directed and centrally planned, will fundamentally distort the allocation of resources.  If there is a lot of slack and inefficiency to begin with (definitely the case in China), these efforts can lead to impressive measured growth (and arguably mis-measured growth, given the dubious nature of Chinese statistics).  (Cf. Soviet industrial development under Stalin.)

But the structural inefficiencies and imbalances build, and more and more drastic measures are necessary to offset them.  This leads to the Michael Jackson economy phenomenon, where artificial measures permit performance to continue for a while, but inevitably ending in a rather gruesome end.

The decrepit Chinese financial system is the key point of vulnerability.  The Chinese have had several banking crises over the years, which they routinely “solve” by taking bad assets off banks’ books, putting the bad assets in Fastow/Enron-like vehicles, and filling the holes in bank balance sheets with claims on the government that are less than ironclad. (They’re not officially government debt, and the willingness of the state to perform on them is very difficult to gauge.  The credibility of these promises in a crunch is questionable.)

Historically state owned firms were the major bad borrowers.  (Go figure.)  Now the debt in question is owed largely by local governments.  (Again, go figure.)  It’s owed not just to the banks, but to shadow banks.  The off-loading of loans and risk to shadowy financial entities has picked up steam as the Chinese government has tried to rein in the effects of its stimulus by cracking down on bank lending.

There has been a growing debate in recent months about whether China will continue to grow, or have a soft or crash landing.  In just the last two days, the WSJ, the FT, and Reuters have run articles on the fraught state of the Chinese banking and shadow banking systems. The articles were sparked by news that China is purchasing equity in major banks.  Jim Chanos has also continued to hammer on the theme of dodgy Chinese banks.

In other words, a meme is developing: China is teetering.  Combine that with the situation in Europe, and our less that sunny circumstances, it’s hard to find any silver linings out there.  This is particularly true given the linkages: European weakness will put strain on Chinese exports.

I remain convinced that China is extremely brittle.  Its resource-intensive growth has been papered over–almost literally–leading to deep problems in its financial market.  That growth is almost certainly overstated in terms of the actual value created: yes, empty housing units and underutilized infrastructure contribute to GDP when built, but represent a massive misallocation of capital: GDP accounting (not reality) and economic accounting (reality) are different things, though eventually the economic reckoning always triumphs in the end, resulting in much lamenting and tearing of garments.  Eventually, that misallocation is recognized and corrected, and with a vengeance, through massive asset revaluations.  And the channel through which that is felt is usually the banking system (pace the subprime crisis in the US, and the sov debt crisis in Europe).

So look west or look east, and there are heavy clouds on the horizon.  We’ll soon know how good a weatherman SWP has been.

Following Europe’s plan of the week to deal with its sovereign debt crisis (and directly associated banking crisis) can make one’s head spin.  It might therefore help to try to identify a few central concepts that can help put the details of this plan or that into perspective.

A key distinction is between measures intended to prevent things from getting worse, and those intended to allocate losses already incurred; the interaction between those issues is an important factor in the dynamics, and will play a huge role in determining the ultimate outcome.

In terms of preventing things from getting worse, the near-term danger Europe faces is runs on sovereigns, especially Italy.  The mechanism for a run on sovereign debt is that lenders will refuse to rollover their holdings as they mature, making it impossible for a government to finance its operation; a similar mechanism is at play for bank wholesale lending, where banks with exposure to dodgy sovereign debt are facing problems rolling over their maturing funding.

A run is one of several equilibria in a coordination game: coordination games typically have multiple equilibria.  I have no incentive to run if no one else runs, but if everybody else runs I have an incentive to run.  In this particular instance, I will rollover my maturing Italian bonds if everybody else but I won’t if nobody else does.

Expectations play a crucial role in determining which equilibrium prevails: whether I run or not depends on what I expect others to do.  Thus, crisis management plans often focus on influencing expectations.   That is why the term “confidence” is bruited about so freely: you want everybody to be confident that nothing bad happens so they won’t run.

It is also why backstop funding mechanisms are typically a part of managing these types of crises. The more public  money available to fund the renewal of maturing sovereign debts, the bigger the flight of private investors required to spark a full-blown run.  These private investors calculate that the likelihood of a big flight is smaller than the likelihood of a small flight, so they are more confident that a run will not occur when there is a big public backstop, so they will not run themselves.  This means that the backstop ideally will not have to be drawn on, because private investors continue to roll their lending to troubled countries.  This is basically the Paulson “bazooka” idea.

