Streetwise Professor

Alexander Golts has a similar take on the Kudrin affair, arguing that (a) Putin is really responsible for the spending spree that unsettles Kudrin, and (b) that Kudrin was sending a message to Putin:

In reality, however, it was Putin and not Medvedev who approved the increase in military spending. Therefore, any talk of a difference between Putin and Medvedev on defense expenditures is meaningless. The real reason for Kudrin’s sharp statement is that he does not want to be held responsible for the looming financial disaster that the Putin government is provoking.

It is no wonder that Kudrin placed so much importance on wasteful spending on defense. The re-armament program alone will cost 20 trillion rubles ($623 billion) from 2011 to 2020. These expenditures were approved despite the fact that all previous weapons programs have ended in complete failure. The plan is being implemented at a time when arguments between the Defense Ministry, military design bureaus and manufacturers over the exorbitantly high price of weapons systems reached their peak this year, resulting in many contracts going unfulfilled.

Putin is more responsible than Medvedev for this state of affairs. After all, it was during Putin’s presidency that the defense industry became a parody of the Soviet military-industrial complex. Several hundred defense companies were corralled into state-owned conglomerates, destroying the remaining elements of competition among military firms. The majority of companies that were merged into state-owned giants were highly ineffective and on the verge of bankruptcy. As a result, the end price for any piece of military equipment — from missiles and armored transport vehicles to combat aircraft — included not only the amounts that were stolen, but also the huge operating losses of inefficient factories.

Kudrin could not remain silent anymore on the massive waste and inefficiency in the defense sector, and there is a good reason for this. He understands perhaps better than anyone that Russia’s fiscal ship is sinking, and he has decided to jump overboard while he still has an opportunity.

Kudrin is the first to jump ship. Who will be next?

The Kudrin-Medvedev thing is going critical very quickly.  This morning Medvedev called out Kudrin at a public meeting in Stalingrad . . . I mean Tsaritsyn . . . I mean Volgograd.

“Such statements appear improper … and can in no way be justified. Nobody has revoked discipline and subordination,” an angry and stern Medvedev told Kudrin at a meeting of officials in the central Russian city of Volgograd

“If, Alexei Leonidovich, you disagree with the course of the president, there is only one course of action and you know it: to resign. This is the proposal I make to you.”

To which Kudrin replied:

Responding to Medvedev, Kudrin said: “Yes, it is indeed true that I have disagreements with you. I will take a decision on your proposal and will consult with the prime minister (Putin).”

In other words: Daddy has to decide this one.

Now Andrew Osborne (@A_osborne) just tweeted:

Russian finance minister #Alexei Kudrin falls on his sword after an insulted President Dmitry #Medvedev pushes him #russia stability?

. . .

Kudrin says he resigned, Medvedev’s people that he was fired. kudrin started it anyway and must have known what he was doing.

Medvedev can’t fire Kudrin–Putin can.  I haven’t seen any statement from Putin.

So stay tuned.

FWIW, the ruble is down about 1.3 percent vs. the dollar now, after being down about .8 percent before I heard the Kudrin resignation news.  But the dollar strengthened generally during that interval (having been down against the Euro earlier in the day, but up now).

This will be something to watch.  Would Putin throw Kudrin under the bus? Was there some grand bargain between Medvedev and Putin that ensured that the former would cede his job to the latter, and Kudrin is the odd man out in the deal?  Osborne thinks that Kudrin is playing it smart here–maybe he’s going for broke because he has no alternative.

The interesting thing going forward is how this affects the balance of power going forward, or put differently, whether this presages a broader struggle for position among the elite.  Like I’ve said many a time, Putin’s job is to balance contending factions within the state.  Is that balance changing?  Will he be able to restore a new equilibrium?  How vulnerable is the balance to external shocks, of which there are likely to be many?

Video of the cage match here:

The most surprising development to follow the unsurprising (to me) Putin return is the revolt of Finance Minister Alexei Kudrin:

“I will definitely refuse,” Kudrin, 50, said when asked whether he would join Medvedev’s government. He spoke in Washington at a World Bank meeting.

“I have many disagreements with Medvedev on economic policy, first of all concerning the significant military spending,” said Kudrin, who is widely seen as the architect of Russia’s economic stability in the 2000s.

Spending on national defense will grow by 2.1 trillion rubles ($65 billion), or 3 percent of gross domestic product, from 2012 to 2014, Kudrin said, adding that this is how much the state is spending on education this year.

He did not comment on a declaration by Putin on Saturday that he would also push ahead with the army’s modernization.

Kudrin’s attack on Medvedev is facially farcical.  Putin has been Mr. Big Spender.  He has been the one who has been promising to spend huge quantities re-arming the Russian military (as suggested in the last quoted sentence).  Moreover, Putin has also been promising the sun and the moon domestically, from higher pensions to delaying increases in utility tariffs that would move prices closer to market levels.  The target of Kudrin’s ire–Medvedev–has done little more than his usual Sancho Panza impersonation.  Putin has led the way.

