Streetwise Professor

GM has finally come to its senses and rejected the sale of Opel to Canadian autoparts maker Magna–and its Russian partner (initially Sberbank, but eventually Avtogaz Gaz).   GM initially agreed to the deal when faced with an existential crisis in the early part of this year; its “choice” of partner was largely driven by Germany’s conditioning of financial support for the deal on GM selling to the Canadian-Russian tandem.   GM got cold feet in the summer, as its bankruptcy/government takeover and cash-for-clunkers gave it a financial respite.   It was explicitly reluctant to get involved in a deal that could lead to the loss of its technology and intellectual property to a potential Russian competitor; no doubt it was also reluctant (though it did not say so publicly) at the prospect of getting enmeshed (as a minority partner) in the financial and business machinations of Oleg Deripaska, victor in the bloody aluminum wars, unscrupulous businessman, and arguably the world’s largest insolvent.  Moreover, recent statements by the EC called into question Germany’s ability to condition its subsidies to favor factories located in Germany at the expense of others in Belgium, Spain, and the UK.

The decision of GM’s board to maintain control of Opel touched off howls of protest from Germany–and Vladimir Putin.   Putin was outraged that GM would act in such a high-handed way.   A deal is a deal, after all–if it works in Russia’s favor.   Putin made heavy hints that Russia would explore legal options.

Cry. Me. A. River.

Actually, the irony here is too rich for words.   Let’s remember the narrative that justified the rough treatment of Shell a few years ago.   When Russia was on its knees, the story goes, opportunistic oil companies exploited Russia’s economic desperation by forcing it to enter into humiliating production sharing agreements that were tilted heavily against the Russians.   In the mid-2000s, the worm had turned, oil prices had risen dramatically, Russia was no longer on its knees, and it redressed the injustices inflicted on it during its time of troubles by forcing Shell (through regulatory thuggery) to tear up the PSAs and sell its interest in Sakhalin at Putin’s price.

Fast forward to 2009.  GM is on its knees.  Russia–with the connivance of a German government facing re-election–takes advantage of the company’s distress to enter into an agreement that it would never countenance under other circumstances.  Months later, its hour of desperation past, GM reconsiders the deal and tells Putin to pound sand.

Tell us how it feels, Vladimir Vladimirovich.

But note one crucial difference: unlike Shell and Russia, GM had not signed on the dotted line.  It backed out before it had entered into a binding legal obligation.

An interesting lesson in corporate governance that Putin might well heed.  A board of directors overrules its management.

Truth be told, there are no truly sympathetic figures in this saga.  A company (GM) that wasted tens of billions of dollars in capital over decades.  Its overprotected, overpaid, unionized labor force.  A government (Germany’s) attempting to buy votes by subsidizing an industry plagued by overcapacity that should shrink, and doing so in a beggar-thy-neighbor fashion, all the while providing assistance to an opportunistic, corrupt Russian government and business that has co-opted wide swathes of the German political and economic elite.

This is an embarrassment to Germany’s Merkel, but one which hopefully will get her to reconsider her rather mystifying obsequiousness towards Putin and Russia.  But it is a particular embarrassment to Putin, for it is a very public demonstration that only the desperate (or the deluded or the corrupted) are willing to respond favorably to his blandishments.

Some would take this as an opportunity to contemplate what changes would make his country attractive to anyone but those with no other option.  But this surely will not happen in Putin’s case.  Instead, we can expect a litany of whines about how the Europeans and Americans are making Russia a pariah.

Actually, VV, no help needed: you’re doing a bang up job of that all by your lonesome.

CFTC Chairman Gary Genlser continues to make concentration and diversity his primary justifications for expanding position limits:

I believe we should consider setting position limits to guard against excessive concentration in the energy futures market,’ said Gensler at a luncheon held by the Natural Gas Roundtable, a nonprofit organization.

The CFTC is weighing whether to set position limits — a maximum market share — for oil and other energy products. The agency already sets limits on agricultural contracts.

‘When the CFTC set position limits for certain agricultural commodities, the agency sought to ensure that the markets were made up of a broad group of market participants with a diversity of views,’ said Gensler.

This raises several questions.

First, what is the statutory basis for position limits designed to reduce concentration and increase diversity? I see none whatsoever.

The relevant statute–available right there on the CFTC’s website–makes it clear that position limits are for the purpose of reducing “excessive speculation” that causes unwarranted price changes:

Excessive speculation in any commodity under contracts of sale of  such commodity for future delivery made on or subject to the rules of  contract markets or derivatives transaction execution facilities causing  sudden or unreasonable fluctuations or unwarranted changes in the price  of such commodity, is an undue and unnecessary burden on interstate  commerce in such commodity. For the purpose of diminishing, eliminating,  or preventing such burden, the Commission shall, from time to time,  after due notice and opportunity for hearing, by rule, regulation, or  order, proclaim and fix such limits on the amounts of trading which may
be done or positions which may be held by any person under contracts of  sale of such commodity for future delivery on or subject to the rules of  any contract market or derivatives transaction execution facility as the  Commission finds are necessary to diminish, eliminate, or prevent such  burden.

It couldn’t be much clearer.  Congress has authorized the CFTC to fix trading limits “for the purpose  of diminishing, eliminating,  or preventing such burden [of “sudden or unreasonable fluctuations or unwarranted changes in the price  of such commodity”].”  Period.  Full stop.  Not a word about “concentration” or “diversity.”  Like Bart Chilton’s musing about “unintentional manipulations,” Gensler’s advocacy of position limits based on these concepts is completely unmoored from the law.

That is, “excessive speculation” that distorts prices can provide a legal basis for position limits; Gensler’s “excessive speculation” (with no attempt to connect such concentration to price distortions) cannot.

Second, what is the evidence that variations in concentration across markets affect market quality?  I am not aware of any.  That is, what constitutes “excessive” concentration?: how would we know when this level is reached?

Third, what does Gensler believe causes variations in concentration across markets?  Could there be fundamental economic considerations that affect the level of concentration?  Could it be that trying to micromanage concentration through position limits would impose costs because these limits conflict with these fundamental economic considerations.

Fourth, more generally, what are the costs of position limits (e.g., in terms of constraining risk transfer)?  Has Gensler made any effort to weigh the costs against his estimates of the benefits?

Fifth, what levels of concentration are problematic?  Under what theory?  What is the evidence that supports this contention?

Sixth, are there any markets that have reached this level of concentration?

Seventh, is there any evidence that position limits materially impact concentration?

In terms of what concerns concentration poses, concentration levels (per CFTC data) are not large as compared to, for instance, industrial concentration in most markets.  In crude and nat gas, 4 firm concentration ratios range between 25 and 40 percent, while 8 firm ratios are in the 30-50 percent range.