Or another analogy.  Someone with a weapon is confronted by a crowd of 100 people.  If all 100 rush him, he’s had it.  But someone has to start the rush, and the first mover is at greatest risk of getting shot, so each person may hold back wanting someone else to take the lead, allowing the outnumbered gunman to escape unharmed.  But some in the crowd may be hotheaded and charge.  Here’s where the nature of the weapon matters.  If it’s a single shot pistol, once the hothead is shot the rest of the crowd knows its in no danger and will charge.  If it’s a revolver, it takes six hotheads to start a run.  If it’s an automatic with 10 rounds in the magazine, it takes even more hotheads. (To make the analogy fit, there has to be some advantage of being first to get to the guy with the gun.)

The European plans are all based on the idea of convincing investors that there are a lot of bullets in the gun in the hope that this will deter a self-feeding run.  This is why Europe is so focused on expanding the size of backstop funds, including the use of ECB leverage.  The bigger the country that is at risk of a run, the bigger the fund must be to reduce the likelihood of a run.  This is why Italy’s problems are a real challenge to Europe.  Italy’s debt is so much larger than Greece’s or Portugal’s that commensurately bigger sums are needed to reassure investors that a run cannot get started.

The expectations idea also helps explain why policy mistakes can have devastating consequences.  Lehman is a good example.  Based on the Bear Stearns experience, investor expectations were that a big financial institution would be bailed out.  This made them less likely to run.  But the decision not to bail out Lehman changed those expectations, and runs began on every major bank. A policy misstep can cause things to go non-linear in a hurry.

This expectations management strategy is most likely to work, the more credible the promise of the provider of the backstop.  Here is where politics comes in, and where the design of the backstop matters.  If funding is not locked in, but it is based on promises by governments to pay in the breach, the backstop is less credible: when called on, governments may find it in their self-interest to renege on their commitments, or voters may force them to do so.  This is a major problem in Europe given its current structure.  Stability is a public good (in the economic sense of the term) and individual nations have incentives to free ride.   But if the backstop is not credible–if investors believe the gun is really empty–it is of limited value in stopping runs.

So the creation of a backstop creates a meta-“global game”* in which there is uncertainty about the credibility of the backstop, and the backstop mechanism may be subject to a run.

Moreover, the public good nature of stability makes it difficult to negotiate the loss sharing agreements in the first place.  There are gains from trade to crafting an agreement that reduces the likelihood of runs, but any such agreement exposes the participants to credit risk.  Yes, an agreement may forestall a run on Italy, but the reason for a run in the first place is the recognition that Italy’s risk for insolvency in the future is greater.  Which means that any backstop fund that acquires Italian debt is at risk of loss as the price of the debt changes to reflect changes in the  likelihood of ultimate repayment.  Each Eurozone county wants to reduce the likelihood of a run, but would like all the other countries to bear the cost of doing that.  Similarly, in the event a run on the backstop does occur, each country would like other countries to pay a disproportionate share of the associated costs.  Negotiating such a loss sharing arrangement, particularly in a polity like Europe, is extremely difficult.

This is complicated even more by the fact that some losses have already been incurred.  This is why Greece matters.  Greece is already a lost cause, and everybody knows that holders of Greek debt have suffered mark-to-market losses.  (The same is true for Portuguese debt too.)  These losses threaten the financial condition of banks and insurers throughout the Eurozone.  The failure and imminent nationalization of Dexia (the Belgian-French bank) and the tenuous condition of major French banks are symptoms of the problem.  The run dynamic threatens the banks, which means that they need to be recapitalized in order to mitigate that potential: this raises the question of where the capital will come from.  Public support may be required here too.

But  the outstanding losses are not distributed equally across countries.  This leads to disputes among EU members over how to provide the public support.  Those facing bigger losses want to use EU-wide mechanisms that spread the losses to other countries facing smaller losses.  The latter want those facing bigger losses to contribute the lion’s share of any public support.

This is quite clear in the case of France (whose banks are acutely exposed) and Germany (whose banks are less vulnerable).  Sarkozy wants to use European Financial Stability Fund monies to recapitalize: that would spread the costs around to all the countries that contribute to the EFSF.  Merkel says “nein”:  private capital first, French government money next, and EFSF money only as a last resort.  In other words, she’s telling Sarko if you want to recapitalize your banks, use your own effing money. Sarko, in essence, is trying to buy insurance from Merkel after receiving a cancer diagnosis: Merkel is not interested.

