Streetwise Professor

A few stories that caught my eye:

From Edward Hugh’s Facebook group page:

Russia’s central bank lowered its main interest rates again today – by a further quarter percentage point – hard on the heels of the announcement of a record economic contraction in the second three months of the year and the growing recognition that the country now faces a painfully slow recovery.

Russia’s economy contracted at the fastest rate on record in the second quarter as rising unemployment and stagnant bank credit lead to a sharp drop in consumer demand.Gross domestic product fell 10.9 percent in the quarter from a year earlier, after a 9.8 contraction in the previous period.

The monthly GDP indicator data suggested the Russian economy continued to contract in August. However, the annual rate of decline slowed further from May’s revised record -9.9%. In August the GDP Indicator registered -3.9%, the highest reading in 2009 so far. The Indicator has now spent nine months in negative territory, a longer sequence than the previous seven-month spell from September 1998 to March 1999. The currentaverage rate of decline is also much sharper than in the previous downturn, at -6.4%.

In other words: Not out of the woods yet, by a longshot.  To put things in perspective, Russia’s best monthly reading of -3.9 percent is between the US first quarter contraction of -6.4 percent and the second quarter contraction of -1.0 percent.  In output gap terms, however, the Russian performance is even worse given Russia’s substantially higher pre-crisis growth rate. The unfavorable comparison to 1998–the supposed nadir of Russian economic fortunes, and the standard by which Putin wants to be evaluated–is particularly dreary.

Lest you think that it’s just me, note that the Russian central bank’s rate cut demonstrates quite clearly and credibly that it is concerned by the economy’s state.  Very concerned.

Also keep in mind that Russia’s performance looks especially bad given that (a) oil prices are more than double their lows of the first quarter, and (b) other emerging markets to which Russia is often compared are doing far better.  China is growing at 8 percent–although as I’ve written repeatedly, I consider that to be 9 parts mirage, 1 part reality.  India is growing at about 6 percent.  Brazil is contracting at about a 1 percent rate and may eke out 1 percent growth for 2009.

Another story that piqued my interest is the latest episode in the Russia-Turkmenistan soap opera.  In brief: despite much happy talk, and a Medvedev visit to Turkmenistan, the gas standoff between the two countries is nowhere close to being resolved:

“Most technical issues, related to the usage of pipelines, have been solved… In the next weeks, Gazprom will contact Turkmen authorities to agree on the parameters to continue cooperation,” said Prikhodko.

When asked whether the date of supply resumption has been discussed, he said : “No such task has been set (ahead of talks)”.

. . . .

“As far as the liquidation of this accident is concerned, I would like to say that (Turkmen state firm) Turkmengas will take a time out with its contacts with Gazprom,” Berdymukhamedov told Medvedev on Sunday.

Pipeline blasts are regular on former Soviet Union territory due to the equipment’s age, but it rarely takes more than a week to restore flows.

“I don’t think we have outstanding questions… I think it is obvious that pricing will be done under a formula,” Berdymukhamedov said.

On Saturday, Medvedev and Berdymukhamedov spent a day in a Kazakh Caspian Sea resort of Temberli and on Sunday attended a truck rally in the Turkmen desert.

In spite of the failure to agree on gas flow resumption, both Medvedev and Berdymukhamedov hugged before and after the talks, with the Russian leader talking up bilateral ties.

“Our trade and economic relations are not just good, but very good,” said Medvedev.

Tell me another one, Dmitri.

Through all the diplospeak smog, it is pretty clear that there has been virtually no progress at resolving a standoff that is going into its 6th month.  This is not a technical issue, but an economic one.  Every day that the gas doesn’t flow provides further evidence, as if any was needed, that the explosion was a deliberate economic act by Gazprom to avoid paying for gas that it couldn’t sell in the teeth of the economic slowdown at the prices it had agreed to.

The next story is a priceless tale of the brazeness of corruption in Russia:

Russian prosecutors opened a criminal investigation into the possible embezzlement of funds earmarked for the restoration of Moscow’s  Bolshoi Theater, founded in 1776.

Auditors uncovered violations in a probe of the  Office for Construction, Redevelopment and Restoration, the federal agency that’s in charge of the Bolshoi project, the Investigative Committee of the Russian Prosecutor General’s Office said on its  Web site today.

In August 2003, the agency signed a contract with  ZAO Kurortproekt to design the second phase of the Bolshoi renovation for 98 million rubles ($3.2 million), investigators said. Under an addendum to the contract, Kurortproekt’s fee rose to 164 million rubles.

“From 2003 to 2009, however, the agency paid Kurortproekt three times for the same design work and documents,” investigators said. The agency paid a total of about 957 million rubles, including 581 million rubles for drawing up documents, investigators said.

When something this blatant can occur in one of the most high-visibility projects in the heart of the nation’s capital, just think what transpires in the country’s darker corners.

The last story is an update on the ongoing Telenor saga:

Telenor ASA’s appeal of a $121 million fine in Russia was rejected by a Moscow court, Telenor spokeswoman Anna Ivanova-Galitsina said by text message today.

The fine was imposed on Telenor for not voluntarily paying $1.7 billion in damages to OAO VimpelCom after a lawsuit brought by a minority shareholder, which Telenor is also contesting.

In other words, Telenor is going to get squeezed every which way until it cries uncle.  No relief while the wheels of “justice” turn in Russia.

On the anniversary of the Lehman collapse, Obama gave a speech on reforming the financial system.  Color me underwhelmed.

One solid idea is to create an enhanced resolution authority that would permit the rapid containment of big, systemically important banks.  I think Obama oversells the idea by saying that it eliminates the “too big to fail problem.”  Indeed, this portion of his speech is maddeningly short of detail.  He says the resolution authority he proposes will differ from the existing FDIC approach, but doesn’t say just how.  He said that “So our plan would put the cost of a firm’s failures on those who own its stock and loaned it money.”  Well, in the crisis, the shareholders of Lehman, AIG, WaMu, etc., were wiped out, and for a time, the shareholders of Citi and BofA and other big banks were nearly so.  Lehman bondholders also lost a great deal, but those of other big institutions that did (unlike Lehman) receive government support were spared for the most part.  Therefore, Obama has to be proposing that those who bought bank debt would suffer losses before any government support would be offered.  That would be desirable, but without more detail I don’t know whether this promise is credible.  After all, during the bailouts, Treasury and the Fed could have crammed down bondholders, but explicitly decided not to do so in many instances because it feared the knock-on effects of bondholder losses (e.g., the effects on money market funds, which could have resulted in runs).  So, is the resolution authority Obama speaks of really credible?

Obama also throws some red meat when he says “And if taxpayers ever have to step in again to prevent a second Great Depression, the financial industry will have to pay the taxpayer back — every cent.”

This is at best meaningless, and arguably actually dangerous for it still means that risk is socialized.  “The Industry” doesn’t make risk-taking decisions.  Individual firms and their managers do.  Sharing the risk among industry market participants still creates a moral hazard.  Although this seemingly tough language has gulled the predictably gullible, it will in fact hardly encourage risk taking discipline.  (“[E]very bank, every banker, every hedge fund manager — . . . a mini-regulator, the eyes and ears of the systemic-risk regulator”?  Get real.)  Why should any individual firm incur an effort/cost to monitor the activities of other financial firms except insofar as it can profit from that information?  Free rider problems are rife here.  Given such free rider problems, no firm has an incentive to be its brother’s keeper.

