Streetwise Professor

Here’s a dramatization of Cromwell’s speech dissolving the Rump Parliament, from the eponymous biographical movie.  The speech is somewhat different than the one I quoted, but Richard Harris gives a convincing portrayal.  The speech starts around the 2 minute mark:  start watching from about 1:30 to get an illustration of the dissoluteness of the Parliament.

And for those who want some biographical detail on Cromwell, here you go!:

Central counterparties work on the principle of mutualization.  CCP default funds are a mechanism for mutualizing–sharing–counterparty loss risk, where the CCP-insurer has some protection in the form of a “deductible” that consists of the defaulter’s margin plus default fund contribution.

Insurance works when risks are diversifiable.  So, to the extent that the risks of default exhibit relatively little correlation across clearing members (CMs), mutualization through a CCP can improve the allocation of risk: through diversification, the variability of the average default loss across all CCP members is smaller than the variability of any CM’s default loss profile.

It should be noted that these diversification effects work in OTC markets too: market participants who deal with multiple counterparties diversify exposure to counterparty losses.  Moreover, in OTC markets, it is often possible to hedge counterparty risk through the CDS market.  [Which raises a question: how do you hedge CCP credit risk?  It is highly unlikely that CDS will be traded on CCPs.  Perhaps using a portfolio of CDS on CMs?  But who clears those CDS?  Sounds like the wrong way risk from hell.]

CCPs have been sold as a means of reducing systemic risk.  The basic story is that in bilateral OTC markets, the failure of one entity can cause the failure of other entities in falling-domino-like fashion.  In this telling, a CCP reduces interconnectivity of the financial market, and thereby reduces the likelihood of that the failure of one firm–even a big one–will cause the failure of others.  Put differently,  in this view default/counterparty risk is insurable because it is diversifiable, and therefore mutualization can improve the allocation of risk.

But is the domino-model really a good description of systemic risk?  Is the system really threatened by the isolated, idiosyncratic failure of one firm, even a big one?

Here’s an alternative story, in which a big, system-wide shock hitting many institutions simultaneously is the source of systemic crisis.  Some examples: Black Monday in 1987, the Asian and Russian crises in 1998, and the subprime meltdown of 2007-2008.

In such episodes, there are large price moves across asset classes.  These price moves often blow through margins–and by a lot.  During the subprime crisis, for instance, even well-before the Lehman episode, some prices moved by huge amounts.  In August, 2007–more than a year before Fannie-Freddie, Lehman, and AIG–David Viniar of Goldman lamented that there had been several 25 standard deviation moves in multiple markets.  In a “normal” (Gaussian) world, 25 sd moves don’t occur.  Period.  People don’t set margins based on the possibility of 25 sigma moves.  So when such moves occur–and they occur in the real, non-normal world–margins get blown through.  Meaning that if someone defaults, they’re well into the default fund, and the protection of the “deductible” is gone.

Moreover, such earth-shaking episodes are typically associated with adverse shocks to bank (CM) balance sheets.  What’s more, such events raise serious doubts about the solvency of banks/CMs: adverse selection problems can run rampant, causing markets to freeze.  This tends to cause funding and liquidity to dry up.  Due to actual insolvency, and illiquidity driven by widespread fears of potential insolvency, those facing big margin calls may face substantial difficulty in meeting them.   Thus, they are more likely to default.  This is what happened to AIG and Lehman.

Since the shock hits all financial institutions simultaneously, and since the shock is big, this risk of default is not idiosyncratic; it is highly correlated across firms.  Given such a shock, if one firm defaults, others are at elevated risk of default too.

If defaults that breach margins occur, the surviving CMs who contribute to the default fund must absorb the loss, and take a hit to their capitals.  But this hit occurs exactly when capital is very valuable/costly for them.  That is, hits to the default fund are likely to come at the absolute worst times–during adverse moves in the overall market.

It is possible that a CCP’s default exposure in such a circumstance could crater the clearinghouse.  But even if the CCP survives, its surviving members suffer a loss (via to their exposure to the default fund) when they can afford it least.

This has some interesting implications.  In particular, it means that the systematic risk of default fund capital is very high, which in turn means that default fund capital is extremely expensive.  The default fund is like a deep out of the money short put on the market.  Such puts are essentially bets on systematic risk, and hence are very expensive.

The expense of such capital means that CMs are likely to want to minimize the amount they post.  They have every incentive to try to construct risk measures that make CCPs look safe, with very low risk of default, in order to reduce their exposure to the default fund.