These distributive conflicts between countries, and the nature of EU governance, are combining to make any resolution an agonizingly long process, and one that may well fail.  It makes it devilish  hard to negotiate an agreement.  It makes the credibility of any agreement doubtful.

Moreover, there is a strong incentive of those governments negotiating an agreement to obfuscate and conceal.  They don’t want their voters to know how big the cost is and who is bearing it.  This helps explain the convoluted financial structures being mooted to provide the backstop support.  These structures would make Enron’s Andy Fastow quite proud.  It is virtually impossible to figure out where the losses would actually ultimately land.  Which is the point.  But convoluted structures raise questions about their credibility as a backstop.  Political self-interest and collective interest are again at odds.

Add all of this up, and you have a situation that is virtually impossible to predict.  Coordination situations are often unstable and result in jumps from good to bad equilibria in the blink of an eye, in response to seemingly trivial information.  The ability to prevent runs on individual countries through the creation of collective backstop mechanisms just transfers the run risk to the backstop mechanism.  The backstop’s run risk depends on the credibility of the commitments made, which depends on political dynamics in numerous countries.  Distributive/rent seeking/free riding problems make it very difficult to negotiate a sharing and commitment arrangement in the first place, and raise doubts about the credibility of commitments.  All of these things are fiendishly difficult to predict, and the resulting uncertainty itself contributes to the likelihood of a run.

Coordination problems.  Problems making credible commitments.  Collective action problems.  Agency problems.  Individually, the knottiest problems in economics and institution design, all in one ugly package.

My read is that although one can construct scenarios in which things play out well, these scenarios are analogous to drawing several inside straights in succession.  Everything has to go right.  Given the natures of the linked problems–coordination problems, the difficulty governments face in making credible commitments, the difficulty of negotiating agreements with distributive as well as efficiency effects–there are many things that can go wrong.   The negotiation and credibility problems are acute given the European political structure, and the uninspiring leadership in place there.  Moreover, feedback loops are positive here, and that’s always very dangerous because small events can have huge consequences that spin out of control.   Put it all together, and there is reason to sweat.

Bottom line.  High risk of things ending badly.  Virtually impossible to predict the timing of the bad end, or the exact way the bad end will play out.

* The literature on global games formalizes the logic of equilibria in coordination games.

Watching Vladimir Putin the last couple of days has been like witnessing a slow motion train wreck.  He’s driving the train, but just think about the poor schmucks that are along for the ride.

Exhibit 1.  Putin says Russia ready to handle Euro debt crisis.

Putin, who turns 59 on Friday, said Russia was ready to handle any fallout resulting from the slowdown in global growth and sovereign debt problems faced by the developed economies of the West.

“I will say straight away that Russia is better prepared than it was in 2008,” Putin said. “We have built up serious experience, a reserve of durability — in the economy and in the financial sector.”

Uh huh.  And that’s exactly what he said in 2008.  Right at the time of Lehman.  When Russia had bigger reserves.  When Russia was coming off several years of robust growth rather than slowly coming back from the ’08-’09 calamity.  When its fiscal balance was better.  When it hadn’t committed to vast increases in social spending, subsidies for utilities, and defense spending.  When there was some prospect, however faint, that the country would modernize somewhat.   When years of kleptocratic stasis did not appear to be fated.

So yeah.  Much better prepared.

Exhibit 2.  In the same speech to western investors, Putin just spun out grandiose fantasies that even the most glassy-eyed Nashibot would realize is utter tripe:

Throughout his remarks, Putin was big on promises. Russia, he said, would soon return to 6-7 per cent GDP growth (versus an estimated 4 per cent this year), while investments would increase to being 25 per cent of GDP instead of 20 per cent.

Twenty-five percent investment.  Riiiggghhtt.  At a time when domestic capital is packing its bags (to the tune of an estimated $50 billion, with the pace accelerating dramatically in September) and foreign investors keep their track shoes laced for a quick getaway—if they are stupid enough to invest in the first place.  Russia has never invested 25 percent of GDP.  Except under Stalin, maybe, and that was literally and figuratively at the point of a gun.

Exhibit 3.  In response to laments that Putin’s standing for election represented a return to Brezhnevian stagnation, his spokesman Dmitri Peskov says: “Hey, that’s a feature, not a bug!”