The top concrete proposal in the speech–a Consumer Financial Protection Agency–doesn’t strike me as addressing a first order problem.

Obama emphasizes increasing capital requirements on banks to control risk taking.  This is the Conventional Wisdom approach to preventing the next crisis.  Unfortunately, it is based on a misdiagnosis of the last crisis, and could in fact have the effect of creating the same dynamic that got us in the current situation.

The 90s and 00s were actually a period in which there was considerable effort devoted to crafting an elaborate set of capital requirements–the Basel I and Basel II rules.  Sadly, these very rules were a major contributor to the financial crisis, as the specific rules, notably the risk weights applied to investments in “AAA” securities encouraged large depository institutions to keep massive amounts of mortgage backed debt (in the form of asset backed securities, CDOs, and the like) on their books, rather than to distribute these securities to non-depository investors.  When the mortgage/real estate bubble burst, in stark contrast to the bursting of the internet bubble in 2000, systemically important financial institutions took huge losses that destabilized the entire financial system.

Moral of the story.  Just saying that you will have higher capital requirements is not enough.  The details really matter.  Actions that were considered the epitome of prudence pre-2007/2008 turned out to be anything but.  Indeed, (a) faulty capital requirements can provide a false sense of security, and (b) higher capital requirements can intensify the efforts to engineer efforts to circumvent them.

Obama sells his plan by saying “[a]nd taken together, we’re proposing the most ambitious overhaul of the financial regulatory system since the Great Depression.”  As I’ve said many times before, the greatest lesson of the Great Depression is that people learned the wrong lessons from the Great Depression.  In particular, most of the regulatory structures put in place in the 1930s were based on a misdiagnosis of the actual causes of the Great Depression.  Methinks that history is about to repeat itself.

Russia, and Oleg Deripaska’s RusAl, is getting a taste of its own medicine of expropriation.  The government of the African country of Guinea voided the sale to RusAl of a large alumina smelter there.  And Russia is none too happy about it:

“Guinean authorities have made an attempt to expropriate UC RUSAL’s property in court,” the Russian Foreign Ministry said in a strongly worded statement.

The ministry said it hoped Guinea would take responsibility for the “possible consequences of such actions for the general climate of traditionally constructive Russian-Guinean relations, as well as for the social-economic situation in the country.”

Given the cast of characters involved in this on all sides, it’s hard to tell whom to believe.  It could well be that Guinea is treating Russians like, well, the Russians are wont to treat folks whose assets they covet.  It could be that Deripaska cut a corrupt deal with Guinea’s late ruler.  Maybe both.  Who knows?

Regardless of culpability, however, the Russian foreign ministry’s umbrage is beyond rich.  Hypocrisy is seldom found in such pure, unadulterated form.

In other Deripaska-related news, contrary to some reporting and my conjecture that GM’s extreme reluctance to partner up with Deripaska would scupper the Magna-Sberbank/Gaz deal for Opel, the American (taxpayer) auto company has opted to sell to the Canadian-Russian bidder.  Apparently German government money was too good to pass up.  I’ve also read that details of the deal haven’t been released, but that the sale contract runs 1000+ pages, and took some very hard bargaining to complete.  Perhaps GM was able to negotiate enough contractual safeguards to feel immune from Deripaska depredations.  We’ll see.

One of the more interesting–and disturbing–things about the deal is the lengths to which Germany and Merkel were willing to go to ensure that a big piece of Opel went to a Russian buyer. According to the WSJ, Merkel deliberately chose Russia over the US:

If completed, it would represent the biggest Russian investment in Western European manufacturing industry to date, adding a significant economic tie with Russia that until now has been largely based on banking and energy transfers.

“It would mark a milestone in Germany’s de facto disengagement from the U.S. and its strategic shift eastwards,” said Douglas Busvine, an analyst at policy research firm Medley Global Advisors.

And Merkel’s “fellow” Europeans are not too happy either:

The deal to sell General Motors’ European business to a Canadian-Russian consortium raised sparks around Europe yesterday.

Belgium accused Berlin of reverting to protectionism, and the deal was criticised by opponents of Angela Merkel, the German chancellor, and by officials in the UK and Spain.

Didier Reynders, Belgium’s finance minister, said he wanted the European Commission to investigate state aid given by Germany to Magna International, the lead investor.

. . . .

Elena Salgado, Spain’s economy minister and deputy prime minister, said any plan for Opel must recognise that its plant in Zaragoza was GM’s most productive in Europe. Magna plans to shift some production to Eisenach, Germany. Talks are due to be held in Berlin next week on how the government aid needed to finance the spin-off will be shared among the countries where Opel and Vauxhall have plants.

There’s also this suggestion that it may not be over after all:

In Germany, Guido Westerwelle, head of the opposition Liberal party, said Ms Merkel’s government had struck a deal designed to help it in the September 27 federal elections.

“If you ask for the small print, nothing has been fixed yet,” he said. “I dread that after the elections there will be hell to pay.”

Maybe.  Maybe not.  But even if Westerwelle is right, there still remains the question of why Merkel was so intent to save a few thousand jobs and please Putin, even at the cost of alienating a major ally and her alleged European “partners.”  If Deripaska and Russia are experiencing bad Karma (cue Warren Zevon) in Guinea, Angela Merkel should worry indeed about a Karmic rebound from snubbing longtime friends and allies to favor the ruthless and trustworthy lot to her east.

I am in Hong Kong for the next couple of days.  (By the way, what day is it anyways?)  Consequently, posting will most likely be erratic, and certainly phase shifted by about 12 hours.  Day shall become night and night shall become day, at least insofar as the SWP schedule is concerned.

I am in HK speaking about central counterparties/clearing at the SWIFT SIBOS 2009 event.  In my few hours here, the city has impressed me.  The view from my hotel over the harbor is quite amazing.  The SIBOS event promises to be fascinating.

And . . . who will submit comment #3000?  Currently at 2991 and counting.  A free SWP t-shirt (yes, there is such a thing) to the submitter of #3000 (if you are brave enough to reveal name and address, LOL).  Domestic shipping only;-)

I don’t watch much TV, and medical shows have always been near the bottom of my list of things to watch.  But one show that I find entertaining from time to time is House.  It’s about a quirky (and now, apparently, actually delusional) physician who, along with a team of young doctors whom he abuses continually, diagnoses strange afflictions.  In the couple of episodes I’ve watched, House and his team make several incorrect conjectures, before fixing on the correct diagnosis, thereby saving the patient du jour from a terrible fate.

Dmitri Medvedev is apparently auditioning for the Russian version of the show, and has delivered a devastating diagnosis–complete with medical metaphors–on the state of the Russian economy, and Russian society.  Indeed, it is so damning that if I, for instance, were to make it (and I have) I would be assailed with howls accusing me of the basest Russophobia.  Don’t believe me?  Read it for yourself, right here on the official Kremlin website:

The global economic crisis has shown that our affairs are far from being in the best state. Twenty years of tumultuous change has not spared our country from its humiliating dependence on raw materials. Our current economy still reflects the major flaw of the Soviet system: it largely ignores individual needs. With a few exceptions domestic business does not invent nor create the necessary things and technology that people need. We sell things that we have not produced, raw materials or imported goods. Finished products produced in Russia are largely plagued by their extremely low competitiveness.

