Streetwise Professor

For those who, like me, are skeptical of the solidity of China’s economic growth and the basis for the commodity rally, this article is for you:

Copper’s 76 percent rally this year may soon end on signs that China has stockpiled more than it can use in new homes, cars and appliances.

Inventories monitored by the London Metal Exchange posted their first back-to-back  weekly gains since February, increasing 8.3 percent from an eight-month low.  Sumitomo Metal Mining Co., Japan’s second-largest smelter, said Chinese imports are slowing after record purchases boosted domestic supplies, and U.S.  copper-scrap exporters report shipments to Asia are dropping.

. . . .

Refined copper imports by the Chinese more than doubled to 1.78 million metric tons in the first half and reached a monthly record of 378,943 tons in June, customs data show.

“China’s copper imports are likely to fall in the second half of this year because it bought so much in the first half, the government has stopped buying and demand from end-users may not be as big as people anticipated,” said  Zhao Mingwang, manager of futures trading at Zhuji, China-based Zhejiang Honglei Copper Co., which produces about 100,000 tons of wire and rods a year. “The imports were so large it’s hard to fathom where it all went.”

Most of the gains in LME-monitored inventories during the past month reflect the eightfold jump in the volume of material in warehouses in Singapore and South Korea, the closest to China.

. . . .

Inventories monitored by the Shanghai Futures Exchange more than doubled this year, sparking concern the pace of consumption in China hasn’t kept up with imports.

. . . .

Imports may have exceeded manufacturing demand by as much as 1.3 million tons in the first half, Kaku said on July 24. “I don’t think copper prices climbed because of a dramatic improvement in supply-demand conditions,” he said. “I’m skeptical about a strong recovery in the market.”

. . . .

Chinese lenders responded to the economic slowdown by tripling loans in the first half of 2009 from a year earlier to 7.37 trillion yuan, according to the nation’s central bank.

The increased lending spurred demand for properties, helping home prices in 70 major Chinese cities rise for the first time in seven months in June. Passenger-vehicle sales climbed 26 percent to 4.53 million in the first half, while commercial-vehicle sales fell 0.5 percent to 1.57 million, the China Association of Automobile manufacturers said July 9.

Dollar Slide

Investment in fixed assets, including water and road projects, jumped 34 percent to 9.13 trillion yuan, the National Bureau of Statistics said. Spending on capital projects accounted for 87 percent of China’s economic growth in the period, according to Morgan Stanley Asia Ltd. Chairman  Stephen Roach, who is based in Hong Kong.

This all suggests that the 8 percent (annualized) Chinese growth in the second quarter is far less than meets the eye.  It is the result of unleashing a flood of credit to finance “capital projects,” the quality of which is highly dubious; tripling the quantity of loans, to an amount representing 40 percent of the loans already on bank balance sheets, inevitably means that a large fraction of these loans are financing uneconomic projects.

Think about it.  Chinese banks are lending three times as much during the most severe world economic downturn since the depression as they did when the Chinese economy was booming last year.  A tripling of lending would inevitably lead to the financing of numerous negative net present value projects even in normal times.  In current circumstances, the waste of resources must be astounding.

As I’ve written before, massive government stimulus like that being undertaken in China and being funneled through the banks can lead to increases in measured output.  But the return on the projects funded is usually negative, and substantially so.  In other words, you pay people to dig holes, and buy cement to fill them in, the expenditure counts as economic “output,” but all you’ve got in the end is cement filled holes that will not do what capital is supposed to do: provide a stream of benefits into the future.

What’s more, when a large fraction of these projects come a cropper, this dramatic expansion of credit will leave the lending banks with a slug of bad debt, forcing the government to: (a) bail them out, or (b) watch them fail or turn into zombies, thereby constraining their ability to finance viable projects in the future.

In other words, the Chinese have responded to a financial crisis caused in large part by an excessive creation of credit in the US and Europe by engaging in their own excessive creation of credit.  The great exporting nation has thus imported the Hair of the Dog theory of economic policy:  Respond to one massive distortion by creating one’s own.

I don’t see how this can end well.  I understand the tremendous social pressures that make the Chinese leadership feel compelled to engage in this policy, but they are, in my view, just deferring the day of reckoning–and arguably making it far worse.

And since the commodity rally is based in large part on Chinese purchases, this also means that the rally is considerably overdone.  Indeed, another Bloomberg article suggests that the copper market (and arguably, other commodity markets as well) is the economic equivalent of a crack addict, dependent on a continuing supply of Chinese government largesse:

Copper climbed in Shanghai, after falling the most in two and a half months yesterday, as China’s central bank damped speculation it would curb lending, boosting the demand outlook for raw materials.

Futures tumbled yesterday as speculation the Chinese government would limit bank loans sent the country’s stock market plunging by the most in eight months, dragging base metals lower. Equities rallied today after the central bank said it will maintain a “moderately loose monetary policy,” aiming to consolidate the nation’s economic recovery.

“The tightening of bank lending has been the major fear in the minds of copper importers and dealers,” Lin Xu, analyst at China International Futures Co. in Shenzhen, said by phone today. “So the reiteration of a loose monetary policy from the central bank helped sentiment.”

Just further illustration that the Chinese are riding the tiger.  It’s damn hard to get off.  The problem is, you can’t ride it forever.

The statistics in the first article regarding the immense quantity of copper imports are truly staggering; perhaps the ChiComs have a special affinity for the Red Metal;-)  Note that China’s imports during a worldwide recession are double what they were when the Chinese economy was booming in 2008.  Stocks in LME warehouses are also beginning to increase even as prices are increasing.  (The same is true for other metals.) Oil inventories are also increasing.  And for the most part, these measured inventory increases do not include Chinese stocks.  Thus, commodity prices have been supported by massive Chinese stocking.  Chinese consumption, such as it is, and as indicated by the inventory build it is far less than their purchases, is driven by a massive stimulus that is not sustainable for an extended period.  The signs of recovery in the US, Europe, and Japan are faint, at best.   And even a recovery in manufacturing in the OECD, or an increase in OECD consumer demand that would give a jolt to Chinese output for export, would have to work through massive stocks in order before any price-supporting fundamental tightness occurs.  Other measures of demand, such as ocean freight rates, have been flat.

Commodity prices and inventories can move together if there is a spike in economic uncertainty that leads people to increase their demand for precautionary inventories: the only way to accommodate the increased demand for inventories is to raise prices to discourage consumption and encourage production.  But if anything, the main metrics of economic uncertainty–such as the VIX volatility index–have been declining while commodity prices have been increasing.  Price volatility for oil and other commodities was at historic levels in December of last year.  (Oil price volatility was higher during December than during the 1990-1991 Gulf War.)  So, increases in uncertainty/risk cannot explain the co-movement of prices and inventories.

All of this suggests that there is considerable downside risk in commodities.  The markets are supported by a Chinese stimulus program that even many Chinese officials recognize is not sustainable, and which is leading to sectoral distortions.  The stimulus has encouraged a buildup of inventories that will weigh on the market for a long time.  The signs of recovery in the US and elsewhere in the OECD are very fragile.  Even the slower than expected decline in US GDP in the second quarter is somewhat misleading as it conceals weaker than expected consumption.  Fundamentals remain very weak, and the market is dependent on extreme Chinese fiscal and monetary policy.  That translates into serious risk of a big selloff in commodities.