Think that this can’t be done?  Think again: that was essentially the entire game in CDOs.  As Coval-Jurek-Stafford show in an AER paper, “super senior” CDOs were claims that had low probabilities of default, but that defaults would occur precisely during periods of crisis–analogous to the foregoing characterization of the risk profile of default funds.  C-J-S present empirical evidence that these CDOs–which were AAA rated–were grossly underpriced, meaning that those who were buying these securities didn’t fully appreciate how heavily they loaded on systematic risk because analysis–and ratings–were framed almost exclusively in terms of unconditional default probabilities, and the rating agencies and many investors and regulators ignored the fact that defaults would occur when the value of capital was very high.  I can see the same thing happening with CCPs–who will reflect the interests of their members–focusing on default probabilities to justify their capitalization to regulators.

Another interesting implication is for what instruments should be cleared.  Instruments that have big losses during big systematic shocks–those that load heavily on systematic risk–are exceptionally dangerous for CCPs.  This means that clearing things like senior or supersenior tranches (or derivatives on them) is exceptionally dangerous.

This has a corollary: anybody that uses AIG to justify clearing mandates doesn’t know what the hell they’re talking about.  AIG’s positions in derivatives on supersenior tranches were, as C-J-S show, systematic risk time bombs.  Clearing those things would dramatically increase the systematic risk of default funds, because they would expose default funds to losses precisely during systemic crises.

Some people know this.  Jon Gregory, for instance.  When discussing “market coverage of a CCP”, he states:

Finally, CDO tranches (especially supersenior) would be expected to have serious correlation [i.e., systematic risk] impact since in a scenario where there are losses on these tranches it is likely that many CCP counterparties [and CMs] are in a distressed state.

The above analysis is to some degree subjective but one general point–probably beyond argument–is that the most important trades products to be traded through CCPs are arguably the most risky from the point of view of the stability of the CCP.  There has been much recent interest to trade all CDS index products and single-name products through CCPs. . . . The general point is that the products that market participants will most want and need to trade through a CCP will be the precise products that are most difficult to handle in this way (pp. 381-382).

In sum, the belief that CCPs can reduce systemic risk is predicated on a particular narrative of  the likely source of a future crisis.  This view is that the failure of a single institution, arising from some shock idiosyncratic to it (a bad trading decision, an operational risk such as a rogue trader) can lead to the failures of other institutions via a contagion mechanism.

But, in my view, that isn’t an accurate characterization of the actual crises that have occurred over the years.  These have been associated with broad-based shocks that hit large numbers of institutions simultaneously.  Again: Black Monday, Asia/Russia, subprime.

There have been multiple examples of large, one-off collapses of highly interconnected and leveraged institutions that have not resulted in a cascade of failures that led to a systemic crisis.  To name several off the top of my head: MG (1992), Barings (1995), Amaranth (2006). For a while, it looked like the Hunt collapse in 1980 could have broader, systemic consequences, but that fear evaporated rather quickly.

The contrast between the effects of the collapse of Amaranth in 2006 and the crisis surrounding the problems of LTCM in 1998 is particularly instructive.  Amaranth was actually bigger than LTCM (though it should be noted that the markets were bigger too), and had large OTC positions.  The difference was that Amaranth’s collapse was not caused by a systematic shock, whereas LTCM’s was.  LTCM engaged in strategies that blew up because of major shocks arising in Asia and Russia.  It was thus on the verge of failure precisely when liquidity had dried up, and its (big bank) counterparties were in bad financial shape because of the crisis.

The Amaranth collapse was effectively a diversifiable risk, and potentially clearing improved the allocation of that risk (many of Amaranth’s positions were cleared).  But the bilateral markets could have likely handled it quite well too.  In contrast, LTCM’s risk was not diversifiable.  Clearing would have still passed the risk of its failure onto stressed financial institutions, and likely resulted in some similar emergency measure to mitigate the impact of its huge losses.  (I’ve long argued that the same would have been the case with AIG.)

Along these lines, FTAlphaville has a very interesting post describing some forthcoming research which shows that incorporating “common jumps” into models of index option prices go a long way towards explaining the volatility skew, and reconciling the skews of index components and the skew of the index:

According to a technical paper published on Risk.net by Alex Langnau, global head of analytics at Allianz Investment Management and Daniel Cangemi, head of FICC trading at EFG Financial Products, Wall Street’s next top (risk) model is actually a copula that attempts to explicitly link correlation skew to systemic risk so as to improve tail risk management of large portfolios.

The basic premise lies in the idea that the downside risk of a portfolio of assets is generally substantially higher than the downside risk of its components — because assets tend to correlate more strongly in times of crisis.

. . . .

As the authors conclude this could become extremely useful for trying to figure out the additional risk attached to asset portfolios:

We have presented a generalisation of the Merton jump option formula to multi-assets as well as diffusive skews and found that common jumps are an appropriate and intuitive way to define copulas that describe the systemic risk of a portfolio.

Financial institutions should start treating systemic risk as market data across asset classes and start to mark, risk-manage and price these effects in a systematic way.