So what is Kudrin’s game?

Possibility 1: he really wants to be prime minister, and this is his way of knee-capping Medvedev.  Putin needs Kudrin way more than he needs Medvedev, and the threat to leave may be a sure fire way to get Putin to jettison Medvedev.

Possibility 2: Kudrin is truly alarmed at Putin’s profligacy, especially in the face of an impending financial crisis that could crater the price of oil and thereby completely undermine the Russian fisc.  Kudrin cannot call out Putin directly, so he slams the hapless Medvedev as a way of sending a message.

Possibility 3 (suggested by @ninaivanova on Twitter): Kudrin is having problems with his deputies, and wants the authority to choose them.  Threatening resignation could lead to Putin to agree to these demands.

Kudrin’s attack on Medvedev (and his silence on the truly culpable one, Putin) is so risible that I am leaning towards Possibility 2.  Kudrin has to know that Russia’s position is precarious (so is everybody’s, but as in 2008 Russia could suffer immense collateral damage that is actually more devastating than the harm suffered at the epicenter of the crisis).  He has to know that Russia has the thinnest margin for error, and that raining rubles on the defense establishment (where much of it will be skimmed, and disappear without a trace) and pensioners, etc., will make that margin disappear–and actually put the country in a hole.  Kudrin knows–and has said repeatedly–that the feasibility of the government’s budget depends crucially on the the price of oil, and that the price of oil is hostage to hair-raising developments abroad.  He further knows that he cannot publicly scold Putin–especially now.  Under these circumstances, sending a message to Putin by slamming Medvedev makes sense, in a perverse way.

It will be far more interesting to watch this play out than the scripted election.  Kudrin is Putin’s brain when it comes to anything economic, and Putin cannot function coherently in this sphere without him.  Hell, he can barely function coherently in this sphere with him.  This goes double in current circumstances, with the rumblings of disaster emanating from Europe.

Two other entertaining sidelights to this story.

One is this quote from the MT article:

Putin pledged to improve the investment climate and fight red tape by “consulting the entrepreneur community” on economic legislation.

Where would that community be, actually?  Putin probably imagines his judo buddies to be entrepreneurs.  As if.

The second is something that came across my Twitter feed.  It purported to be a quote from Kudrin: “Я бы предпочел работу в более гетеросексуальном коллективе”: “I would prefer to work in a heterosexual team.”  My inclination is to believe that this is a joke–in which case it is pretty funny.  But perhaps it isn’t–in which case it would be riotously funny.  Either way, I can see it being an accurate reflection of the way the manly men in the Putin circle view the elfin Medvedev and his group.  Can anybody cite a reliable source that quotes Kudrin saying this?

Dmitri Medvedev announced today his support for Putin’s return to the presidency in 2012.  According to the NYT story, Medvedev made the announcement in a voice cracking with emotion.  His statement touched off uproarious applause: this seems like something out of a Communist Party Congress of Soviet days.

Forcing Medvedev to make the announcement, standing alone before the United Russia party members, was the ultimate humiliation to this rather pathetic figure.  It completes his slow-motion emasculation, and although the process has gone so far it would seem to require microsurgery to finish the job, Putin did it with a figurative chainsaw–just so no one could miss the point.

I admit that I was surprised–wrong–that Putin did not attempt some constitutional judo to remain in the presidency in 2008.  So why the change in 2011?  The answer to the question is overdetermined.  Numerous factors all push in the same direction.

First is Putin’s narcissism and love for power.  I don’t put too much weight on this factor as even as mere Prime Minister he has remained the dominant force in Russian politics, and has been able to work non-stop at building an ego building cult of personality.

Second, there is no constitutional obstacle this time around.  Legitimacy is important, and although the issue could have been finessed in 2008, doing so would have compromised his legitimacy and left him open to challenge on constitutional grounds.  He squared the circle by appointing a cipher to succeed him, all the while retaining an iron grip on the true sources of power in Russia (even though these are formally in the remit of the president).

Third, Russia felt itself to be flying high in 2007-2008.  Oil prices were soaring.  Growth was robust.  The US was reeling from its engagements in Iraq and Afghanistan.  There were no readily apparent threats to stability.  A relaxation of the system of unitary control seemed safe.

But everything changed almost exactly 3 years ago, mere months after Medvedev’s election, with the financial crisis in the West.  Although Putin at first boldly stated that Russia would weather the storm with no difficulty, that turned out to be a wildly inaccurate prediction.  The crisis hit Russia harder than any major country, and shook the country’s economic and political system to the core.  The seemingly inexorable rise of the country proved chimerical: collapse and chaos were serious possibilities.