Following the CFTC hearings on position limits in energy reminds me of Through the Looking Glass:

‘Let the jury consider their verdict,’ the King said, for about the twentieth time that day.

‘No, no!’ said the Queen. ‘Sentence first – verdict afterwards.’

‘Stuff and nonsense!’ said Alice loudly. ‘The idea of having the sentence first!’

‘Hold your tongue!’ said the Queen, turning purple.

‘I won’t!’ said Alice.

‘Off with her head!’ the Queen shouted at the top of her voice. Nobody moved.

Chairman Gensler is an odd casting choice for the Red Queen, but he clearly has his heart in the part, given his opening remarks at the hearing:

But Gensler, the former Goldman Sachs’ executive who almost didn’t get the chairman’s nomination this year because of his past role in shielding over-the-counter derivatives from regulation, adopted a tough tone throughout the hearing.

“No longer must we debate the issue of whether or not to set position limits,” he said.

Then what are the hearings about?

And there’s this:  “There seemed, at least, that the commission is hearing support. I think it’s more a question of how, than whether.”

And his understudy, Bart Chilton, is clearly ready for the part:  “Whatever manner the agency proceeds, ‘going slow’ is not an option.”

Given that position limits are a mantra of the Senators to whom Gensler genuflected to get the job, it’s not really a surprise that they are now deemed inevitable.

Position limits in general are dubious at best.  There is little in the way of viable theories, and even less in the way of persuasive empirical evidence, that speculators distort prices in general, or cause prices to be excessively volatile.  There is no plausible theory or evidence that speculators caused energy prices to be artificially high in 2008.  As a consequence, position limits will almost certainly not reduce volatility for energy products, or reduce the frequency of price spikes.

After all, we’ve had considerable experience with position limits in agricultural commodities.  Note that the CFTC is essentially proposing to extend to energy and other commodities “in finite supply” (again, and examples of other types of commodities are . . . ) the same type of regime that has been in place for ags for years.  Yet, despite these limits, there has been substantial volatility in ag prices–including last year.  Moreover, there have been large spikes and crashes in ag prices despite the existence of a position limit regime there.  This should not be a surprise, as the theory of storable commodity pricing predicts that such price behavior is characteristic of efficiently functioning, competitive markets undistorted by speculation.

This perhaps explains the monomaniacal focus on index investors.  Via hedging exemptions, these types of firms have been able to amass positions in individual commodities (as parts of larger portfolios) in excess of the position limits.  Since position limits are in place in ag commodities, the fanatical opponents of speculation (fanatical in the Churchillian sense of “can’t change their minds and won’t change the subject”) need to focus on participants not subject to the limits.  Never mind that extant empirical evidence provides no support for the hypothesis that index investors are moving prices.  Or that the “theory” that these funds contribute to “demand” are completely bogus.  (It would be interesting for someone to see whether price correlations across components of major commodity indices have increased in recent years; if index investors are the dog and prices are the tail, since index investors act in a mechanical fashion across markets, they should induce very similar price movements across markets.)

Position limits have been around since the Grain Futures Act was supplanted by the Commodity Exchange Act in 1936.  I’m sure you’ve noticed what a dramatic effect they had on volatility–even before the rise of index investors.

So, we’re about to go for yet another run on the hamster wheel.

It is interesting to me to note that something that is almost impossible to be distorted by speculation–shipping rates–experienced almost the same spike and plunge as energy over the 2007-2009 period.  Shipping rates aren’t assets; they are the rental rate on assets.  Even if you have a speculative bubble in the prices of ships (i.e., a lot of ships are built on spec in anticipation of higher rates in the future), this should result in a fall in shipping rates; the entry of large numbers of ships should depress charter rates.  You can’t store the ability of a ship to make a voyage today for use in the future; you either use the space today, or you don’t.  You can’t buy up today’s space in anticipation of a higher rate in the future.  So, when you have price spikes in a non-storable like shipping space, you can’t attribute that to a speculative asset bubble, cuz it ain’t an asset.

What’s more, shipping rates are driven by global industrial activity.  The eerie similarity of the trajectory of oil prices and shipping rates (as measured by the Baltic Freight Index, for instance) therefore strongly suggests that underlying fundamentals, namely strong world industrial demand, drove both oil prices and shipping prices over the period of the energy price spike.  Indeed, I have some preliminary econometric evidence (more to come later) that shows that the Baltic Freight Index is strongly correlated with, and in fact leads, the price of oil.  (Lutz Killian has similar evidence, up through 2007: mine goes through April, 2009).

And then there’s  the issue of the details of implementation.  Given the complexity of the markets, the greater variety of products and instruments, and the greater variety of market users and strategies, designing a coherent position limit regime will be nigh on to impossible.

One disturbing matter relates to the aboveforementioned index investors, and financial market participants in commodities more generally.  Gensler stated:  “While I believe that we should maintain exemptions for bona fide hedgers, I am concerned that granting exemptions for financial risk management can defeat the effectiveness of position limits.”

So, “financial risk management”–by which I presume Gensler means investors that use commodity derivatives to improve the risk-return performance of their portfolios–are not bona fide hedgers apparently.

This reflects a widespread mindset, redolent of what Thomas Sowell calls the “physical fallacy” that physical commodity derivatives are properly for physical market players, and that others should not participate.  That is, commodity markets and financial markets should be separate.  To put it more pungently, those holding this mindset endeavor to make the commodity derivatives markets a kind of ghetto, limited to a certain group of players.

This makes no sense from the perspective of financial theory.  Integration of disparate markets with disparate risks improves the sharing of those risks, leading to a more efficient allocation and pricing of those risks.  Segregated markets–ghettoized markets–don’t permit the full scope of risk sharing, and lead people to bear more risks than is necessary.

In earlier posts I have explained why some commodity market participants may prefer that these markets be ghettoes, rather than having them integrated in the broader financial markets.  This can explain the support for position limits from some quarters of the commodity community.  No doubt these are some of the sources of support Gensler has been hearing from.

Thus, the whole position limit hysteria–which is a particular symptom of the broader underlying disturbance of speculator hysteria–is, as Alice said, stuff and nonsense.*

And for saying that, I may anticipate the sentence: “Off with his head!”

*”Stuff ‘n’ Nonsense” is also the title of an excellent Supersuckers rocker.

In the early-1990s Exxon entered into a deal with the Russian government to develop the Sakhalin I project.  As part of the deal, Exxon received an exemption from Gazprom’s legal monopoly on exports of gas from Russia.  Now, in a shocking development (irony alert), it seems that the exemption is under threat:

The government will step up pressure on U.S. major Exxon Mobil to sell cheap gas from Sakhalin, analysts said Thursday, a day before construction begins on a new gas link to the Pacific.Prime Minister Vladimir Putin will travel to the far eastern city of Khabarovsk on Friday to inaugurate the start of the pipeline to the Pacific port of Vladivostok, which will ultimately liquefy gas from Sakhalin Island for export to Asia.

