Streetwise Professor

The meltdown of FTX continues to spark controversy and commentary. A recent theme in this commentary is that the FTX disaster represents a failure of centralization that decentralized finance–DeFI–could correct. Examples include contributions by the very smart and knowledgeable Campbell Harvey of Duke, and an OpEd in today’s WSJ.

I agree that the failure of FTX demonstrates that the crypto business as it is, as opposed to how it is often portrayed, is highly centralized. But the FTX implosion does not demonstrate that centralization of crypto trading per se is fundamentally flawed: FTX is an example of centralization done the worst way, without any of the institutional and regulatory safeguards employed by exchanges like CME, Eurex, and ICE.

Indeed, for reasons I have laid out going back to 2018 at the latest, the crypto market was centralized for fundamental economic reasons, and it makes sense that centralization done right will prevail in crypto going forward.

The competitor for centralization advocated by Harvey and the WSJ OpEd and many others is “DeFi”–decentralized finance. This utilizes the nature of blockchain technology and smart contracts to facilitate crypto trading without centralized intermediaries like exchanges.

One of the exemplars of the DeFi argument is “automated market making” (“AMM”) of crypto. This article provides details, but the basic contours are easily described. Market participants contribute crypto to pools consisting of pairs of assets. For example, a pool may consist of Ether (ETH) and the stablecoin Tether (USDT). The relative price of the assets in the pool is determined by a formula, e.g., XETH*XUSDT=K, where K is a constant, XETH is the amount of ETH in the pool and XUSDT is the amount of Tether. If I contribute 1 unit of ETH to the pool, I am given K units of USDT, so the relative price of ETH (in terms of Tether) is K: the price of Tether (in terms of Ether) is 1/K.

Fine. But does this mechanism provide price discovery? Not directly, and not in the same way a centralized exchange like CME does for something like corn futures. DeFi/AMM essentially relies on an arbitrage mechanism to keep prices aligned across exchanges (like, FTX once up an time and Binance now) and other DeFi AMMs. If the price of Ether on one platform is K but the price on another is say .95K, I buy ETH on the latter platform and sell Ether on the former platform. (Just like Sam and Caroline supposedly did on Almeda!) This tends to drive prices across platforms towards equality.

But where does the price discovery take place? To what price do all the platforms converge? This mechanism equalizes prices across platforms, but in traditional financial markets (TradFi, for the consagneti!) price discovery tends to be a natural monopoly, or at least has strong natural monopoly tendencies. For example, it the days prior to RegNMS, virtually all price discovery in NYSE stocks occurred on the NYSE, even though it accounted only for about 75-80 percent of volume. Satellite markets used NYSE prices to set their own prices. (In the RegNMS market, the interconnected exchanges are the locus of price discovery.)

Why is this?: the centripetal forces of trading with private information. Something that Admati-Pfleiderer analyzed 30+ years ago, and I have shown in my research. Basically, informed traders profit most by trading where most uninformed traders trade, and the uninformed mitigate their losses to the informed by trading in the same place. These factors reinforce one another, leading to a consolidation of informed trading in a single market, and the consolidation of uninformed trading on the same market except to the extent that the uninformed can segment themselves by trading on platforms with mechanisms that make it costly for the informed to exploit their information, such as trade-at-settlement, dark pools, and block trading. (What constitutes “informed” in crypto is a whole other subject for another time.)

It is likely that the same mechanism is at work in crypto. Although trading consolidation is not as pronounced there as it is in other asset classes, crypto has become very concentrated, with Binance capturing around 75-80 percent of trading even before the FTX bankruptcy.

So theory and some evidence suggests that price discovery takes place on exchanges, and that DeFi platforms are satellite markets that rely on arbitrage directly or indirectly with exchanges to determine price. (This raises the question of whether the AMM mechanism is sufficiently costly for informed traders to insure that their users are effectively noise traders.)

The implication of this is that DeFi is not a close substitute for centralized trading of crypto. (I note that DeFi trading of stocks and currencies is essentially parasitical on price discovery performed elsewhere.) So just because SBF centralized crypto trading in the worst way doesn’t mean that decentralization is the answer–or will prevail in equilibrium as anything more than an ancillary trading mechanism suited for a specific clientele, and not be the primary locus of price discovery.

The future of crypto will therefore almost certainly involve a high degree of centralization–performed by adults, operating in a rigorous legal environment, unlike SBF/FTX. That’s where price discovery will occur. In my opinion, DeFi will play an ancillary role, just as off-exchange venues do today in equities, and did prior to RegNMS.

One last remark. One thing that many in the financial markets deplore is the fragmentation of trading in equities. It is allegedly highly inefficient. Dark pools, etc., have been heavily criticized.

Fragmentation and decentralization is also a criticism leveled against OTC derivatives markets–here it has been fingered as a source of systemic risk, and this criticism resulted in things like OTC clearing mandates and swap execution facility mandates.

It’s fair to say, therefore, that in financial market conventional wisdom, decentralization=bad.

But now, a failure of a particular centralized entity is leading people to tout the virtues of decentralization. Talk about strange new respect!

All of these criticisms are largely misguided. As I’ve written extensively in the past, fragmentation in TradFi is a way of accommodating the diverse needs of diverse market participants. And just because some hopped up pervs found that running a centralized “exchange” was actually a great way to steal money from those blinded by their BS doesn’t mean that centralization is inherently unfitted for crypto because decentralized mechanisms also exist.

If crypto trading is to survive, well-operated centralized platforms will play an outsized role, supplemented by decentralized ones. Crypto is not so unique that the economic forces that have shaped market structure in stocks and derivatives will not operate there.

So don’t overgeneralize from a likely (and hopefully!) extreme case driven by the madness of woke crowds.

As day follows night, the vaporization of FTX has spurred calls for regulation of crypto markets. Well, what kind of regulation, exactly? It matters.

It appears highly likely that SBF and his Merry Gang (of pervy druggies?) broke oodles of laws, in multiple jurisdictions. Class action lawsuits are definitely incoming, and the DOJ’s SDNY attorneys’ office is commencing a criminal investigation. No doubt criminal investigations will follow in other locations. So what would more laws accomplish, and what kind of laws and regulations would help?

It is interesting to note that SBF was going around DC and the media talking up regulating the industry, and winning effusive plaudits (but not from CZ!) for doing so, but his proposals didn’t come within a million miles of his alleged wrongdoing. I’m sure you’re shocked.

On CNBC, Bankman-Fried endorsed three regulatory endeavors: stablecoin auditing, “markets regulation” of spot trading, and token registration (at about the 4:30 mark):

None of which touches on the fundamental issue in the FTX fiasco, and in crypto market structure generally: the role of “exchanges” in supplying broker dealer and banking services, including liquidity, maturity, and credit transformations.

No doubt SBF was adding to his savior glow by pushing regulation that he knew was utterly irrelevant to the core of his business (and the business of all other crypto “exchanges”). And look at how many suckers fell for it.

So what would help? As I noted at the outset, FTX, Bankman-Fried, et al likely violated numerous laws. So what additional laws would reduce the likelihood and severity of such actions?

