Streetwise Professor

The frantic sewing of parachutes in a plane that is 30,000 feet in the air continues apace. Last week the Office of Financial Research (a Son of Frankendodd) released its 2015 Annual Report. This tome received attention mainly because it raised alarm about potential systemic risks arising from central clearing mandates. An improvement, I guess, but like most official evaluations of the systemic risks of CCPs, it misses the real problems.

It gets off on the wrong foot by misstating the real benefits of CCPs. According to OFR, the top two benefits of clearing are related to the ability of CCPs, and via them regulators, to get more complete, accurate, and timely information on derivatives positions and trading prices. But these can be achieved by transaction reporting alone, without going the full monty to clearing, which also entails collateralization (including both initial and variation margining) and mutualization of default risk. (Trade reporting has turned into a nightmare, which I will write about further soon. But the point is that you don’t need clearing to get the benefits OFR touts.)

But the main problem, yet again, is that OFR focuses on the “single point of failure”/interconnectedness/default loss contagion channel for CCP systemic risk. This is not immaterial, but it is not the main thing. The main thing is that CCPs create potentially massive contingent demands for liquidity, where the liquidity contingency is likely to occur precisely at the worst time–when the system is undergoing a financial crisis.

Further, OFR gets it wrong when it states that CCPs “reduce the risk of counterparty default.” CCPs redistribute the risk of the insolvency or illiquidity of a large financial institution away from its derivatives counterparties towards its other creditors. It protects one group of creditors at the expense of others.

It is very much open to question whether this reallocation is systemically stabilizing, or is instead a means whereby one relatively concentrated group of market participants can advantage themselves at the expense of others.

Reading Izabella Kaminska’s excellent FT Alphaville post on Real Time Gross Settlement (RTGS) mechanisms makes plain that this phenomenon of substituting liquidity risk for credit risk, and redistributing credit risk away from core banks, is not limited to derivatives clearing. RTGS replaced deferred net settlement (DNS) because of banks’ and central banks’ concern that in the latter, interbank credit balances could accumulate, resulting in a default loss to settlement banks in the event that an net payer bank failed before the next netting cycle. RTGS eliminates interbank credit exposure.

But, of course, this doesn’t make credit exposure go away. It redistributes it to settlement banks’ other creditors. To a first approximation, the total losses from the inability of a bank to meet its obligations are the same under RTGS and DNS. The difference is who gets a chair when the music stops. Settlement banks–and crucially, the central banks–like RTGS because they almost always are going to get a chair.

Furthermore, as even its proponents acknowledge, RTGS is much more liquidity intensive. To be able to make every payment in real time, a settlement bank either has to have the cash on hand, or the ability to borrow it on demand intraday from the central bank. Liquidity needs scale with gross payments, which are substantially larger than net payments. Thus, like CCPs, RTGS substitutes liquidity risk for default risk.

This risk is exacerbated by the fact that a prisoner’s dilemma problem exists in RTGS. Participants concerned about the creditworthiness of other banks have an incentive to delay payments and hoard liquidity, since once a payment goes into the system, it is final and the payer is at risk to loss of the entire gross amount if a bank that owes it fails before it pays. This can lead to a seizing up of the liquidity supply mechanism, as the prisoner’s dilemma logic kicks in and everyone starts to hoard.

Since holding cash in sufficient amounts to meet all payment obligations is extremely expensive, RTGS has evolved to permit central banks to lend intraday on a collateralized basis. But as was seen in the 2008 crisis, collateralization poses its own risks, including ballooning haircuts that can set off price spirals due to collateral fire sales. Further, due to the potential for the breakdown of long and large collateral chains, this creates an interconnection risk, and represents a further coupling of the system. And it is coupling, remember, that is at the root of most catastrophic accidents. Secured lending can create a false sense of security.

Izabella’s post also points out another problem with RTGS, which is common to central clearing. It creates a much more tightly coupled system that is very vulnerable to operational risk. This risk crystalized in October, 2014, when a seemingly innocuous change to the system (deleting a member bank) caused the failure of the UK’s CHAPS  settlement system for a day. Ironically, this was the result of an interaction between one part of the system, and another part (the Liquidity Savings Mechanism) that was intended to economize on the liquidity demands of RTGS, and essentially created an RTGS-DNS hybrid. As in most “normal accidents”, unexpected interactions between seemingly unrelated parts of a complex system led to its failure.

There is another way to see all of this. Both central clearing and RTGS are intended to create “no credit” systems. That is true only in a very limited sense–a profoundly unsystemic sense. Yes, CCPs and RTGS are designed so that participants in those arrangements don’t have credit exposure to one another. But those participants aren’t the entire system, just a part of it: the exposure is pushed away from them to others. Further, the method for reducing credit exposure among the participants is to require extensive reliance on liquidity mechanisms that are prone to breakdown in stressed market conditions. Further, these liquidity mechanisms are based on credit: banks (or the CCP) borrow from other banks, or from central banks in order to obtain liquidity. Further, the credit moves into shadowier places.

Not to sound like a broken record, but things like CCPs and RTGS redistribute and transform risks, rather than eliminate them altogether. Unfortunately, these transformations do not necessarily reduce the risk of a systemic crisis, and arguably increase it in some cases. The failure of officialdom, and large swathes of the banking sector, to recognize or address this reflects in large part a failure to take a systemic perspective. Perhaps cynically, this can be explained by the fact that the central banks and banks that drive these reform efforts mistake their own interests for the interest of the system as a whole: le système, c’est nous. As a result, “Devil take the hindmost” could well be applied as the motto of RTGS and central clearing.