This suggests that these common jumps are of first order importance.  And these common jumps aren’t diversifiable.  What I argue above is that the major risk that CCPs face arises from such system-wide, common shocks.  And in the event, mutualization is all but irrelevant.  Except, perhaps, to the extent that CMs attempt to limit their exposure to this risk via the default fund by undercapitalizing CCPs, thereby threatening the ability of these vital–and soon to be even more vital–pieces of market infrastructure to survive a systematic shock.  In which case, mutualization makes things worse because if some CCPs don’t survive, the knock-on effects from the original shock will be even more catastrophic.

In some respects, the issues I’ve discussed here reflect an older literature on bank runs.  One view of bank runs is that they are idiosyncratic in origin (i.e., a bad shock–perhaps even a sunspot–hits a single bank, leading to a run), but have systemic effects due the interconnectedness of the financial system.  In this view, widespread panics spread like a wildfire from a single, isolated spark.

An alternative view, associated most strongly with the work of Calomiris and Gorton, is that runs occur when depositors receive adverse information about the aggregate economy, which raises concerns about the viability of all banks.  In this view, panics involving runs at many financial institutions reflects the fact that all banks are exposed to a common risk.

The Calomiris-Gorton view, and the evidence they amassed to support it is persuasive.  In more recent times, major periods of crisis have been associated with a common shock hitting many financial institutions, rather than from the contagion of an idiosyncratic shock to one big institution laying low otherwise healthy institutions.  In these types of events, mutualization of risk isn’t of much help, and can actually make things worse.  Meaning that clearing mandates were sold largely on the basis of a misleading portrayal of, or misunderstanding of, the real dynamics of financial crises.

One takeaway from this is that there should be a very hard look at CCP capitalization, and at measuring the cost of default fund capital.  The exposure that default funds face to systematic risk affects the cost of capital–and hence the cost of clearing.  That cost should be taken into consideration when deciding the scope of clearing mandates–that is, when deciding what should be cleared.   For the analysis suggests that clearing can be very expensive, and that a major source of cost has been largely overlooked.  Forcing too much to be cleared can create costs with no corresponding benefit.

Today is August 1.  This article suggests that 31 days of tragedy are on the way in Smolensk and points east.  It’s a long article–and it only chronicles August disasters since 1998.  (Which means that the ’91 coup is not included.  Whether you would put that in the disaster category tells a lot about you.)

August started early this year.  In July, actually, with two nautical disasters, including one in right in the center of Moscow on Sunday.  Walter Russell Mead notes that Russia is held together by duct tape, and wonders whether there is a shortage of the stuff:

Since the Brezhnev era, Russia has been skimping on maintenance. Factories, highways, bridges, rail networks, schools, hospitals: Russians have been trying to keep them running rather than investing money they don’t have to maintain, upgrade and replace them.

Corruption, low salaries and the general malaise of post-Soviet Russia make things worse.  Russia has been running on duct tape for twenty years, and now the duct tape is starting to fray.

. . . .

Ceci n’est pas un bric.

I would put more emphasis on the “general malaise” explanation.  That, and one Mead overlooks: vodka.

It is interesting to conjecture, though, why August seems so cursed.  Is it so?  And if so, why?  Thoughts, people?

The Exchange Formerly Known as the Chicago Mercantile Exchange–now dubbed the CME Group–has announced that the tax situation in its current corporate home of Illinois is “untenable“:

“Our tax situation is untenable,” [CEO Craig] Donohue told Reuters, noting that CME is taxed more heavily than any of its global competitors. The company is talking with at least three states — Texas, Florida and Tennessee — about relocating some of its business to take advantage of lower tax rates there, Donohue said.

Did he say Texas?  Well, come on down!  Plenty of room!  Might I suggest Houston?

I am a native Chicagoan, and a latter-day Texan. As someone who still identifies with Chicago, and who is deeply proud of the city’s history, I am truly saddened by the circumstances that led to the CME thinking seriously about pulling up stakes.  It is the company that arguably has the deepest, longest, and most emotional tie with the city.  Their destinies and identities have been linked for almost 160 years, if you include the CBT, and nearly 100 just looking at CME alone.  The exchanges have long been iconic symbols of the city.  When derivatives exchanges began to spring up around the world beginning in the 1980s, they all looked to emulate Chicago.   The futures exchanges were the city’s unique and enduring contribution to the world of finance.

But, as they say in Texas, bidness is bidness.  Illinois has become an unbelievably hostile environment for business.  As Walter Russell Mead has blogged about regularly, the Blue State model is broken beyond repair.  And Illinois is about the bluest and brokenest state in the country–in many senses of the word “broke.”  “The City That Works”–Chicago’s old-time motto–is no longer operative.  The state is well into the fiscal death spiral: bloated spending leading to high taxes that drives out business and people.  The writing was on the wall before the last election, but the new governor and the legislature refused to make fundamental changes in the way the state spends and operates, deciding instead just to ratchet up taxes.  When businesses and people can move, that never works.  Never.