In thinking about this, remembering the distinction between ex ante and ex post regulation is important. Ex post regulation involves the imposition of sanctions on malfeasors after they have been found to have committed offense: the idea is to deter bad conduct through punishment after the fact. In contrast, ex ante regulation attempts to prevent bad acts by imposing various constraints on potential wrongdoers.

The choice between ex ante and ex post depends on a variety of factors. Two of the most important (and related) are whether the bad actor is judgment proof (i.e., will have the resources to recompense those he has harmed) and the probability of detection. (These are related because a low probability of detection requires a higher penalty to achieve deterrence, but a higher penalty increases the chances that the wrongdoer is judgment proof).

In the case of things like what has apparently happened here, the probability of detection is high (1.00 actually), but the magnitude of the harm is so great and the (negative) correlation between the harm and the wrongdoer’s ability to pay is so high (essentially -1.00) that ex post deterrence is problematic.

(Judgment proof-ness is actually a justification for criminal law and the use of incarceration as punishment. Deterrence through fines doesn’t work with broke bad guys, so non-monetary punishment is necessary–but often not sufficient!)

So there is a case for ex ante regulation here, just as there is a case for ex ante regulation of banks and intermediaries like broker dealers and FCMs. Banking examiners, regulatory audits, customer seg rules, and the like.

But these are obviously not panaceas. Bank fraud still occurs with depressing regularity, and the things that facilitate it, like valuation challenges, accounting shenanigans, and so on, occur in spades in crypto. And, even in highly regulated US markets, violation of seg rules and misuse of customer assets occurs: yeah, I’m looking at you John Corzine/MF Global.

The big problems in crypto markets are essentially agency problems, especially since the crucial agents–crypto “exchanges”–are so concentrated and so vertically integrated into both execution and various forms of financial transformations.

Ex ante regulation focused on such issues could be a boon, and could help stabilize crypto markets generally. The spillovers we are seeing from FTX’s vaporization are essentially a reputational contagion: the mini (so far) runs on other “exchanges” reflect FUD about their probity and solvency. (NB: Binance, as the biggest “exchange,” and as opaque as FTX, is a serious run risk. BlockFi and AAX may already be in the crosshairs here: glitch in the systems upgrade. Riiiiigggghhhht.)

The challenge is that the demise of financial intermediaries is well-described by a famous Hemingway quote:

“How did you go bankrupt?” Bill asked. “Two ways,” Mike said. “Gradually, then suddenly.”

An intermediary can go along swimmingly, meeting all seg requirements and the like, and a big market move or bad bet or an operational SNAFU can put it on the brink very suddenly–and encourage gambling for resurrection by using customer funds to extend and pretend. So don’t expect such regulation to be a panacea, and prevent the recurrence of FTXs. Regulation or no, this happens with intermediaries that engage in liquidity, maturity, and credit transformations that are inherently fragile. (And may be fragile by design, as Doug Diamond has pointed out.)

On the regulation issue, one fascinating sidebar is my old bête noire, Gary Gensler. You don’t need to play 6 Degrees From SBF to ensnare most of the Democratic establishment: one or two degrees will do, and Gensler definitely qualifies.

In addition to the MIT connection, Gensler apparently had other interactions with Bankman-Fried. And of course Gensler is a player in the Democratic Party (he was Hillary’s campaign’s finance chair, after all), and Bankman-Fried was a major Dem donor (second largest after Soros in the most recent cycle, and he had talked about spending up to a billion in the 2024 campaign).

Questions have been raised.

When initially questioned about FTX, Gensler was very defensive:  “Building the evidence, building the facts often takes time.”

I am reserving judgment, but I hope someone takes the time to examine the links and interactions between SBF/FTX and Gensler (and other DC creatures)–and build the evidence and facts, if it comes to that.

My guess is that Gensler will try to pull a judo move and use this fiasco as a justification for expanding the power of the SEC. Indeed, I expect him to be in high dudgeon precisely to deflect attention from his (and his party’s) links to SBF. Don’t let him get away with it.

And don’t think that these links can be exposed through a FOIA. Gensler has long been known for using his private email to conduct official business. (Which is precisely why I didn’t bother FOAI-ing him years ago regarding my suspicions of his interactions with David Kocieniewski.) So deeper digging is required, and it should commence, post haste.

Another blizzard hit the winter-bound crypto industry, with the evisceration of crypto wonder boy Sam Bankman-Fried’s (SBF to crypto kiddies) FTX and its associated hedge fund Alameda Capital. (Which should be renamed Alameda No Capital.) The coup coup de grâce was delivered by SBF’s former frenemy (now full fledged enemy), Binance’s Changpeng Zhao (CZ, ditto). But it is now evident that FTX was a Rube Goldberg monstrosity and all CZ did was remove–call into question, really–one piece of the contraption which led to its failure.

The events bring out in sharp detail many crucial aspects of the crypto landscape. (I won’t say “ecosystem”–a nauseating word.).

One is crypto market structure. FTX (and Binance for that matter) are commonly referred to as “exchanges,” giving rise to thoughts of the CME or NYSE. But they are much more than that. FTX (and other crypto “exchanges”) are in fact highly integrated financial institutions that combine the functions of trade execution platform (an exchange qua exchange), a broker dealer/FCM, clearinghouse, and custodian. And in FTX’s case, it also was affiliated with a massive crypto-focused hedge fund, the aforementioned Alameda.

Crucially, as part of its broker dealer/FCM operation, FTX engaged in margin lending to customers. Indeed, it permitted very high leverage:

FTX offers high leverage products and tokens. The exchange currently offers 20x maximum leverage, down from its previous 101x leverage products. This is still one of the highest maximum leverage a crypto exchange offers when compared to FTX’s other competitors. Leveraged long and short tokens for BTC, ETH, MATIC, and others are also offered by the exchange; for example, the ETHBULL token allows investors to trade a 3x long position in Ethereum.

FTX also engaged in the equivalent of securities lending: it lent out the BTC, etc., that customers held in their accounts there.

These are traditional broker dealer functions, and historically they are functions that have led to the collapse of such firms–more on that below.

FTX supersized the risks of these activities through one of its funding mechanisms, the FTT token. Ostensibly the benefits of owning FTT were reduced trading fees on the exchange, “airdrops” (a distribution of “free” tokens to those holding sufficient quantities on account with FTX, a promise to return a certain fraction of trading revenues to token holders by repurchasing (“burning”), and some limited governance/voting rights. The burning also served the function of limiting supply. (I plan to write a separate post on the economics of valuation of these tokens, though I do touch on some issues below.)

So FTT is (or should I say “was”?) stock-not-stock. Not a listed security, but an instrument that paid dividends in various forms.

FTT was in some ways the snowman here. For one thing, FTX allowed customers to post margin in FTT.

Huh, whut?

Risky collateral is always problematic. (Look at the reluctance of counterparties to accept anything but cash as collateral even from pension funds as in the UK.) Allowing posting of your own liability as collateral is more than problematic–it is insane. Very Enron-y!