This illustrates a broader problem in public policy. Government is too often invoked as a deus ex machina that internalizes externalities. But the fact that most regulatory change efforts are driven by, or ultimately controlled by, a small subset of interested parties who have the most concentrated stake in an issue. Given the diffuseness of other impacted parties this is inevitable. But it means that in practical terms internalizing externalities via regulation of something as complex as the financial system is a chimerical goal. The externality hot potato gets tossed from one segment of the financial sector to another. Government regulation, as opposed to self-regulatory initiatives, mainly affect the makeup of the subset of participants who are involved in influencing the process, and the distribution of the bargaining power. This works through the entire process, from the crafting of legislation, to the writing of regulations, to their implementation. This is why we get things like RTGS or CCP mandates, which make a certain set of participants better off, but which it is heroic indeed to believe are truly welfare increasing.

The Bank of England has received a lot of attention for its just-released study on the liquidity impact of swap execution facilities (SEFs). It finds that:

as a result of SEF trading, activity increases and liquidity improves across the swap market, with the improvement being largest for USD mandated contracts which are most affected by the mandate. The associated reduction in execution costs is economically significant. For example, execution costs in USD mandated contracts, where SEF penetration is highest, drop, for market end-users alone, by $3 million–$4 million daily relative to EUR mandated contracts and in total by about $7 million–$13 million daily.

The basic methodology is to use a difference-in-difference approach to compare measures of liquidity pre-and-post SEF mandate, and which exploits the fact that non-US banks can avoid the mandate by avoiding trading with US banks: this avoidance issue will is important, and I will discuss it later.

The study is carefully done, but I am not persuaded. For one thing, the measures of liquidity employed are driven by data availability (transactions prices), and are not the ideal measures of liquidity. The primary liquidity measures employed are really measures of price dispersion, rather than preferred measures of liquidity such as bid-ask spreads, depth, or price impact (although greater (lower) price dispersion could be associated with lower (greater) price impact).

There is also the issue that transaction characteristics are endogenous. For instance, it may be the case that it is cheaper to do large deals off-SEF than on-SEF. These deals will tend to be done at prices that are further away from the mean price (or the end-of-day midpoint price), and in the volume-weighted measures employed in the paper, these deals get a bigger weight in the liquidity measures. Thus, price dispersion may be greater pre-mandate, and in Europe, where the mandate can be avoided not because SEFs improve liquidity, but because it is prohibitively costly to transact large deals on SEFs. That is, the results could be symptomatic of a loss of liquidity on some dimensions, rather than proof that the mandate improves liquidity.

The paper documents that there is less dealer intermediation where the mandate is binding. This could also reflect changes in transactions characteristics. Dealers are more likely to be needed to intermediate big deals, or deals that are exceptional on some other dimension.

The paper doesn’t break down transaction characteristics by mandate-impacted and non-mandate-impacted subsamples, and in particular doesn’t include a measure of the dispersion of transactions sizes. As a result, it’s not possible to determine whether the mandate has altered the mix of transaction characteristics.

This relates to another finding of the study: namely, that the mandate has led to the fragmentation of the interest rate swap markets along geographic/currency lines, with SEFs gaining far lower penetration in Euro-denominated swaps that are dominated by European banks who can avoid the mandate by trading with one another, and by trading with European end-users. There is confirmation of this result from Tabb Group, which finds that “European derivatives market continues to resist electronic trading.”

Well, this raises the dog food question: If the dog food is as great as the ads say, why don’t the dogs eat it? if SEFs are so much more liquid, why don’t traders flock to them?

When given a choice between a statistical finding, and revealed preference, I go with the latter. Those who actually internalize the cost of trading largely avoid SEFs. This suggests that they are actually costlier to use, at least for some users, such as those who want to trade in large size, or have other idiosyncratic needs. The choices of those who have the choice strongly suggests that the statistical evidence purportedly showing lower execution costs on SEFs is flawed and misleading.

With this in mind, it was gratifying indeed to see CFTC Chairman Massad stating that he favors allowing market participants to decide whether they transact swaps electronically or using traditional voice execution. There was never a compelling case-or even a weak one-for forcing diverse market users with diverse transactional needs to use a one-size-fits-all execution method. Massad’s free-to-choose approach is therefore a vast and welcome improvement over his predecessor Gary Gensler’s monomaniacal determination to bash everybody over the head with a CLOB.

Update. Here’s a more detailed description of the Tabb Group study I linked to above. One important takeaway: European end users really hate electronic execution, and really love voice execution:

Despite the cost benefits of e-trading, institutional investors still prefer to interact with their dealers via phone. Nearly 80 [!] per cent of the more than 200 European investors interviewed as part of the Greenwich Associates 2015 European Fixed-Income Study confirmed their trading protocol of choice was the phone.

“These trades often require white-glove treatment, and clients work with dealers that are best at limiting market impact and providing the support needed to get the trade done,” says Greenwich Associates Managing Director Andrew Awad (pictured). “As a result, clients still place a high value on the support provided by swaps salespeople in executing complex and large trades.”

This strongly suggests that there are likely to be considerable differences between deals done on SEFs and those done the old fashioned way. Not particularly the point about “limiting market impact.” Those who want to do trades that are “complex and large” go to dealers to trade bilaterally to avoid price impact. If they are not able to do that, because of an electronic execution mandate, they will almost certainly trade differently. Fewer big, complex trades. If that is correct, then the Bank of England study is comparing grapes to grapefruit. If so, the difference in price dispersion documented in the study does not demonstrate greater liquidity on SEFs: it demonstrates worse liquidity, at least for some kinds of trades.

Mind you: end users were the supposed beneficiaries of the SEF mandate. According to GiGi et al, they were being shamelessly exploited by dealers, and SEFs would set them free. Apparently they like their chains just fine, thank you very much.

Again: revealed preference rules. Believe it over a stat every time.

Policies can be misguided, but coherent: that characterizes the Bush II Middle East policy for the most part. Then there are policies that are so bizarre and contradictory so as to be utterly incoherent. That’s the Obama Middle East policy.