Although Russia and Putinism survived the crisis, the country–and Putin–were shaken by the experience.  Listen to Putin’s rants against the West generally, and America in particular.  They reveal a control freak who rages against the fact that there are existential things outside of his control.

The country emerged from the crisis–the first crisis–shaken and weakened.  The crisis undermined the flow of rents that keep the natural state together.  Although growth has returned, it is not nearly as strong as in 2006-2007, and is unlikely to reach those levels any time soon.

Thus, whereas Putin probably calculated that circumstances were so favorable in 2007 that the country’s political and economic system could withstand a division of the power vertical, his calculations are doubtless far different now.  A near death experience has a way of concentrating the mind.  The heady visions of 2007 have proved illusory.

And importantly, another crisis looms, a crisis could actually be more shattering than the last.

In brief, it is likely that Putin believes that his system can no longer operate safely with the ambiguities and slippages and potential for conflict and division inherent in a duumvirate.  Hence Medvedev’s public humiliation and Putin’s triumphant return.

A final note on the implications of this for the US.  It is clear that this development puts paid to Obama’s sucker bet–the “Reset.”  The administration foolishly thought it could play divide and conquer, and quite transparently courted Medvedev and treated Putin with disdain.  Indeed, it is hard to express just how self-evidently foolish this was, and harder still to explain how the administration could have possibly thought this would work.

The administration will soon find out that payback is truly a bitch, and that Putin is all about payback.  It is in his DNA.  Expect Russia to become even more truculent, obstructionist, and revanchist in the months to come.  Putin and Obama–and whoever succeeds Obama, either in 2013 or 2017, for Putin will be around that long, health permitting–will not be burger buddies.  But I hear Dmitri has time on his schedule.  (Would that they share their burger in retirement, reminiscing about the old days when they were somebody.  In 2013.)

What happens in the coming months is highly contingent on what happens in Europe.  The EU is teetering on an economic precipice, and I cannot conceive of a plausible scenario which does not involve it plunging over the edge.  In that (likely, IMO) event, the consequences will be shattering worldwide, but especially so in Russia.  The last crisis showed its vulnerability, and a bigger crisis closer to home will subject the system to a daunting test.

The real possibility of such a crisis is exactly why I believe Putin is returning.  Putnism is under threat, and Putin has concluded that it can survive only in its pure, unadulterated form.

Felix Salmon heard the big raspberry that the Euro FinMins blew at Geithner, which is good: other coverage (like in the WSJ) downplayed the Eurodis (the FT at least alluded to it).   But then Felix writes this:

It’s pretty clear, here, that in the wake of the debt-ceiling debacle Geithner has lost a significant amount of international heft.

Wrong, wrong, wrong.  The debt-ceiling debacle has absolutely nothing–zip, nada, zero–to do with Timmy!’s lack of “international heft.”  I wrote three posts in June alone remarking on the astounding lack of respect Geithner gets overseas, and those posts referred to even earlier episodes in which various Euros (notably the Germans) had given Timmy! the backs of their hands.  All of these episodes occurred before the debt-ceiling standoff crescendoed in July and August.   No, Timmy! had entered the Dangerfield Zone well before the debt-ceiling circus.

Salmon’s interpretation is a piece with the standard left-leaning narrative that it was the failure to raise the debt ceiling expeditiously, rather than the failure to deal with debt period, that is the main symptom of American political dysfunction.   The debt-ceiling battle pitted those who believe that business as usual can work against those who believe that it can’t, and that the time to change course fundamentally is alarmingly short.  At present, neither side has a decisive advantage, hence the standoff and subsequent cold war.  It’s the issue that will dominate the next election.

No doubt Timmy!’s (and Obama’s) political impotence during the ceiling standoff makes his lecturing them on the need to be decisive now even more galling to the Euros.  But his stature was already sub-Lilliputian well before he rode his limo to the Polish concert hall where the meeting with the merely Lilliputian FinMins (who arrived by bus) occurred.

The thing about the Dangerfield Zone is that it’s a helluva lot easier to get in than get out.  It’s hard, in fact, to think of an example of someone truly emerging. Which means that we’re stuck with a SecTreas that can’t get no respect during a time of an existential world economic crisis.

Although there is a dark humor to the entire spectacle, it is in fact truly serious.  Financial Crisis II is a truly international event.  Its epicenter is Europe, but a Euroimplosion would suck in everyone, not least the US.  Hence, it is deeply troubling that the American point man is disliked, disdained, and disrespected around the world, and especially in Europe.

Pace Lincoln, changing horses in midstream is usually something to be avoided.  But if the horse you are on has no chance of making it, changing is the best of bad alternatives.  This is unlikely to happen, though, given Geithner’s close relationship with Obama, who needs all the friends he can get.  What is truly depressing, though, is the realization that no one with the requisite standing comes to mind as a replacement.  Which means that the entire country is on the verge of the Dangerfield Zone.