Why? A subject I’ve written on a lot in the past: wrong way risk.

If for any reason FTT goes down, the value of collateral posted by customers goes down. Which means that your assets (loans to customers) go down in value.

A doom machine, in other words.

The integrated structure of FTX exacerbated this risk, and bigly. If customers start to get nervous about its viability, they start to pull the assets (BTC, ETH, etc.) they have on account there. Which is a problem if you’ve lent them out! (Recall that AIG’s biggest problem wasn’t CDS, but securities lending.)

And this has happened, with customers attempting to pull billions from the firm, and FTX therefore being forced to stop withdrawals.

And things can get even worse. The travails of a big broker dealer can impact prices, not just of its liabilities like FTT but of assets generally (stocks and bonds in a traditional market, crypto here) and given the posting of risky assets of collateral that can make the collateral shortfalls even worse. Fire sale effects are one reason for these price movements. In the case of crypto, the failure of a major crypto firm calls into question the viability of the asset class generally, with some of them being affected particularly acutely.

The integrated structure of crypto firms is also a problem. Customer assets are held in omnibus accounts, not segregated ones. Yeah yeah crypto firms say your assets on account are yours, but that’s true in a bookkeeping sense only. They are held in a pool. This structure incentivizes customers to run when the firm looks shaky. Which can turn looks into reality. That’s what has happened to FTX.

The connection with a hedge fund trading crypto is also a big problem. (The blow up of hedge funds operated by big banks was a harbinger of the GFC in August, 2008, recall.). And it is increasingly apparent that this was a major issue with FTX that interacted with the factors mentioned above. FTX evidently lent large amounts–$16 billion!–of customer assets to Alameda Research. Apparently to prop it up after huge losses in the first blizzards of Crypto Winter. (In retrospect, SBF’s buying binge earlier this year looks like gambling for resurrection.)

SBF described this as “a poor judgment call.”

You don’t say! I hear that’s what Napoleon said while trudging back from Russia in November 1812. Probably Custer’s last words, but we’ll never know!

Also probably an illegal judgment call.

But it gets better! Alameda held large quantities of FTT, also apparently emergency funding provided by FTX. And it used billions of FTT as collateral for its trades and borrowing.

And this was the string that CZ pulled that caused the whole thing to unravel. When he announced that he had learned of Alameda’s large FTT position, and that as a result he was selling FTT the doom machine kicked into operation, and at hyper speed: doom occurred within days.

Looking at this in the immediate aftermath, my thought was that FTX was basically MF Global with an exchange operation. A financially fragile broker dealer combined with an exchange.

Think of MF Global operating an exchange.

— streetwiseprof (@streetwiseprof) November 8, 2022

And the analogy was even closer than I knew: FTX’s using customer assets to “fund risky bets” revealed this morning is also exactly what MF Global did. Except that Corzine was a piker by comparison. He filched almost exactly only 1/10th of what FTX did ($1.6 billion vs. $16 billion). (Maybe SBF should take comfort from the fact that Corzine walks free–though I don’t recommend that he walk free at LaSalle and Jackson or Wacker and Adams). (I further note that SBF is a huge Democrat donor. Like Corzine, his political connections may save him from the pokey, though by all appearances he should spend a very long stretch there.)

In sum, FTX’s implosion is just a crypto-flavored example of the collapse of an intermediary the likes of which has been seen multiple times over the (literally) centuries. As I’ve written before, there is nothing new under the financial sun.

The episode also throws a harsh light on the supposed novelty of crypto. Remember, the crypto narrative is that crypto is decentralized, and does not rely on trusted institutions: it is trustless in other words.

Wrong! As I’ve written before, economic forces lead to centralization and intermediation in crypto markets, just as in traditional financial markets. Market participants utilize the services of firms like FTX and Binance, and have to trust that those firms are acting prudently. If that trust is lost, disaster ensues.

In brief, crypto trading could be decentralized, but it isn’t. For reasons I wrote about years ago. (Also see here.)

Indeed, the issue is arguably even more acute in crypto markets, for a reason that SBF himself laid out in now infamous interview with Matt Levine on Odd Lots. Specifically, that token valuation relies on magic–belief, actually.

That is, tokens are valuable if people believe they are valuable–that is, if they have trust in their value. Furthermore, there is a sort of information cascade logic that can create market value: if people see that a token sells at a positive price–especially if it sells at a very large positive price–and they observe that supposedly smart people hold it, they conclude it must have some intrinsic value. So they pile in, increasing the value, validating beliefs, and extending the information cascade.

But this is Tinker Bell economics. If people stop believing, Tinker Bell dies.

And when someone very influential like CZ says “I don’t believe” death is rapid: the information cascade stops, then reverses. Especially given how FTT was the keystone of the FTX arch.

In brief, crypto theory is completely different than crypto reality. Crypto markets share all major features with the demonized traditional “trust-based” financial system. To the extent they differ, they are even more based on trust, given the ubiquity of Token Tinker Bell Economics.

There is a huge amount of hysteria going on about the diesel market. Tucker Carlson is prominent in flogging this as an impending disaster:

Thanks to the Biden administration’s religious war, this country is about to run out of diesel fuel.https://t.co/51oLY1LDak pic.twitter.com/mwuBQcLu5u

— Tucker Carlson (@TuckerCarlson) October 28, 2022

Like so much of Tucker these days, this is an exaggerated, bowdlerized, and politicized description of what is happening. There is a kernel of truth (more on this below) but it is obscured and distorted by the exaggerations.

First off, it is complete bollocks to say “in 25 days there will be no diesel.” Current inventories–stocks–are about equal to 25 days of consumption. But production continues, at a rate of about 4.8 million barrels per week. So, yes, if US refineries stopped producing right now, in 25 days the US would be out of diesel. But this isn’t France! US refineries will keep chugging along, operating close to capacity, supplying the diesel market.

Stocks v. flows, Tucker, stocks v. flows.

Yes, by historical standards, stocks are very low, although there have been other periods when inventories have been almost this low. But low stocks are not a sign of a broken market, or of impending doom.

Low stocks do happen and periodically should happen in a well-functioning market. That is, “stock outs” regularly occur in competitive markets, for good economic reasons.

Assume that stock outs never occurred. Well that would mean that something was produced but never consumed. That makes no economic sense.

The role of inventories is to buffer temporary (i.e., short term) supply and demand shocks. I emphasize temporary because as I show in my book on the economics of storage, storage is driven by scarcity today relative to expected scarcity in the future. A long term demand or supply shock affects current and expected future scarcity in the same way, and hence don’t trigger a storage response. In contrast, a temporary/transient shock (e.g., a refinery outage) affects current vs. future scarcity, and triggers a storage response.

For example, a refinery outage raises current scarcity relative to future scarcity. Drawing down on stocks mitigates this problem. For an opposite example, a temporary demand decline raises future scarcity relative to current scarcity. This can be mitigated by storage–reducing consumption some today in order to raise consumption in the future (when the good is relatively scarce).

To give some perspective on what “short term” means, in my book, I show that for the copper market inventory movements are driven by shocks with a half life of about a month.