I think that Gensler’s clear desire to shift the grounds of the debate from the (legally required) “excessive speculation” issue to something else (the legally meaningless idea of “excessive concentration”) reflects the fact that there is clear lack of both logic and evidence to support any claim that “excessive speculation” has, in fact, caused “unwarranted” price fluctuations.  Lacking such evidence, Gensler is attempting to hitch a ride on the financial crisis.  As the article quoted above says,  “Chairman Gary Gensler of the Commodity Futures Trading Commission said the financial crisis last fall showed the risk posed by ‘large concentrated actors on the financial stage’.”  He provides no evidence that this concentration caused problems in the futures market even during the height of the crisis (which would, interestingly, undercut his argument that clearing is a panacea to systemic risk).  And even if it did, it still provides no legal basis for position limits, which must as noted above, can be imposed only “for the purpose  of diminishing, eliminating,  or preventing” undue price fluctuations caused by excessive speculation.

By repeatedly invoking “concentration” and almost completely ignoring the sole legal basis for position limits, Gensler may actually call into question the legitimacy of any position limit regulation the Commission does pass.  If Gensler really believes that concentration is a problem, he should advocate amendment of the Commodity Exchange Act to make concentration a justification for imposing limits.  By straying from statutory authority in his advocacy for position limits, Gensler risks becoming another out of control regulator attempting to ensure that no good crisis goes to waste.  He has a lot of company in that, but that’s no excuse.

From The Austrian Economists a timely reminder that this is the 50th anniversary of the second of Coase’s three great papers, on the FCC (which presaged his most important paper on social cost).  (Actually, Coase wrote more than 3 great papers by the standards of the profession, but even by his own high standards three stand out.)

It is gratifying to see a case where a scholar produced his greatest research at around age 50, and then has lived another 50 years (and counting) to observe the transformative effect of that work. (What is it about Chicago and great nonagenarian economists, e.g., Director and Friedman in addition to Coase?)

But perhaps not transformative enough, for much has been written and said on public policy and regulation in the aftermath of the financial shock could have been written or said had Coase never lived.  Which is a shame, and which means that it is highly, highly likely that the legal and regulatory changes that do occur will be pernicious rather than beneficial.

Prior to Coase, it was common for economists to argue that market failures necessitated government corrective.  In particular, those operating in the dominant Pigouvian tradition saw externalities everywhere, and recommended corrective taxes (or other mechanisms) to address them.

Coase asked more basic questions: why do externalities exist? and why, if they are so costly, don’t greedy maximizing individuals do something about them?  This led him to the insight that transactions costs are at the root of any supposed market failure; people do not internalize externalities because the (transactions) costs of doing so exceed the benefits.  This does not eliminate the possibility that government intervention can make things better, because government action may entail lower transactions costs than private alternatives.  But once one recognizes that government policy is not (transactions) costless, the Coasean logic necessarily makes any analysis a comparison between imperfect alternatives, rather than a morality play starring a flawed market and a redeeming government.

This, in turn, necessitates a thorough examination of the sources of transactions costs that make market outcomes less than ideal.  This process of examination frequently identifies underlying conditions, such as information asymmetries, that do not disappear with the passage of a law–and which may in fact be worse in a regulated environment.  In other words, it is often the case that if you are think things are bad now, just think how much worse they’ll be when we fix them!

And that is what is largely missing in the current debate.  In the case of the financial markets, among policymakers and many commentators there has been far too little effort made to answer the question implicit in all of the proposals for a root-and-branch restructuring of the system: why did greedy individuals systematically make such costly choices?  For instance, the proposals to completely restructure–and indeed, largely eliminate–OTC derivatives markets presume that market participants systematically chose the wrong institutional arrangements, at huge cost.  From the Coasean perspective, the greed meme used to justify much government policy actually cuts the other way: greedy individuals have strong incentives to find ways to reduce these costs.

In my view, such an evaluation produces several conclusions which should combine to make those eager for a legislative and regulatory restructuring of the markets far more circumspect.  First, there are strong economic justifications for many of the institutional choices.  Second, by failing to understand better why particular institutional arrangements evolved (i.e., what transactional and transactions cost characteristics affected these arrangements), policymakers run the very serious risk of imposing new institutions that are badly adapted to these fundamental characteristics.  Third, many of the most perverse choices resulted from previous regulations and policies.  (The Calomaris interview that I linked to earlier this week in the Friedman post provides several examples.)

Put differently, things as immense and complex as the OTC derivatives markets are emergent orders, complex systems with rich and inscrutable feedback mechanisms.  These orders have evolved to economize on scarce resources–including to economize on transactions costs.  Intervening to change one part of the system, or several parts of it, will have unfathomable consequences.

Before taking the (often irreversible) step of trying to reshape an emergent order by fiat, it is imperative to understand better why it has taken the shape it has.  Using Coasean, transactions cost concepts is an essential ingredient to achieving such an understanding.  It is also a good antidote to legislative and regulatory hubris.  It is, alas, almost completely lacking in the current policy debate, which bodes ill for the future.

Barney Frank and Timmy! Geithner have reached an agreement on a bill intended to reduce systemic risk.  I emphasize “intended to,” because it is by no means clear that it will have that effect.

The WSJ reports that one element of the proposal “would require financial firms with more than $10 billion of assets to pay for the unwinding of a collapsed competitor.”  The Journal continues:

During the recent financial crisis, the government bailed out several large firms at taxpayer expense, fearing their collapse could sink the economy or financial markets. Policy makers hope the new rules will discourage companies from growing too large and would cushion the blow if they collapse.

A future flashpoint: Which companies will have to pay for the collapse of one of their competitors? Initially, the costs of safely unwinding a failing firm would be borne by the Federal Deposit Insurance Corp., based on borrowing from the Treasury Department. But under the proposal, the FDIC would seek to recoup the money from banks with more than $10 billion of assets — a category that includes roughly 120 U.S. banks. The FDIC would likely be able to also recoup money from broker dealers, insurers and possibly even hedge funds.

So let me see if I get this.  Banks that know that taxpayers will bail them out grow too large and take on too much risk.  But banks will be more cautious, won’t grow so large, and won’t take on so much risk if they are assured of being bailed out . . . by other banks?  Huh?  From the perspective of the incentives of the managers of a given financial institution, does it matter where the money to bail them out comes from?  Not bloody likely.

WIth 120 banks (and perhaps broker dealers, insurers, and hedge funds as well) on the hook for the failure of one (or more) of their number, this loss sharing rule will provide little additional incentive for banks to monitor the riskiness or size of other banks, or take actions that would reduce the growth or risk taking of other banks.  Why should a bank incur the costs of taking actions that penalize the risk taking of another bank when (a) it internalizes the entire cost of those actions, and (b) any benefit accruing to such actions is shared by 118 other banks?