On the one hand, for the past several years the administration has bent over backwards to make deals with Iran. In the months since the deal was sealed, it has made concession after concession to the mullahs, including obsequiously thanking the Iranians for releasing sailors whom they illegally seized and mistreated, and arguably paying $1.7 billion in ransom to secure the release of Americans held by Iran. The obsequious attitude to Iran is driving the Saudis into paroxysms of paranoia, which stokes proxy wars throughout the region, most notably in Yemen, Iraq . . . and Syria.

But in Syria, the US is on the side of the Saudis fighting Iran’s allies. Indeed, in Syria the Saudis pay for US covert support of anti-Assad forces fighting Iran’s puppet, the Assad regime. Just today John Kerry–who always has one more cheek to turn to the next Iranian insult–said: “The position of the United States is and hasn’t changed; that we are still supporting the [Syrian] opposition politically, financially and militarily.” You know, the opposition that is fighting Iranian forces on the ground in Syria.

But the US being on the side of the opposition may be old news. Now the rumors are rife that the US has backed away from its previous stance that Assad must step aside during the transition to a new government. This is setting off yet even more paroxysms of paranoia among the Gulf Sunni oil tick states. He said this, by the way, in the context of trying to arrange peace talks between the warring sides. How can you be a peace broker when you are “supporting the opposition politically, financially, and militarily”? That’s incoherence!

So maybe in its dying days the administration is groping for coherence, by going the full Monty on Iran. But I’m betting on continued incoherence.

More incoherence. Obama has been adamant about “no boots on the ground” (a phrases that triggers severe teeth-gnashing by yours truly) in the anti-ISIS campaign. Yet in the past few weeks Defense Secretary Ashton Carter has been going around saying yes, there will be American boots on the ground in Syria and Iraq to fight ISIS. Which is it? (Annoyingly, as of yet I have not heard anyone demand an explanation from Obama for this glaring contradiction. Is Carter off the reservation? Or is Obama merely dodging responsibility, and the press is eagerly enabling? Don’t bother answering. Rhetorical question.)

Then there’s US policy towards the Kurds, where Biden simultaneously supports the Turks in their war against the PKK and supports the PKK’s Syrian offshoot, the YPG, which the Turks hate as much as the PKK.

Yet more incoherence. We frantically support peace efforts in the region (most of them futile) but attempt to appease Saudi and Qatari anger at our concessions to Iran by showering them with weapons . . . which the Saudis turn around and use to bomb the crap out of Iranian proxies in Yemen, which angers the Iranians. And around and around it goes.

In the region, this playing both sides is viewed with deep suspicion. Paranoia is part of the Middle Eastern DNA, and the slightest inconsistency is perceived as double dealing and backstabbing. As a result, we undo our attempts to mollify one element (e.g., the Iranians) by doing something to mollify their enemies (e.g., the Saudis) who are angry at our attempts to mollify the first element.

It’s a policy feedback loop from hell.

Somewhat to my surprise, the Iranians released the 10 American sailors whose boats they had seized yesterday. This immediately set of a coordinated spasm of self-congratulation in the administration, and among its media enablers. The party line was laid down by Kerry, who gushed with gratitude for Iran’s gesture and generosity, and with self-praise, stating that the quick end to the situation was proof positive of the benefits of the Iran deal which he and Obama had so brilliantly brought to fruition. Without the deal, it wouldn’t have ended so quickly or smoothly, according to Kerry.

Excuse me, but if the Iran deal was so great, this incident would not have happened in the first place. If the Iran deal was so great, it would not have happened the way it did, with the US personnel being held at gunpoint, and photographed kneeling with their hands behind their heads while the IRGC went pawing through their equipment. If the Iran deal had been so great, they would not have been taken prisoner by the Iranians, and at one time held blindfolded (and again photographed): even if they were in Iranian waters, they would have been warned away and left to proceed. If the Iran deal was so great, the photographs of the humiliation of the American crews would not have been plastered all over the Internet and Iranian television.

But Kerry did not utter one peep of protest about the seizure of the vessels. He did not question whether the seizure was justified, or necessary. He did not slam the releasing of photographs and videos of American servicemen in submissive positions, a direct contravention of international law (of which Kerry claims to be so fond).

If anything Joe Biden (yeah, the guy Obama has tasked to cure cancer–wrap your head around that one) was even worse, saying that it is “standard nautical practice” to help boats in distress at sea.

I can tell you this: it is not standard nautical practice to assist distressed vessels by forcing their crews to kneel like drug runners on a cigarette boat chased down by the USCG.

And about that distress thing. I called BS on it yesterday, and today the Pentagon sidled away from that: they kinda had to, given that both boats motored away under their own power.

The entire episode remains cloaked in mystery, but I find the Pentagon’s claims of ignorance to be incredible. They continue to say they lost contact, and don’t know how that could have happened. I am pretty sure that the crews would have radioed the situation in as it was unfolding the only way I can conceive that their messages weren’t heard is if the Iranians jammed their communications, which would put a whole different  spin on things, wouldn’t it?

The Iranians have also claimed that US ships (including the USS Harry S. Truman) and helicopters made “unprofessional moves” for 40 minutes after the boats were captured. This suggests that the US was aware of the capture and made attempts to interfere. That would blow the entire Gilligan’s Island and “lost contact” narrative.

The US should have had more than enough situational awareness to realize something was up immediately. If they didn’t, some people have some explaining to do. If they did, they have some other kinds of explaining to do.

But it is clear that there will be a concerted effort to draw a curtain over the initiation of the incident in order to celebrate its end, so that little, if any ‘splaining will be going on.

Not. Good. Enough. There are serious issues here, and a full and public accounting of the episode is necessary.