“I think Exxon Mobil knows that they will twist their arm. It is pure pressure,” said Mikhail Krutikhin, an analyst with RusEnergy.

. . . .

Valery Nesterov, analyst at Troika Dialog, said that despite a growing belief among investors that the government’s grip over resources is easing after deals with Total and Shell in recent months, foreign firms will often remain under pressure.

“Exxon does not have a free choice. Past experience shows that if [Moscow] has a strong desire, the foreign partner has to agree,” he said.

The Khabarovsk-Vladivostok pipeline will run 1,460 kilometers, and Nesterov estimates its cost at $2.9 billion to $4.4 billion.

Sakhalin is already connected to Khabarovsk with a gas link, which is supplying local consumers.

Krutikhin said that even if Exxon is forced to sell all its gas from Sakhalin-1 to Gazprom, volumes will not exceed 7 billion to 8 billion cubic meters per year, while Gazprom is eyeing a peak capacity of up to 47 bcm a year.

“So to fill the pipeline, you need to discover new fields or build a pipeline from Yakutia,” he said.

Bloomberg adds some details:

OAO Gazprom, Russia’s state-owned natural-gas exporter, started building a pipeline in the Pacific Ocean that may damage  Exxon Mobil Corp.‘s plans to export the fuel to China.

Workers welded the first joint on the initial 1,350 kilometers (840 miles) of the pipeline at a ceremony attended by Prime Minister  Vladimir Putin and Gazprom Deputy Chief Executive Officer  Alexander Ananenkov. The pipeline will link Sakhalin Island with the mainland city of Vladivostok.

“The development of gas transportation infrastructure in the east will let us diversify our exports,” Putin said today at the event in Khabarovsk, which is on the pipeline’s route. “But I would like to stress that the domestic market will be a priority for the Far East and eastern Siberia.”

I repeat: “The domestic market will be a priority for the Far East and eastern Siberia.”  To translate: If XOM has a deal that allows them to export the gas, well, that’s just its tough luck.

So how will Putin bludgeon ExxonMobil into moving the gas to the domestic market–and likely at controlled domestic prices–rather than to a more lucrative export market?

With apologies to Elizabeth Barrett Browning: “How can I screw thee?  Let me count the ways.”

There’s environmental laws (Sakhalin II); licensing (BP, various mining firms, and perhaps now MOL); taxes (Yukos, and myriad others); blowing stuff up (Turkmenistan); legal harassment of employees, including accusations of espionage (TNK-BP); legal fraud and theft (Heritage Capital); abusive lawsuits in pocket courts (Telenor).  I could go on, but you get the picture.  If they want it, they will take it.  The only question is what they’ll pull out their bag of tricks.

So why does anyone invest there, let alone go back after getting bashed around before (Shell, most notably).  When I gave a talk to some Foreign Service and Civil Service officers with energy-related responsibilities who visited Houston earlier this week, the analogy that came to mind was battered spouse syndrome.  Hopefully Exxon will fight this hard, and won’t succumb to the same syndrome.

As I said in an earlier post, I expect that this will all be a prelim to big confrontations between China and Russia on energy.  Note that the China angle plays into the Sakhalin I issue.  Moreover, China is becoming increasingly aggressive, and successful, in areas that Russia considers its fiefdoms, notably Central Asia (especially Turkmenistan) and now Moldova, of all places.  And finally, the big one: the Rosneft/Tatneft-China oil pipeline/loan deal.  That one will turn very interesting once the pipeline is done, especially if oil prices are well above those at the time of the signing of the deal.  And absent another world economic catastrophe, that’s almost a given.

h/t R

The events surrounding the closing of the vast Cherkizovsky Market are fascinating.  They present an intriguing illustration of the natural state in action, and the consequent intersection between the personal and the political.  The New York Times has a story on the closing of the market that is worth reading.  This paragraph was particularly illuminating:

Government agencies quickly took up the theme of the market’s seedy side — which was hard to deny. The powerful director of the Investigative Committee of the Prosecutor’s office, Aleksander Bastrykin, called the market a “hell-hole” that had become a “a state within a state” on the edge of Moscow. “It has its own police, its own customs service, its own courts, its own prosecutor and stand-alone infrastructure, including brothels,” he said.

State-within-a-state.  Bug or feature?  “Hell hole” or (relative) paradise?

Well, it appears that the traders thought it pointless to rely on the officially constituted authorities for protection, or contract enforcement.  So they created their own system of third party enforcement, much as did the operators of fairs in Medieval Europe.  That is, the market not only served as a convenient way place for people to congregate to buy and sell, it also facilitated the creation of an institutional infrastructure to support trade–an infrastructure sadly lacking in Russia.  No doubt this is one reason that it presented a daunting competitive challenge to more conventional Russian retailers and wholesalers; the traders’ costs were lower because they had a functioning system of third party enforcement conspicuously lacking in the formal economy.

Thus, the market in a way was a living reproach to Russia’s institutional backwardness.  Perhaps that is another reason it was the focus of such intense official antipathy and hostility.

There are some other jewels in the article.  Here’s one:

Before the market was finally closed late last month, the authorities said that one in every 40 traders had an infectious disease like tuberculosis or syphilis.

The authorities’ concern for public health is touching, and distinctly out of character.  How come it seems that public health is trotted out as a justification for state action primarily when that action serves to protect some economic interest (e.g., the periodic rows over food safety with Poland, the US, and Belarus; the swine flu silliness; and now, the Market)?  I am quite curious to know how the rate of infectious disease in the Market differs from the rate in Russia at large, and how many communities in Russia have similar rates of incidence.  I am also curious to know the source of the 1 in 40 figure.

From a purely scholarly perspective, it is very sad that the Cherkizovsky Market has closed.  It would have provided a fascinating case study for institutional economists (and sociologists).  A living laboratory to study the spontaneous evolution of self-enforcing rules and norms.  I hope that before it closed, some enterprising Russian (or Central Asian, or Chinese) scholar had had the opportunity to study the market, its traders, the institutions that had developed, and the process of that evolution.  Alas, that opportunity is now gone, another casualty of Putinism and the natural state.

Joe Biden has attracted a lot of attention with his prediction that Russia’s “withered” economy would give us a decisive advantage in our relationship with it.  I think Biden is wrong, because he has committed the cardinal sin of projecting our logic on the Russians.  Big mistake.

I take the opposite view.  I think that for a variety of reasons, Russia will become even more aggressive and difficult to deal with.

Reason one: “Withering” is relative.  Yes, the Russian economy has taken a body blow, but compared to some neighbors, notably Ukraine and Lithuania and the other Baltic states, it is doing well.  Throughout the CIS states and Eastern Europe, many countries and companies are doing very badly, and are in serious financial straits.  The Russians still have money in the bank, and resources to deal with.  Although those have diminished, they are still enough to exert pressure on, and find bargains in, countries whose economies have been even more devastated.

In other words, the Russians realistically view power as relative, and in crucial areas the crisis has actually increased their relative strength.

Indeed, although one would have hardly considered it possible, even Germany is being more solicitous in its dealings with Russia, as this depressing article by Vladimir Socor demonstrates:

Russian President Dmitry Medvedev and German Chancellor Angela Merkel headed large governmental delegations for bilateral talks on July 16 in Munich. The process, known as Russo-German inter-governmental consultations, involves informal semi-annual summits at which leading business representatives join the cabinet ministers on either side. The Munich meeting reviewed ongoing cooperation projects and considered new ones.