Put differently, if there is a too big to fail problem, it is because benefits are privatized and losses are socialized.  Under the present framework, if the ad hoc, seat of the pants approach deserves such a name, losses are socialized broadly among the taxpaying public.  Under the proposed alternative, they are socialized more narrowly, among the claimants of the banks (and other entities) that are subject to being dunned by the FDIC.  Socialization occurs regardless, and as a result, the proposal does nothing to affect the incentives of financial institutions to gamble on somebody else’s dime–because they can still gamble on somebody else’s dime.  Only the owner of the dime changes. Hence my earlier skepticism that the bill will do little to reduce systemic risk.

By itself, this provision will affect the distribution of losses from the failure of a large financial institution, but it is unlikely to affect the frequency or magnitude of those failures because losses are still socialized.  It does not affect incentives in a meaningful way; it affects how the consequences of those incentives are shared.

The relevant question is whether the share-among-120 banks (and others) rule spreads risk more efficiently than the share-it-among-the-taxpayers rule.  I have no strong initial reactions to this choice, though it does seem problematic to adopt a rule that would impair the ability of financial institutions to lend during periods of market stress, as this rule would.  A likely outcome is that the Fed (or the Treasury) would feel compelled to provide assistance to these financial institutions if the additional cost of paying for the failure of other institutions impairs their ability to lend.  Relatedly, it seems odd to fight the alleged effects of financial contagion by creating a new channel whereby the effects of the failure of one institution are imposed on others.

In sum, the first priority of an effort to reduce systemic risk should be to attack TBTF by reducing the socialization of risk.  This piece of the proposal doesn’t do that.

Rather than a serious effort to address systemic risk, this seems to be populist boob bait, a response to popular outrage against taxpayer banking bailouts, rather than a serious attempt to address TBTF.  Not a surprise, and quite understandable, but not a major improvement of incentives.

I can’t count the number of times I’ve heard that the financial/economic crisis has discredited Milton Friedman and Chicago School economics.  This argument was raised repeatedly during the shrill debate over the creation of the Milton Friedman Center at UC, but it has been made repeatedly in other contexts as well.

I say let’s look at the record.  First consider Friedman’s scholarly work.  Note that one of his most important contributions, with Anna Schwartz in A Monetary History of the United States, was to demonstrate the salient role of the Federal Reserve in causing economic contractions–including the Great Depression.  He subsequently argued quite presciently that Fed policy during the 1960s and 1970s would cause inflation, and were the cause of the inflation that in fact occurred.

If anything, the monetary policy of the 2000s, which played a central role in the 2008-2009 crisis, provides a ringing confirmation of Friedman’s fundamental point about how a discretionary, fine-tuning monetary policy is ultimately highly disruptive and likely to end in economic misery.  The crisis of 2008-2009 would therefore be fertile ground for another chapter-or four–in an updated version of Friedman’s history.  Thus, a compelling argument can be made that the crisis is actually a testament to Friedman’s prescience in warning of the dangers of bad monetary policy.

It should also be noted that in setting monetary policy during the crisis, Bernanke was consciously striving to avoid the Fed’s mistakes of the 1930s–mistakes that Friedman pointed out long ago.  Note too that Bernanke’s own research on monetary policies and depressions owes a great debt to Friedman’s (and Schwartz’s) pioneering scholarship.

One of Friedman’s other seminal contributions–the theory of the consumption function/permanent income hypothesis–has also stood up extremely well.  The temporary tax cut in 2008 was about as close to a controlled experiment of an economic theory as you can get, and the permanent income hypothesis came through with flying colors.  (The effects of the stimulus are much more difficult to test, given that the stimulus occurred simultaneously with a massive monetary policy intervention.)  Also, the sharp decline in personal consumption resulting from the large decline in personal wealth due to the fall in housing prices is just what one would have predicted based on Friedman’s permanent income hypothesis.

Now consider Friedman’s more polemical advocacy of capitalism.  The current crisis is commonly considered to be a resounding failure of capitalism requiring government correction.  But note well: The Great Depression was also widely considered a failure of capitalism, but scholarship emanating from Chicago, much of it done by Friedman, eventually largely refuted that verdict.  As Friedman notes in his joint memoir with his wife Rose, Two Lucky People (p. 41), at Chicago

teachers widely regarded the depression as largely the product of misguided policy–or at least greatly intensified by such policies. . . . During that period, the small minority of economists who did not succumb [what a choice of verbs!] to the Keynesian Revolution consisted disproportionately of Chicago-trained economists.

Friedman’s above-mentioned scholarship on monetary policy during the Depression was instrumental in overturning the conventional wisdom, and convincing most economists that perverse monetary policy and perverse banking legislation was the primary culprit for the onset of the Depression, and its persistence.  Moreover, Friedman was also an outspoken proponent of the view that government policy during the Depression, most notably the NRA and the Wagner Act, by cartelizing the product and labor markets, also undermined normal recovery.  This view has recently received considerable support from the research of Cole and Ohanian.  This goes to show that early, facile judgments that economic crises demonstrate the inevitable failures of capitalism do not necessarily stand the test of time.

It’s not sporting to pick on the dead; or put differently, the silent dead can’t resist the efforts of the living to discredit them.  I daresay that if Friedman were alive today, and in his form of the 1960s and 1970s, those who state with such assurance that the current situation is evidence of the inevitable instability of a capitalist system that requires a firm government hand to fix would have quite a fight on their hands.  And I’d put my money on Friedman.  The thought of him slicing Krugman or Stiglitz to ribbons is too delicious for words.  Alas, it is not to be.  (Not to mention the fact that Friedman had so much more class than those two.)

Friedman’s absence does not mean that the facile snap judgments are going unanswered.   There are many scholars active today that have a decidedly Friedmanesque take on the current crisis, arguing that in fact the events of 2007-2009 (and the years leading up to the explosion of the crisis) are traceable in large part to egregious government failures.  Some of these are monetary policy failures, but others relate to the perverse regulation of the supposedly unregulated banking and financial systems.  And no, I’m not talking about the repeal of Glass-Steagall, or the CFMA.

For a very clear explanation of this view, I strongly recommend this interview (by former colleague and fellow Chicago guy Russell Roberts) with Charles Calomaris.  Charles deftly destroys most of the shibboleths that dominate today’s discourse on the crisis, and makes a very persuasive case that myriad government policies were necessary conditions for the crisis.  These policies (some of the most egregious traceable directly to Barney Frank) created a perverse incentive system that made it rational for banks to do what they did.  All I can say is, listen to this and you’ll realize that the Beltway conventional wisdom is 99.99 percent unadulterated BS.  (His disquisition on Glass-Steagall is particularly choice, making it clear that people as various as Paul Volcker and Mara Liasson–whom I heard blame the financial crisis on G-S repeal last week–have no clue.  None.  Zero.  Zip.)