Yesterday I expressed my wish that German Finance Minister Schaeuble back off the control freak (“ban the OTC market”) stuff, and get back to bashing our Timmy! Well, he evidently reads SWP–and has company:

It was an unprecedented visit designed to spur the euro zone into action. But Treasury Secretary Timothy Geithner’s high-profile trip to Europe left some European officials more dumbstruck than starstruck.

. . . .

But however good Geithner’s intentions, the indications were that the meeting did not go as smoothly as he might have hoped.

Held in a concert hall, the gathering lasted for about 30 minutes. The euro zone ministers arrived together by bus. Geithner was sped to the doors in a private car.

There was no word on whether voices were raised or what the temperature of the exchanges was, but Austria’s finance minister, for one, was less than warm to Geithner’s message.

“I found it peculiar that even though the Americans have significantly worse fundamental data than the euro zone that they tell us what we should do and when we make a suggestion … that they say no straight away,” Maria Fekter told reporters afterwards, recalling a difference of opinion between Geithner and German Finance Minister Wolfgang Schaeuble on how to reinvigorate the euro zone and tax financial deals.

Although some dropped hints of disagreement behind the meeting’s closed doors, few were prepared to disclose Geithner’s full prescription to heal the euro zone crisis.

. . . .

But his language was perhaps too blunt for European ministers, fatigued by the crisis and the countless disagreements it has prompted amongst them.

“We can always discuss with our American colleagues. I’d like to hear how the United States will reduce its deficits … and its debts,” Belgian Finance Minister Didier Reynders said somewhat tartly.

Jean-Claude Juncker, the chairman of the Eurogroup, was even more to the point.

“I don’t think it would be wise for me to report from an informal meeting that we have with the treasury secretary. We are not discussing the expansion or increase of the EFSF with a non-member of the euro area,” he said.

. . . .

For many in the meeting, Austria’s Fekter most particularly, his message fell flat.

“I had expected that when he tells us how he sees the world that he would listen to what we have to say,” she said.

Not that this wasn’t perfectly predictable.  I’ve written several times before about how I cannot recall an American cabinet officer, let alone a Secretary of the Treasury, being treated with the disdain that Geithner regularly encounters abroad.  He is truly DC’s Rodney Dangerfield.  He has yet to learn that gratuitous and hypocritical advice is not the way to win friends and influence people.  The hectoring and lecturing is the last thing people facing an existential crisis need to hear: and it’s not just Timmy!, but Obama too, and the president is rapidly entering Dangerfield territory as a result of his supercilious lecturing to everybody about everything, while pretending that he’s responsible for nothing that goes wrong.

Europe’s leaders are Lilliputians.  But sadly, at times like this they appear to tower over ours.

Take it away, Rodney!

I have a warm spot in my heart for German Finance Minister Wolfgang Schaeuble, because of his periodic slapdowns of Timmy!  (I think there is another slapdown-ready opportunity arising, given Timmy!’s–and Obama’s–recent penchant for giving the Euros gratuitous advice on dealing with their existential crisis.)

But he said a couple of things recently that give me pause.  First (h/t R) is this speech:

German Finance Minister Wolfgang Schaeuble said that while markets are the most efficient means of creating wealth in an economy, they can also be irrational and therefore need regulation.

“Markets are the best means of finding solutions, but they’re not always rational” and can destroy themselves, Schaeuble said today in a speech in Berlin. “That’s why they need rules and bounds.”

It is the job of the government to create an order that promotes, rather than hinders, moral behavior, Schaeuble also said at an event organized by the Catholic Academy in Berlin.

On an abstract level, that’s not really objectionable, because only some anarchists deny the need for market rules.  (Anarchocapitalists believe that rules shouldn’t be imposed, but created by cooperation and consent.)  The questions are: What rules are the right ones?  Where should the bounds be set?  Who decides?  How?

In this speech, Schaeuble gave an example of how he answers these questions, and those answers suggest that his pro-market rhetoric is boilerplate camouflaging another statist control freak:

German Finance Minister Wolfgang Schaeuble on Wednesday called for regulating all innovative financial products and urged banning so-called over-the-counter trade.

“We must apply the rules of transparency to all market participants–hedge funds and private equity funds,” Schaeuble said at an event sponsored by the Konrad Adenauer Foundation and the Catholic Academy ahead of a planned state visit to Germany by Pope Benedict XVI.

“We should ban OTC trade where possible, because we don’t have transparency (in these markets). And then we should try to regulate all innovative financial products. We cannot achieve everything through regulation, but we can try to tighten the rules.”