Put differently, storage of a commodity (diesel, copper) is like saving for a rainy day. When it rains, you draw down on inventories. When it rains a lot for an extended period, you can draw inventories to very low levels.

And that’s basically what has happened in the diesel market.

Carlson is right about one thing: the Russian invasion in Ukraine precipitated the situation. This is best seen by looking at diesel crack spreads–the difference between the value of a barrel of diesel (measured by the Gulf Coast price) and the value of a barrel of oil (measured by WTI):

Although the crack was gradually increasing in 2021 (due to the rebound from COVID lockdowns) the spike up corresponds almost precisely with the Russian invasion. After reaching nosebleed levels in late-April, early-May, the crack declined to a still-historically high level and roughly plateaued over the summer, before beginning to widen again in September. This widening is in large part a seasonal phenomenon–heating oil (another middle distillate) demand picks up at that time.

In terms of storage, the initial market response made sense. The war was expected to be of relatively short duration. So draw down on inventories. However, the war has persisted longer than initial expectations, and the policy responses–notably restrictions on Russian exports, including refined products to Europe–have also taken on a semi-permanent cast. So the shock has endured far longer than expected, but the (rational) response of drawing down on stocks has left us in the current situation.

To extend the rainy day example, if you don’t expect it to rain 40 days and 40 nights (or for 9 months) you will draw down on inventories and you’ll go close to zero if the rain lasts longer than expected. That’s what we’ve seen in diesel.

As in any textbook stockout situation, price will adjust to match consumption with productive capacity. Inventories will not buffer subsequent supply and demand shocks, meaning that prices will be pretty volatile: storage dampens volatility.

I should note that low inventory levels can create opportunities for the exercise of market power–manipulations/corners/squeezes. So it is possible that some of the price and spread moves in benchmark prices may reflect more than these tight fundamentals.

Hopefully the hysteria will not trigger idiotic policy responses. The supply shock has been most acute in Europe (because it consumed a lot of Russian middle distillate). This has resulted in a substantial uptick in US exports (diesel and gasoline) to Europe, which has led to suggestions that the US restrict exports, or ban them altogether. This would be beggar–or bugger–thy neighbor, and would actually feed the recent narrative advanced by Manny Macron and others in Europe that the US is exploiting Europe’s energy distress.

Further, this would reduce the returns to refinery capital, reducing the incentive to invest in this sector–which would be a great way of perpetuating the current scarcity.

But this administration, and in particular its (empty) head, somehow think returns to capital are a bad thing:

This is throwing pearls before a swine, but here goes. Investment raises wealth and wages, and lowers prices. People invest only if they expect to earn a return. https://t.co/LjC2zdrlg4

— streetwiseprof (@streetwiseprof) October 28, 2022

Believe it or not, there are even worse proposals than export bans, windfall profits taxes, and restrictions on returning cash to investors bouncing around. In particular, supposedly serious people (who travel in the best of circles) like Columbia’s Jason Bordoff are suggesting nationalization of the US energy industry.

Yeah. That’ll fix things.

What we are seeing in diesel (and in other energy markets as well) is their efficient operation in the face of extreme supply and demand shocks. You may not like the message that prices and stocks are sending–that fundamental conditions are really tight–but suppressing those signals, or other types of intervention like export bans–will make the situation worse, not better.

And yes, energy market (and commodity market generally) conditions should definitely be considered when evaluating how to handle Russia and the war in Ukraine. But that evaluation is not advanced by hysterical statements about the nation grinding to a halt at Thanksgiving because we’ll be out of diesel.

I have long called myself “the Clearing Cassandra” for my repeated and unheeded warnings about the dangers of letting the Trojan Horse of clearing (and the margining of uncleared trades) into the financial citadel. Specifically, clearing/margining can create financial shocks (and indeed financial crises) rather than preventing them (which is the supposed justification for mandating them).

We have seen several examples of this in the past several years, including the COVID (lockdown) shock of March 2020 (a subject of a JACF article of mine) and the recent energy market tremors. The most recent example, and in many ways the most telling one, is the recent instability in the UK that led the Bank of England to intervene to prevent a full-on crisis. The tumult fed a spike in UK government yields and contributed to a plunge in the Pound.

The instability was centered on UK pension funds engaged in a strategy called Liability Directed Investment (LDI)–which should now be renamed Liquidity Danger Investment. In a nutshell, in LDI defined benefit pension funds hedge the interest rate risk in their liabilities through interest rate swaps that are cleared or otherwise margined daily on a mark-to-market basis, rather than investing in fixed income securities that generate cash flows that match the liabilities. The funds hold non-fixed income assets (sometimes referred to as “growth assets”) in lieu of fixed income. (I discuss the whys of that portfolio strategy below.)

On a MTM basis, the funds are hedged: a rise in interest rates causes a decline in the present value of the liabilities, which matches a decline in the value of the swaps. Even if there is a duration match, however, there is not a liquidity match. A rise in interest rates generates no cash inflow on the liabilities (even though they have declined in value), but the clearing/margining of the swaps leads to a variation margin outflow: the funds have to stump up cash to meet VM obligations.

And this has happened in a big way due to interest rate increases driven by central bank tightening and the deteriorating fiscal situation in the UK (which has been exacerbated substantially by the energy situation, and the British government’s commitment to absorb a large fraction of energy costs). This led to big margin calls . . . which the funds did not have cash to cover. So, cue a fire sale: the funds dumped their most liquid assets–UK government gilts–which overwhelmed the risk bearing capacity/liquidity of that market, leading to a further spurt in interest rates . . . which led to more VM obligations. Etc., etc., etc.

In other words, a classic liquidity spiral.

The BofE intervened by buying gilts in massive amounts. This helped stem the spiral, though the problem was so acute that the BofE had to extend its purchases beyond the period it initially announced.

So yet again, central bank intervention was necessary to provide liquidity to put out fires created by margining.

FFS. When will people who should know better figure this out? How many times is it necessary to hit the mule upside the head with a 2×4?

I just returned from France, and while walking by the Banque de France I thought of a conference held there in the fall of 2013 at which I spoke: the conference was co-sponsored by the BdF, BofE, and ECB. It was intended to be a celebration of the passage and implementation of various post-Crisis regulations, clearing mandates most prominent among them.

I did my buzz kill Clearing Cassandra routine, in which I warned very specifically of the liquidity spiral dangers inherent in clearing as a source of financial instability. I got pretty much the same response as the Trojan Cassandra–a blow off, in other words. Indeed, I quite evidently got under some skins. The next speaker was Benoît Cœuré, a member of the ECB governing council. The first half of his talk was a very intemperate–and futile–attempt at rebuttal. Which I took as a compliment.

Alas, events have repeatedly rebutted Cœuré and Gensler and all the other myriad clearing cheerleaders.

The LDI episode has validated other arguments that I made starting in late-2008. Most notably, clearing was touted as a “no credit” system because the clearinghouse does not extend any credit to counterparties: variation margin/mark-to-market is the mechanism that limits CCP credit exposure. Since one (faulty) narrative of the Crisis was that it was the result of credit extended to derivatives counterparties, clearing was repeatedly touted as a way of reducing systemic risk.