The Calomaris interview is long, but worth it.  If for nothing else, it is worth it to hear him tell, with considerable relish, the story of how Joe Stiglitz and Peter Orszag (now Obama’s head of OMB, who presumes to tell us the best way to reorganize the entire health care system) wrote a paper for Fannie Mae in which they confidently stated that the probability that Fannie or Freddie would ever cost the taxpayers a penny “was essentially zero.”  Calomaris says that they were right!  It didn’t cost a penny!  It cost $350 billion.

Keep that in mind the next time you hear Stiglitz bloviate on the crisis, or regulation, or the financial system, or capitalism.  Or whether the sun rises in the east.

Even though Russ Roberts is sympathetic to Calomaris’s arguments, he is a good interviewer, and challenges him repeatedly.  Another reason for listening.

As I’ve said over and over, the great lesson of the Great Depression was that people learned the wrong lessons from the Great Depression.  Milton Friedman was instrumental in helping us unlearn the wrong lessons, and grope for the truth.  There are many parallels between the thirties and the noughties, and I think that two of the most important ones are the rush to heap responsibility on the market system and the related drive to swell the power of government.  Some of the blame the market-laud the government sentiment is intellectual error; some (probably more) is an opportunistic power grab.

Those who are so anxious to dance on Milton Friedman’s grave today should remember that the easy verdicts of lazy minds about the Depression did not withstand the power of his scholarship.  They should take this as a lesson, and consider the very real possibility that their easy, lazy verdicts about the implications of the recent crisis are similarly vulnerable.

The Stratfor articles on the Kremlin clan wars do not break any new ground, but they provide a useful summary of what goes on under the Kremlin carpets.  Their main thrust is that the GRU-centered clan, which includes Gazprom and which is led by Vladislav Surkov, is attempting to enlist the “ciliviki”–the (relatively) liberal reformers including Kudrin and Gref (and perhaps Medvedev)–to undermine the FSB-centered clan which includes Rosneft and the big state corporations which is led by Igor Sechin.  Kudrin et al have an extremely strong economic case against the FSB goonocracy and its statist, centralized, resource rent-driven model.  Surkov, it appears, has no such basis for his opposition to Sechin and the FSB crowd; after all, he comes from the GRU (military intelligence), so he just represents the competing goon squad looking to maximize its share of the loot.

The advent of the Putin-Medvedev tandem led to much discussion of the stability of duumvirates.  But if Stratfor is correct–and it presents a plausible case–Russia is actually dominated by a triumvirate.  History suggests that triumvirates are truly unstable, as there is always the temptation for two to get together and gang up on the third.  Cf., Caesar, Pompey, and Crassus.  Or, better yet in the Russian context, Stalin/Bukharin, Trotsky, and Kamanev/Zinoviev, which Stalin played like a fiddle to eliminate first Trotsky and then Kamanev and Zinoviev, before turning on his erstwhile ally Bukharin.

It is hard to imagine the most hopeful outcome, which would involve the defeat of both security-service clans, and the dominance of the ciliviki.  I concur with Stratfor that eminence grise Surkov is merely looking to use Kudrin et al to strike at their common enemy–Sechin and his allies.  If that were to succeed, the ciliviki would be powerless before Surkov and his henchmen.  Lacking an independent power base, and importantly, control over any force structure, it is almost impossible to imagine a scenario in which the ciliviki can prevail over the two power clans.  They can be decisive in the battle of one power clan against the other, perhaps, but once that battle is decided they are vulnerable, alone, and defenseless.

Stratfor suggests that Putin would like to continue to balance Surkov and Sechin, and that makes perfect sense.  What makes this much more complicated is the economic and financial crisis, which Kudrin and his allies (including Medvedev, at least in words) have forcefully argued reveals the ultimate unsustainability of the statist model.  But siding with Kudrin and striking against the Rosneft-state corporation nexus would undermine the Sechin clan, and destabilize the entire edifice.

My guess is that for lack of a better option, Putin will try to maintain the status quo.  Even if he believes that Kudrin is right, and the current model dooms Russia to a dismal economic future, acting on his advice and attacking the Sechin interests would almost certainly spark chaos and conflict that could result either in a bloody stalemate, or the dominance of one security clan or the other.  Conversely, if there is some possibility that Kudrin is wrong, and the system can muddle along without economic collapse, such conflict can be avoided.  Put differently, attacking Sechin will result in destabilization and conflict with a probability near one, whereas muddling through will result in such an outcome with a smaller probability, where that probability is in large part dependent on factors outside of the control of anybody in Russia, including the world economic recovery and hence the prices of raw materials, and the willingness of foreign investors to return to Russia.

Such is the logic of the natural state.  Accepting stasis and stagnation, with the likelihood of pronounced decline, while reducing the potential for conflict, is preferable to taking actions that are economically sensible but which would upset the delicate political equilibrium that keeps violence in check.

The amendment that would have limited dealer ownership of clearinghouses to 20 percent  has been stripped from Barney Frank’s OTC derivatives bill:

In a bill passed last week by the House of Representatives’ financial services committee to reform the  over-the-counter derivatives markets, an amendment was inserted at the last minute by Massachusetts congressman Stephen Lynch that appeared to limit the stake banks could collectively own in a clearing house to 20 per cent.

. . .

Susan Milligan, special counsel at the OCC, said it was “purely anti-competitive” and would have favoured for-profit clearers compared with quasi-utility clearers like the OCC.

Steve Adamske, spokesman for the financial services committee, said on Thursday the 20 per cent limit had intended to limit dealer control of clearing houses but legal experts had decided it was invalid as it conflicted with another amendment.

The bill would, however, limit to 20 per cent the voting rights of dealers for “designated contract markets, exchanges and alternative swap execution facilities” – and not for clearing houses.

Wonderful, isn’t it, to observe the careful deliberation with which our Solons weigh decisions that affect trillions of dollars of risk exposures?  Just throw a bit of offal into the grinder–who’ll notice?  And at whose behest was this inserted?

Legislators react with high dudgeon to bankers’ cavalier attitudes towards risk and limited accountability, but they run far greater risks with other people’s money with virtually no accountability every day.  They have no room to talk.  Whatsoever.