Another slave to the god of transparency.   Like that will solve everything.  And apparently a market in which consenting adults make mutually advantageous transactions about which they don’t reveal everything is far worse than no market at all.

I would further note that there is no perfectly transparent market.  Futures and stock exchanges have a great deal of pre-trade and post-trade price transparency, but the identity of traders is concealed: the markets are anonymous, and the buyer does not know the identity of the seller.  Thus, even on exchanges not everything is transparent.  OTC, the buyer typically knows the seller, but there is less pre- and post-trade transparency.  There are trade-offs involved, and different mechanisms have developed to permit market participants to choose which kinds of transparency rules work best for them.  The side-by-side existence of exchanges and OTC markets gives choices that can accommodate differences in the costs and benefits of alternative forms and levels of transparency across market participants.

And if transparency is such an unalloyed good in markets, Herr Schaeuble, does the same principle hold for governments?  Is Germany’s government a paragon of transparency?  Do you conduct all of your discussions and decisions in the full public glare?  Does your government have secrets?  Does Europe’s?  Is this a good thing?

We all know the answers to those questions.  It would be quite illuminating to hear why secrecy–very incomplete transparency–is acceptable and even necessary for governments that wield vast coercive powers, but some modicum of secrecy is completely unacceptable for private actors who cannot coerce anybody.

Schaueble’s remarks, and the place where he delivered them, suggest a typical European conservative mindset that is ambivalent, at best, towards markets and individual choice.  Hayek’s essay “Why I Am Not a Conservative” provides an illuminating analysis of this mindset.

So please confine yourself to putting the (verbal) boot into Timmy!, Wolfie.  There are enough control freaks about, thank you.

This week marks the beginning of a whirlwind couple of months in which I give talks or participate in conferences on either clearing or Frank-n-Dodd (there of course being a big overlap there).  Tuesday I moderated a panel at the ISDA Annual New York Conference, and yesterday I participated in a panel on Frank-n-Dodd at a Futures Industry Association event in New York.

First, the FIA event.  What came through loud and clear was the widespread belief that the SEF mandate in Frank-n-Dodd is wholly wrongheaded.  The consensus is that it is an attempt to jam a one-size-fits-all model on an inherently heterogeneous and non-standardized business–the business of executing OTC derivatives transactions.  That heterogeneity reflects the inherent heterogeneity of particular transactions, and the firms that want to execute them.  The market has evolved to accommodate heterogeneity, and the SEF mandate will impose uniformity.  Everybody better fit a 42-regular sportcoat, because that is what Frank-n-Dodd is going to force everybody to wear.

Of course there are dissidents from the consensus: most prominently those who do, or want to, operate SEFs.  Big surprise.  The NYT recently ran an article describing the efforts of these firms to influence policy.  The point you should take away from that article is that the idea of SEFS is not new, that SEFs have tried to gain traction in the market for some time (they are not “Johnny-come-latelys” in the words of one exec quoted in the article), but they have not made a big dent in the marketplace.

The failure to this point of SEFs to transform execution in the swap market, the way electronic trading did for listed derivatives, is a crucial fact.  It is not dispositive proof that the SEF mandate is misguided, but it does raise serious questions about it.  Before remaking the world, it is a pretty good idea to understand why the world is the way it is and why it isn’t the way you want to remake it.  Competition is never perfect, but competitive forces usually work inexorably towards the adoption of more efficient practices.  The rebuttable presumption should be that competition has pretty much gotten it right, and that policy prescriptions that are wildly at odds with existing practice are likely based on ignorance.  Those advocating a wholesale re-engineering of the results of market processes should be required to advance a coherent justification, based on rigorous logic and empirical evidence.

This the SEFocrats have not done.  Not even close.  And no, invoking the magic word “transparency” or advancing theories that presume that half the market is suffering from something akin to battered spouse syndrome don’t cut it.

The SEF rules are a particularly prominent example of the deficiency in cost-benefit analysis in CFTC rulemaking.  I have it on good authority that some analysis will soon be forthcoming that demonstrates that the cost of these rules will be immense.  As for benefits, the six members of the FIA panel couldn’t name one–even when pressed to do so.  We, collectively, couldn’t even come up with a “well you don’t sweat too much for a fat girl” compliment.  (If you don’t like that remark, direct your complaints to Ty Cobb:  I stole it from him.)  So, insofar as cost-benefit analysis is concerned–you should be able to do the math pretty easily.

The title for the post, by the way, is a joint product.  Tom LaSalla of CME Group coined “SEFdom” to describe what Frank-n-Dodd will soon bring on us.  I added the Hayekian allusion.  (Go figure.) I think the comparison is apt.