Access to the Russian market is seen as critical to Germany’s export-oriented economy at any time. As an export nation, Germany’s reliance on the Russian market has developed in parallel with its overdependence on Russian energy supplies. The Russian market’s perceived importance increases during the ongoing recession, as global markets shrink and Russia has also significantly reduced its imports of German goods. In these circumstances, the German government agreed at this meeting on some measures to subsidize Russian imports of German goods.

. . . .

The inter-governmental meeting also considered an ambitious program for manufacture and delivery of Siemens trains and locomotives to the Russian Railroads state company. In parallel, Siemens is negotiating to establish a joint venture with Russia’s Rosatom for building nuclear power plants and electricity transmission systems. In March of this year, Siemens withdrew from its joint venture with the French nuclear power plant manufacturer Areva and proceeded to sign an agreement of intent with Rosatom instead. This move hurt the overall Franco-German partnership in Europe while highlighting the structural trend toward Russo-German cooperation. According to Russian Energy Minister Sergei Shmatko, the contract with Siemens is expected to be signed before the end of this year and will greatly improve Rosatom’s international competitiveness through technology transfers from Siemens (Die Presse, July 23).

The German government is tentatively looking at Gazprom to rescue the ailing German shipyards Wadan, in the Baltic ports of Wismar and Rostock. Under proposals under discussion, a Gazprom subsidiary would place orders for liquefied natural gas (LNG) tankers to be manufactured at those German shipyards. If implemented, this move would facilitate Gazprom’s entry into German and European LNG markets, with a corresponding increase in German dependence on Russian gas. The German government apparently feels that it must consider the proposal in this election-recession year, when job-saving is a top priority.

Reflecting that same short-term German priority, the Munich meeting discussed a Russian rescue of Opel, the German subsidiary of General Motors.

I think I need an aspirin.

Seriously, though, even though by every measure the German economy dominates the Russian, and even though the badly shaken German economy has still outperformed Russia’s, the dispiriting litany in Socor’s article (and I left some stuff out!) shows that even Merkel (no Schroeder she) is bending over backwards to supplicate Russia.  Look at all the things that Germany is doing to advance “withered” Russia’s interests, especially in energy, and then ask yourself “what the hell is Biden talking about?”

What’s the difference?  Well, a major factor is that the relative lack of organized political opposition within autocratic Russia, the state’s ability to crack down on the opposition that does appear, and the asymmetric vulnerability of the leadership in democratic Germany (especially with an election coming up).  The German government is anxious to appease important domestic constituencies, especially major corporations that do business in Russia, and those that work for these corporations.  This gives the Russians a lot of leverage, which they have used to the hilt.

Reason two: Aggressiveness abroad and obnoxious nationalism is one of the ways to distract Russian public opinion, weakened and apathetic as it is.

Reason three: Russia is obsessed with status, reputation, image.  The myth of Russia on its knees humbled before the West is ubiquitous, and powerful.  The Russian leadership is more than willing to do things that are objectively counterproductive economically and geopolitically just to avoid the appearance of subservience to the West.  (In fairness, Biden admitted that Russia’s prickly pride might make it more aggressive in the short run before it was forced to bend to objective economic realities.  The short run could be long indeed given the raging complexes that drive Russian relations with the West.)

Reason four: The very desperation of the situation tends to shorten time horizons, and make the elite willing to take huge risks.  Faced with ruin, gamblers will often double down.  What’s there to lose?  This would suggest that Russian behavior is more likely to moderate if their economic circumstances moderate.  Biden’s argument leads to the opposite conclusion.

So, I disagree with Biden’s diagnosis.  I think that we are in for a protracted period of testy relations with Russia, and that economic hardship will actually exacerbate these problems rather than ameliorate them.

That said, the Russian reaction to Biden’s interview has had immense entertainment value.

And Biden has it all over Hillary, who (like Obama) is apparently a firm believer in the Self Esteem Theory of Diplomacy.  Just tell them that we want them to be big and strong, and a great power, and express admiration for their contribution to history (and boy, do you have to leave a lot of stuff out to do that!) and they’ll be biddable.  Sheesh.  As if.

Maybe the NoKos are onto something in their evaluation of Hillary.  It is especially painful to watch such transparent diplomatic clumsiness.  Also, the discordant notes struck by Biden on the one hand, and Hillary and Obama on the other, hardly present an image of a well-oiled team executing a thoughtful and coherent Russia policy.

Regardless of whether the Biden view or the Obama-Hillary approach prevails, I think that our policy vis-a-vis Russia is in for some very rough sledding.

No, I haven’t succumbed to the Stockhome Syndrome and begun to love Vladimir Putin.  (And anyways, if that were the case, I would have written “Vladimir, Darling.”)  No, what I mean is that UK Chancellor of the Exchequer Alistair Darling is doing his best Putin imitation, and trying to browbeat banks into lending:

Ministers have warned Britain’s banks to increase the supply of affordable loans to businesses or face the threat of a competition probe if evidence of market failure emerges.

Alistair Darling, chancellor, has ordered ministers to hold a series of one-to-one meetings with bank chiefs through August to establish whether margins and fees have risen excessively on loans to small and medium-sized companies.

The bosses of seven big banks were yesterday told that ministers would leave “no stone unturned” and could present their research to the Office of Fair Trading if there was a suspicion that competition was not working effectively.

“It is very important that each and every bank knows that there is someone looking over their shoulder,” Mr Darling said after the Treasury meeting. “I want to make sure that we have a competitive banking system in this country.”

But Philip Hammond, shadow chief secretary, said Mr Darling was “asleep on the job and the public will take his synthetic anger with a pinch of salt”.

The chancellor’s aides said he did not yet have any evidence of anti-competitive behaviour. To encourage more competition, Mr Darling wants to cut the two years it takes to obtain a banking licence. Paul Myners, City minister, and Shriti Vadera, small business minister, have been charged with going through banks’ lending policies over the next few weeks.

The Treasury claims that in 2007, only 2 per cent of SMEs paid margins on their loans of more than 9 per cent; in 2009 that had risen to almost a third.

Just out of curiosity, what would “evidence of market failure” be, oh Olympian one? And, has there been a substantial decline in competition between 2007 and 2009 that could account for a widening of margins?  Or, is it more likely that the widening in margins reflects a decline in the credit quality of borrowers, and the fact that the banks are likely constrained in their ability to borrow due to their own straitened balance sheets?  And what does “affordable” mean?  Loans that businesses and individuals can afford to take–or ones that banks can afford to make?  Will pressure to lend lead to a decline in the quality of loans, thereby deepening the British banks’ already weak condition?  Is that a reasonable, not to say sane, policy objective of the Chancellor of the Exchequer?

So, the UK is hiding behind the fig leaf of “competition policy” to engage in the same type of pressure tactics that Putin is exerting on Russia’s banks.  Great example to follow there, Alistair.  It will almost certainly do nothing to actually help the British economy.  Instead, it is more likely to put British banks even deeper into a hole, thereby hamstringing growth going forward.