New York University Stern School of Business professors Aarya, Engle, Figlewski, Lynch, and Subrhmanyam (AEFLS) contributed a chapter advocating centralized clearing of credit derivatives in the recent volume Restoring Financial Stability: How to Repair a Failed System edited by Acharya and Richardson. Although the authors are a distinguished lot, they utterly fail to make the case. Here are a few of the problems with their analysis:

• Their argument rests on the propositions that (a) due to the interconnectedness of the financial system and the implicit public subsidy of systemically important financial institutions, the default by a CDS transactor can impose costs on others, and (b) a clearinghouse can internalize this externality. As a matter of logic, second best considerations imply that even if these propositions are true, they do not support the claim that creation of a clearinghouse (central counterparty) for some derivatives products is efficiency enhancing. As I discuss in more detail momentarily, AEFLS’s propositions imply that such externalities are present in every transaction that systemically important institutions undertake. In such circumstances, it is well known that internalizing one of many externalities can reduce efficiency, rather than improve it.
• Indeed, second best concerns may be most acute when a CCP addresses only one narrow segment of the market—e.g., CDS—as AEFLS do.
• Even under the AEFLS proposal of mandatory clearing of some of the risks that big financial institutions undertake (i.e., the clearing of only some derivatives), the CCP will only see a sliver of the risk exposure of its member firms. Given that overall portfolio risk determines the systemic risk posed by a financial institution, a CCP will have neither the information nor the incentive to price risk (through its collateral or position limit choices) efficiently (which would require understanding and pricing all of the externalities). Indeed, raising the price of default/counterparty risk on one sliver of transactions can induce banks to substitute to other transactions that impose equal or greater external costs. [The analogy to multitasking agents is apt here. Giving high-powered incentives to such an agent on one dimension can have extremely perverse effects on the allocation of effort. ]
• That is, the AEFLS argument proves too much. Or put differently, under the AEFLS theory, every loan, every investment, every dollar of interbank borrowing, every capital structure choice by a big financial institution is beset by externalities. Their logic, in a sense, compels them to conclude that market-based allocation of capital through financial intermediaries is inefficient, and that a centralized mechanism is required to ensure that financial institutions do not take on inefficiently large risks. Everything through a clearinghouse!
• Now, there is some merit to the view that in a world of Too Big To Fail or other implicit or explicit subsidies to bank risk taking that there are (potentially large) externalities. But the foregoing means that a CCP, and especially a CCP focused on a relatively narrow range of products, is a highly defective means of addressing this externality problem. It is defective because it is incomplete, and in a world with multiple externalities, or multiple decision margins with external effects, partial and incomplete internalization does not necessarily enhance welfare.
• Instead, if externalities in financial intermediation are an important concern, it is preferable to devise policies that either (a) eliminate the common source of the externalities (i.e., eliminate the TBTF subsidies that encourage the excessive risk taking), or (b) price all risks consistently across all decision margins and all decision makers. With respect to (b), this would entail theoretically setting capital charges or risk haircuts based on the entire portfolio of systemically important institutions. I say “theoretically” because measurement issues make this impractical. What’s more, institutions themselves will almost certainly have better information about portfolio risks, and crucially, the marginal contribution of a given transaction or class of transactions, to portfolio risks than will the regulators that set the capital charges/haircuts. This gives rise to adverse selection problems in which institutions load up on risks that they know are underpriced and avoid ones that they know (based on their private information) are overpriced. Moreover, as demonstrated with the Basel requirements that made it very attractive to invest in AAA CDOs, incorrect, centrally-set, universally applicable capital charges can induce institutions to engage in highly correlated investment strategies that exacerbate systemic risk.
• [Parenthetically, some (including the EC and the US Treasury) propose applying different capital charges to OTC and cleared deals. This is mystifying. If a deal with given characteristics is executed by financial institution A, the effect of that trade on default losses (across all deals that A does) is the same, regardless of whether the deal is cleared or not. Clearing merely affects the allocation of those losses. Indeed, the clearing can exacerbate the systemic consequences of A’s default. For in a clearing structure, the members of the clearinghouse bear the effects of A’s default, whereas in an OTC structure, counterparties do. Since CCP members are likely to be systemically important institutions, clearing can actually increase the financial cost of a default by A to these other institutions. That is, if A deals with hedge funds OTC and defaults, the hedge funds lose. If A deals with hedge funds, and those deals are cleared, when A defaults the hedge funds are protected, but the CCP members incur a cost.]
• AEFLS also fail to come to grips at all with the information asymmetries and heterogeneity-induced collective action problems that CCPs must face when setting collateral levels.  I’ve beaten that horse’s corpse to a pulp, so I’ll just suggest that those interested in the argument enter “clearing” into the search bar and while away too many hours reading what pops up.
• To put it as succinctly as I can, AEFLS ignore altogether any analysis of the challenging problem of understanding how CCPs will act in practice, given the information and incentive issues that they must confront.  Instead, as is sadly too often the case in CCP advocacy, in AEFLS clearinghouses are a deus ex machina that descends on the financial stage to resolve all of the dilemmas confronting the financial markets.
• AEFLS assert that it is desirable to establish margin levels that “ensur[e] minimal, near zero counterparty risk.” They have no basis whatsoever for concluding that zero CP risk is efficient. Indeed, it is almost certainly not the case, just as it is not the case that it is efficient to ensure that flying is perfectly safe. Reducing risk is costly. The necessary task is to balance the costs and benefits of risk reduction. For instance, in a clearing setting, setting margins equal to the maximum possible loss would eliminate counterparty risk. But collateral is costly. As a result of draconian margins, transactors would forgo some trades—including some trades that could reduce systemic risk (e.g., hedging trades that transfer risk efficiently). It is imperative to avoid such simplistic “zero risk” thinking of the type that AEFLS indulge in. The real world is about trade-offs, and those trade-offs must be acknowledged and considered in evaluating public policy.