It is particularly serious precisely because it raises grave issues about the Iran deal that Obama and his long-faced Sancho Panza are desperate to defend in spite of–or is it because of?–repeated Iranian provocations.

It is also serious because it raises issues about whether the military is being compromised in order to protect the deal at all costs.

Obviously a tick-tock detailing the exact sequence of events is imperative. But there are other questions (which a supine press has apparently not thought of, or has refused to ask).

For instance, what were the Rules of Engagement? Were the crews given the option of fight or flee, or were they expected to capitulate if confronted by the Iranians?

Did US units in the area find out about the seizure? How? How did they respond? Were they ordered to stand down?

I have to believe there is fury throughout the Navy at this episode. The sight of American sailors kneeling as prisoners on their own combatant vessel must rankle deeply.

Those feelings must be even worse because one of the sailors was shown on Iranian TV apologizing to, and thanking, his captors:

“It was a mistake that was our fault and we apologize for our mistake,” said the U.S sailor, who was identified by Iran’s Press TV as the commander. “It was a misunderstanding. We did not mean to go into Iranian territorial water. The Iranian behavior was fantastic while we were here. We thank you very much for your hospitality and your assistance.”

Not acceptable. At all.

I had the Code of Conduct of the United States Armed Forces drilled into my skull plebe year at Navy, and it has remained embedded ever since. And I can tell you that this behavior is clearly contrary to the Code.

One part of the Code is that you will not do anything that gives aid and comfort to the enemy in exchange for better treatment. It is clear that this statement benefited the Iranians: they are using this entire episode for propaganda value, but more importantly, to demonstrate their mastery over Obama: don’t believe for a moment that this isn’t having major repercussions throughout the region. Further, the only reasonable inference is that making such a statement was a precondition for release.

The sailor should not have made this statement. His only possible excuse is that he had been ordered to in order to seal the deal for the release, a possibility which I cannot discount. If anything, that possibility would be even worse, for it would mean that command authority would be ordering the violation of the Code, which was adopted to solve very serious problems with collaboration by POWs during the Korean War that (a) sapped morale, and (b) was used to wage a propaganda war against the US around the world.

This entire episode is disgraceful. A full and searching inquiry is necessary. But that is unlikely to happen: this event is destined for consignment to the memory hole. And that may be the biggest disgrace of all, not least because it will require the complicity of the military. In the past months have noted with dismay repeated examples of military dissembling and outright lying in order to protect Obama. This is contagious, and corrosive. It is also inimical to the effectiveness of the armed forces. This could be one of Obama’s most malign legacies, and that is saying something.

Lily Tomlin once said “We try to be cynical, but it’s hard to keep up.” She didn’t know the half of it, because she said this before the age of Obama.

Tonight Obama gives his last (thank God!) State of the Union Address. To guilt us all about the widespread reluctance to admit tens of thousands of Syrian refugees, Obama is trotting out a poor boy who lost his family–and his arms–to an bomb strike in Syria.

This is the most rank emotional manipulation I have ever seen in politics, and that is saying a lot. It is cynical beyond belief.

For one thing, as tragic as his story is, this boy is not representative of the refugees that will attempt to get in the US. It is well known that the refugees in Europe are disproportionately young adult males, not women and young wounded waifs.

You could get a more representative example of would-be refugees in front of the Cologne Cathedral on New Year’s Eve.

For another, Obama’s policies in Syria have been cynical beyond belief, and have dramatically worsened the humanitarian crisis in the country. As is his wont in such matters, he chose the worst option. He did not intervene decisively early in the crisis, thereby allowing it to spin out of control. That is defensible. But he also has supported the arming (via the CIA) of opposition groups in Syria, including Islamist groups. This has increased the intensity of, and extended, the war.

Don’t take my word for it. Walter Russell Mead, a very middle-of-the-road guy who started with high hopes for Obama, wrote a scathing article about Obama’s Syria cynicism back in November.

It hasn’t gotten better. Indeed, tonight’s farce shows that it’s gotten even worse.

All of this takes place against the background of the Iranian seizure of two US riverine patrol craft, two Swedish-built CB90 boats.

There is zero doubt-zero-that the Iranians did this to troll Obama’s SOTU. But the show must go on! So rather than make an issue out of this that might detract attention from Obama’s swan song star turn, the administration, with the appalling assistance of the Pentagon, is saying “no big deal! Just an accident!”

Here is one story puked up by the Pentagon:

Pentagon spokesman Peter Cook told The Associated Press that the boats were moving between Kuwait and Bahrain when the U.S. lost contact with them.

“We have been in contact with Iran and have received assurances that the crew and the vessels will be returned promptly,” Cook said.

U.S. officials said that the incident happened near Farsi Island, situated in the middle of the Persian Gulf. They say it stemmed from some type of mechanical trouble with one of the boats, causing them to run aground. The troops were picked up by Iran.

I have only two words in reply. Bull. Shit.

First, there is no way both boats had mechanical issues. If only one had problems, the other could tow it.

Second–and more outrageously–these are bleeping riverine boats intended to operate in very shallow waters. They draw .8 meters. That’s less than 3 feet, boys and girls. They wouldn’t go aground in your back yard after a heavy rain.

Third, in these days of GPS, a navigation error can be ruled out.

My conclusion: they were seized. Without a fight. Which tells you something about the Rules of Engagement vis a vis Iran that we operate under in the Gulf.

Josh Earnest actually had the audacity to say that it is incidents like this that make the Iran deal worthwhile.

I’d explain what he means, but I’m hopelessly trapped by archaic Western concepts like “logic,” so I can’t.

How many cheeks does Obama have to turn to domestic critics? Zero. How many to Iran? I can’t count that high.

Of course this will only stoke the Sunni freaks in the Gulf into even greater frenzies of paranoia about Obama’s Shia sympathies, thereby intensifying an already fraught situation.