This is why production declined such much, more than in other economies, during the current crisis. This also explains excessive stock market volatility. All this proves that we did not do all we should have done in previous years. And far from all things were done correctly.

The energy efficiency and productivity of most of our businesses remains shamefully low, but that is not the worst part. The trouble is that it seems that owners, directors, chief engineers and officials are not very worried about this.

As a result Russia’s influence in global economic processes is, quite frankly, not as great as we would like. Of course, in the era of globalisation the influence of any country cannot be unlimited. That would even be harmful. But our country must have substantial opportunities, as befits Russia’s historic role.

As a whole democratic institutions have been established and stabilised, but their quality remains far from ideal. Civil society is weak, the levels of self-organisation and self-government are low.

Every year there are fewer and fewer Russians. Alcoholism, smoking, traffic accidents, the lack of availability of many medical technologies, and environmental problems take millions of lives. And the emerging rise in births has not compensated for our declining population.

We managed to gather the country together to stop centrifugal tendencies. But many problems still remain, including the most acute ones. Terrorist attacks on Russia are continuing. Residents of the republics in the North Caucasus simply do not know peace. Military and law enforcement personnel are dying, as are government and municipal employees, and civilians. Of course these crimes are committed with the support of international criminal groups. But let’s face up to it, the situation would not be so critical if the socio-economic development of southern Russia were more viable.

To sum up, an inefficient economy, semi-Soviet social sphere, fragile democracy, negative demographic trends, and unstable Caucasus represent very big problems, even for a country such as Russia.

Of course we do not need to exaggerate. Much is being done, Russia is working. It is not a half-paralyzed, half-functioning country as it was ten years ago. All social systems are operating. But this is still not enough. After all, such systems only propagate the current model, and do not develop it. They cannot change current ways of life and therefore bad habits remain.

Achieving leadership by relying on oil and gas markets is impossible. We must understand and appreciate the complexity of our problems. We must frankly discuss them in order to act. In the end, commodity exchanges must not determine Russia’s fate; our own ideas about ourselves, our history and future must do so. Our intellect, honest self-assessment, strength, dignity and enterprise must be the decisive factors.

My starting point while setting out five priorities for technological development, offering specific measures for the modernisation of the political system, as well as measures to strengthen the judiciary and fight corruption, is my views on Russia’s future. And for the sake of our future it is necessary to liberate our country from persistent social ills that inhibit its creative energy and restrict our common progress. These ills include:

1. Centuries of economic backwardness and the habit of relying on the export of raw materials, actually exchanging them for finished products. Peter the Great, the last tsars and the Bolsheviks all created – and not unsuccessfully — elements of an innovative system. But the price of their successes was too high. As a rule, it was done by making extreme efforts, by using all the levers of a totalitarian state machine.

2. Centuries of corruption have debilitated Russia from time immemorial. Until today this corrosion has been due to the excessive government presence in many significant aspects of economic and other social activities. But it is not limited to governmental excess — business is also not without fault. Many entrepreneurs are not worried about finding talented inventors, introducing unique technologies, creating and marketing new products, but rather with bribing officials for the sake of ‘controlling the flows’ of property redistribution.

3. Paternalistic attitudes are widespread in our society, such as the conviction that all problems should be resolved by the government. Or by someone else, but never by the person who is actually there. The desire to make a career from scratch, to achieve personal success step by step is not one of our national habits. This is reflected in a lack of initiative, lack of new ideas, outstanding unresolved issues, the poor quality of public debate, including criticism. Public acceptance and support is usually expressed in silence. Objections are very often emotional, scathing, but superficial and irresponsible. Well, this is not the first century that Russia has had to confront these phenomena.

Other than that, things are just great!!!  And feel free to point out how what I’ve been saying for the last 3 years has differed all that much from what Medvedev is saying today.

Where Medvedev and House part ways, however, is in the cure to the properly diagnosed disease.  House being fictional, he always can come up with the life saving treatment right before the last commercial break.  Medvedev, in contrast, having to deal with reality, can do no more than prescribe a placebo:

I recently identified five strategic vectors for the economic modernisation of our country. First, we will become a leading country measured by the efficiency of production, transportation and   use of energy. We will develop new fuels for use on domestic and international markets. Secondly, we need to maintain and raise our nuclear technology to a qualitatively new level. Third, Russia’s experts will improve information technology and strongly influence the development of global public data networks, using supercomputers and other necessary equipment. Fourth, we will develop our own ground and space infrastructure for transferring all types of information; our satellites will thus be able to observe the whole world, help our citizens and people of all countries to communicate, travel, engage in research, agricultural and industrial production. Fifth, Russia will take a leading position in the production of certain types of medical equipment, sophisticated diagnostic tools, medicines for the treatment of viral, cardiovascular, and neurological diseases and cancer.

. . . .

These goals are realistic. The targets we have set for achieving them are difficult but attainable. We have already developed detailed, step-by-step plans to move forward in these areas. We will encourage and promote scientific and technological creativity.

The chasm between the description of the disease–or more properly, diseases–and the proposed treatment is vast.  And indeed, diagnosis and treatment seem diametrically opposed.  Symptom one of the Russian disease, according to Medvedev, is “economic backwardness and the habit of relying on the export of raw materials.”  But what is treatment one?   Hair of the dog: “First, we will become a leading country measured by the efficiency of production, transportation and   use of energy.”

Now I realize there are some differences here; for instance, Medvedev bewails Russia’s wasteful use of energy, and proposes to fix that.  But still, it seems rather difficult to overcome a crippling dependence on raw material extraction–notably energy extraction–by focusing on energy production and transportation.

The other proposals are fantasy absent some complete revolution in the way Russia works.  Dirigiste, corrupt, “vertical” economic systems with poor protection of property rights–including intellectual property rights–are not going to become leaders in marketable technology.  And for a country with as appalling a health system as Russia’s to become a leader “in the production of certain types of medical equipment, sophisticated diagnostic tools, medicines for the treatment of viral, cardiovascular, and neurological diseases and cancer” is, well, beyond fantasy.  When it comes to healthcare, I suggest that Medvedev should make more down-to-earth goals, like running water in all hospitals and access to basic treatments.

This season’s Medvedev may share something else with this season’s House–delusions.  What other explanation could there be for this?:

Russia’s political system will also be extremely open, flexible and internally complex. It will be adequate for a dynamic, active, transparent and multi-dimensional social structure. It will correspond to the political culture of free, secure, critical thinking, self-confident people. As in most democratic states, the leaders of the political struggle will be the parliamentary parties, which will periodically replace each other in power. The parties and the coalitions they make will choose the federal and regional executive authorities (and not vice versa). They will be responsible for nominating candidates for the post of president, regional governors and local authorities. They will have a long experience of civilized political competition: responsible and meaningful interaction with voters, inter-party cooperation and the search for compromises to resolve acute social problems. They will bring together in one political entity every element of society, citizens of all nationalities, the most diverse groups of people and territories of Russia endowed with ample powers.