So the mystic chords of memory only go so far, and the CME owes it to its shareholders to make a rational decision.  And a rational decision means start humming “Southbound.”  The tax environment is better, and the regulatory environment is too.  In Texas specifically, tort reform has made a big difference in the business environment.

And unlike Boeing (also a Chicago company, as of recently), CME Group won’t have to worry about the NLRB if–or should I say when?–it decides to move.

Like the bumper stickers say, I wasn’t born in Texas, but I got there as soon as I could.  And damned glad I did, for a variety of reasons.  Paradoxically, it is in many ways more like the US of a long time ago, but its future is a lot brighter than that of virtually any other “progressive” place in the US–including progressive Illinois and Chicago.

Though actually that’s not really a paradox, IMO.

There is reporting based on leaks describing the results of US intelligence investigations that the explosion at the US Embassy in Georgia was the work of the Russian GRU (military intelligence).  This allegation had been made originally by the Georgians, which touched off the usual torrent of accusations that the claims of Russian involvement were Georgian propaganda.  That’s a harder–though not impossible–case to make if US intelligence has independently arrived at the same conclusion.

The administration’s response: “It’s not necessarily pointing a finger, but part of a dialogue expressing our deep concerns.”  Wow.  That’ll put the fear of God into them.  Wouldn’t want to label, now would we?

IMO this is just one of the periodic surfacings of the ongoing covert and dirty conflict between Russia and Georgia.  Evidence of US involvement is absent, but as Rumsfeld noted, absence of evidence is not evidence of absence.  I would surmise that one explanation for the Russian action–if it indeed occurred–is that the US has been actively assisting the Georgians and in fact did something that struck very close to Russian operations and interests.   If that’s true, then it would mean that the vaunted reset is pretty much a fraud.  If it isn’t, and the Russian action was unprovoked, the vaunted reset is pretty much a farce.

I would imagine that the covert conflict will continue unabated.  And the prospects of it breaking out into something not so covert are always there, given the volatility of the personalities involved, and the political uses of conflict.  The political uses are particularly important given the impending Russian presidential election.  Depending on your theory of what the real dynamics of that election are, you could easily construct scenarios in which a renewal of conflict between Russia and Georgia would be beneficial for Putin or Medvedev (if you believe that they are truly rivals wrestling under the carpet), or both (if you really believe in the fundamental unity of the tandem).

I further imagine that given the near Pavlovian reactions to anything involving Russia and Georgia, the comments will soon revert to free-fire mode.  Counting down.  Ten, nine, . . .

Autocrats and would-be autocrats invariably attempt to project an image of unconstrained power and authority, in large part to overawe those lower in–but still relatively high up–in the hierarchy.  Putin is no exception to that rule.  Nor is he an exception to the rule that autocratic appearances are often deceiving, and that underneath the projected image of order powerful factions vie for rents and control.  Particularly in a sprawling country like Russia, and one with a sprawling bureaucracy, these internecine struggles are almost impossible for the one at the pinnacle of the vertical to control.  Projection of an image of unchallenged authority is often little more than an attempt to mitigate the consequences of the fact that the nominal ruler’s control is sharply circumscribed.

Pavel Baev argues that this is the case in Russia today, with Putin and Medvedev exercising only weak authority over siloviki and other bureaucrats:

Elections in Russia are not about selling a vision or swaying the electorate, they concern showing who is the boss – and demonstrating that the boss means business. In this crucial respect, the ongoing election campaign is a complete mess, and not because it is still unclear whether President Dmitry Medvedev will cling to his slim chance to stay for the second term, but because Prime Minister Vladimir Putin, who is seen by the whole country as the “real boss,” cannot assert control over the self-serving bureaucracy. Putin has been busy filling and dressing the ranks of the Popular Front, which is supposed to secure an electoral triumph of the discredited United Russia party, and is not responding to the embarrassing scandals that leak out of numerous cracks in the executive pyramid with increasing intensity (Nezavisimaya Gazeta, July 7).

Perhaps the highest resonance scandal spins around the defense ministry, which is loudly accused by industrial lobbyists of sabotaging the implementation of the armaments procurement program, first of all in the top priority area of strategic missiles (Kommersant, July 6; Moskovsky Komsomolets, July 8). Allegations of gross incompetence appear more convincing due to the resignation of several top brass, and Medvedev provides Serdyukov no defense perhaps assuming that a scapegoat would be needed closer to the elections (Ezhednevny Zhurnal, July 6). That might cool some tempers but will not resolve the core problem created by the plain fact that the stretched state budget in years of slow growth could not possibly sustain the over-ambitious rearmament program.