“Brezhnev is not a minus sign,” Peskov said. He was a “huge plus for our country. He laid the foundations for the economy and agriculture.”

That would be the foundation that is crumbling everywhere, if you haven’t noticed.

Insofar as foundations goes, it reminds me of this bit: scroll forward to the riff about the castles falling into the swamp:

Said spokesman also admitted that the epic Sea Hunt episode in which Putin, doing his best Lloyd Bridges impersonation, recovered the long lost Greek vases was staged.  I’m sure you’re stunned at the revelation.

If you want to get a dose of the reality that is on its way, listen to this interview of my friend Sergei Guriev. Pay special attention to the part where he is asked about whether Russian under Putin risks a Soviet-style collapse. That should tell you all you need to know about where Russia is and where it is going. If you can’t even talk about the prospect for collapse if changes are not made, you are flirting with disaster.

Since Jesus is not on his way, I guess Russians will just have to sing that Brezhnev/Putin is just all right, because that’s what they’re stuck with.

When I was in London last week, I went to a cafe that is located in what used to be the trading floor of the London Stock Exchange.  History-phile that I am, I thought I would take a picture of the quite attractive building.  I had my phone cam up and was just about ready to take the shot when I felt a burly hand grab my shoulder, and heard a gruff voice–“No photographs ‘ere, sir.”

I thought this ironic, given that one is photographed pretty much everywhere on the street in London.  They can photograph you: you can’t photograph Them, I guess.

This came to mind when I read about the NY Fed’s plan to monitor “key bloggers” and various social media (Facebook, Twitter, etc.) for conversations mentioning the Fed.  More ominous than the passive “listening” part of the program is the active “influencing” part, intended to “identify and reach out to key bloggers and influencers.”

“Reach out” sounds so innocuous.  Brings to mind old ATT ads: “reach out and touch someone.”  But there is always reason to be concerned that the Fed’s touch will not be a light one.  We don’t need the government doing much more outreach and “influencing”, thank you very much.

I’m not big on conspiracy theories, but the potential for mischief here is large, especially given the government’s (and the Fed’s) proclivity to rationalize ever greater intrusions on privacy and liberty as essential for national security.  One can see the Fed convincing itself that to fight “rumors” and “speculation” that call into question the stability of the financial system, it is necessary to exert pressure on those that need to get their minds right, to make sure they get with the program.

This was illustrated by an interaction with an executive from a major French bank that has been in the news of late (which one hasn’t?) who went ballistic when someone else in the conversation asked what financial blogs I read, and I mentioned FTAlphaville and heaven forfend Zerohedge.  I mean ballistic. The Gallic spit was flying before  he turned on his heel and left in a huff.

Yes, there are potentially multiple equilibria in these markets, and social media and blogs can in theory coordinate shifts from good equilibria to bad (“run away!”) equilibria.  But it is quite ominous that the Fed appears to be contemplating the creation of systems and measures that could be used to manipulate information flows.

Hey.  Maybe I’ll ask Ben about this when I see him next week.  Maybe that’s a great way to get SWP at the top of the list!

Given that Kudrin has resigned, it appears that Putin has not interceded on Kudrin’s behalf; Kudrin ran to daddy, and daddy did not intervene on his behalf.  Perhaps not surprising, given that one interpretation of Kudrin’s outburst is that it was directed not at its ostensible target–Medvedev–but at Putin instead.  But who knows for sure?  Perhaps Putin told Kudrin to keep his powder dry, and at some decent interval after the election, Medvedev will have served his purpose and be kicked to the curb.  But I cannot get beyond the fact that everything Kudrin said about Medvedev’s profligacy (especially with respect to defense) really applies to Putin.  This cannot have escaped Putin.

Playing that out, the implication is that Putin has decided that short run political goals are of overriding importance, and that medium-to-long run economic consequences are of lesser concern.  Pushing that line of reasoning still further, that is hardly a signal of confidence and political strength. It would mean that Putin is convinced that he needs a splashy, decisive political victory in December (the Duma elections) and May (the Presidential election), and that he needs to politic and bribe to get it.  If he were truly a Russian Colossus, standing astride what used to be 11 time zones, why would he think this way?

No, the Kudrin affair suggests deep fissures within the Russian elite, and deep insecurity at the very top.  Very deep.