So what’s the State of the Union? I’ll let you know when I get caught up on my cynicism. This may take a while.

The decline in oil prices is producing a predictable political outcome: attempts to prop up the domestic US industry. Some initiatives would make sense regardless of the financial distress of the US upstream sector: the Clinton and Obama administrations in particular have imposed a variety of inefficient regulations and restrictions on US hydrocarbon production, and it would be desirable to roll these back, as is being proposed:

Among the proposals under discussion: Expediting the process for exporting liquefied natural gas, and upgrading infrastructure to move energy to market more quickly and cheaply.

Another top priority for the two Republicans is loosening environmental and other regulations.

But then there’s just the plain stupid:

Some lawmakers are floating the possibility of taking retaliatory trade measures against Saudi Arabia, which has flooded the market with cheap oil in what some analysts see as a bid to drive America’s growing shale oil industry out of business.

. . . .

North Dakota Rep. Kevin Cramer (R) said lawmakers could begin to mull retaliatory tariffs against Saudi Arabia in the future but emphasized he is not advocating for that yet.

“I’m very hesitant to go down that path at this time but clearly that would be a possible option should the Saudis not play fair. Because as much as I advocate for free and open markets, I also advocate for fair markets,” he said.

Saudi Arabia, taking advantage of its low extraction costs, has refused to curb oil production in a bid to expand market share and undercut competitors. This has raised the prospect of the U.S. government taking action to level the playing field for domestic companies.

“I’m not prone to a lot of government intervention in terms of propping industry up, per se. What would be the most helpful is to roll back regulations that get in the way of further development and profitability,” said Cramer, who cited the Endangered Species Act as one burdensome regulation.

“Obviously they have access to our market and I suppose to some degree there is a role that can be played there. I’m not at the point where I’m ready to advocate tariffs or restricting their access necessarily,” he added.

Any tariff on Saudi imports would be special interest protectionism pure and simple, tarted up in the usual rhetoric (and whining) used to justify protectionist measures. “Fair markets” is a sure tell. Anyone who says “I’m for free markets but they should be fair markets” is a liar, and should drop the pretense. Any such person is all about protecting a favored industry or firm. When someone, regardless of party, says “fair markets”, I strongly advise you to check your wallet, because they are trying to rob you.

And why should Saudi Arabia “refuse to curb oil production”? Indeed, “curbing oil production” is the exercise of market power, for which the US (rightly) criticized OPEC and the Saudis in the past. What’s more, low cost producers are the ones who should sustain output in the face of a demand decline: high cost producers are the ones who should cut back.

Furthermore, although North Dakota is an oil long, the US as whole is an oil short, still producing only about 1/2 of its consumption, despite the spurt in oil production in the past 5-6 years. So low oil prices are still in the interests of the US.

It should also be noted that the “flooding the market with cheap oil” meme is vastly overstated. Saudi output in June, 2014, right before the price collapse began, was about 10mm bpd. It is now about 10.5 mm bpd. That difference represents a whopping .5 percent of world output. Even given an elasticity of 10 (which is probably too high) that could cause at most at 5 percent decline in prices. As I write, Brent just went below $33/bbl, and hence is down almost exactly 70 percent off its pre-collapse levels. So this collapse is not the result of the Saudis flooding the market.

Nor are the Saudis engaged in some predatory pricing strategy. At least I doubt that they are, because such a strategy would be irrational.

The price decline is the result of increased output in a variety of places (including the US), but mainly due to a steep decline in demand growth, especially from China.

Yes, the upstream sector in the US is suffering severe financial distress. So be it. That’s the nature of the business, and the nature of a market system generally. Resources should exit sectors that suffer demand declines. They should not be propped up through trade restrictions, especially trade restrictions that will impose far greater costs on the US economy as a whole than they will benefit one sector in that economy.

It is also perversely ironic that the very same Republicans (I am speaking of the individual legislators, like Murkowski and Cramer, not the party as a whole) who pushed for ending the idiotic export ban are now mooting an equally idiotic restriction in imports. This makes it plain that it’s not about principle, in the least. It’s all special interest politics. That’s not surprising, but it’s not admirable. And it’s not any better when Republicans push it than when Democrats and Obama do.

So yes, eliminate or cut back inefficient restrictions that a relentlessly anti-hydrocarbon administration has imposed, in order to eliminate unnecessary burdens on US oil and gas production that hurt both US producers and consumers in the US and around the world. But don’t impose large costs on American consumers of oil in order to prop up the US upstream sector. The sector should shrink if the demand for its product declines due to increased production elsewhere, or reduced demand. So be it.

There is no good guy and no bad guy in the conflict between Iran and Saudi Arabia (and its GCC allies). In its essentials, it is a struggle for regional dominance between two benighted and malign powers.

The theater of the conflict is Iraq and Syria. Iran has some advantages, most notably, it is allied with the government of Syria (now supported by Russia), and for sectarian and geographical reasons has advantages in Iraq. In Syria, Saudi Arabia and its allies must resort to funding and arming the opposition. Its options in Iraq are more limited, but it is likely objectively pro-ISIS.

Neither Iran nor Saudi Arabia can pose a conventional military threat to the other. Iran’s air force is a collection of museum pieces (F-4s, F-14s and F-5s!) seized from the Shah and kept together with bubble gum an duct tape, and some Russian aircraft gifted to them by a desperate Saddam 25 years ago. Iran’s ground forces have no power projection capability. Its units have struggled in Syria and Iraq, and were noted during the Iran-Iraq war mainly for their ability to absorb appalling casualties. Iran’s navy also lacks any power projection capability. Logistics would also render impossible any Iranian attack on KSA.