The political system will be renewed and improved via the free competition of open political associations. There will be a cross-party consensus on strategic foreign policy issues, social stability, national security, the foundations of the constitutional order, the protection of the nation’s sovereignty, the rights and freedoms of citizens, the protection of property rights, the rejection of extremism, support for civil society, all forms of self-organisation and self-government. A similar consensus exists in all modern democracies.

This year we started moving towards the creation of such a political system. Political parties were given additional opportunities to choose those occupying leadership positions in the federal regions and municipalities. We relaxed the formal requirements for the creation of new parties. We simplified the conditions in place for the nomination of candidates for election to the State Duma. We passed legislation guaranteeing equal access to public media for parliamentary parties. A number of other measures were adopted as well.

Another yawning chasm between word and deed/fact. No need to belabor this point.

Indeed, the vast difference between what Medvedev says, and the facts on the ground and the government’s actual policies is the source of much skepticism, not to say cynicism.  For instance, in a post titled “Medvedev’s call for Reform Rings Hollow” James at Robert Amsterdam writes:

There is a reasonable argument that it is better to have this kind of empty dialogue rather than no dialogue at all, but when the former Chairman of Gazprom is the one voice to complain about the excess influence of the state in the business sector, then we know we have a problem taking it seriously.

Other observers have taken it a bit further.   My thanks to a commenter, who points us to this acerbic reaction to the Medvedev article by  Aleksander Ryklin:

“My first reaction when I read the piece was a desire to copy it and rework it a bit. For example, maybe put it on a pink background and decorate it with flowers here and there. To mark out particular paragraphs with lipstick kisses and others with smiley faces.”

Ouch.

The Ryklin article is brutal:

After all, no grown-up, self-respecting person should appear so pathetic. They shouldn’t so openly and publicly display their own helplessness.

On the other hand, people shouldn’t so brazenly and with such open, unconcealed cynicism demonstrate their complete contempt and spite for the intellectual abilities of the population temporarily under their power. He isn’t taking just me for an idiot, but everyone in the country. So I also felt discomfort on behalf of the country.

Playing For Laughs

As soon as I read it, I was asking myself: What is this? A cry of the soul? A suicide note? A letter to Vladimir Putin? To his wife? To posterity? To historians? No, no, my friends. This letter is addressed first and foremost to idiots. But you and I are not idiots. At least, not all of us.

. . . .

To be honest, I’m not very sorry for Medvedev. Because I don’t believe for a second that he is sincere. He wants to “cooperate”? Then he can start by firing Putin, by dissolving the Duma, and then we’ll see. He can’t, you say? Then what is he pretending for? So that maybe someday something will happen? It would have been better to stick his letter into a time capsule and bury it under the biggest Kremlin tower than to humiliate himself like this in front of all honest people.

I don’t know whether it’s pathetic, or cynical, or what, but the complete disconnect between the gravity of the diagnosis, and the lack of serious effort to treat the diseases doesn’t bode well for the future.

Indeed, after finishing reading Medvedev’s long piece carefully, what comes to mind is not the typical TV doc-drama ending with the patient saved in the nick of time, but the punchline to an off-color joke about a guy who gets bit in an unmentionable place by a poisonous snake: “You’re gonna die.”

Last week I hypothesized that the real reason GM was balking at the Magna deal for Opel was that it wanted nothing to do with Oleg Deripaska and Gaz, widely considered to be the ultimate buyer of the stake originally slated to go to Sberbank.   And right on cue, what should I read in today’s news?:

Russian billionaire Oleg Deripaska’s carmaker GAZ (GAZA.RTS), the Russian industrial partner in a Magna-led bid for Germany’s Opel, is not interested in an equity stake in Opel, Deripaska told Vedomosti newspaper.

As Gomer Pyle would say: Surprise, surprise, surprise.

Seeing, however, that this involves Deripaska and his moving lips, it’s hardly a credible commitment that GM can rely upon.   It is more likely a sweet nothing intended to overcome resistance to the German-sponsored sale to Magna and Sberbank.

I would strongly recommend that even as minority shareholder in any deal that GM (i.e., US taxpayers) signs to sell Opel should give the company a veto over the sale of any large stake.   Otherwise, the likely outcome if the deal goes through, and Sberbank gets a big piece, is for Deripaska to say: “What was I thinking? Of course I want an equity   stake.”   Or: “That was my good twin who said that.   He’s been dealt with.   Of course I want in.”

GM should hang tough and refuse any deal involving Gaz, or other dodgy companies.   It should prevent falling victim to the Lucy-and-the-football scam by insisting that it have veto over any transfer of a material portion of Opel by any of the original equity investors.

It would be interesting indeed to see how German interest, and Sberbank’s, would change in response to GM’s insistence on such a term.   I imagine that the interest of both would cool pretty fast.   But if I were GM, I would put my faith in a veto, and pay no attention to anything Oleg Deripaska says.

Spiegel has released a long article chronicling the Opel saga.  In brief, the story appears to be that GM originally agreed to the Magna-Sberbank/Avtogaz deal out of desperation, but as its existential crisis eased due to the infusion of massive amounts of US taxpayer support, relief from debts resulting from the lightening bankruptcy, and latterly cash-for-clunkers, GM decided that it wasn’t in any hurry to sell Opel.  And in particular, it wasn’t in any hurry to sell it to Magna-Gaz.

This shouldn’t be a big surprise.  Magna isn’t in great financial shape itself (what autoparts manufacturer is?).  There is also reason to be concerned about IP.  Also, the competing offer from RHJ gives GM a stronger opportunity to buy back Opel.

But I think that the main reason is that GM doesn’t want to be a minority partner in a business with Gaz–and hence with Oleg Deripaska.  Being a minority shareholder in a deal involving a company like Gaz, and a character like Deripaska, is often quite unpleasant.  Deripaska and Gaz are in very bad financial shape, and would have every incentive to try to exploit Opel through myriad means (including transfer pricing and capital expenditures) that would divert funds and resources from Opel into Gaz in order to prop up their tottering operations.  GM would know that the Russian government would throw its weight around in Gaz’s support.  What’s more, with Germany being so subservient to Russia, and providing a good deal of financial support to this deal (but no other), GM (and hence us, fellow American taxpayers) would face the prospect of having the Germans put pressure on GM to favor the Russian partner.  Now Gaz would not have a majority stake, but the Russians are past master at playing divide and conquer, and could exploit and foment divisions between GM and Magna in order to favor Gaz.  With the Russian, and likely German, governments on its side, it could make GM’s life miserable.

GM’s original embrace of the deal is understandable, given its straits at the time it agreed to it.  Similarly, its current reluctance to proceed is understandable, given the unsavory nature of its partner and the passing of its existential crisis.

What is hard to understand is Merkel’s (and Germany’s) intense interest in this deal, as opposed to an alternative like the RHJ offer.  The Magna-Gaz deal and RHJ deal would have about the same impact on jobs in Europe overall (about 10K), but the Magna-Gaz plan would cut fewer jobs in Germany.  (So much for “Europe”–it still usually comes down to national interests.)  But I doubt that the difference of a couple of thousand of German jobs fully explains the German dedication to the Magna-Gaz offer.