• AEFLS recognize that they have to have an explanation as to why CCPs must be mandated if they are such a great thing. They make a rather limp effort on p. 258, stating that “[l]arge players benefit from the lack of transparency in OTC markets since they see more orders and contracts than other players do.” They seem to be arguing that the lack of transparency generates higher profits for dealer firms, and this induces them to resist clearing. Indeed, they have to argue that this private benefit from opacity is so large that it exceeds the benefits that these firms could obtain through better pricing of counterparty risk, netting, etc. (Not that I agree that these benefits exist—that AEFLS do is the point.)
• I made a similar argument over a decade ago, positing that resistance to clearing could be due to a “raising rivals’ cost” strategy.
• I am far from persuaded by these arguments, however, both on theoretical and empirical grounds.
• Theoretically, well hell, big players in every industry want to maintain market advantages that allow them to reap market-power profits. That’s why GM dominates the car business today, and is enormously profitable. Just kidding.
• Taking AEFLS seriously, they posit that the existing market structure inflates the costs of those trading with dealers relative to costs that could be achieved by trading in a more transparent structure. This creates an incentive for institutions offering more transparent mechanisms to enter the market, thereby reducing trading costs for the dealers’ current customers, and inducing them to trade on the new transparent mechanism rather than the more costly dealer market. Indeed, note that exchanges with central clearing have tried to compete with dealers in CDS trading—and failed miserably even in relatively simple index products.
• One could argue (though AEFLS do not) that this could reflect the effect of network externalities which create a coordination problem; an alternative system is more efficient than the incumbent (dealer) system if it attracts enough traders to supply liquidity, but it is costly to coordinate the necessary movement of such a number of traders, leaving the inefficient incumbent in place.
• However, in other segments of the derivatives market, there are exchange traded instruments that are close substitutes for OTC products, yet the OTC market has maintained or increased market share. Eurodollar futures and interest rate swaps are one example. Ditto many FX products and equity derivatives, including equity options. For these markets, there is a closely related, highly liquid exchange traded product, but many prefer to contract in OTC markets instead. Why would market participants agree to be screwed by dealers if the dealer structure is so inefficient, and if dealers profit at their customers’ expense due to opacity and reduced competition? It is incumbent on those advocating a forced change in market structure to answer that question forthrightly and persuasively. AEFLS don’t. Nor do most of the mandate mandarins in Congress, Treasury, or the EC.
• Relatedly, note that bilateral dealings prevail in many markets where margins are extremely thin, and dealer profits are commensurately small. For instance, bilateral dealings are quite common in vanilla interest rate and FX and equity derivative trades where spreads are very small. In vanilla IR swaps, about 50 percent of interdealer trades are cleared, and since dealer-customer trades are typically not cleared, less than a majority of vanilla IR swaps are cleared. Clearing of vanilla FX swaps is non-existent, and many equity derivative trades are not cleared. Given the competition in these markets (where a large number of institutions actively bid and offer to trade vanilla swaps), the “we don’t adopt clearing to protect profits” hypothesis is quite dubious.
• That is, although low margins appear to be a necessary condition to result in a migration of products to clearing, they are not a sufficient condition. This calls into question the theory that the failure to adopt clearing is the result of the exercise of market power by self-interested dealer firms looking to preserve their profits.
• It must also be noted that neither opacity or systemic risk externalities related to TBTF are necessary to explain failures to adopt clearing.  As I noted in an FTAlphaville article over the summer, the CBOT steadfastly refused to adopt clearing for 35 years even though it operated a highly liquid, transparent, centralized exchange.  The same was true of the LME; it failed to adopt clearing until forced to do so even though it also operated a transparent auction market.  Moreover, neither the CBT members nor the LME members were TBTF institutions benefiting from implicit or explicit public subsidies.
• The experience in energy markets, in which post-2003 (and post the 2002 merchant energy meltdown) the market by its own devices migrated to clearing also demonstrates that there are not insuperable obstacles to the organic development of clearing, sans mandate.
• Thus, a serious attempt to understand why clearing has not been adopted more widely by voluntary consent must at least contemplate the possibility that bilateral dealings offer some efficiency benefit that must be traded off against alleged external costs when determining whether compulsory adoption of clearing is justified. This AEFLS—and the rest of the mandate mandarins—signally fail to do.
• Several other issues in AEFLS deserve comment.
• First, they assert, rather than prove, that the correlation in financial institution CDS spreads demonstrates the existence of a contagion effect (p. 256—the use of the “interconnectedness” concept in this context is the key). This is a hypothesis (at best), not a fact. Exposure to a common risk can do so as well. Indeed, Jean Helwege (in a recent Regulation Magazine piece) argues persuasively that the contagion effect is vastly overstated, and the common-risk exposure effect is the real explanation for the CDS spread correlation that AEFLS discuss. As I mentioned before, virtually all major financial institutions made correlated investments in AAA MBS CDOs.  When these tanked, so did the banks (and AIG).  No need to invoke contagion.  Indeed, this raises the very real possibility that more centralization and standardization can increase systemic risks.  Since clearing entails just such an increase in centralization and standardization . . .
• Second, they use the difference between the CDS spread and an equity implied spread produced by Hayne Leland based on a particular model to argue for the existence of “counterparty risks and clearing concerns.” To which I say: when given a choice between the market and a model, I choose the market every time (with all due respect to Hayne Leland). Moreover, this could just be a manifestation of the market price of risk which causes deviations between default rates implied by CDS (which are the default rates in the equivalent, pricing measure) and default rates in the true, “physical” measure.  Given the non-linearity of a CDS exposure, and its strong correlation with overall market conditions, it is very plausible that the market price of risk was large and increasing during the period of the crisis.  (A CDS on a Goldman or other big financial firm was akin to a short put on the market.  Such an instrument has a very high systematic risk exposure, which will lead to a substantial divergence between default rates in the true and pricing measures.)
• Third, they use the AIG episode repeatedly. They ignore the equilibrium implications of the alternative histories that they contemplate (unlike what I have done in It’s a Wonderful Life: AIG Edition and in a recent comment in Regulation.) And again: the plural of anecdote is not data. Moreover, one episode is insufficient to base a restructuring of an entire system based on one episode, and even if this particular episode is so egregious, it is necessary to consider alternative ways of preventing its recurrence. This AEFLS do not do.