Russia and Britain are not the only ones who are treading on very dangerous ground when it comes to banking policy.  China is concerned that the huge amount of credit it is pumping through its banks is feeding a real estate and stock bubble:

Chinese regulators on Monday ordered banks to ensure unprecedented volumes of new loans are channelled into the real economy and not diverted into equity or real estate markets where officials say fresh asset bubbles are forming.

The new policy requires banks to monitor how their loans are spent and comes amid warnings that banks ignored basic lending standards in the first half of this year as they rushed to extend Rmb7,370bn in new loans, more than twice the amount lent in the same period a year earlier.

Beijing’s concerns are echoed in other countries across the region, most notably South Korea, where the government says it is taking steps to cool a real estate bubble, and Vietnam, where the government has ordered state banks to cap new lending to head off inflation.

The situation in much of Asia is very different from most Western economies, where governments have flooded the financial system with liquidity to encourage unwilling banks to lend more.

. . . .

In statements published last week, Wu Xiaoling, who recently retired as deputy governor of the central bank, warned new lending this year would probably reach as high as Rmb12,000bn, a staggering increase of 40 per cent of the entire stock of outstanding loans in just one year.

She called this sort of growth excessive and said it would lead to bubbles in the property and stock markets.

The flood of new lending also has implications for the quality of bank loans and the country’s overall growth.

“China’s economic recovery is being constructed on the back of a savaged banking system,” said Derek Scissors, a research fellow at the Heritage Foundation in Washington. “Tens of billions – and perhaps hundreds of billions – of dollars of loans will not be repaid.”

He points out that in recent years total loan growth of around 15 per cent has supported gross domestic product growth of higher than 10 per cent but in the first half of this year total loan growth of around 33 per cent supported GDP expansion of only 7 per cent.

“China’s economic policies have shifted from being unsustainable over the very long term to being unsustainable for any more than one year,” Mr Scissors said.

New loans are 40 percent of outstanding loans!  (That is, the flow is 40 percent of the stock.)  That is un-freaking-believable.  And as the wonderfully-named Mr. Scissors said, is un-freaking-sustainable.

Just how does one ensure that loans don’t go into equity or real estate markets?  Lend a money to a company, and it is very difficult to keep it from going where it will.  Like industrial companies can’t buy real estate?  And what’s more, even if there is a way of walling off real estate and equities, why would one believe for a second that loans being made so indiscriminately to the “real economy” are really flowing to high value uses.  It seems like the Chinese banks are lending to anybody with a project and a pulse.  Not only does that raise the risk of a spike in bad loans, but relatedly, it will lead to mal-investment; a distortion in the pattern of investment as well as the level of investment.

In other words, China is setting up itself–and the world–for the mother of all Austrian-style crashes.  Austrian business cycle theory emphasizes how credit expansions lead to distortions in the pattern of investment that are corrected through sharp contractions.  The shovel-the-money-out-the-door theory of loan underwriting will almost certainly distort the allocation of capital, requiring a reckoning when the government cuts back on the stimulus, as it must, if not now, in the coming months.

The banking system in China already had a lot of bad loans.  Indeed, in 2007-2008 I had conjectured that if the world economy were to crash, it would be because of a banking problem in China.  Uhm, right diagnosis (banking crisis), wrong location.  Well, one out of two ain’t bad.  But even though I erred in identifying China as the world’s leading likely source of a systemic shock, that’s not to say that its financial foundation is strong.  Rapid growth in recent years has helped obscure the vulnerabilities in the banking system.  The policy of promiscuous lending will only exacerbate those vulnerabilities.  Thus, China has climbed on the tiger’s back through its aggressive stimulus; how can it climb off, knowing that doing so will increase its bad loan problem?  There’s no immediate answer to that question.

The Russia and Britain and China stories could be supplemented by stories about the way the US in particular has handled its banking problems.  None of these inspire confidence.  Indeed, to me it seems that all of these policies are setting the stage for bigger problems down the road.  The extremely short-run orientation of these policies, which have the whiff of panic about them, carry the very great risk of laying the foundations for future crises, and at the very least, impeding the process of recovery from the current one.

The first rule of holes is that when you’re in one, stop digging.  When it comes to banking problems, politicians around the world are ignoring that lesson, and are making the dirt fly as fast as they can.  And in so doing, they risk burying us all.

I am a guest poster on today’s FTAlphaville.  The subject: clearing.  The post riffs off an article in the FT that notes the importance of price information for clearing to work efficiently.  The basic points are that price information is necessary but not sufficient for clearing to work; that clearinghouses are consumers of information, not just producers of it; and that the debate about standardization has focused on what is really a red herring–contractual standardization–and overlooked the difficulties of economic standardization.

Many thanks to Stacy-Marie Ishmael for providing this opportunity.

It had been a slow news week or so, Russia wise, but today a bunch of interesting stuff came down the pike, so here it goes.

First on the hit parade.  After his triumphs at  Pikalyovo and Pork Chop Hill, Vladimir Putin strode into the offices of Sberbank, and ordered Russian bankers assembled there to lend more.  And, as a bonus, he dictated the interest rate: 14 percent:

Russian Prime Minister Vladimir Putin on Wednesday ordered banks to dole out more loans at lower rates to get the economy out of recession, but the country’s biggest lender said such cheap credit was unrealistic.

Russia’s government is looking to banks to help restart economic growth with affordable loans. In return, the sector has received billions of dollars of state funds to boost capital as bad loans rise and asset values fall.

“Of course you need to improve the quality of loans, but you cannot close your portfolio either,” Putin said at a meeting of bankers at the headquarters of state-controlled Sberbank. (SBER03.MM) “It’s very easy to just shut the box. It is harder to work with clients and understand which of them are reliable.”

In a bid to encourage banks to offer more affordable loans, the central bank has slashed interest rates by 200 basis points since April, taking the benchmark refi rate to 11 percent.

Putin told bankers that a loan interest rate at 14 percent “is quite acceptable in current conditions”, but Sberbank Chief Executive German Gref told journalists such demands were unrealistic.

Apparently, no pens were thrown.

Consider this part again:

“Of course you need to improve the quality of loans, but you cannot close your portfolio either,” Putin said at a meeting of bankers at the headquarters of state-controlled Sberbank. (SBER03.MM) “It’s very easy to just shut the box. It is harder to work with clients and understand which of them are reliable.”

. . . .

Putin also ordered Sberbank not to close branches.

“A significant part of the (branch) network is not profitable but you cannot abandon it. This is your payment for the state support,” he said.

What great advice!  Make more loans, but make better loans.  What a great banker he would make!  I mean, the guy is just amazing, he knows everything about everything.  I’m sure all the bankers in the room slapped their heads in a collective I-coulda-had-a-V8 moment and said as one: “Why  didn’t I think of that!?!”  And of course Putin knows just what the interest rate should be.  14 percent is Just Right.  Pretty amazing to watch a bald guy do a Goldilocks impersonation.

Actually, reading this and other articles about the performance brought to mind visions of the Red Queen from Through The Looking Glass.  I can just imagine the self-control that the assembled bankers had to exercise, forcing themselves not to roll their eyes–in full knowledge that the eyes of Putin’s creatures were watching for any sign of disrespect for The Great Leader.