Saudi Arabia has a very well-equipped air force, with 70 F-15E strike aircraft, 86 F-15C and D air superiority fighters, 72 Eurofighter Typhoon multirole aircraft, and 80 Tornado ground attack planes. This is more than adequate to defend KSA against anything that Iran could throw against it on air, sea, and land. But KSA’s ground forces are, like most Arab armies, woefully ineffective, and mainly intended for regime protection. The Saudis are bogged down in neighboring Yemen, and could not hope to project any force into Iraq, let alone Iran.

Even if Iran develops a nuclear weapon, it will have little effect on the balance of power. The Saudis will almost certainly obtain one as well, and a nuclear weapon is more of a regime protection weapon than an instrument of power projection.

Iran’s main weapon is subversion, but this is difficult to employ against a police state like KSA. Indeed, the execution of Nimr Nimr that precipitated the latest crisis was no doubt a signal to Iran that the Saudis were willing to use extreme measures to crush any uprising in the Shia population in the eastern provinces. Also look at the brutal crackdown in Bahrain to see how the KSA and its allies deal with Iran-fomented Shia internal dissent.

So there will be an intensified shadow war between KSA and Iran, fought mainly in Syria and Iraq. Things have intensified now because the Iran deal and the Russian intervention in Syria disturbed the previous equilibrium in the region: this was one of the main reasons the Iran deal, and the administration’s subsequently fecklessness in responding to Iranian provocations, was so ill-advised. The most likely outcome is an intensified struggle resulting in a renewed stalemate.

In terms of oil, the most likely outcome is that the Saudis will figure that Iran suffers from lower oil prices more than they do, so they will not cut output. The Iranians have every incentive to produce as much as they can.

There are loud calls from some quarters that we intervene on behalf of our Saudi “allies.” With allies like this, we need no enemies, given lavish Saudi support for Islamism (and terrorist groups) around the world: indeed, I consider the Iranians’ in-your-face chants of “Death to America” more palatable than the Saudis’ two-faced duplicity. The relationship between the US and KSA is transactional, at best, and is unfortunately suborned by Saudi money which greases far too many palms in DC and Europe.

Stalemate is probably a good outcome from the US perspective. Getting in the middle means we will get it from both sides.

Our main interest is continued flow of oil through the Persian/Arab Gulf. A policy similar to that adopted by the Reagan Administration during the Iran-Iraq War, which largely took a hands-off approach to the conflict on the ground, and focused on assuring the free navigation of the Gulf, is a prudent one. If either side tries to escalate by attacking shipping or laying mines, like during the Tanker War, the US can intervene and smack them down as it did in Operation Praying Mantis.

We have no interest in a civilizational and sectarian war, and probably couldn’t intervene effectively even if we decided to. Neither country is capable of achieving a decisive victory over the other. The main stakes are who gets to rule (albeit indirectly) over a ruined Syria and a dysfunctional Iraq. So limit our involvement to keeping the oil flowing and deterring and preventing terrorist spillover. And definitely don’t take the side of Wahhabi freaks, or think that they are allies worthy of the name.

The combination dumpster fire, shit show, and clusterfuck AKA the Middle East got even more disastrous today when the Saudis beheaded a prominent Shia cleric (along with 46 Sunni radicals). The reaction from Iran was immediate: the Saudi embassy was sacked by outraged Shia.

And the reaction from certain quarters in the US was almost as swift: the usual (neocon) suspects in the US (e.g., Max Boot) immediately swung into action, shrieking loudly about the Iranian violation of the sanctity of the Saudi embassy (I wonder what really goes on there, besides, you know, slavery and stuff) but saying nary a word about the morals or justice or reasonableness of going medieval on Nimr al Nimr.

It is beyond bizarre that certain quarters of the right are so obsessed with Iran that they are willing to go all in with the Saudis and the other oil ticks of the GCC. How can they be blind to the facts that (a) the most direct terrorist threats that we face are all Sunni, and specifically Wahhabi-influenced, (b) these threats receive material and ideological support from Saudi Arabia, and (c) the Saudis have spent billions propagating their hateful creed, including supporting the very mosques in the US and Europe where terrorists are radicalized and recruit?

I stipulate that Iran under the Mullahs is dangerous. I further stipulate that Assad is evil. I further stipulate that Putin is a malign force.

It does not follow, however, that their enemies–the Wahhabi Sunni extremists–are good guys, or that following the enemy-of-my-enemy strategy is even remotely wise.

This is particularly true in the case of Syria, which is a proxy war between the Saudis and the other oil ticks (and the Sunni Turks) and the Iranians. Opposing Assad means throwing in on the side of the very same types of jihadis that are trying to kill us in Paris, Brussels, and San Bernardino. Empowering them today is a recipe for disaster tomorrow.

Just how far the anti-Iran cabal is willing to go is illustrated by their deification of Zarhan Alloush, whose extreme Sunni-sectarian background (he openly advocated a genocide of the Alawites in Syria) has been whitewashed in order to transform him into some martyred potential interlocutor of peace.

Insane.

There is a civil war in Islam. Indeed, there are multiple civil wars. Sunni vs. Shia. But even within the Islamist Sunni “community” there are deep divisions and vicious, brutal fights.

Intervening in a civil war, especially one between extreme sectarians with mindsets completely alien to our own–and indeed, actively hostile to our own–is a recipe for disaster.

But those who counsel staying out–such as Ted Cruz–are pilloried as “isolationists.” Rushing in where angels fear to tread is not isolationism. It’s prudence.

Cruz in fact was-and is-an ardent foe of the Iran deal. So he’s not dew-eyed about the mullahs, or an isolationist. But he’s smart enough to realize that you have to pick your battles, and even if you don’t like Iran (which he doesn’t), that doesn’t mean you have to fight their proxy in Syria.