Instead, the singleminded way in which Merkel and Steinmeier are pushing for GM to accede to the Russian-Canadian offer seems to be further evidence of their thralldom to Russia, and Russian business interests.  Why Germany should be in thrall to Russia in this rather embarrassingly public way is a puzzle.

Germany has had economic problems, to be sure (who hasn’t?), but its economic fundamentals are far stronger than anything Russia can achieve of ever dreaming.  Why does it seem so intent to tie itself to a shambolic Russian economy, decrepit and corrupt Russian companies, crooked and thuggish Russian oligarchs, and an authoritarian Russian government?  What does it get in return?  Can it really be gas?  If so, does it believe that all this groveling will really make a difference when Putin (or whoever succeeds him) finds it profitable to turn the screws some day hence?

It is really demeaning and unseemly.  Rational calculation seems incapable of explaining this at-the-feet display; some psychological phenomenon seems at work here.  I’m an economist, so I’ll leave the diagnosis to professionals.

In the meantime, I hope GM hangs tough–and leaves Gaz, Deripaska–and Merkel–twisting in the wind.

The joint CFTC-SEC meeting about how the two agencies can play better together has spurred numerous suggestions that the agencies merge, or better yet, that the government create an uber-regulator responsible for all aspects of regulation of financial markets and financial firms.

I’ve written before that this is a very bad idea, and in light of the return of attention to this issue, thought it worthwhile to explain again why I think that’s so.  I’ll also lay out an alternative regulatory scheme that I think makes sense than either the existing system, or the uber-regulator alternative.

The argument against a regulator with myriad responsibilities for myriad firms rests in economic theory, notably agency theory.  Avinash Dixit has laid out the argument in a nice book that is somewhat accessible to a non-professional audience, so I’ll just hit the high points.

The idea here is that a regulator is an agent.  Who is the principal?  Well, Congress is the primary principal.  Thus, fundamental mechanism design issues that arise in the context of agency theory as typically applied to a firm (principal) trying to motivate and control its employees (agents) apply to the Congress-regulator relationship too.

Dixit notes that Congress designs regulators.  Moreover, Congress, both through the statutes it passes establishing and governing the regulators, and through the oversight process, provides regulators with incentives.  In particular, Congress can subject a regulator to very strong, “high powered” incentives, or very weak “low powered” incentives.  Agency theory tells us that the power of the incentives will depend on the nature of the organization/regulator.

Specifically, agency theory implies that low powered incentives are generally desirable when an agent has to perform multiple tasks.  The more tasks, typically, the weaker the incentives.  If you provide really high powered incentives, unless it is possible to measure everything the agent does with high and roughly equal precision, the agent will have an incentive to game the incentive system and do the things that provide very high rewards, and neglect the tasks that don’t.  As an example, let’s say you let cops keep a portion of the stolen goods or drugs that they seize.  You can bet that the cops would spend all their time looking for thieves and drug dealers, and have very little incentive to solve murders or intervene in domestic disputes: where’s the money in that?  Moreover, it’s hard to measure the effort or effectiveness or benefit of murder solving or separating Mr. and Mrs. Smith, so it’s hard to design an incentive to reward what you can’t measure.  So, when that 911 call comes from the Smith residence, don’t expect much of a response: the cops will be out looking for the dealers.

The resulting allocation of effort can be very perverse.  To give an incentive for the agents to do things that are hard to measure, you have to provide low powered incentives.  You can’t reward drug seizures, because that would induce the cops to spend all their time looking for drugs, and little time policing other kinds of (less remunerative to them) crimes.  Thus, low powered incentives are necessary to induce an optimal allocation of effort across tasks.

The more alternative things that the agent can do–the more tasks he performs–the more possibility for gaming high-powered incentive systems, and typically the weaker the incentives have to be.  Therefore, it is typically optimal to subject an agent that is  responsible for many tasks with lower powered incentives.

If the agent has many principals, the problem gets even worse.  Each principal has an incentive to get the agent to do what that principal wants, at the expense of the other principals.  So, it may be optimal to subject an agent working on a single task to weak incentives (fixed salary, no bonus, 9-5 hours) if he works for many principals.

Put these problems together, and you usually have to impose extremely weak incentives in order to reduce opportunistic gaming of the incentive system.  A multi-tasking agent working for many principals should typically be subject to very weak incentives.  And having very weak incentives, he is unlikely to work either hard or smart.  That may seem bad, but it’s less bad than having the agent work hard and smart to game a high-powered incentive system.

This means that a big, uber-regulator responsible for regulating everything in the financial space would be a disaster if Congress subjected it to strong incentives.  The uber-regulator would have many, many tasks to perform: oversight over security issuance, disclosure, bank capital and risk taking, derivatives trading practices, and on and on.  Moreover, it would have many principals.  It might seem there is only one–Congress–but Congress is not a unitary body.  It has numerous committees, many of which would have a piece of the responsibility for overseeing the agency.  Moreover, on a given committee, there are multiple Congressmen, each of whom is responsive to distinct interests unique to his district or state.

So, Congress would likely respond to this by providing the regulator with very weak incentives.

Thus, the alternative outcomes with an uber-regulator: an out of control body gaming high powered incentives, or a slothful, inefficient organization subject to weak incentives.  The likely outcome would be the latter, a living illustration of Eugene McCarthy’s statement that “the only thing that saves us from bureaucracy is its inefficiency.”

So what do I propose instead?  A more functional division of regulatory responsibilities, and one that mitigates the multi-tasking/multi-principal problems.  In a nutshell:

• Split off the primary market, accounting, and disclosure parts of the SEC into a separate organization.  Call it the “Securities Commission” or the “Corporate Financial Information Commission.”  This agency would police fraud in the issuance of securities, and fraudulent disclosures and accounting practices.
• Combine the market operation parts of the SEC and the CFTC into a Trading and Markets Commission.  This body would have responsibility for overseeing the operation of exchange and OTC trading mechanisms.  It would essentially be a “microstructure” regulator responsible for secondary market structure issues in securities and derivatives, manipulation and fraud in securities and derivatives trading, and the policing of agents who execute transactions for principals (e.g., stock brokers).  Under this system, there wouldn’t be the turf battles over the regulation of different kinds of financial products, or attempts to design products in order to have their trading overseen by one regulator or the other.  All trading would be under one regulator.  These trading-related matters are largely distinct from the information/disclosure related issues, and there is no good reason to combine all under one regulator.
• Create a prudential regulator with the responsibility of regulating the risks of financial institutions.  This regulator would cover major financial intermediaries, regardless of corporate form, that potentially pose a systemic risk.  Thus, banks, investment banks, large insurance companies, and other levered institutions whose failure would pose a risk to the financial system would be subject to this prudential regulator

This division of authority along more functional lines would mitigate the multi-tasking and multi-principal problems that an uber-regulator would pose.  Of course, there would still be multiple principal and multiple task problems under this allocation of responsibilities, but the organizations would be more focused, and could be provided with stronger incentives to do their jobs than would be the case under a single, overarching regulator.