Insofar as the ISDA panel on clearing is concerned, I walked away from it thinking what I do after hearing any informed discussions of this subject: that it is the most devilishly complex issue you can possibly imagine.  It is one of the world’s biggest onions, and neither I nor anyone who has spent considerable time and effort thinking about it or actually doing it has gotten through even a small fraction of its layers.  The number of serious issues, their complexity, and their interconnectedness, is hard to exaggerate.

Which further demonstrates the frivolity of legislators and regulators around the world,who seized upon it as a panacea and imposed it without due consideration of these complexities.  The idea was hatched out of superficial understanding by panicked people who then proceeded to let others deal with the brain-twisting realities.

One hopes (though I do not expect) that regulators will be sufficiently patient and flexible to permit people who actually know something accommodate these complexities, and make the hard trade-offs that are necessarily involved.  New ideas on ways to perform the same functions as CCPs are still being developed: ISDA chief Conrad Volstad mooted a promising approach that would achieve the purposes of the clearing mandate, but at far lower cost.  These approaches deserve analysis and development before another one-size-fits-all approach is locked in.

I don’t like clearing mandates, but think that clearing has its virtues if it is done right, and in a way that reflects its comparative benefits and costs.  In this way it differs from the SEF mandate, which is why I gave the latter my Worst of Frank-n-Dodd Anniversary Award.  But rigid and superficial conceptions about how the mandate should work (and you know whom I am talking about) raise the very serious possibility that the potential benefits of clearing will be swamped by the unintended costs of imposing it where it is inappropriate, or in a way that is not adapted to its strengths and weaknesses.

I read Mark Thoma’s Economist’s View blog to get a view on the views of people who think quite differently than I.  It is particularly useful in that regard because although Thoma writes quite a few posts, he is more of a linker than a writer, so EV is an efficient way to get exposed to the views emanating from the Keynesian-left of the blog world.

Which means that whereas I think “aggregate demand” has something to do with the cement market, Thoma is definitely of the what-we-have-here-is-a-failure-to-demand-enough-in-aggregate kind of guy.  Which further means that he is frequently looking to rebut alternative explanations for poor economic performance.  Him being him and me being me, I usually find his efforts implausible, but this one particular effort of his is particularly lacking, and is sufficiently close to my bailiwick to warrant a rebuttal.

“Of his” might be a little strong, for the post in question primarily endorses the analysis of another blog, but he doesn’t even quibble, so attributing ownership is fair.  In any event, the alternative theory at issue is “regime uncertainty”; the view (originally developed by Robert Higgs) that uncertainty about government policy (and the economic environment at large) discourages hiring and investment.  Higgs originally applied the idea to the Great Depression: he argued that the frenetic regulatory activity of the Roosevelt administration created investment-killing uncertainty that prevented a normal rebound.  The similarities between what happened in the 1930s and what is happening today has led to an application of this view to current circumstances, just as it has led to a revival of old school Keynesianism which was born during the Great Depression.

Thoma links to a Gary Burtless piece that purports to debunk regime uncertainty as a cause of the current lack of growth in hiring and investment:

A couple of hours after talking to an ABC correspondent about the woeful job numbers and what might be done to improve them, I was in the Bloomberg TV studios debating a guy from Heritage. He went on for several minutes about the damage being done by high taxes, excess regulation, business “uncertainty” about future tax hikes and regulatory burdens.  I asked Bloomberg’s host whether he was aware that corporate profits relative to national income had just hit a 60-year peak?  He had heard rumors to that effect.  Was he aware that taxes on corporate earnings were at a 60-year low?  The Heritage guy had heard that might be the case.

Then why was uncertainty about taxes and the future burden of the Affordable Care Act holding back business investment and hiring right now?  If managers thought taxes or regulatory costs might go up in the future, wouldn’t it make sense to take advantage of today’s low taxes and lower burdens to invest and hire today?  According to the “uncertainty” argument, businesses are fearful they might face high taxes and extra health costs in 2016 or 2018.  Shouldn’t they expand hiring right now and scale back employment when they actually face higher costs (if they ever do)?

The “tax uncertainty” and “regulatory uncertainty” arguments would make more sense if, say, taxes were already high and might be going higher or regulatory burdens were heavy and might be getting heavier. But when taxes are at a 60-year low and the regulations are pretty much the same as they were in the 1990s boom, the argument makes no sense at all.  As we used to say down on the farm, you should “make hay while the sun shines.” In other words, if you think it’s going to rain later in the week, it strengthens the case for cutting and baling right now.

This is utterly confused, and a complete mischaracterization of the regime uncertainty view.  It focuses on expected costs associated with policies like Obamacare (and, I might add, like Frank-n-Dodd and the EPA and the NLRB and on and on); the argument is essentially that if costs are expected to be higher in the future, why not hire more today?