In sum, AEFLS fail completely in making a coherent economic case for mandated clearing, especially for a subset of OTC derivatives like CDS. They ignore crucial economic considerations and blithely overlook fundamental trade-offs. If there is a case for mandated clearing, I’d love to hear it. I haven’t heard it yet—least of all from this distinguished group of NYU-Stern professors.

For months I have been extremely skeptical about the Chinese economy.  I am not alone.

In the aftermath of China’s release of its GDP numbers, indicating 3Q growth of 8.9 percent, many voices–including those from within China–are expressing doubts about the sustainability of the government’s frenzied stimulus policies. From the FT:

Most fiscal rescue packages stimulated consumption of tradable goods. China, however, has gone the other way. It has been frantically  building roads and power plants.

That approach was based on the assumption that a collapse in exports would be a blip – one that could be offset by state-sponsored splurges on fixed assets. Itsthird-quarter gross domestic product numbers showed that the strategy had been a success, on its own terms. Over the first nine months, the economy grew 7.7 per cent. Of that, investment accounted for 7.3 percentage points and consumption 4 percentage points. The decline in net exports lopped off 3.6 percentage points.

But what if that assumption was wrong? The decline in exports was slowing, yes, but shipments in September were still 15 per cent worse than they were in the month of Lehman’s demise – the 11th straight month of falls, and not much better than the 17 per cent fall in the darkest days of March. The longer they remain sluggish, the longer fixed-asset investment will have to compensate, raising the risk of growth being hit by an investment-led slump.

With unusual frankness, the statement from the National Bureau of Statistics noted that the export picture was “severe”. Otherwise, the gap between rhetoric and reality keeps widening. While regulators and sundry bank executives keep popping up to warn about the  risks piling up in financing new assets, for example, the banks keep lending. September’s total of Rmb517bn of new loans was a quarter bigger than August’s. M2, a measure of money supply, grew a record 29 per cent year-on-year. A gentle contraction from here, as policymakers seem to be indicating, would take years to bring M2 growth down to its long-run average.

A temporary fix is developing more than a whiff of permanence.

Qin Xiao, Chairman of the Chinese Merchant’s Group and the Asian Business Council is alarmed:

While consumer prices are mostly under control, asset price bubbles are growing rapidly because of huge liquidity injections by governments around the world. Globally, there does not seem to be an exit strategy in place to drain this liquidity from the system. Certainly, in China, stock and property bubbles are a concern.

While we have avoided the worst recession since the Great Depression, we are probably  heading for another asset bubble and more financial turbulence. What can we do? Compared with pouring money into the economy, draining money from the economy is a much tougher job for central banks. The dilemma is this: if we tighten monetary policy, there is a high possibility of a “second dip” next year; and if we continue the loose policy, another asset bubble might be not far away.

I do not believe a quick, steep bounce driven by fiscal fixed investment is a good thing for China. Nor is a moderate slowdown anything to be afraid of. Monetary policy must not neglect asset-price movements. Therefore, it is urgent that China shifts from a loose monetary policy stance to a neutral one.

I am also worried about the role of governments after the crisis. There are some who say that this is a crisis of the market economy. It is not; nor is it a time to turn our backs on markets. There have been failures of regulation and oversight, particularly in the west. In China we are still developing our regulatory system. It is a time to strengthen oversight, improve governance and push for freer and more efficient markets in China and abroad.

However, there is growing concern, especially in China, that the temporary stimulus programme might evolve into permanent government control of the economy. The Chinese government should continue to loosen its grip. Prices, especially of energy but including water and food, need to be freed further. The currency needs to be liberalised. Privatisation needs to move ahead. China needs freer markets, not more state control.

FTAlphaville provides some additional background:

And lo and behold — China’s third-quarter GDP  statistics have just been released, and they show an 8.9 per cent growth compared with the same period last year.

Make no mistake, however. This is a growth almost entirely driven by government policies and stimulus packages.

Fixed asset investment, China’s main measure of capital spending, jumped a massive (and probably still  questionable) 33 per cent. At the same time, however, exports are still contracting, falling 15.2 per cent in September, and 23.4 per cent in August. The trade surplus narrowed $45.5bn to $135.5bn.

China’s seems to be a Michael Jackson economy.  Its apparent vigor is the product of a regimen of drugs prescribed to mask organic weaknesses (in China’s case, a massive fiscal and monetary stimulus intended to offset the effect of a collapse in exports)–and to treat the side-effects of previous drug regimens. This putatively therapeutic approach can permit apparently normal function–and even result in seemingly superhuman performance–for some time, but the cumulative effects are ultimately destructive.  In many cases, the denouement is catastrophic–as with Michael Jackson.

China’s Enron-like GDP management seems to be attempting to buy domestic peace by engaging in vast infrastructure investments until such time as export demand picks up, thereby permitting a reversion to the previous model of export-driven growth.  Timing is everything here.  The deleterious effects of the drug regimen cumulate at an increasing rate.  Larger doses need be given in order to achieve the same effect.  The risk of a brutal popping of myriad asset price bubbles, with the consequent shock to the financial system and the real economy, grows with the duration of the fiscal and monetary imbalances.  Unless exports turn around rather quickly, the imbalances in the Chinese economy are highly likely to result in a huge bust.

To the extent that markets outside of China have been bouyed by the ripple effects of that country’s massive stimulus, such a bust would erode asset values and economic growth in said markets.  And nowhere would the effects be more pronounced than in the commodity markets–and commodity-intensive countries.  It is hard–nigh on to impossible, IMHO–to ascribe the robust performance in commodity prices (in the face of persistently high and sometimes ballooning stocks) to anything but the effects of China’s natural resource-intensive stimulus spending, commodity hoarding encouraged by cheap credit, and (arguably) Chinese government stockpiling.  A messy end to the Chinese stimulus would translate into an extremely bloody fallout in primary commodity producing nations.

And that means you, Russia.  In bailing out itself, China has almost certainly saved Russia from an absolute economic catastrophe.  Not that things are rosy in Russia, by any means, but the current situation would be immeasurably worse without China’s stimulus-fueled commodity binge supporting prices. (And it must be noted that Helicopter Ben has pitched in too. I wonder if Putin has sent him a thank you note?)

I am not predicting an inevitable collapse in China, followed by fallout elsewhere.  It is possible that the huge Chinese bet on exports recovering before the baleful effects of the stimulus regimen take hold may pay off.  But the nature of the stimulus does create a significant downside risk in the Chinese economy, and in the world economy, especially in primary resource producing nations.

In the past couple of years, I’ve often drawn the analogy between Russia and a cartel.  In a cartel, competing interests agree to cooperate, in setting prices for instance.  Cooperation maximizes the aggregate profit, but this cooperation is unstable because by defecting from the cooperative agreement, one cartel member can profit at the expense of the rest.  The fear of retaliation, and the outbreak of profit-destroying competition, is sometimes sufficient to deter such opportunistic conduct.  But there are circumstances in which the short run gains from defection can exceed the long run losses from the resulting competitive phase.  When this happens, the cartel falls apart.  This can often occur in response to shocks that make the old cooperative deal no longer optimal.

In Russia, there are competing interests–the clans.  They cooperate because conflict is costly. But that cooperation is always vulnerable to opportunistic defections; the short run gains from defection may more than offset the costs of retaliation that such defection triggers.

In some earlier posts, I hypothesized that the economic crisis could be the shock that destablizes the cooperative agreement between the clans.  Heretofore that has not happened, but several stories suggest that conflict may be imminent–or may have already begun.

Most notably, Stratfor is about to run a five part series titled “Kremlin Wars,” the subject of which is a breakdown in the uneasy truce between the major clans headed by Sechin and Surkov.  In its email announcing the series, Stratfor writes:

Strange things are happening inside Russia these days. Pro-Kremlin political parties have boycotted the parliament, our sources say lawsuits are about to be filed against some of the state’s favorite companies, and rumors are circulating high within the Kremlin that the Russian economy is destined to be liberalized.