Indeed, one of the reasons that the Iran deal was a disaster was precisely that it stoked the conflict between Iran and the Saudis. This was predictable, and predicted: well over a year ago I argued that one of the reasons the deal was a bad idea is that it would intensify the conflict in the Gulf specifically, and the Muslim civil war generally, because the Saudis would feel the need to take matters into their own hands and fight Iran before Iran became too strong. We are seeing that happen right before our eyes.

What’s particularly maddening about the interventionist crowd is that they have no specific strategy. This is epitomized by this Garry Kasparov article. Kasparov waxes eloquent about American exceptionalism, and our need to do something:

But the Iraq War was a rebuke to bad planning and lousy implementation, not a refutation of the idea that America can be an essential force for good in the world. America must do better, not do nothing.

OK. I’ll stipulate that doing nothing is not good. But it’s a long way from saying “do something!” to specifying just what that something is, and showing that it will make things better, not worse. After all, in this very paragraph Kasparov admits that we are capable of “bad planning and lousy implementation”: what’s to say we won’t have a repeat? Vacuous generalities about spreading democracy and freedom are exactly what gets us into trouble.

It is particularly irritating that Kasparov invokes Reagan’s name (as many neocons do, though he didn’t care for them, and the feeling was quite mutual). Reagan indeed engaged in soaring rhetoric about freedom and democracy. But he had a concrete strategy that he developed over years and implemented methodically when in office. The new interventionists have the rhetoric. The strategy, not so much.

Further, the situation Reagan faced–a Cold War with a military peer and ideological rival–is completely different than the one we currently face in the Middle East. There are no one size fits all solutions, and anyone who claims to know how Reagan would respond to these completely different circumstances is just full of it. That’s unknown and unknowable.

Perhaps as a chess player, Kasparov is used to there being  black pieces, and white pieces. But in the Middle East, there is no such clean divide. It is just different shades of anti-western and anti-modern sectarians looking to extirpate their enemies–who include us, by the way. Democracy and freedom are on no one’s agenda there, and we shouldn’t pretend otherwise. We made that mistake in Iraq: why repeat it again.

I am not a huge fan of Kissinger, James Baker, and Brent Scowcroft, but on these issues they have a more measured understanding of the realities. They recognize the importance of idealistic goals, but temper that with a recognition that realistic means are needed to achieve them.

Scowcroft:

Scowcroft does not believe that the promotion of American-style democracy abroad is a sufficiently good reason to use force. “I thought we ought to make it our duty to help make the world friendlier for the growth of liberal regimes,” he said. “You encourage democracy over time, with assistance, and aid, the traditional way. Not how the neocons do it.”

(The whole piece is worth reading.)

Kissinger and Baker:

Like most Americans, we believe that the United States should always support democracy and human rights politically, economically and diplomatically, just as we championed freedom for the captive peoples of the Soviet empire during the Cold War. Our values impel us to alleviate human suffering. But as a general principle, our country should do so militarily only when a national interest is also at stake. Such an approach could properly be labeled “pragmatic idealism.”

. . .

Sixth, and most important, the United States must develop a firm and differentiated understanding of its vital national interests. Not every upheaval in the region has the same origin or remedy. The Arab Spring has the potential to become a great opportunity for the people of the region and the world. Over time, fostering democracy may provide an alternative to Islamic extremism; it may also, in the short term, empower some of its supporters. We need to develop a realistic concept of what is achievable and in what time frame.

The last point is a jab at the End of History strain of neoconservatism, which is universalist and believes that everyone wants to be like us, and that the world is inevitably destined to be like us, as the result of some progressive, Hegelian process.

No and no.

Insofar as Syria in particular is concerned. Our national interest there is limited, and the cost of doing anything is prohibitive. Putin’s intervention there is not a bug, but a feature: if he is a fool who rushes in, we should take grim satisfaction, not engage in hysterical reactions like Kasparov (and Max Boot and Michael Weiss). (Relatedly, Boot slandered Cruz, tweeting that he has affection for Assad. This is scurrilous: not wanting to fight him does not imply affection, especially since those whom Assad is fighting are Islamic extremists.)

In sum, the isolationism charge is a canard when hurled at people who don’t want to get deeper into Syria, and who don’t want to take sides between medieval combatants in a sectarian civil war. Saying that the Iranians are bad is not sufficient to justify intervening on the side of their Wahhabi foes–who are just as bad, and are in fact more directly involved in attacking the US and the West than are the Iranians.

To paraphrase Kissinger again (specifically, his remarks about the Iran-Iraq War): we should hope that they both lose. In the meantime, we should look for ways of shielding ourself from the fallout. Jumping into the fray is not the way to do that.

I have long hypothesized that an intense war between the White House and the Pentagon has been raging for years.

Exhibit 1 in support of this hypothesis is the simple fact that Obama is on his fourth defense secretary, whereas no other major department has had more than two. The most recently defenestrated SecDef, Chuck “Hapless” Hagel, recently blasted the administration, savaging it for micromanaging, and entrusting the micromanaging to certifiable idiots like Susan Rice, whose major qualification, of course, is her willingness to say anything–anything–in defense of the administration, no matter how ludicrous.

Hagel’s complaints about micromanagement merely echo those of his predecessors, Bob Gates and Leon Panetta. And of course, there are many other stories (some discussed here) that provide further support.

Hagel also claims that the White House tried to “destroy” him with a slanderous leak campaign. The White House no doubt did this pour encourager les autres: no independent thought will be tolerated! This apparently had the desired effect. One candidate,  Michele Flournoy, withdrew her name from consideration precisely because of her concerns about micromanagement by The Incompetent One.

All of this of course should make you look askance at anyone who would take the job.

Today brought another story of the Pentagon-White House War: Reuters reports that the Defense Department has been doing everything in its power, and pulling every bureaucratic trick imaginable, to impede Obama’s obsession with emptying Gitmo.