Several juicy scandals unfold simultaneously between the interior ministry and the state prosecution as the investigation of the protection racket involving illegal casinos in the Moscow region produces more compromising evidence (Vedomosti, July 7).  [Bootleggers and Baptists, again!]  Medvedev has launched a campaign to clean up the ranks of law enforcement but it has deteriorated into back-stabbing between various services and agencies and all attempts to put a lead on revealing these feuds to the public have only made the quarrels noisier (www.gazeta.ru, July 6). On the local level, the merger between police and organized crime has left many municipalities defenseless, and only in rare cases – such as the village of Sagra near Yekaterinburg – dare the inhabitants to take a stand against the violent gangs, much as in old Western movies (www.lenta.ru, Ekho Moskvy, July 7).

. . . .

Putin’s half-hearted efforts at tightening control are in fact as helpless as Medvedev’s attempts to assert his authority. Russia’s “national leader” can no more discipline the “power structures” than he can control Ramzan Kadyrov, whom he appointed to rule Chechnya – and who has turned it into a personal fiefdom prospering from the ransom paid by Moscow. It is the predatory behavior of the uncontrollable siloviki that increasingly compels successful Russians to consider emigration and drives the capital flight. This outflow of people and money may erode the support base for democratic opposition but it hardly prolongs the regime’s durability. Putin cannot allow the elections to expose the weakness of his grasp on power, or mobilize the self-serving repression apparatus – he can only rely on the lack of alternatives, which is never a lasting advantage.

But this is not new, not by a long shot.  Consider William C. Fuller’s Strategy and Power in Russia, 1600-1914.  Describing 18th century Russia, Fuller writes:

But their [sic] were other, less readily apparent limitations, or at least so some historians have contended.  Such scholars have argued that all of the lip service paid to the “unbounded power” of the autocracy actually masked the reality of an essentially feeble state.  The “all-powerful autocrat” in this view was a fictitious creation of mythmakers anxious to dupe people both at home and abroad into thinkng that the Russian state was much stronger than in fact it was.  Since autocrat-usurpers frequently owed their crowns, if not their lives, to the efforts of favorites and clans, the schemes and preferences of those courtiers represented a self-evident check on the monarchical will.  As one historian puts it, the power of the autocracy “was in fact very narrowly circumsribed,” for “the articulation of tsarist will depended upon the familial and personal patronage networks that dominated the court and the upper administration. . . . At the very least, any autocrat had to seek to balance all the various factions and “parties” against one another.

Clan politics and factional strife are often blamed for the lumbering inefficiency of the highest organs of administration in eighteenth-century Russia. (pp. 118-119).

And see if you can tell whether this is from Baev describing Russia circa 2011 or Fuller describing Russia circa 1750:

This same confusion of personal interest with the interests of the state is all supposed to to explain the extraordinary corruption of Russia’s governing class.

In fact it is Fuller, but it is a fitting description of current affairs.  Fuller continues:

Embezzlement, extortion, graft, the acceptance of foreign bribes–none of these practices was uncommon among the aristocratic elite.

In other words, Putin is facing problems inherent to autocratic systems, and is, within the constraints of a nominally democratic system, attempting to employ many of the same techniques to deal with them.  He cannot rely on the formal and traditional allegiance due a hereditary autocrat, so he is using media control to create a personality cult and an aura of unchallengeable authority and infallibility.  Like tsars and tsarinas before him, he is a really a balancer, not a true ruler.  He is limited in his ability to control his nominal agents.

These considerations may prove decisive in determining Putin’s decision regarding the presidency.  The tandem is vulnerable to attempts to play one of the two off against the other in the same way that Putin keeps the siloviki under control by pitting clans and factions against each other.  Hence the emphatic and almost ritualistic assertions that Putin and Medvedev are of one mind, despite evidence to the contrary.  The agency problems of a would-be autocracy are bad enough, without the potential for conflict and coordination problems at the top.    Thus, I would conclude that if Baev’s description is at all accurate, the duumvirate will pass into history with the next election.

But even if it does, the age-old disabilities of autocratic, personalized, a-institutional systems will continue to operate.  The hamster wheel has spun for centuries, and will continue to do so for the foreseeable future.

Ariel Cohen Leon Aron has an interesting retrospective on the fall of the USSR.  He dismisses material and materialist causes.  The Soviet economy, he notes, was not prospering, but it was not imploding either.  The Soviets had experienced some setbacks abroad, but nothing catastrophic.  Instead, Cohen says that the collapse was impelled by glasnost and perestroika, and these were in turn rooted in a moral revulsion at the corruption of the USSR, and what the Soviet system had done to the human spirit:

For though economic betterment was their banner, there is little doubt that Gorbachev and his supporters first set out to right moral, rather than economic, wrongs. Most of what they said publicly in the early days of perestroika now seems no more than an expression of their anguish over the spiritual decline and corrosive effects of the Stalinist past. It was the beginning of a desperate search for answers to the big questions with which every great revolution starts: What is a good, dignified life? What constitutes a just social and economic order? What is a decent and legitimate state? What should such a state’s relationship with civil society be?