At least German Gref had the stones to rain some reality on Putin’s fantasy:

“With today’s price of central bank money, I do not think banks can reach 14 percent (on loans),” Gref said, noting that the central bank offers funding to the sector through collateral free loans at rates of 12 to 13 percent.

“That is the real cost of money. Then you need to add the bank’s margin of at least 3 percent and the result is that minimum (commercial loan rates) are 15 to 16 percent,” he said.

And some fun facts and figures to spoil the fun:

Putin’s comments came minutes before Sberbank published its first-half results to Russian accounting standards, showing its profit tumbled 92 percent year-on-year to 5.3 billion roubles ($170.6 million).

Sberbank’s bad loans rose to 2.8 percent of its portfolio by the end of June from 2.6 percent at the start of the month.

Bankers reckon bad loans for the system as a whole have already reached 10 percent according to international standards, MDM Bank chairman Oleg Vyugin said after the bankers met with Putin [ID:nLM83854].

So, in his desperation to stave off the immediate crisis that is besieging him and his government, Putin is going to crater the banking system.  The end results will be that: (a) he will damage Russia’s longer term prospects, and slow recovery from the current depression, and (b) the state will need to commit more funds to bail out the banking system.

Funds, as it turns out, that  were draining away rapidly as he spoke:

Russia will transfer 1.36 trillion rubles ($43.7 billion) from the  Reserve Fund, one of its two sovereign wealth funds, in the third quarter as the government tries to plug its first budget shortfall in a decade.

The Finance Ministry will use the cash to finance spending during the quarter, according to a decree signed by Prime Minister Vladimir Putin and published on the government’s  Web site late yesterday.

The Reserve Fund, which  contained 2.96 trillion rubles as of July 1, will have 1.6 trillion left by October. The government started tapping the stockpile in March to cover the deficit that’s expected to reach about 8 percent of gross domestic product this year.

Russia will exhaust the 3.6 trillion-ruble Reserve Fund by the end of next year if the deficit is 5 percent, Finance Minister Alexei Kudrin said on May 25. Rising crude oil prices may help the country reduce the use of the fund, Putin said last month.

Russia’s  budget deficit widened in the first half to the equivalent of 4.2 percent ofgross domestic product as the government spent 753.6 billion rubles more than it collected.

In this environment, Kudrin and the rest of the Russian government must be stressed out in the extreme by the substantial volatility in the price of oil over the past six weeks, given the dependence of government finances on oil taxes.  But even if the price of oil strengthens, the dismal situation in the real economy, and the increasingly likely prospect that the banks will require a large injection of state funds, will put the Russian budget under extreme pressure.  And Putin is just intensifying that pressure by forcing these already shaky banks to shovel rubles out the door in a desperate attempt to businesses and consumers afloat.  This is just deferring the day of reckoning, and increasing the price to be paid when that reckoning comes.

The next thing that caught my eye is the story about a group of Russian “entrepreneurs” pleading for the government to ban Skype:

Russia may curb the development of VoIP telephony, notably  Skype, in the country. The Russian Union of Industrialists and Entrepreneurs (RSPP) intends to propose amendments that would regulate internet telephony in Russia and protect the interests of Russian mobile operators. One of the arguments that the RSPP has taken up is that calls through Skype cannot be wiretapped.

Mr Valery Yermakov, first deputy director general of the Russian mobile operator, MegaFon, pointed out that VoIP calls can be made without any control by state authorities whatsoever. In particular, he mentioned software like Skype, which are not connected to Russia’s state wiretapping system (SORM).

RSPP will draft proposals for regulating IP telephony in Russia that would give precedence to Russian telecom operators. Mr Yermakov said local telecoms have two options: either to fight against VoIP services or begin providing those services themselves. While MegaFon has chosen the second option, one can be sure that its VoIP service will meet the RSPP’s requirements…

What a cosmic convergence of sleazebags from government and business.  First, a set of obviously self-interested telecom operators wants to impede competition from VOIP.  Second, it realizes that the best way to achieve this is to appeal to the intense desire of the Russian government to exert control over its citizens.  VOIP is “not connected to Russia’s state wiretapping system.”  We can’t have that, can we? Jeez, what kind of country HAS a state wiretapping system that is specifically directed at its citizens?  That tells you all you need to know about Russia.

Note that the telecom jackals leapt into action immediately following the government’s move to empower the security services (seven of them, in fact, if memory serves) to open everybody’s mail and packages.  There is clearly a trend to clamp down on every means by which Russians can communicate and express themselves.

But that’s relatively benign, as compared to what the Russian state can do to you if it really sets its mind to it.  Consider this horrifying story from the Washington Post:

A Russian police official conducting research under the auspices of Virginia’s George Mason University has been arrested after he reported obtaining evidence incriminating influential figures in Moscow and the far eastern city of Vladivostok, colleagues and local authorities said this week.

Col. Alexander Astafyev, 50, a senior anti-corruption investigator affiliated with a GMU research center in Vladivostok, had been working on an academic paper about “raiding,” or the criminal takeover of businesses with the help of corrupt officials, police or judges, when he was detained last month.

. . . .

Astafyev worked closely with FBI agents investigating organized crime, and he visited Washington last year at the invitation of the State Department, said Louise Shelley, director of the Terrorism, Transnational Crime and Corruption Center at GMU, which operates research and training institutes in Vladivostok and three other Russian cities.

“I think it’s very disturbing,” she said of his arrest. “It’s U.S.-Russia relations without the reset.” [Louise, you are a sucker indeed if you believe this reset thing is a two-way street.]

Shelley said Astafyev had a “long-standing reputation for integrity” and has been affiliated with the Vladivostok center for several years. He was conducting research on the criminal raiding of businesses under a $3,000 grant when he was arrested June 16, she said.

In a draft paper he submitted to the center, Astafyev estimated that 10,000 cases of criminal raiding occur every year but that fewer than 100 are prosecuted and result in convictions. “Law enforcement organs today are either participants or spectators of the takeovers,” he wrote.

In his letters, Astafyev suggested that his research had been a factor in his arrest, noting that he had submitted his paper shortly before he was detained and had included information about the criminal group that he thinks framed him. He also noted that police seized photos of him with American colleagues.

In his paper, Astafyev outlined cases of criminal business raiding in Vladivostok. In the process of seizing a trucking firm, he said, one outfit killed a senior executive of the company and injured several people, including a judge and a prosecutor.

In his letters, Astafyev said that the same group seized a major fishing enterprise and was deeply involved in smuggling. He linked it to officials in the Interior Ministry and the Federal Security Service, the domestic successor to the KGB, as well as to an adviser to the mayor, a former deputy governor of the region and a law enforcement official in Moscow, all of whom he identified.

Just consider the outrages packed into a few brief paragraphs.  10,000 corporate “raids” a year.  10,000 businesses extorted and stolen.  Resist–and die.  Multiple tens-of-thousands of lives ruined. And to think, every other business owner in Russia lives with this specter hanging over his or her head.  All with the active involvement of national and local politicians, law enforcement, and security services.  Not to mention the omnipresent cop, or fire inspector, or building inspector, or tax inspector, all with their grubby mitts extended.  Is it any wonder that small business represents such a small fraction of Russian economic activity, as compared to eastern Europe, not to mention the US.