When looked at separately, each of these currents can be rationalized, for Russia has just recently completed elections and the global financial crisis is still hammering its economy. But a deeper look reveals instability inside what is normally a consolidated, stable and politically-locked Russia. Something much bigger and more fundamental is afoot: a war among the most powerful men of the Kremlin is coming.

Stratfor buys into the cartel analogy, and the implications of the economic crisis for the stability of the inter-clan cartel:

It is the classic balance-of-power arrangement. So long as these two clans scheme against each other, Putin’s position as the ultimate power is not threatened and the state itself remains strong — and not in the hands of one power-hungry clan or another.

But having all major parts of Russia’s government and economy fall under the two clans creates a certain structural weakness, a problem exacerbated over the past few years by the effects on the Russian economy of chronic mismanagement, falling oil prices and, most recently, the global financial crisis.

Shocks–such as a financial crisis–can affect the calculus that drives the choice between cooperation and conflict.  The shock can make the old arrangement clearly inefficient, but navigating the way to negotiating a new arrangement is quite difficult.  The necessity of renegotiation presents opportunities for rent seeking, gamesmanship, and brinksmanship that can often result in conflict.  Stratfor believes this is a real possibility in Russia:

[Putin] likes the idea of fixing the Russian economy and making it work like a real economy, but it would mean throwing off the balance of power in the country — the equilibrium he has worked all these years to achieve. And should this balance be thrown off, the effects could ripple throughout every part of Russia — all levels of government, influential security institutions and even the country’s powerful state-owned companies.

When these issues came to our attention some months ago, our first thought was that they were merely the machinations of just another high-level Russian source hoping we would promote his agenda. So we sought confirmation with a number of unrelated sources — and we received it. The final convincing event in our minds was  Putin’s Sept. 29 declaration that some heavy economic reforms are indeed necessary. We cannot rule out that this could all be a disinformation campaign — those are as Russian as vodka and purges — but we cannot ignore our intelligence from such a broad array of sources, especially when it’s combined with signs of  political and  economic instability now cropping up inside Russia.

I will read the Stratfor series with interest, and look for other indications that a breakdown may be imminent.  A couple of possible harbingers.  First, Medvedev has renewed his criticism of the state corporations:

Dmitry Medvedev, Russia’s president, yesterday called for sweeping curbs on state corporations that control swathes of the economy, declaring that many should be closed.

Without naming specific companies, he told a meeting of Russian business leaders at the Kremlin that the corporations should “simply disappear” or become joint stock companies, with many of their state privileges removed. “I think that at some moment the creation of state corporations got out of control,” Mr Medvedev said.

These corporations are the domain of important siloviki.  A strike at the corporations would be a strike at them.

Second, John Helmer’s Dances With Bears reports a development which sounds like a preemptive strike by the Sechin/Rosneft interests against the Gazprom interests:

Gazprom, Russia’s leading company, has told Fairplay that reports that Deputy Prime Minister Igor Sechin agreed this week with the Turkish government to reroute the South Stream gas pipeline on to Turkish territory do not mean that Gazprom has decided to lay a land segment of the pipeline in Turkey, and bypass Bulgaria altogether (for the route until this week, see map).

Sechin, who is a well-known rival and critic of Gazprom CEO, Alexey Miller, was reported as agreeing on October 19 with Turkey’s Minister of Economics, Taner Yildiz, to reroute South Stream through Turkish territorial waters, and in exchange, to supply Russian crude oil to a new pipeline across Turkey from the Black Sea port of Samsun to the Aegean Sea port of Ceyhan. According to a Kommersant reporter granted special access to Sechin, the new scheme has been in negotiation with the Turks since Prime Minister Vladimir Putin was in Ankara on August 6. Ahead of Sechin’s arrival to meet Yildiz in Milan on Monday, Russian officials were working out a more ambitious scheme, according to the Kommersant report, which has the dramatic effect of replacing Bulgaria as Russia’s energy transit partner for both oil and gas with Turkey.

. . . .

The hint in Kommersant, however, that Sechin has moved South Stream away from Bulgaria altogether produced angry press comment in Sofia, the Bulgarian capital, where the government denies it is losing to Turkey both the gas pipeline and the Burgas-Alexandropoulos crude oil pipeline, which Moscow has been backing for more than a decade — until now. Bulgaria’s Minister of Economy, Energy and Tourism Traycho Traykov flew to Moscow for talks today.

Gazprom’s principal spokesman Sergei Kupriyanov refuses to answer questions, adding to the impression that his company’s leadership is in disarray over Sechin’s moves towards Turkey. A Gazprom source told Fairplay Russia has asked Turkey for permission, and received it, to explore the territorial waters of Turkey to find out whether the area is suitable for the pipeline. A southward deviation of the planned route under the Black Sea is being sought by Moscow in order to skirt Ukrainian territorial waters. “If it is suitable”, the Gazprom source said, “then the pipeline may be laid across the Turkish marine territory. Where it goes next – to Turkey or to Bulgaria or elsewhere – is not decided yet.”

The doubt in that last sentence is challenged by the Bulgarians, who claim they have already signed commitments with Putin to lay South Stream across Bulgarian land territory.

Still somewhat murky, but given the history between the Rosneft and Gazprom interests, it is highly plausible that this represents a glimpse of a fierce row between the two.  (Also, it provides yet another illustration of something that I discussed in a post on BP’s hapless dealings in Russia: what could BP management possibly have been thinking when they went to Sechin for help to broker a deal with Gazprom?)

It will be of great interest to see what specifics Stratfor produces to support its view that a Kremlin war is underway.  The dynamics of the duumvirate are likely to be the most visible manifestation of any tension.  Medvedev’s escalation against the state corporations–a Putin creation–could be one important indication of destabilization.  Similarly, public feuds over privatization and government support for certain businesses would be another indication of political ferment.  Perhaps ironically, efforts to promote political stability and conformity, and stamp out any means by which opposition elements could coordinate and coalesce are another indicator of political fissures; the natural reflex of the insecure is to attempt to extend and strengthen control, whereas the secure can tolerate a modicum (or more) of criticism and opposition.  The almost comical election rigging is consistent with a fear of instability and a perceived imperative to restore control; so are the moves against the last vestiges of (relatively) independent television in the country.

Churchill famously remarked about the bulldogs fighting under the carpets in Russia.  The balance of power between competing interests in a natural state like Russia is tenuous, and prone to breakdown during periods of stress.  Given the opacity of the system, growls emanating from under the carpets are often the first sign that such a breakdown is occurring.  Stratfor claims to hear them.  It bears keeping an ear cocked to determine whether it is right.