The most lurid war story came out some days ago, when Seymour Hersh wrote a long piece in the London Review of Books claiming that the Defense Department actively opposed administration policy in Syria. One must always take Hersh stories with a large grain of salt, but this one has a high degree of verisimilitude. The Pentagon was aghast at Obama’s support for jihadi groups fighting Assad, and for its deference to Turkey which was supporting every jihadist in sight–including ISIS.

The strongest piece of evidence in favor of the Hersh claims is the failed Pentagon program to arm allegedly moderate opposition groups. The Pentagon knows how to arm, equip, and train insurgent forces: indeed, this was the original purpose of Special Forces. The only possible reason that the Pentagon could have fucked it up as badly as it did in Syria is that it wanted to fuck it up.

Another piece of evidence in favor of Hersh is that he writes that ex-DIA head Michael Flynn was the most aggressive opponent of Obama’s Syria policy (with Dempsey playing a more devious Yes Minister role). Flynn has been very outspoken recently, including this recent interview.

So there you have it folks. The Defense Department and Obama and his thugs have gone to the mattresses. Helluva way to run a war. Or wars.

This piece in War on the Rocks challenges seven common beliefs about Russia. Two were of particular interest.

The first challenges the view the Russia is brittle. As someone who long ago advanced this hypothesis, I challenge the challenge. The basic problem is that I don’t think author Michael Kofman really understands the concept of brittleness. Here’s what he says:

With each new outbreak in what has become an almost routine series of political, economic, or foreign policy crises, a segment of the Russia-watcher community invariably begins to make predictions of Putin’s imminent demise. Unfortunately, the science of predicting regime change seems to lag significantly behind astrology. We should remember that few predicted the Soviet Union’s rapid demise, the start of the Arab Spring, or anticipated the rapid fall of Victor Yanukovich in Ukraine following the start of the Maidan.

There are two ongoing case studies on the merit of such predictions. The first is Pakistan, a country that by the same theory should have collapsed long ago under the weight of its many problems. The second is North Korea, which soldiers on despite decades of predictions and estimates of the regime’s imminent implosion. As former Secretary of Defense Robert Gates remarked on our ability to predict the nature and location of the next conflict, “our record has been perfect” given that “we’ve never once gotten it right.” The same should be said of our ability to judge regime brittleness. The point is not that neo-Kremlinology or assessments of political stability are a waste of time, but that this is a single layer of analysis that should be taken with a healthy dose of skepticism.

The point about brittleness is exactly that the process is not linear and that collapse occurs suddenly and unpredictably. Brittle systems survive most things, but when they fail, they fail completely and suddenly . . . like the USSR, Arab regimes, and Yanukovych.

Brittleness arises from coordination games in authoritarian regimes. Preference falsification is one mechanism. Coercive mechanisms and social pressures induce people to claim allegiance to an authoritarian regime, or remain silent, even when they don’t like it. This can be self-reinforcing, because people don’t receive contradictory information, and think that their own dissatisfaction is not widely held, and thereby remain silent (or feign support) which convinces others that their dissatisfaction is not widely held, and on and on. This system is stable, until some shock (a military adventure gone wrong, for instance, or an economic calamity, or an incompetent response to a natural disaster) induces enough people to express their opposition to convince the remainder that their dissatisfaction is indeed widely shared. The equilibrium then flips from uniform support or acquiescence to widespread opposition.

Preference falsification is a brittleness mechanism that works through the broad populace. Natural state mechanisms work through the elite. Elite support for the regime is predicated on the beliefs that it commands control over enough resources that can be distributed to the elite, and that this control will endure for some time. When an adverse economic shock reduces the stream of rents that is used to buy elite support, or if the durability of the regime comes into question (due, for instance, to a health crisis at the top of the regime), the elite can suddenly withdraw support or challenge the existing leadership, leading to regime collapse.

Both of these mechanisms are non-linear. Small shocks can lead to large changes. Since the shocks are unpredictable, the shattering of a brittle regime is unpredictable as well.

Highly personalized and institutionally impoverished systems tend to be more brittle, in large part because these systems are more dependent on the vagaries of individual health, personality, and sanity. In this respect, it is interesting to consider the case of Stalin. The Soviet system survived Stalin’s death in part because it did have developed institutions that facilitated succession. Putin, in contrast, has followed the more traditional authoritarian approach of becoming the indispensable person. Such as system is inherently more brittle.

The second point I’d like to challenge is related to the first, namely, whether Putin (and the Russian government generally) is obsessed with regime survival. Kofman argues that this is an empirically empty hypothesis.

This is incorrect. Putin is clearly obsessed with regime change. Look at his rhetoric on color revolutions and the Arab uprisings. He sees dark plots everywhere, most of them emanating from the US. His fears are matched by actions. Putin’s resumption of the presidency, and the relentless campaign to control civil society and eliminate independent media especially in the aftermath of the late-2011 protests are the clearest examples domestically, and the hysterical response to Ukraine, Syria and even backwaters like Montenegro are the foreign policy manifestations of this fear. The obsession with stability at home and abroad is also symptomatic of of concerns about regime survival.

The domestic reactions are classical authoritarian responses to anxieties about brittleness. Controlling information enforces the preference falsification equilibrium. The confident don’t fear open expression of discontent. Those who know that stability depends the shared belief that the regime has near universal support, do.

Obsession with regime survival is an acknowledgement of brittleness: that’s why these concepts are related (though Kofman does not connect them, which is revealing). Michael Kofman may not believe that Russia is brittle, but Putin’s behavior strongly suggests that he does.

Again, the whole point about brittle regimes is that the timing of their demise is almost impossible to predict, as that brittleness is a non-linear process that involves the risk of a large and sudden change in equilibria in response to a modest shock. Non-brittle systems muddle along. Brittle regimes don’t: they sometimes fall to pieces all at once, like the one hoss shay.