Not so fast! I said. Such a view is profoundly unsystemic because it neglects the fact that market participants can substitute other forms of credit for the credit they no longer get via derivatives trades. And indeed, in the recent LDI episode exemplifies a very specific warning I made over a decade ago: those subject to clearing or margining mandates would borrow on the repo market to fund margin obligations, including both initial margin and variation margin.

And indeed the UK funds did exactly that. This actually increased the connectedness of the financial system (contrary to the triumphant assertions of Gensler and others), and this connectedness via the repo channel was another factor that drove the BofE to intervene.

My beard is not quite this long (though it’s getting there) but this is pretty much spot on:

Again: Clearing converts credit risk into liquidity risk. And all financial crises are liquidity crises.

Maybe someday people will figure this out. Hopefully before I snuff it.

And the idiocy of this is especially great with respect to the UK pension funds because they posed relatively little credit risk in the first place. So there was not a substitution of one risk (liquidity risk) for another (credit risk). There was an addition of a new risk with little if any reduction of any other risk.

The LDI strategies were right way risks. Interest rate movements that cause swaps to lose value also increase the value of the funds (by reducing the PV of their liabilities). The funds were not–and are not-leveraged plays on interest rate risk. So the prospects of defaults on derivatives that could be mitigated by clearing were minimal.

Here I have to part ways with someone I usually agree with, John Cochrane, who characterizes the episode as another example of the dangers of leverage. He cites to a BofE document about the LDI episode that indeed mentions leverage, but the story it tells is not the classic lever-up-and-lose-more-when-the-market-moves-against-you one that John suggests. Instead, in figure in the BofE piece that John includes in one of his posts, the increase in interest rates actually makes the pension fund better off in present value terms–even including its LDI-related positions–because its assets go down less in value than its liabilities do. In that sense, the LDI positions are an interest rate hedge. But there is a mismatch in the liquidity impacts.*. It is this liquidity mismatch that causes the problem.

The BofE piece also suggests that the underlying issue here is pension fund underfunding. In essence, the pension funds needed to jack up returns to close their funding gap. So instead of investing in fixed income assets with cash flows that mirrored those of its pension liabilities, the funds invested in higher returning assets like equities. Just investing in fixed income would have locked in the funding gap: investing in equities increased the odds of becoming fully funded. But just investing in equities alone would have subjected the funds to substantial interest rate risk. So the LDI strategies were intended to immunize them against this risk.

Thus, the original sin was the underfunding. LDI was/is not a way of adding interest rate risk through leverage to raise expected returns to close the gap (gambling on interest rate risk for resurrection). Instead it was a way of managing interest rate risk to permit raising returns to close the gap by changing portfolio composition. (No doubt regulators were cool with this because it reduced the probability that pension fund bailouts would be needed, or at least kicked that can down the road, a la US S&L regulators in the 1980s.)

No, the real story here is not the oft-told tale of highly leveraged intermediaries coming to grief when their speculations turn out wrong. Instead, it is a story of how mechanisms intended to limit leverage directly lead to indirect increases in debt and more importantly to increases in liquidity risks. In that way, margining increases systemic risk, rather than reducing it as advertised.

*The BofE document describes an LDI mechanism that is somewhat different than using swaps to manage interest rate risk. Instead, it describes a mechanism whereby positions in gilts are partially funded by repo borrowing. The borrowing is necessary to create a position large enough to create enough duration to match the duration of a fund’s liabilities. But a swap is economically equivalent to a position in the underlying funded by borrowing, so the difference is more apparent than real. Moreover, the liquidity implications of the interest rate hedging mechanism in the BofE document are quite similar to those of a swap.

Gary Gensler has long lusted to get his regulatory hooks into cryptocurrency. To do so as head of the SEC, he has to find a way to transform crypto (e.g., Bitcoin, Ether, various tokens) into securities, as defined under laws dating from the 1930s. Although Gensler has stated that crypto regulation is a long way off–presumably because it is no mean feat to jam an innovation of the 2010s into a regulatory framework of the 1930s–he thinks that he may have found a way to get at the second largest crypto, Ether.

Gensler pictured here:

Sorry! Sorry! Understandable mistake! Here’s his actual image:

Ether just switched from a “proof of work” model–the model employed by Bitcoin–to a “proof of stake” model. Gensler recently said that Ether may therefore qualify as a security under the Howey test, established in a 1946 Supreme Court decision–handed down when computers filled large rooms, had no memory, and caused the lights to dim in entire cities when they were powered up.

Per Gensler:

Securities and Exchange Commission Chairman Gary Gensler said Thursday that cryptocurrencies and intermediaries that allow holders to “stake” their coins might pass a key test used by courts to determine whether an asset is a security. Known as the Howey test, it examines whether investors expect to earn a return from the work of third parties. 

“From the coin’s perspective…that’s another indicia that under the Howey test, the investing public is anticipating profits based on the efforts of others,” Mr. Gensler told reporters after a congressional hearing. He said he wasn’t referring to any specific cryptocurrency. 

To call that a stretch is an understatement. A huge one. Because the function of proof of stake is entirely different than the function of a security.

Proof of work and proof of stake are alternative ways of operating an anonymous, trustless crypto currency. As I’ve written in several pieces here and elsewhere, eliminating the need for trusted institutions to guarantee transactions does not come for free. Those tempted to defraud must incur a cost if they do in order to be deterred. A performance bond sacrificed on non-performance or deceit is a common way to do that. Proofs of stake and work both are effectively performance bonds. With proof of work, a “miner” incurs a cost (electricity, computing resources) to get the right to add blocks to the blockchain: if a majority of other miners don’t concur with the proposal, the block is not validated, the proposing miner gets no reward, and sacrifices the expenditure required to make the proposal. Proof of stake is a more traditional sort of bond: you lose your stake if your proposal is rejected.

A security is something totally different, and serves a completely different function. (NB. I favor the “functional model of regulation” proposed by Merton many years ago. Regulation should be based on function, not institution.). The function of a security is to raise capital with a marketable instrument that can be bought and sold by third parties at mutually agreed upon prices.

So with a lot of squinting, you can say that both securities and staking mechanism involve “the efforts of others,” but to effect completely different purposes and functions. The fundamental difference in function/purpose means that even if they have something in common, they are totally different and the regulatory framework for one is totally inappropriate to the regulation of the other.

This illustrates an issue that I often come across in my work on commodities, securities, and antitrust litigation: the common confusion of sufficient and necessary conditions. Arguably profiting from the efforts of others could be a necessary condition to be considered a security. It is not, however, a sufficient condition–as Gensler is essentially advocating.

But what’s logic when there’s a regulatory empire to build, right?

I’m also at a loss to explain how Gensler could think that proof of stake involves the “efforts” (i.e., work) of others, but proof of, you know, work doesn’t.

Gensler’s “logic” would probably even embarrass Sir Bedevere:

“What also floats in water?” “A security!”