Is this likely to happen?  Surely not.  But hopefully people will start to awake to the fact that the seeming elegance and simplicity of one-stop regulatory shopping is actually a recipe for the next crisis.  Think that regulators failed last time?  Just wait until you have only one, and you’ll see a real failure.  Just like businesses are subject to diseconomies of scale and scope, regulators are too.  Sure, securities issuance and securities trading are related.  So are steel manufacture and automobile manufacture.  But it proved very inefficient to combine steel and car production in a single firm, and in my view it is very inefficient to combine all of the many aspects of financial market regulation in a single agency or commission.

I’m sure that no one would be surprised that CFTC Commissioner Bart Chilton was not pleased by my recent post that lambasted his equation of the activities of ETFs with manipulation.  Well, the sarcasm was arguably overdone (that NEVER happens, I’m sure you’re saying), but I stand foursquare by the substance.

Well, now Commissioner Chilton penned an editorial in the Des Moines Register that lays out his argument for the need to restrict speculation.  It is a very weak argument indeed, and it would be a tragedy if anything like it is the basis for major changes in the regulation of derivatives markets.

He starts with a wild mischaracterization of history:

For a hundred years, farmers in Iowa and around the nation have been able to hedge their business risks in the futures markets. The entire endeavor has worked well for farmers, futures exchanges and our economy. In the last few years, however, things have changed. New “non-traditional” speculators, such as hedge funds, index funds, pension funds and endowments, have all entered the futures markets, bringing with them massive new liquidity but also some very real concerns. Unlike commercial speculators – for example, farmers, processors and refiners who actually do business in the underlying commodity, be it corn or beans, natural gas or crude oil – the new speculators have no such similar interests. The new speculators are only interested in one thing: increasing long-term profits in their investment portfolios. Therefore, their trading strategy differs significantly from the commercial traders who move in and out of the markets on a regular basis, depending upon many market-based factors.

This is to suggest that speculators looking only to make money, without “do[ing] business in the underlying commodity” are a new phenomenon.  I’m sure that readers of the Register in 1909 or 1899 or 1889 would have begged to differ.  Moreover, speculators of whatever age “have moved in and out the markets on a regular basis, depending on many market-based factors.”

This argument seems to make motive the primary criterion for determining whether somebody is eligible to trade a futures market.  This is truly disturbing.  It also suggests that Commissioner Chilton believes that commodities should be fenced off from other financial markets.  This is bad finance, and actually harms market users by interfering with the efficient transfer of risk.

Chilton also says: “The new speculators buy into the markets for years, and stay there.”  And we are to conclude . . . ?  And again, there have been many speculators that have made it their living for long periods.

Additional remark (9/2/2009): I find this criticism of Chilton’s ironic that the classical criticism of speculators is that they are quick buck artists that have no long term stake in any market or company, and hence trade on meaningless short term information.  Now, we have a class of speculators that are not short term, quick-buck traders, but are instead patient investors in the market for a long haul–but that’s bad too.  Damned if you do, damned if you don’t.

As for evidence, Commissioner Chilton relies on one of the least creditable tropes: the “some suggest” argument:

Due to the influence some suggest the new speculators may be having on prices, however, there may be some changes on the horizon for these new players.

I (and others) suggest otherwise.  So where does that leave us?

Then he pulls out the “it’s possible” justification:

Just as the tide raises all boats, it is possible that this massive influx of capital helped to raise commodity prices beyond what the simple forces of supply and demand would dictate. The crude oil “commodity bubble” is a good example. To date this year, crude oil is trading at roughly $70 a barrel. While that is a far cry from the incredible (and some say irrational) high of $147 last summer, the current price is still up over 60 percent from the beginning of this year. Does that make sense?

A lot of things are possible.  Some evidence would be helpful.  The role of evidence is to help sort out what’s probable from what’s possible.  You can’t make policy on the possible, since so much of the possible is contradictory.  X may be possible.  Not X may be possible too.  We’re right where we started.  Reasonable analysis requires effort to determine which of these possible outcomes is more likely, and to estimate the costs of incorrect conclusions.  Identifying the possible is the beginning of an inquiry.  It clearly cannot be the end.

And note the second helping of the “some say” trope: “incredible (and some say irrational) . . .”

In fact, economists have known for a long time that commodities can exhibit substantial variability, and that in particular, in models where only fundamentals drive prices, prices spike and crash with regularity.  That’s exactly what you’d expect in a market for a commodity like oil.  There’s no reason to invoke the “bubble” word to explain big moves in commodity prices.

Indeed, the reason speculators are attracted to commodities is the volatility.  That’s a lot more plausible statement than to say that the speculators cause the volatility.

Now we get to the punchline:

Supply is at a 10-year high and demand is at a 10-year low. You do the math; prices should be lower. And if the cause was uneconomic speculative activity (that is, not caused by the forces of supply and demand), then regulators have a responsibility to act.

There is no doubt that the current commodities market is more puzzling on the surface than what happened in 2008 or early 2009.  But speculation by financial players in the US or the UK is hardly the first thing that bears scrutiny.  Indeed it should be about the last.  In all major commodities, the big buyers have been China, China, and China.  China has engaged in a stimulus that beggars the imagination, and probably in part to reduce its exposure to the dollar, a lot of that money has gone into commodities from aluminum to zinc.  The CFTC–with considerable Congressional cheerleading–is on a snipe hunt, and ignoring major factors in the market.  If Commissioner Chilton is puzzled, he needs to read more.

And note the tricky segue in the argument: “if the cause was uneconomic speculation . . . then regulators have the responsibility to act.”  But the “if” remains just that.  Chilton certainly has not provided a scintilla of evidence to support that contention.  He mentions the CFTC hearings on position limits, which generated zip, zero, nada in terms of anything that would pass the laugh test in terms of evidence.

And Commissioner Chilton then fails to man up and take a stand himself, instead invoking the “some say” argument yet again (for the third time!):  he describes the hearings as a step in a process “to address what many call ‘excessive speculation’ in our futures markets.”  Again.  Many say it ain’t.  “Some say”–even “many say”–is hardly a legitimate basis for any major policy initiative.

Amazingly, Commissioner Chilton repeats the “unintentional manipulation” gaffe:

The clear message is that physical commodities – like those in the agricultural, energy and metals arenas –  are too important to our nation to allow even the possibility of price manipulation, intentional or unintentional.

He will undoubtedly say that he is using the word “manipulation” in some common-sense use of the term to mean the actions of traders that affect prices.

That doesn’t cut it, for at least three reasons.

First.  There is no common-sense use of the term.  That’s been a problem for a long time–and is exactly why I quoted the Texas cotton broker in my original post.  Or to quote my book on manipulation, if Ambrose Bierce was writing the Devil’s Dictionary of Finance, I would define manipulation as anything that causes me to lose money.