Cohen Aron depicts a similar moral crisis today, and intimates that it may be the catalyst for a 1991-style collapse of the ruling regime:

Which is why today’s Russia appears once again to be inching toward another perestroika moment. Although the market reforms of the 1990s and today’s oil prices have combined to produce historically unprecedented prosperity for millions, the brazen corruption of the ruling elite, new-style censorship, and open disdain for public opinion have spawned alienation and cynicism that are beginning to reach (if not indeed surpass) the level of the early 1980s.

One needs only to spend a few days in Moscow talking to the intelligentsia or, better yet, to take a quick look at the blogs on LiveJournal (Zhivoy Zhurnal), Russia’s most popular Internet platform, or at the sites of the top independent and opposition groups to see that the motto of the 1980s — “We cannot live like this any longer!” — is becoming an article of faith again. The moral imperative of freedom is reasserting itself, and not just among the limited circles of pro-democracy activists and intellectuals. This February, the Institute of Contemporary Development, a liberal think tank chaired by President Dmitry Medvedev, published what looked like a platform for the 2012 Russian presidential election:

In the past Russia needed liberty to live [better]; it must now have it in order to survive.… The challenge of our times is an overhaul of the system of values, the forging of new consciousness. We cannot build a new country with the old thinking.… The best investment [the state can make in man] is Liberty and the Rule of Law. And respect for man’s Dignity.

It was the same intellectual and moral quest for self-respect and pride that, beginning with a merciless moral scrutiny of the country’s past and present, within a few short years hollowed out the mighty Soviet state, deprived it of legitimacy, and turned it into a burned-out shell that crumbled in August 1991. The tale of this intellectual and moral journey is an absolutely central story of the 20th century’s last great revolution.

There is one major problem with this conjecture: Putin et al saw the same movie.  Worse yet (in their eyes)–they lived it.  They saw that the attempts at reform set off a reaction that led to the collapse of the system.  They may not have read de Tocqueville, but they understand what Cohen Aron takes from the Frenchman:

Delving into the causes of the French Revolution, de Tocqueville famously noted that regimes overthrown in revolutions tend to be less repressive than the ones preceding them. Why? Because, de Tocqueville surmised, though people “may suffer less,” their “sensibility is exacerbated.”

They certainly despise Gorbachev, most particularly for what they perceive to be his softness and sentimentality.

And they profit quite handsomely from the corruption, thank you.

Having lived the past, Putin and his ilk are not keen to repeat it.  Quite the contrary.  Hence the parallels Cohen Aron sees–notably, the widening belief that “we cannot live like this any longer!”–are exactly why things will play out quite differently.  Putin et al see that cry as a warning, and will not repeat Gorbachev’s mistake by reforming the system.  To the contrary, they will see it as a reason to redouble their efforts to atomize society, manage the politics, create a simulacrum of democracy and representation to gull the gullible, and lean on or suborn those who are less gullible.  No, Putin will make his own mistakes: he certainly will not repeat the mistakes he believes–knows–Gorbachev made.

The Russian state and Putinism are brittle.  They could collapse quickly and unexpectedly.  But they will not collapse in the way that the USSR collapsed.  The very fact that those in control today lived through what happened 20 years ago virtually guarantees that.

FT Alphaville reports that the UK Parliament’s Science and Technology Committee is all hot and bothered about bank ownership, and particularly JP Morgan’s ownership, of LME delivery warehouses:

79. We heard that there were large companies dealing metals within the UK and an allegation was made by the MMTA that a company through a subsidiary may be behaving in an anti-competitive manner: on the London Metal Exchange there are four very large companies that own the very warehouses that people deliver metal into, J.P. Morgan is one of them.

They own a company called Henry Bath. They are, therefore, a ring-dealing member of the exchange and they also own the warehouse. That is restrictive. They were also reported, at one point, to have had 50% of the stock of the metal on the London Metal Exchange.[113] 80.

We would be concerned if the ownership of metals storage warehouses by a dominant dealer on the London Metals Exchange were to be anti-competitive. We would also be concerned if a dealer who had the resources to own over 50% of stock on the London Metals Exchange impeded the correct functioning of the market.

81. We use this report to bring the alleged activities of large dealers on the London Metals Exchange to the attention of the Office of Fair Trading. We would be concerned if a dealer were undermining the effective functioning of the market and we look for assurance that the market is functioning satisfactorily.

The confusion about the anti-competitive effects–or, more correctly, the lack thereof–of vertical integration is pervasive.  This is just another example.   JPM ownership of a delivery warehouse is not per se anti-competitive, and indeed, it is difficult to see how it could be a way of leveraging market power as the Committee insinuates.

Insofar as ownership of 50% plus of deliverable supply is concerned, that is a completely separate issue.  Sumitomo never owned any delivery warehouses, but it (and its pilot fish) cornered the market with abandon in the 1990s.  To my knowledge, none of the other frequent squeezes on the LME in recent years have been facilitated by ownership of warehouses.  What’s more, it’s most effective to attack corners and squeezes directly, rather than through restrictions on asset ownership.