I was going to say that Russia is like Sicily with snow, but even the Mafia was never that connected.

These last two stories give the lie to all the fine things that Medvedev supposedly advocates.

A knowledge-based, entrepreneurial economy?  Creative endeavors cannot flourish in a society where success is likely to result in extortion by armed thugs–including thugs employed by those ostensibly there to protect you.  Moreover, stifling free communication and expression, and surveilling all means of communication, is hardly conducive to creative, entrepreneurial endeavors–especially when it is well-known that those in the employ of the state routinely use commercial espionage for competitive advantage and to facilitate extortion.

Entrepreneurial?  Make me laugh.  Entrepreneurial, in a country a large organization that supposedly represents entrepreneurs appeals to the state’s basest instincts in order to stifle competition?

The end of legal nihilism, and the establishment of a rule of law?  With tens of thousands of businesses harassed by all levels of law enforcement?  The abolishment of corruption?  Tell it to Colonel  Astafyev.

Dmitri Medvedev is either the world’s biggest fool, or the most mendacious bastard in eleven time zones–which would be saying a lot.

Thus endeth a post bracketed by Russia’s Bobbsey Twins, Putin and Medvedev.  Which is worse?  Is death an option?  Sadly, in Russia, the answer to that question is all too often: Yes.

In the wake of Goldman Sachs’s huge earnings, Morgan Stanley just reported a quarterly loss.  CEO John Mack blamed the loss on the company’s cautious attitude towards risk taking:

A week after  Goldman Sachs Group Inc. proved securities firms still can rake in record profits from taking big risks, Morgan Stanley reported a $159 million second-quarter loss from continuing operations that left Chairman and Chief Executive John Mack conceding that parts of the company got too conservative after surviving its near-death experience last fall.

. . . .

“We are not satisfied with our performance” in “key areas of fixed-income trading and in asset management,” Mr. Mack said in a statement. To turn things around, Morgan Stanley is bringing in new blood in its managerial ranks, expanding its trading with clients and “increasing capital commitments in a disciplined way,” he added.

Translation: Morgan Stanley now plans to rev up its risk taking, which it has been averse to doing since the company came close to perishing or being forced into a government-assisted takeover last fall.

“We were encouraged that they had a more aggressive tone than in past quarters” on trading, said Barclays Capital analyst Roger Freeman. “But the quarter itself doesn’t leave much to be encouraged about. They’ve let opportunity slip by.”

In bond trading, Morgan Stanley’s revenue was barely a third of that reported by Goldman, even after the impact of Morgan Stanley’s own credit spreads were excluded. Stock-trading revenue was less than half what Goldman brought in during the quarter.

Earlier this year, Morgan Stanley executives said they were reluctant to take the sorts of chances that were common before the financial crisis erupted, concluding that the returns wouldn’t be generous enough to justify the possibility of losses.

But hold on!  Felix Salmon reports that Morgan Stanley’s value-at-risk went up by about 25 percent from the fourth quarter of 2008 to the second quarter of 2009.  The WSJ article also reports that the firm increased its leverage from the end of last year.  So much for the “oh-we-lost-money-because-we-were-so-conservative excuse.”  Actually, it should be “we-lost-money-because-we-took-more-risk-and-and-made-bad-calls.”

Salmon expresses puzzlement at MS’s poor performance as compared to Goldman and J.P. Morgan.  I’m puzzled why he’s puzzled.  Goldman took on more risk, sure, and made money.  But you don’t make more money just because you take on risk.  You make money because you bet, and bet right.  And if you bet big and right, you make a lot of money.  That’s what Goldman did. MS’s performance gap isn’t due  it not betting, it’s due to its betting bigger–and wrong.  No mystery here.

And this represents more bad news, because the lesson the firm has apparently drawn from its experience, and no doubt Goldman’s, is that it needs to take on more risk:

On Wednesday, though, Morgan Stanley Chief Financial Officer Colm Kelleher said he feels more “constructive” about taking trading risks as markets stabilize. He said some traders avoided riskier trades during the second quarter, despite management’s willingness to take more risks. “Some of the trading desks didn’t see the opportunity and weren’t prepared to put capital to work,” he explained in an interview.

. . . .

“We’ve been seeing clear signs of stability,” Mr. Kelleher said, noting renewed activity in the bond and commercial-paper markets. But the firm plans to continue to tread carefully, mainly ramping up risks in well-traveled areas such as government bonds and currencies.

“It takes awhile,” he said. Late last year, “we stared into the abyss,” and some traders may still be “gun-shy.”

Why is this bad news?  To me it suggests that seeing Goldman’s performance, and concluding that it too is too big to fail, Morgan Stanley thinks that loading up on risk is the way to go.  Why be a chump and reduce risk, when Goldman has shown you can swing for the fences and rely on Uncle Sugar if the bets don’t go the right way?  

To me, this line blaming the losses on excess conservatism is just bull, and an excuse to use the losses to justify ramping up the risk taking.  Given that equity holders benefit from the Treasury put of a too big to fail institution, they will be cheering MS on.  Me, on the other hand, being one of the guys who is (involuntarily) short the put, will be groaning.

The Economist recently ran an article describing the soul-searching going on in academic economics, especially macroeconomics. For the most part, I don’t have a dog in this fight, because when in graduate school so many moons ago, like many of the students described in the Economist article, I decided that macro was too abstract and detached from real world institutions for a relatively literal-minded person like me (literal-minded for an academic, anyways). Taking Robert Lucas’s macro sequence was an amazing experience—an intellectual tour de force—but I knew that despite my original intentions to go into macro, it was not for me.

The gravamen of the article is that Lucas-style dynamic stochastic general equilibrium models have failed to predict, or even explain, the current recession. With regards to prediction, that’s a red herring, because such models never aspired to such a goal, and indeed, were the basis for conclusions that such predictions were nigh on to impossible.

What’s galling about the article is the (somewhat implicit) endorsement of the Krugman-DeLong view that we need to atone for the sins of the New Classical synthesis by embracing the Old Time Religion of Keynesianism. Give me a freaking break. Keynesianism fell out of favor the first time around because of ITS abysmal failure to explain economic developments in the 1970s, most notably stagflation. And its applicability to the current situation is incredibly dubious as well. The article criticizes DSGE models for failing to incorporate a financial sector and financial institutions. Like Keynesian models (new or old) do? And, as the article notes, the Keynesian theory goes like this:

In his scheme, investment was governed by the animal spirits of entrepreneurs, facing an imponderable future. The same uncertainty gave savers a reason to hoard their wealth in liquid assets, like money, rather than committing it to new capital projects. This liquidity-preference, as Keynes called it, governed the price of financial securities and hence the rate of interest. If animal spirits flagged or liquidity preference surged, the pace of investment would falter, with no obvious market force to restore it. Demand would fall short of supply, leaving willing workers on the shelf.