Gensler might have more of a leg to stand on when it comes to tokens. But with Bitcoin, Ether, and other similar things, hammering the crypto peg into the securities law hole is idiotic.

But never let logic stand in the way of Gary’s pursuit of his precious:

GiGi is not solely focused on crypto of course. He has many preciouses. This week the SEC released a proposed rule to mandate clearing of many cash Treasury trades.

Clearing of course has always been a mania of Gary’s. His deep affection for me no doubt dates from my extensive writing on his Ahab-like pursuit of clearing mandates in derivatives more than a decade ago. Clearing is Gensler’s hammer, and he sees in every financial problem a nail to be driven.

The problem at issue here is the periodic episodes of large price moves and illiquidity in the Treasury market in recent years, most notably in March 2020 (the subject of a JACF article by me).

Clearing is a mechanism to mitigate counterparty credit risk. There is no evidence, nor reasonable basis to believe, that counterparty credit risk precipitated these episodes, or that these episodes (whatever their cause) raised the risk of a chain reaction via a counterparty credit risk channel in cash Treasuries.

Moreover, as I have said ad nauseum, clearing and the associated margining mechanism is a major potential source of financial instability.

Indeed, as I point out in the JACF article, clearing and margin in Treasury futures and other fixed income securities markets is what threatened to turn the price (and basis) movement sparked by Covid (and policy responses to Covid) into a systemic event that required Fed intervention to prevent.

I note that as I discussed at the time, margining also contributed greatly to the instability surrounding the GameStop fiasco.

Meaning that in the name of promoting financial market stability Gensler and the SEC (the vote on the proposal was unanimous) are in fact expanding the use of the very mechanism that exacerbated the problem they are allegedly addressing.

Like the Bourbons, Gensler has learned nothing, and forgotten nothing. He has not forgotten his misbegotten notions of the consequences of clearing, and hasn’t learned what the real consequences are.

Of course these two issues do not exhaust the catalog of Gensler’s regulatory imperium. Another big one is his climate change reporting initiative. I’ll turn to that another day, but in the meantime definitely check out John Cochrane’s dismantling of that piece of GiGi’s handiwork.

As Gideon John Tucker said famously 156 years ago: “No man’s life, liberty or property are safe while the Legislature is in session.” Nor are they when Gary Gensler heads a regulatory agency.

European politicians are desperate, and desperate politicians thrash around and grab stupid ideas–any idea–that they think will alleviate the source of their desperation.

The cost of energy is extremely high now in Europe, and that is stoking political desperation. The politicians don’t like the price signals that the market is sending, and so they are exploring myriad ways of interfering with the price system. These policies (e.g., price controls) cannot solve the underlying problem: Europe is structurally short energy. Moreover, they will create their own problems, which will result in panicked reactions that will create new problems. Wash, rinse, repeat. The whole thing is doomed to collapse. In tears.

There is no better illustration of the European failure to come to grips with their real problems than some of the recent proposals surrounding LNG. One is to cap the price of imported LNG.

Brilliant! That way you’ll have even less gas, and the marginal value of power will go up! Yay!

Er, the LNG market is a world market. Yes, Europe collectively is large enough to have some monopsony power and thus can reduce price: but one exercises monopsony power by cutting purchases. That is, less gas will flow to Europe. Europeans will consume less electricity, and they will substitute higher cost ways of generating it. The shadow price (the opportunity cost, i.e., the real cost) of electricity and gas will increase, not fall.

Another proposal is in some ways even whackier: to replace the Dutch Title Transfer Facility (TTF) price with the Japan-Korea Marker (JKM) as the benchmark price for gas in Europe. Because the JKM price is lower. Or something:

As a last resort in case of supply disruption in Europe the EU could also explore temporarily pegging the TTF to the JKM Asian benchmark as a dynamic cap. Yet that would require the use of other hubs or mechanisms to allocate gas inside Europe, the commission said in the document on benchmarks for the wholesale gas market. “In this situation, JKM would become the world price for international gas for some time,” the commission said. “The wholesale market would be therefore determined by LNG supply/demand, and not by the EU’s internal bottlenecks. LNG would still be attracted by the fact transport costs are lower to the EU.”

In other words, the EC doesn’t like the basis between the price of pipeline gas in Europe (as measured by the TTF price in the Netherlands) and JKM. So, voilà! Make JKM the benchmark and tie the TTF price to the JKM price.

This begs the question of why the basis is what it is. The basis–the spread–reflects bottlenecks as well as shipping costs. If TTF is at a premium to JKM (which it is) even though shipping costs to Europe are lower, that means that there is some bottleneck to transform LNG on the European coast into gas in a pipeline on the continent. The most likely bottlenecks is gasification capacity. The Europeans are scrambling to get floating LNG gasification facilities operating, but the basis/spread is saying that a lot more capacity is needed.

The EC concedes that TTF is at a premium, and that the premium has increased: ““The price premium between the TTF and Europe’s LNG delivered ex-ship indices has widened significantly bringing up questions about its representativeness as an index for linking the contracts in the whole EU-27.”

It only brings up questions to fools. Non-fools get it.

If by “pegging” the Europeans impose some spread between TTF and JKM (adjusted for shipping cost differentials) that does not reflect these EU bottlenecks and their associated costs, the supply of LNG to Europe will be reduced. The only way to incentivize the flow of gas from overseas into European pipes is to have a price that covers the cost of that transformation. If there are bottlenecks, that transformation is expensive.

Thus, it is utterly delusional to think that a price that does not reflect “the EU’s internal bottlenecks” is a good thing: you want a price that does reflect them. The bottlenecks don’t go away because you don’t let the market price reflect them. If you don’t let the market price reflect them, the gas will go away. (Asia will send its regards, by the way.)

You may not like the message the price sends, but you cannot wish it away. And if you try, the message will be sent in an even more painful way. The Europeans (and the UK) seem hell bent on proving this very basic point the hard way, rather than learning from the hard experience of others dating back millennia.

While writing the post on European electricity prices, I was wondering about the drivers. How much due to fuel prices? How much due to capacity constraints? Risk premia?

Spreads, specifically spark and dark spreads, are the best way to assess these issues. Spark spreads are the difference between the price of electricity and the cost of natural gas necessary to generate it. And no, dark spreads are not the odds that Europe will shiver in the dark this winter–though I’m sure that you can find a bookie that will quote that for you!: a dark spread is the difference between the price of power and the cost of coal required to generate it. In essence, spark and dark spreads tell you the gross margin of generators, and the value of generation capacity. High spreads indicate that capacity is highly utilized: low spreads that capacity constraints are not a maor issue.

Sparks and darks depend on the efficiency of generators, which can vary. Efficiency is measured by a “heat rate” which is the number of mmBTU necessary to generate a MWh of electricity. Efficiency can be converted into a percentage by dividing the BTU content of electricity (3,412,000).

Electricity is a highly “spatial” commodity, with variations across geographic locations due to the geographic distribution of generation and load, and the transmission system (and the potential for constraints thereon). Moreover, since electricity cannot be stored economically (although hydro does provide an element of storability) forward prices for delivery of power at different dates can differ dramatically.