Second, this is sort of the immaculate conception theory of prices.  If trading activity doesn’t affect prices, what does?  Surely public information releases (e.g., a crop report) have an effect, but people still interpret those releases differently and trade on their interpretation.  Moreover, some traders have private information, and trading on that information moves prices.  That tends to make prices more informative.  That’s a good thing.  It’s called price discovery.  How can you have price discovery if trades don’t affect prices?  I should also note that hedgers’ trades can affect prices.  Putting on a big hedge may require a move in price to find somebody willing to take the risk.  Here the market is discovering the price of risk, and consenting adults will negotiate a mutually agreeable price.  And such a price will almost certainly be different than if no such trade had taken place. Thus, hedgers can have a price impact.  Are they manipulators too? (And, I might add, hedgers will have a bigger price impact if speculation is constrained.  So, if trades that impact price are manipulative, and hedgers have a bigger price impact when speculation is constrained, wouldn’t that make the party that constrains the speculation an accessory in the manipulation?  That question is only half in jest.)

In other words, defining manipulation to mean any trade that has a price impact is complete non-sense, not common sense.  Such markets exist in textbooks, and nowhere else.

Additional remark (9/2/2009): Price impact may be a necessary condition for concluding that regulatory intervention is needed.  It is definitely not a sufficient condition as Chilton suggests.  A regulatory intervention should require a showing that a certain kind of trading moves prices away from competitive values.  Even if a price impact is demonstrated, it is absolutely wrong to conclude that this is inefficient.

Third, and most importantly, Commissioner Chilton is one of those responsible for enforcing the anti-manipulation laws.  These laws make manipulation a felony.  They also subject manipulators to the prospect of heavy fines, and great reputational damage.  As a result, no CFTC Commissioner should use this term imprecisely, or make statements using words that have legal meaning in such a cavalier way.  In other words,  I don’t believe that someone in the position of enforcing the law has the luxury of making such implicit distinctions on matters of potential legal import.

The term is provocative, and its use suggests that the markets have been manipulated.  People believe that manipulation is wrong, and many know that manipulation is a crime.  This creates a presumption that there is something wrong–manipulated–in the markets that need correction.

I would also suggest that this could lead to serious difficulties for the Commission, and for Commissioner Chilton, if the Commission ever has to rule on a manipulation case.  I can see a defendant appealing an adverse Commission decision on manipulation by saying that one of the Commissioners had written in a way that could suggest ignorance of the law, and/or a prejudicial view of the activities of speculators, and/or is inclined to see a manipulator lurking behind every trade.

It seems to me that Commissioner Chilton is attempting to have it both ways: to insinuate that the markets have been manipulated to persuade people of the need to regulate more aggressively and intrusively, while avoiding having to provide evidence to support his insinuation, escaping instead with evasions about how he’s not using the term in the legal sense, just in some “common sense” way.  But if the activities aren’t illegal, then what is the justification for the regulation?  And if there is a justification other than manipulation as legally defined, why use such an inflammatory term that has a specific legal meaning, rather than explain precisely what that justification is?  Why not set out in plain terms exactly what he thinks is wrong with the activity of speculators, and their effect on prices, and let people analyze that contention without waving the bloody shirt of manipulation to inflame passions?  And maybe, just maybe, provide some reliable evidence in the bargain, rather than relying on the “some say” evasion.

I don’t think that’s too much to ask of those responsible for the regulation of markets with huge sums on the line.  In fact, I think it’s far too little to ask.  But I’ll take it as a start.

Trying to figure out what is going on with the Chinese economy is a first-order issue.  Superficially, everything looks great; growth is right on official targets, and is at levels that the world would envy even during boom times.  In spite of that–no, because of that, among other things–there are many reasons for disquiet.

An article in today’s Reuters strikes a very odd note:

A report that Chinese state-owned companies will be allowed to walk away from loss-making commodity derivative trades provoked anger and dismay among investment bankers on Monday as they feared it may set a damaging precedent.

The State-owned Assets Supervision and Administration Commission, the regulator and nominal shareholder for state-owned enterprises (SOEs), told six foreign banks that SOEs reserved the right to default on contracts, Caijing magazine quoted an unnamed industry source as saying in an article published on Saturday.

While the details of the report could not be confirmed, it was Monday’s hot topic in financial circles from Shanghai to Singapore as commodity marketers feared that companies holding underwater price hedges could simply renege on the deals, costing banks millions of dollars in profit.

This could be a very big deal.  A major default on derivatives by huge Chinese SOEs would hurt the banks on the other side of the deal, but more importantly, raise huge questions about the reliability of Chinese SOEs as counterparties not just on derivatives, but on other transactions as well.

But this is all very inscrutable (stereotypically?) as one of the companies allegedly involved denied it sent any letter.  From Bloomberg (no link yet):

China Eastern Airlines Corp., which  had $916 million of unrealized losses last year on wrong-way  bets on fuel prices, denied a Reuters report that it sent a  letter to banks about its futures contracts.

Air China Ltd. and China COSCO Holdings Co. also sent  letters to banks about futures contracts, Reuters reported today,  citing an unidentified Singapore-based banking executive who had  heard of the letters. Companies owned by China’s central  government may terminate derivative contracts with six foreign  banks that provide over-the-counter commodity hedging services,Beijing-based Caijing Magazine reported earlier on Aug. 29.

“No, we didn’t” write letters to banks about futurescontracts, China Eastern Board Secretary Luo Zhuping said byphone today without elaborating. Air China spokeswoman Rao Xinyu  declined to comment. China COSCO spokeswoman Yang Ling didn’t  immediately answer calls to her office today seeking comment.

Now, both stories could be true.  Note that Reuters reports that the threat came from State Assets Supervision and Administration Commission, which oversees companies like China Eastern.  The Reuters story does not claim that the companies wrote the letters on their own behalf: it claims instead that SASAC wrote the letters in its role of regulator of these companies.  So, the Reuters story could be true AND China Eastern’s denial could be true too.

But this raises the question of why would such a course be contemplated, let alone threatened.  One interpretation is that these companies are in financial trouble, and the government doesn’t want to spend its money making western banks whole.  Another interpretation is that the government wants to clamp down on speculation in general, and derivatives speculation in particular, by Chinese companies, and figures that raising doubts about the reliability of Chinese companies as counterparties is a very effective way to do that: It may be very hard to crack down on trading by Chinese companies directly, but if they have nobody to trade with because no banker in his right mind would take the risk of giving away a free default option, the “problem” is “solved.”  Although this may seem to be limited to Chinese SOEs, it will no doubt have the effect of raising doubts about the reliability of all Chinese counterparties, thereby making it costlier for them to trade, and perhaps shutting them out of the market altogether.

There is some hint of this in the Reuters article:

The warning from SASAC follows a series of measures from Beijing this year to crack down on the sale of derivative products by foreign banks to Chinese enterprises, principally big consumers, who bought protection against higher prices last year only to watch the market collapse — leaving them with losses.

There may also be an old school-new school battle going on:

SASAC took over the job of overseeing SOEs’ derivatives trading from the securities regulator in February after several Chinese firms reported huge losses from derivatives.

I would wager that SASAC is dominated by old school industrial types and party types who are not in the least financially sophisticated, and who are probably not all too down with the idea of derivatives anyways, thinking that they smack of speculation, even if they are used for hedging.  (I’ve taught at some Chinese SOEs, and the level of finance knowledge is pretty thin even among higher level execs–or should I say especially among such types.  I imagine that goes exponentially for the SASAC.)