This bears no relationship whatsoever to what transpired 2007-present. There was no exogenous surge in liquidity preference; the race for liquidity was a response to another shock—the decline in real estate prices—that called into question the safety of financial institutions invested heavily (directly or indirectly) in real estate. The liquidity panic was an effect, which had knock-on effects: it was not the Prime Mover.

What’s more, the increase in savings that has occurred in the last months undermines one of the rationales for a fiscal stimulus—namely, that there are large numbers of liquidity constrained households that would consume more but for this constraint. But the implication of the constraint is that people will draw savings to zero to consume as much as possible; they would borrow to consume more, but can’t, and government spending can loosen that constraint thereby permitting an increase in consumption. How you can square a liquidity-preference theory of economic slumps in which consumers spontaneously decide to save more and consume less, with a policy recommendation based on the assumption that individuals would like to consume more but cannot due to liquidity constraints escapes me at the moment. Krugman et al blithely blab away without even recognizing the contradiction.

And, for the most part, even modern economists who consider themselves Keynesian adopt much of the Friedman-Lucas-Prescott-et al critique of the Old Time Keynesian Religion that Krugman and DeLong are preaching. Specifically, they discard the silly Keynesian consumption function demolished by Friedman and adopt aspects of the permanent income hypothesis. They assume individuals are forward looking, and make forecasts about policy in a pretty rational way. They assume that individuals are not subject to fiscal illusion, and thereby recognize that government spending increases must be financed by future taxes. They depart from the New Classical approach by assuming wage and price rigidities, but allow a more reasonable, expectations-based adjustment mechanism. The rigidities lead to some broadly Keynesian features, but even in the presence of these rigidities, many aspects of the Friedman et al critique survive.

This is illustrated very well in a paper by Cogan, Cwik, Talyor and Weiland, which uses a New Keynesian model to estimate the effects of the 2009 “stimulus” package. A crude Keynesian model predicts very strong multiplier effects; as Cogan et al note, moreover, this conclusion also depends on the insane assumption that the central bank can keep the nominal interest rate at zero forever without sparking a massive inflation. As if.

A New Keynesian model that incorporates wealth effects from taxation, forward looking households, nominal rigidities with a more realistic adjustment mechanism, and a monetary policy that does not result in a hyperinflation (fingers crossed on that one) generates very small multipliers. Indeed, more realistic characterizations of the nature of the fiscal stimulus (including characterizations based explicitly on the 2009 stimulus package) generate NEGATIVE multipliers fairly soon in the future—and can generate negative multipliers immediately. This means that the “stimulus” can actually reduce output. Great.

Moreover, the increase in GDP in the analysis comes entirely from the increase in government expenditure. Indeed, the increase in government expenditure causes consumption and investment to fall because this expenditure crowds out private consumption and investment due to the wealth effects; consumers anticipate the higher tax burden, and cut back their expenditures accordingly, and business anticipate the lower consumption and cut back investment. Great again.

And as Cogan et al note, this result, as awful as it is, is based on some assumptions very favorable to the stimulus. Most notably, it assumes that $1 of government expenditure provides $1 worth of goods. Not likely, given the nature of the spending. I’d rather have $1 in private consumption than $2 in government spending, giving the stupid stuff the government actually buys with my money. But the Cogan et al analysis assumes that the $1 of government stuff is worth $1 to you and me.

Moreover, and perhaps more importantly, the Cogan experiment assumes that the taxes used to finance the higher spending are not distorting. We know taxes distort and thereby reduce output. Thus, the already paltry positive effects of the stimulus implied by the model are likely to be smaller in practice.

All in all, even a Keynesian-influenced model makes predictions very similar to what I argued in my jeremiads against the stimulus. Wasteful government consumption crowds out beneficial private consumption, and when you take into account the effect of distorting taxes, the effect of the stimulus is likely to be baleful indeed.

The Bacchanal of future spending contemplated by Congress and the administration will, in my view, be even more disastrous. I would surmise (based on the above) that New Keynesian models would come to similar conclusions.

So, I stand by my conclusion that the “saltwater” economists like Krugman and DeLong are all wet. And remember, if you drink saltwater, you go crazy.

Does that leave the New Classical folks blameless? No. But I think the diagnosis of The Economist and the saltwater types misses the problem.

I remember distinctly Lucas’s lectures on business cycles. He started out his discussion by referring to the seminal empirical work on cycles done by Wesley Mitchell for the NBER. Lucas argued that virtually every cycle that Mitchell documented exhibited a very similar pattern. From this, he (and others) concluded that there must be a common cause to these cycles. This motivated a search for the cause. The Friedman and Schwartz work suggested that monetary fluctuations were a prime suspect. Real business cycle theory went in another direction. But, both were predicated on this view that the “business cycle” is a unitary thing, with a single, primary cause.

In retrospect in particular, this reasoning is suspect. Perhaps it is the case that most fluctuations in output are traceable to a single cause, but it is possible that there can be unique circumstances that also lead to large output changes. To me, it seems that the recent experience with a housing price runup and subsequent collapse triggering a financial crisis in large part because of the heavy investment of financial institutions in assets strongly tied to housing prices is a pretty unique event.

In other words, economists of all stripes—New Classical types and Keynesians New and Old—arguably vastly overstated the temporal homogeneity and regularity of the economy. They constructed models that were conceivably Theories of a Lot, but which weren’t Theories of Everything. Unfortunately, the decent empirical success of these models in characterizing the historical record, especially the post-War experience, provided undue confidence in the universality of the models. But with models, as with investments, the old caution that Past Performance is No Guarantee of Future Performance holds. Successful backcasting, and even somewhat successful forecasting, does not imply that unprecedented outside-the-model events will not occur in the future.

This represents a challenge to economics as a science, and one that is likely to be insurmountable. The evolution of vast, complex, unplanned, interconnected systems of (mostly) maximizing agents operating in conditions of sharply limited knowledge will inevitably produce unique historic contingencies. Sure, there are regularities. Sure, some features may repeat over time (e.g., technology shocks that induce business cycles, or monetary policy changes), and these will lead to many fluctuations that exhibit some similarities over time. But from time to time, something completely unique will happen; some unique confluence of contingencies will lead to economic changes that confound the models. The primary regularity is that irregularities periodically occur, and some of these irregularities can be quite extreme.

This does not mean that the entire modeling exercise was a waste. All it means is that we should have relatively humble expectations about economic models in general, and macro models in particular. Stuff happens, and no model will ever be capable of capturing all the stuff that could happen.

Methodologically, this means that although I am sympathetic to the logical rigor that formalization brings, a diversified portfolio of approaches is needed. Less formal approaches, and militantly anti-formal ones, like Austrian Economics, can produce important insights. In particular, Austrian-influenced approaches that emphasize the implications of radically constrained knowledge and innovation in complicated systems can provide a useful framework for coming to grips with the unexpected, and the unmodelable (to coin a word). And history—and the study thereof, and narrative history in particular—matters too. Not because the past provides all that reliable a guide to the future, but because studying it makes one more aware of the role of contingency, and the confluence of unique circumstances resulting in unique effects in systems where purposeful action by billions of people leads to outcomes intended by no one.

In other words, when casting back for great economists whose work years ago can better help us understand the present and future, I look not to Keynes, but to his rival, Hayek.