Looking at sparks and darks in Europe reveals some very interesting patterns. For example, comparing the UK with Germany reveals that German day ahead “clean” sparks (which also adjust for carbon costs) are negative for relatively low efficiency (~45 percent) units, and modestly positive (~€35) for higher efficiency (~50 percent) generators. In contrast, UK day ahead sparks are much higher–around €200.

Another example of “identify the bottleneck.” The driver of high spot power prices in Germany is not limitations on generating capacity–it is the high fuel prices. (Presumably the lower efficiency units are offline in Germany now, as their gross margin is negative.) Conversely, generation capacity limits are evidently much more binding in the UK.

But if you look at forward prices, the story is different. Quarter ahead clean sparks in Germany are around €200, while in the UK they are over €300. Two quarter ahead (the depth of winter) are almost €600 in Germany and a mere €300 or so in the UK. (All figures for 50 percent efficiency units).

These suggests that capacity will be an issue in both countries, but especially Germany. Way to go, Germany! Relying on solar in a country with long nights ain’t looking so good, is it?

The wide sparks also undermine attempts to blame it all on Putin. Yes, high gas prices/gas scarcity courtesy of Vova is contributing to high power prices, but that’s not the entire story. Though to be fair, more gas generating capacity wouldn’t help that much if they become energy limited resources due to a lack of Russian gas.

The high forward prices may also reflect a high risk premium. My academic work from the 2000s showed that there is an “upward bias” in electricity forward prices. That is, forward prices are above–and often substantially above–expected future spot prices. My interpretation was that this reflects “spikeaphobia”: power prices can spike up, but they are supported by a floor. This means that being caught short is much riskier than being long. This creates an imbalance between long hedging (to protect against price spikes) and short hedging (to protect against price declines that are likely to be far smaller than upward spikes). This creates “hedging pressure” on the long side: if speculative capital to absorb this imbalance is constrained, this hedging pressure drives up forward prices relative to expected spot prices.

The imbalance is likely exacerbated by the fact that there are large fuel price spike risks too. Moreover, the price and liquidity risks that speculators absorbing the imbalances must shoulder is likely raising the cost of speculative capital in electricity trading, meaning that there is both a demand pull and cost push driving the risk premium. Thus, I conjecture that some portion–perhaps a hefty portion–of the large spark spreads for German and the UK is risk premium. (Back in the days I started to estimate the risk premium in the US markets in the late-90s, the risk premium was as much as 50 percent of the forward price. That decline substantially over the next decade to about 10 percent for summer peak as the electricity markets became more “financialized.” Financialization, by the way, is usually a pejorative, which drives me nuts. Financialization typically reduces the cost of hedging.).

In the aftermath of the mooting of EU proposals to intervene massively in electricity markets, especially through price controls, forward power prices have plummeted: the above figures are from before the collapse. Price controls would impact both the expected spot price and the risk premium–because they take the spikes out of the price. However, as I noted in my prior post, this is not good news: if prices cannot clear the market, rationing will.

Dark sparks also tell a fascinating story. They are HUGE. The German dark spark for 2 quarters ahead (Jan-Mar) is over €1000, and the UK dark spread is over €600. In other words, it’s good to own a coal plant! By the way, these are clean darks, so they take into account the cost of carbon. Meaning that the market is sending a signal that the value of coal generation–even taking into account carbon–is very high. This no doubt explains why despite massive green and renewable rhetoric in China, the Chinese are building coal capacity hand over fist. It also points out the insanity of European policies to eliminate coal generation. Even if you believe in the dangers of carbon, the way to deal with that is to price it, rather than to dictate generation technology.

To give some perspective, the above figures imply that a 500MW coal plant in Germany was anticipated to produce €870 million in value in 23Q3 (24 hours/day x .80 operating rate x 91 days/quarter x 500 MW x €1000/MW). That’s more than the cost of a plant. Even if you cut that in half to take into account today’s power price collapse, it’s a huge number.

Think about that for a minute.

In sum, spreads tell fascinating stories about what is happening in the European electricity market, and in particular the roles of input prices and capacity constraints and risk premia in driving the historically high prices. But perhaps the most fascinating story they tell is the high price that Europe is paying to kill coal.

European power prices are going hyperbolic, with day ahead prices in swathes of the continent varying between €660 and €750/MWh.

For those who want to play at home–spot the congestion!

Even more remarkably, Cal 2023 power prices are around €1000/MWh in German and France:

That’s for baseload, folks. 24/7/365. Peak Cal 2023 French power is currently at €1425. Ooh la la!

This has of course set of a flurry of policy proposals.

None of these proposals will mitigate the fundamental problem–energy supply is extremely scarce. Most of these proposals will actually exacerbate the underlying scarcity.

Instead, these proposals are all about how to distribute the cost of scarcity. They are fundamentally redistributive in nature.

The proposals include price controls (natch), windfall profits taxes, and nationalization.

Price controls always exacerbate the scarcity and create actual shortages by encouraging consumption and discouraging production. They will necessitate rationing schemes. In electricity, rationing often involves brownouts and blackouts. Planned blackouts, such as no power availability at all for some hours of the day.

WIndfall profits taxes attempt to capture the surplus of inframarginal (i.e., low cost) suppliers, and redistribute that surplus (somehow) to consumers. Redistributing through subsidized prices exacerbates scarcity because it increases demand.

Windfall profits taxes may otherwise have few distorting effects in the short run, given that supply from the inframarginal firms is likely to be highly inelastic (they basically operate at capacity). (Ironically, the scheme to hit Russia by capping the prices it receives on oil is predicated on a belief that supply is highly inelastic.). However, windfall profits taxes have very deleterious long run incentives. They deprive those who invest in production capacity of the value of those investments precisely when they are greatest (which really distorts investment incentives). Even the risk that windfall taxes will be imposed in the future depresses investment today. Meaning that although such taxes may not do too much damage in the present, they increase the likelihood of future scarcity.

The reach of windfall profits taxes is also limited. Many of the rents resulting from the current world energy situation accrue to input suppliers (e.g., owners of LNG liquefaction capacity, coal miners that export to Europe) who are beyond the reach of grasping European hands via windfall profits taxes. (And are the Norwegians going to transfer wealth to Europe by imposing windfall taxes on their gas production and writing a check to Brussels? As if: the Norwegians are already talking about limiting energy exports to Europe.)

Nationalization can be a crude form of windfall profits tax: nationalizing low cost producers basically seizes their surplus. Nationalization can also be a form of subsidization: seize unprofitable firms, or firms that can only survive by charging very high prices, and sell the output below cost. Losses from below cost sales are socialized via taxpayer support of loss-making nationalized enterprises (which creates deadweight costs through taxation present and future).

Nationalization of course generates future operational and investment inefficiencies due to low power incentives, corruption, etc. Moreover, to the extent that nationalized entities subsidize prices, they will encourage overconsumption, and thereby create true shortages and necessitate rationing.

All of these policies aim to mitigate the pain that power consumers incur by shifting the costs to others–and in the forms of subsidies funded by general taxation, the overlap between those who receive the subsidies and those who pay them is pretty large. But even this transforms a very visible cost into a much less visible one, and thus has its own political benefit.