But, if my conjecture that this is an effort to tamp down speculative trading, it would fit in with a good deal of other stories coming out of China that it is struggling mightily with its efforts to stimulate the economy.  These efforts are leading to manifest distortions, and reports suggest that the authorities are operating in a very ad hoc way to try to control the distorting effects of the stimulus.  Like a financial sorcerer’s apprentice, China has unleashed a massively power monetary, fiscal, and credit stimulus, but cannot control it.

The Chinese stimulus is immense, as I’ve written before. The fiscal stimulus is on the order of 15 percent of GDP.  Chinese banks have created huge amounts of credit:

In the first half of 2009, bank credits increased Rmb7,300bn, above the official target for the full year. Credit growth was surprisingly high, and the same was true of the broad money supply, M2, which grew at a record rate relative to GDP. As a result, the inter-bank money market has been inundated with liquidity.

But these efforts have led to the growth of bubbles in real estate and the stock market.  The government is trying to tamp down on the flow of funds into these areas, and it is evidently having some effect: the Shanghai stock index was down 23 percent in August, far and away the worst performer among major world markets.  Moreover, the market is extremely sensitive to signs that the government is tightening credit.

Moreover, there is other evidence that the deluge of spending has led to severe dislocations in the allocation of resources.  Some amazing figures from the same FT article just quoted, by Chinese economist (and former central banker) Yu Yongding:

To maintain decent growth and avoid massive unemployment, the Chinese government was left with no option but to replace flagging external demand by domestic demand. But in the short run it is difficult to stimulate domestic consumption; investment demand became the only alternative. As a result of the stimulus package, the growth rate of fixed asset investment hit 36 per cent year-on-year in the first half of 2009, and China’s investment rate may have surpassed 50 per cent of GDP.

The government knows very well that the economy has been suffering from overcapacity. This is why government-financed investment in the stimulus package is concentrated in infrastructure, rather than new factories. However, there are still problems with an investment-centred expansionary fiscal policy. Due to the hasty and under-supervised implementation, waste in infrastructure construction is ubiquitous, and the prospective returns of this big push into infrastructure are less than promising.

Investing 50 percent of GDP, a nearly 50 percent increase from an already huge 36 percent of GDP, means that it is almost certain that many of the projects are hastily conceived, and ill conceived to boot.  I think that Yongdong is a master of understatement when he opines that “the prospective returns of this big push into infrastructure are less than promising.”  That is the gravamen of the analysis I gave on BNN (Canadian Business Television) earlier in the month.

And indeed, there is evidence that the government is trying to get control of the brooms its fiscal and monetary spells have brought to life.  Not so much in infrastructure, but in other parts of the economy:

China’s cabinet said it’s studying curbs on overcapacity in industries including steel and cement as policy makers seek to rein in investment growth fueled by a record credit expansion this year.

The government will also increase “guidance” over parts of the coal, glass and power industries, the State Council said on its  Web site today. Controls on stock and bond sales by companies in targeted sectors will be strengthened, it said.

China is aiming to prevent excessive investment in the world’s biggest user of steel and cement without imposing restrictions that may endanger an economic recovery. The nation’s  benchmark stock index has dropped 15 percent from its Aug. 4 high on concern banks may tighten credit after extending a record $1.1 trillion of loans in the first six months.

There is a very Austrian lesson in this Chinese story.  The government may be able to manipulate aggregates, but its attempts to do so can aggravate resource misallocations.  In the Austrian story, these misallocations eventually come back to haunt: eventually they result in a contraction that is necessary to force resources out of bloated sectors and into more productive uses.  The Chinese government apparently recognizes this, and is attempt to fall back to its comfort zone–state directed allocations of resources.  But that just raises another problem the Austrians were quite familiar with: the Knowledge Problem.  How can the central planner know where resources should go?  Answer: He can’t.

I don’t think this will turn out well.  There’s no Big Sorcerer to sweep in and undo Apprentice Sorcerer’s mischief.  The Apprentice learned, it’s easy to unleash the magic, but it’s very hard to direct it.  In the Chinese case, it’s easy to go on a spending binge, but it’s hard to ensure that the money is spent well.  It may result (especially given the idiosyncrasies of Chinese income accounting) in high rates of measured growth, but this growth is likely to be chimerical, and even destructive in the long run as resources spent today may prove very unproductive months from now when the world economy begins to turn around and the stimulus-driven investments are ill-suited to serve the resulting demand.

In other words, China may represent history’s biggest free cash flow problem.  (A reference to the finance literature that suggests that companies with free cash flow tend to fritter it away on unproductive investments).

The effects of this will spill over far beyond China, most notably in the commodity sector.  China has been on a commodity import splurge, but apparently that is another thing that is already slowing down, and likely to slow down even further soon.  And that is already having an effect on the canary in the commodity coal mine: shipping rates.  From another Bloomberg story:

Just as global trade starts to recover, the shipping market is crashing for the second time in a year as China reduces raw-material imports and record numbers of new vessels set sail.

The rate for leasing capesize ships, boats three times the size of the  Statue of Liberty, will drop about 50 percent from the current price of $37,865 a day to as low as $18,000 before the end of the year, according to the median in a Bloomberg survey of six analysts and fund managers. Forward freight agreements traded by brokers show the fourth-quarter average price will be 7 percent lower.

Shipping rates, which already fell 59 percent from this year’s high, are retreating as the  Organization for Economic Cooperation and Development predicts a 16 percent drop in world trade for all of 2009. China’s State Council called for curbs on steel and cement production last week.

. . . .

From their low of $2,316 in December, rates rebounded to $93,197 in June as China imported record amounts of everything from coal to  iron ore, used to make steel. Almost two in every five tons of steel are  made in China, according to the Brussels- based World Steel Association. The nation consumes the same proportion of the world’s coal, BP Plc estimates.

Industrial Overcapacity

Rates are poised to keep falling, the survey shows. China’s State Council, the nation’s cabinet, said it’s studying curbs on overcapacity in industries including steel and cement. The government will provide more “guidance” over parts of the coal, glass and power sectors, the group said in a statement.

Imports of refined copper fell 23 percent in July from the previous month. Coal shipments shrank 13 percent, customs data show.  Iron-ore purchases will likely average about 16 percent less in the remainder of the year than in the first seven months, according to  Will Fray, an analyst at Maritime Strategies International Ltd. in London.

“China could very easily turn the taps off,” Fray said. “Rates will keep sliding.”

The commodity import channel is the primary mechanism connecting the Chinese stimulus to the rest of the world.  It’s hard to explain the robustness of commodity prices in recent months (which has redounded to the benefit of Australia–and Russia) on the basis of conditions in OECD countries.  The EU, US, and especially Japan have hardly done well during that period, with the first maybe experiencing an anemic recovery, the second bottoming out at best, and the third still imploding.  The most likely explanation is that this is the direct consequence of the Chinese stimulus, and the related policy of accumulating strategic inventories of everything from aluminum to iron ore to oil to zinc.

But all of the foregoing suggests that this is coming to an end, if it hasn’t come to an end already.  And that’s why very peculiar stories like the one about a threatened default on derivatives trades may just be shadows of larger, looming developments.