But this focus on expectation (itself flawed–more below) is to misstate completely the essence of the regime uncertainty argument, which, believe it or not, is about uncertainty–variation around the expectation.   It can be conceived best as a real options argument.  Hiring is like an investment: there is a cost of hiring–and firing–workers.  This cost is not immaterial.  This cost is like the strike price of an option on the right to hire a worker and receive a stream of benefits from employing her.

This stream of benefits is uncertain.  Moreover, policy uncertainty is a major driver of the variability of this stream of benefits.  Nobody knows how Obamacare is going to play out.  Nobody knows what the actual costs of compliance are going to be.  If the burden turns out to be very high, the stream of benefits from hiring a worker (or investing in a new machine or a new product) could be quite low, and even negative.  If the burden turns out to be low, the stream will be commensurately higher.

Options pricing theory basically implies that in the face of such uncertainty, it is often optimal to defer paying a sunk cost (the strike price) until the uncertainty is resolved.  This is why it is usually better to defer the exercise of an option as long as possible, unless there is a stream of benefits (e.g., dividends, interest on the strike price) that can be obtained only after the option is exercised.  When to exercise the option–including exercising the option to hire somebody–depends on a trade-off between getting some benefits immediately, and waiting for the resolution of uncertainty about the value of those benefits in the future.

An immediate implication of this is that the greater the uncertainty about the future, the costlier it is to exercise an option early.  In the present context, higher uncertainty about the future means that firms will hire less today, all else equal.  Hiring a worker today (or investing in a machine or product) generates a stream of benefits for the employer in the short term, but if there is considerable uncertainty about the future value of that stream, it is often wise for potential employers to defer incurring the strike price (the cost of hiring) until some of that uncertainty is resolved.

In the investment literature, the option value of waiting for the resolution of uncertainty drives a wedge between the rate at which firms discount risky expected cash flows and the discount rate implied by something like the CAPM.  It helps explain why firms frequently use very high hurdle rates in capital budgeting decisions–and high hurdle rates tend to discourage investment, relative to those that would be undertaken using CAPM.  In other words, real optionality tends to reduce investment.

The same effect is at work here.   The Burtless argument endorsed by Thoma focuses on expected future benefits.  But since these future benefits are risky, and a cost must be sunk to achieve these benefits, there is a cost wedge–the option value of waiting–that is attributable to uncertainty.  The more the uncertainty, the greater the wedge.

In other words, the Burtless-Thoma “rebuttal” of the regime uncertainty analysis is nothing of the sort, because it completely misses the basic insight of that analysis.  When hiring is viewed as a real option–which is a fair analogy–uncertainty matters.  It is variation around the expected value that matters, but Burtless-Thoma focus on the expected value.

In other words: swing and a miss.  (Burtless’s argument is also strange even on its own terms because it presumes that firms don’t take future costs into account when making hiring decisions today.  Even absent uncertainty, higher future costs will deter hiring today if there is a fixed cost to hiring.)

There is no doubt that uncertainty is abounding today.  Just look at Europe for one example.  But even closer to (my) home, the uncertainty is immense.  One small example: the Obama administration’s request that the EPA defer action on ozone rules.  The key word here is defer.  It hasn’t been killed with certainty.  Its return depends on future political and economic developments: Obama loses, it is likely dead forever; Obama wins, it is likely to be revived, especially if the economy is doing somewhat better.  These future developments are fraught with uncertainty.  Moreover, the costs of the rule itself are highly uncertain, ranging from the EPA’s (typically risible) estimate of around $100 billion to more than ten times that.  Which means that although the suspension of the rule should reduce the expected cost of compliance which should in turn lead to greater economic activity, the suspension also creates a significant increase in uncertainty that will offset this effect.

One could repeat this exercise over and over and over.  Just focusing on one agency–the CFTC–would provide numerous examples.  And if you think that particular policy uncertainty would just affect, say, banks, you would be so wrong.

It is foolish in the extreme to disregard the economic drag that such policy uncertainty can create.   Most economic decisions–hiring and investment notable among them–are effectively real options.  The decisions to exercise real options depend on the amount of uncertainty.  Uncertainty has first-order effects on these decisions.  Thoma (and Burtless) may believe they have discredited regime uncertainty as an explanation for our current malaise, but they have done nothing of the kind.  Indeed, they completely miss the point and thrash a straw man.  Regime uncertainty is still a very viable and plausible explanation of the reluctance of firms to hire and investment.

Izabella Kaminska writes very interesting posts at FTAlphaville.  She finds unusual things in the markets, including the commodity markets, and writes about them intelligently and provocatively.  I have to take issue, however, with one of her more recent efforts.