I’ve also written from time to time on how ownership of physical assets is an important part of many commodity trading firms’ strategies.  In particular, commodity trading firms can optimize use of physical assets based on their access to information and their ability to exploit the option value of these assets.

With respect to delivery warehouses in particular, come on.  In the grain markets in Chicago, big merchants like Cargill, Continental, and ADM long owned delivery houses.  They did so for the exact same reason that many energy and metals traders today own physical assets like storage.

Where ownership of physical assets may be somewhat problematic is when it gives the owners privileged access to information.  By trading on that information, the asset owners create an adverse selection problem that reduces market liquidity.

Perhaps the most famous example of this occurred in the Chicago grain markets in the 1860s.  At that time, there was a veritable war between grain brokers and traders and the owners of the grain elevators in Chicago.  The Chicago Board of Trade was the representative of the interests of the brokers and traders, and fought hammer and tong against the “piratical” elevators.

The elevator operators had information about the quantity and quality of grain in store.  This information advantage allowed them to trade profitably.  For instance, elevator operators from time to time learned that grain was getting out of condition–“heating.”  Given this knowledge, they would go short, and cover their positions at a profit when news of the spoilage became public.

This is akin to inside trading, and has deleterious effects on market liquidity: it transfers wealth from the uninformed to the informed.

The elevator operators also allegedly operated a cartel that fixed storage rates at supercompetitive levels.  This again harmed grain merchants–and also farmers.   Elevators also took advantage of their ability to mix grain down to the minimum required to meet grade.  This effectively transferred wealth from those who stored above average quality grain into the warehousemen’s pockets.

The CBOT tried mightily to get the elevator operators to report information about the quality and quantity of grain in their facilities, and to charge reasonable rates.  The elevators basically told them to pound sand.  The CBOT had little leverage over the elevators: the brokers and merchants needed the elevators, but the elevators didn’t need to the CBOT, so threats of expulsion had little effect.

Eventually, the CBOT prevailed on the legislature of Illinois to regulate grain warehouses.  This is actually an extremely important event in American legal and regulatory history, for one of the elevator operators, Ira Munn, challenged the Illinois regulation.  He appealed all the way to the Supreme Court, which decided in favor of the state, thereby establishing the power of states–and the federal government–to regulate business “in the public interest.”  The regulatory state in the US traces its roots to that decision in Munn v. Illinois.

One of my favorite papers discusses this episode in more detail.  You can find it here.

Going back to the hyperventilating Parliamentary Science and Technology Committee and JP Morgan’s ownership of a delivery warehouse, the things that were arguably inefficient in 1867 Chicago are completely absent in 2011 Bath.  The LME announces stocks held in warehouses on a daily basis, meaning that elevator operators don’t have privileged information on quantities in store.  Quality is monitored by independent inspectors.  The fears of vertical integration resulting in a leveraging of market power are neurotic.  Merchant ownership of delivery and storage facilities is a virtually universal feature of the commodity landscape.

In other words: Move along.  Nothing to see here.

I won’t comment much about Obama’s speech on the Middle East, except to say that it was a stitched together mess that will likely have the opposite of the intended effect.  Even those typically fairly well-disposed towards Obama are having a difficult time saying anything positive about it: this is one example.

But the foreign policy focus of the last few days combined with recent events in Russia made me think about the “Reset” with Russia.  This was one of Obama’s early, signature foreign policy initiatives, and at the time but especially in retrospect it was a harbinger of the unrealism at the heart of his putatively Realist foreign policy.

Those clever folks in the Obama foreign policy team thought that they could manipulate the duumvirate, and in particular work with Medvedev the Modernizer.  Medvedev and Obama have had a veritable bromance, for instance being burger buddies at Five Guys. Administration people made clunky attempts to portray Medvedev as the future, and Putin as a relic of the past.  They put their chips on building a relationship with the president in the hope that he would prevail over Putin.

This was a sucker bet from the outset, given the clear dominance of Putin in the Russian political landscape.  It is now an utter embarrassment given that Medvedev has gone from being perceived as someone with only a slight chance of supplanting Putin, to an object of disdain and mockery.

Medvedev’s much hyped press conference at Skolkovo was a disaster that has unleashed a torrent of criticism and outright ridicule, and is widely reckoned to be the death knell of his political ambitions.  The Economist asks what the point was.  Time is scathing:

It was impossible to pinpoint the exact moment of the transformation, but by the time Russian President Dmitri Medvedev left the podium after his first big press conference on Wednesday, he had morphed into a lame duck. The problem was not so much that he failed to state his plans for re-election next year, but, as some members of his own circle now admit, the President seemed to be courting a constituency of just one man — Prime Minister Vladimir Putin, who will alone decide whether Medvedev stays or goes.