The Germans–at least the Green Party ministers in the government–are advocating a fundamental change in the market mechanism, specifically, eliminating marginal cost pricing:

“The fact that the highest price is always setting the prices for all other energy forms could be changed,” Economy Minister Robert Habeck, who is also the vice chancellor in the ruling coalition in Berlin, said in an interview with Bloomberg.

“We are working hard to find a new market model,” he said, adding that the government must be mindful not to intervene too much. “We need functioning markets and, at the same time, we need to set the right rules so that positions in the market are not abused.”

Marginal cost pricing is a fundamental economic tenet: price equal to marginal cost gives the right incentives to produce and consume. Below marginal cost pricing (the cost of the most expensive resource sets the price) encourages overconsumption. Further, unless marginal units are compensated there will be underproduction. Both of these create inefficiencies, exacerbate scarcity, and can lead to actual shortages and the necessity of rationing.

On a whiteboard you could draw up a pricing mechanism that perfectly price discriminates by paying each resource its marginal cost. This effectively appropriates all of the producer surplus which can be redistributed to favored political constituencies. But this doesn’t cover fixed costs and a return on capital, which discourages future investment.

Further, classroom whiteboard exercises are usually impossible even to approximate in reality. Knowing what marginal cost is for each resource in a complicated system is a major problem, especially when you take transmission into consideration. The likely outcome would be some sort of kludge with roughly average cost pricing combined with some Rube Goldberg scheme to compensate producers. This whole system would involve massive redistribution and all of the politicking and corruption attendant to it.

The real problem the Europeans have is that they want to kill the market messenger. The market is signaling scarcity. The scarcity is real, and acute, but they no likey! And by the nature of energy production–capital intensive, with moderate to long lead times to enhance capacity–the scarcity will continue for some time, with little the Europeans can do about it.

In other words, they can’t fix their real problem (scarcity), which is the harvest of their previous policy follies. So they are left to find redistributive schemes to allocate the costs in a politically satisfactory way. These redistributive schemes–price ceilings, windfall profits taxes, nationalization, fundamental restructuring of the market mechanism–all tend to exacerbate scarcity in both the short and longer runs.

The fact is, when you’re screwed, you’re screwed. And Europe is well and truly screwed. What is going on in policy circles in Europe right now is figuring out who is going to get screwed hardest, and who is going to get screwed not so much. And there will be substantial costs, both in the short but especially the longer term, as whatever Frankenstein “market” emerges from these frantic policy stopgaps will wreak havoc in the future, and will be very hard to put down.

Missed me on Twitter? Well, probably not, but if so, there’s an explanation. The thumbsuckers on Twitter locked me out for a week for this innocuous (IMO) tweet:

(NB: “Thumb” is a euphemism. Know what I mean? Nudge Nudge. Say no more.)

The beatdown notice came literally within seconds of posting, meaning that the tweet offended Twitter’s algorithms. Who knew they were so solicitous of rednecks’ feelings?

Lesson learned: next time I’ll say “peckerwoods” instead.

I guess Randy Newman must be banned for life, like James Lindsay (with trannies claiming credit for the censorship):

Twitter’s algo also apparently has some logical issues. The phrase “redneck racists” does not imply that all rednecks are racists. Just that there are racists who are rednecks. Does anyone deny this? Actually, does anyone at Twitter deny this? Indeed, I think it is more likely that the average pierced tattooed fascist at Twitter is highly likely to believe that all rednecks are racists. And they think all people like me are rednecks.

Or maybe Twitter is hypersensitive about accusations that leftists can be racists. They probably should be, because as my tweet suggests, leftist racism is pervasive and far more insidious than the traditional peckerwood variety. Insidious because of its fundamental dishonesty. Its condescension. Its manipulative use of blacks in particular to advance its anti-freedom, anti-American agenda. And the fact that leftists hold far more power in 21st century society than some Klansman wannabe.

Case in point: the leftist effort to rename monkeypox, because the name allegedly stigmatizes black people. Well, if your first association with the word “monkey” is black people, who is the racist, exactly?

Ironically, my time in the penalty box coincided with my reading of a Coase essay “The Market for Goods and the Market for Ideas,” and my watching of a documentary on Monty Python. They both demonstrate how much the left has changed from they heyday of American liberalism to today.

Back in the day, the liberals–the 1960s establishment left (not the New Left)–were the defenders of free speech, not its sworn enemies, as the left is today. The ACLU was all about free speech then: it is all about suppressing it now.

The Python documentary covered the controversy over The Life of Brian, which, among other things, resulted in its censorship in South Carolina at the behest of Strom Thurmond. The documentary showed earnest young liberals protesting the censorship, and defending free speech.

You know that their modern day successors hate free speech, and are the prime supporters of censorship on campus and throughout society generally.

The Coase essay is of particular interest, because he was trying to explain why the left of his day were anti-economic freedom (“market for goods”), but near absolutists on freedom of speech (“market for ideas”). His explanation was that liberals had a vested interest in freedom of speech since they were disproportionately represented in media and academia.

Well, they are even more dominant in the commanding heights of speech today than they were in 1974, when Coase wrote. (In the American Economic Review, I might add. The thought of anything similar appearing in the AER today would be ludicrous. In fact, the thought of anybody like Coase being a leading light in economics today is ludicrous).

So what explains the undeniable shift in attitude from pro-free speech to ardently anti-free speech in the space of 50 years, in the face of the strengthening of the force that Coase identified as the driver of pro-free speech attitudes?

Well, I hypothesize that it is exactly the overwhelming dominance that exists in traditional fora today, combined with the emergence of non-traditional outlets in the internet age. Although liberals held the upper hand in the 1960s, they did not have a monopoly over traditional media or academia then. The environment was more competitive, and liberals thought that they could prevail in that competition and feared they would be squelched to prevent them from prevailing. So they supported free speech because they thought that it worked to their competitive strength.

Now, however, they have a virtual monopoly over print media, television, and academia. They dominate social media, but they face more competition there. So their economic, social, and political interests have flipped: they benefit from suppressing competition, rather than encouraging it.

And as is the case with the regulation of the “market for goods,” vested interests in the “market for ideas” conspire with government in order to advance those interests. The unseemly–and almost certainly unconstitutional–collaboration between the United States government in particular and social media companies is not at all different from the collusion between industry and government to suppress entry and competition that is at the root of Stigler’s now 51 year old article on the economics of regulation.

In a nutshell, the Old Left was in favor of free speech because they believed it worked to their competitive advantage. The New Left hates free speech because they believe it works to their competitive detriment.

This reversal of polarity has nothing to do with principle. It is about power, pure and simple. The “principles” are purely instrumental, and intended to advance the political and social interests of a particular class. The censorship of some peripheral figure over a mild comment indicates how dominant that class is, and how sensitive it is to the maintenance of its dominance. Not a sparrow falls, as it were.

In other words, this isn’t about protecting rednecks from hateful comments: it’s about protecting the social dominance of today’s reds.