She takes as her inspiration an article by the improbably named (to an American ear, anyways) Hilda Ochoa-Billembourg.  Izabella’s takeaway from HOB (you didn’t think I was going to type that again, did you?) is that the Achilles heel of QE2–which, remember, was specifically designed to produce some inflation–was that it did not produce the right kind of inflation (something which Bernanke adamantly, and not too plausibly, denies):

If you work with the premise that QE2 led to what has been described as ‘bad inflation’ — inflation being exported into commodity and emerging market securities rather than domestic ones — you could argue the Fed has always had an interest in sterilising that inflation effect.

What to do then?  Have the Fed intervene in the commodities markets by selling longer-dated futures, of course!  Kaminska suggests that the Fed–or some Government Body To Be Named Later–did this, although her argument here is highly circumstantial and, uhm, speculative.  Now that deflation fears are reviving given the European tumult and the palpably slowing US economy, she suggests that it could be just the right time for the Fed or GBTBNL to buy commodity futures.

Or not.  I have problems with the argument from start to finish.  It is predicated on the view that speculators are driving the curve (although Kaminska admits that it doesn’t affect spot prices)–a highly dubious proposition.  It presumes a sort of disconnect between the Treasury market and the energy (and other commodity) futures markets (“One might even say that the market has shifted from expressing inflationary views via the Treasury market to the oil market.”  If so, there’s money to be made!) Although she recognizes–blessedly–that speculators affect the risk premium embedded in futures prices, she confounds a risk premium with an inflation expectation effect (which should be impounded in the interest rate terms structure in any event).  Most notably, she makes the all-too-common mistake of confusing Keynesian contango/backwardation–which is a difference between a spot price and an unobserved expected future spot price–and contango/backwardation of the observed curve, which is the difference between traded prices.  (An expected spot price is not traded.)    The risk premium can change without having any impact on the shape of the futures curve; the effect of the risk premium–and hence hedging/speculative balance–on the futures curve is indirect, operating through the effect of the risk premium on inventory decisions: roughly speaking, more Keynesian backwardation (hedgers pay speculators a greater risk premium) leads to less inventory which tends to reduce the contango/increase the backwardation in the curve.  But detecting this effect is hard even in a simulated market, let alone in a real one.  Her story also depends on an implausible relation between speculation and the Brent-WTI spread.

But put all that aside.  Assume it’s all correct.  Do we really want the Fed, or any other GBTBNL, monkeying around with still more relative prices?  Really?

Several times I’ve recounted the story of the great economist Sherwin Rosen, who in 1982 startled an 830 AM section of his Econ301 class at Chicago by shouting: “And that’s the problem with inflation.  It FUCKS UP RELATIVE PRICES.”  Well, of late the Fed apparently thinks that effing up relative prices is its job.  Heretofore, its efforts (unless Izabella is right that the Fed has been active in commodity markets as well) have focused on the yield curve and inflation expectations: twisting this rate relative to that–or is it torquing?

How is that working out for us?  Trivial growth in the H1 2011.  And how about that last jobs report!  Or should I say, that no jobs report?

We really don’t need it attempting to affect–to f*ck up–the relative prices of commodities or anything else.  Indeed, the now common diagnosis of the failure of QE2 (which you might have read here first, well before its end) is that the Fed’s intervention screwed up relative prices: forcing down the dollar, which induced other countries to intervene to prevent undue appreciation of their currencies, thereby sparking inflation in emerging markets, which has led to yet further policy responses; forcing up commodity prices, which put a drag on developed economies.  So we should now believe that there will not be any unintended consequences on other relative prices from an attempt to intervene into the commodity markets?  Really?

The probability that the Fed could somehow tweak relative prices just right this time based on a theory that would do Professor Irwin Corey proud, and which could use a good trip to the barber for a shave with Occam’s razor, is vanishingly small.  The probability that it would wreak yet additional havoc through such an intervention approaches one.

The problems are almost beyond numbering.  There is the knowledge problem: how could the Fed possibly know what the “right” relative prices are?  There is the implementation problem: how could the Fed actually achieve the relative prices it wants to, if by some miracle it could divine what they should be?  There is the strategic/expectations problem: how could the Fed succeed given that it would not be acting on automotons, but on live, thinking, reactive, strategic actors who respond to the Fed in ways that are hard to predict?

No, as Sherwin might say if he were still alive: the Fed has f*cked up relative prices enough, thank you.

So Ben, et al: Stop before you do even more damage, and inject more uncertainty into an economy that is already reeling from it.  We need no more Sorcerer’s Apprentice interventions.  Don’t just do something, stand there.  Become what you were intended to be–a lender of last resort to address liquidity problems and banking crises–and stop trying to be some grandiose central planner that manipulates price signals to achieve some “aggregate” outcome.  It hasn’t worked up to now, and it won’t work any better if you double down.  Do more by doing less.  Go away and leave us alone.

In brief, we may need to revise Reagan’s statement of the ten scariest words in the English language: now, it should be “I’m from the Fed, and I’m here to help you.”  With help like this . . .