Some Russian commentors were equally dismissive:

His unprofessional performance added to the overall commotion and silliness of the event. Medvedev was clearly agitated by the challenge, constantly losing his breath during the first half of the conference, apparently caused by public speech stress. Time and again Medvedev had fits of seemingly uncontrollable giggling when answering questions, also apparently caused by public speech stress. The Kremlin press service announced “the president was pleased by his performance at the conference” (RIA Novosti, May 18). Officially approved observers were bewildered by the uninspiring performance. Known critics of the regime posted angry comments about Medvedev on the Internet demonstrating his utter inability to reform or lead Russia (RIA Novosti, www.newsru.com, May 18).

It seems Putin in 2007 wisely chose Medvedev as his “successor” or a de facto figurehead president. Medvedev, who this week demonstrated the absence of his leadership capabilities and charisma—a lack of intelligence and integrity—will hardly ever be able to effectively lead Russia in a time of change. Many Russians and foreigners who believed that Medvedev—the young and progressive president—will actually modernize, Westernize and liberalize Russia may forget their dreams. Medvedev’s constant chatter about “modernization,” with little or nothing being done, may only cause the Russian populace to begin to hate the term, as the word “democracy” became a popular curse after the unfair and lawless reforms of the 1990’s. Former Kremlin insider Gleb Pavlovsky believes Medvedev’s dismal press conference performance was intended to appeal to Putin to gain endorsement for a second presidential term (Vedomosti, May 19). This is a popular version in Moscow—Medvedev was doing his best to be seen as an incompetent and harmless political nobody for Putin to allow him six more years as a figurehead in the Kremlin.

Ouch.

And Foggy Bottom and the White House–the one on the Potomac, not the Moskva–should be feeling the pain.  The alternative scenarios: (a) Medvedev is shoved aside by Putin, or (b) Putin keeps Medvedev like an organ grinder keeps his monkey or a ventriloquist keeps his dummy.  Either way, the entire basis of the Reset collapses.

It would probably be best for the US if (a) occurs.  For if Putin chooses door (b), it is quite possible that the fantasists in the State Department and the White House will continue to delude themselves that they can build a mutually beneficial relationship with Russia through Medvedev, and make deals and concessions in the hope of building the Reset, whereas even they would have to concede to the reality of Putin’s domination and the futility of the Reset under option (a).  Thus, (b) would let Putin to continue to manipulate the United States by exploiting its delusions.

The manipulative potential is one factor that may lead Putin to choose (b).  But domestic political considerations will almost certainly prove decisive.

In the US, the Reset has largely faded from view.  Obama has moved on to other things.  But it should not be forgotten because it provides a very dispiriting example of his foreign policy judgment–or more properly, the lack thereof–and that of his entire foreign policy cadre.

There is a concerted effort underway to portray Bin Laden as exerting operational control over Al Qaeda, based on material collected during the raid on his compound. Color me skeptical.

First, it’s hard to imagine how he could exercise any control at anything but the broadest strategic and conceptual level while he was relying on couriers to communicate with subordinates. Second, this hierarchical model is contrary to virtually all that has been written about Al Qaeda going back to its early days: the organization has been consistently portrayed as networked and distributed rather than hierarchical. Indeed, the conventional characterization of Al Qaeda represents it as more of a franchise operation in which the franchisees have considerable autonomy.

But let’s assume for a moment that the organization was hierarchical, and that operational elements required direction and approval from Bin Laden to implement any attack.  If that’s true, we may have actually done ourselves a disservice by killing Osama.  For it would be almost trivially simple to get inside AQ’s OODA (“observe, orient, decide, and act”) loop and disrupt and destroy its operations.  Even if we didn’t know what AQ was up to, we could disrupt their plans just by mixing (randomizing) our strategies, by unexpectedly changing up the way we do things.  If response to such changes required  the locals carrying out missions to report back to OBL via a painfully slow communications system, await a decision, and wait for the decision to be couriered back, they would be unable to do anything serious.  In this case, killing OBL would free the locals to be more flexible and responsive–and hence more dangerous.  It would permit AQ to become more of a network, less predictable, and more able to adapt to our moves.

Given these difficulties, I find it hard to believe–exceedingly hard–that AQ actually operated this way.  Even if OBL wanted to play terrorist mastermind, how could he enforce decisions?  Put different, if he was the principal, how could he overcome the agency problems that would bedevil his ability to impose his will on his subordinates?

Which is why I’ll go with my original analysis: that OBL was primarily a symbolic figure, and operationally irrelevant.  No doubt the various minions tried to humor the old man, and to feed his belief that he was in control of the war against the Great Satan.  But there’s an intent to deceive behind the “OBL was in operational control” narrative too.  It is an attempt to make the achievement bigger than it truly is, and perhaps, to justify an Obama pivot on a variety of issues–Afghanistan and the military-law enforcement mix of anti-terror policy come to mind.  It was indeed important, but we would be harming ourselves by exaggerating that importance.