Streetwise Professor

Eminent economist Paul Romer has assumed the role of professional scold. A few years ago he excoriated other eminent economists (notably Robert Lucas) for “mathiness.” Now he is chastising the profession for enabling deregulation that has wreaked havoc across the land.

I have to say his essay is unpersuasive, not to say incoherent. One way of framing the issue is to contrast the view of Keynes:

Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.

with that of Stigler (speaking of the passage of the Corn Laws):

economists exert a minor and scarcely detectable influence on the societies in which they live . . . if Cobden had spoken only Yiddish, and with a stammer, and Peel had been a narrow, stupid man, England would have moved toward free trade in grain as its agricultural classes declined and its manufacturing and commercial classes grew.

Romer is clearly in league with Keynes, rather than Stigler.

But he fails to make the case. This is true for many reasons. For one, he argues by anecdote, and hence his style is journalistic rather than rigorously scholarly. A few cherry-picked anecdotes–and Romer uses only three–are clearly insufficient to support Romer’s broader claim that the deregulation favored by many economists (not all) was on the whole baleful. There are entire areas of deregulation (e.g., transportation, telecommunications, restrictions on advertising) that he says nothing about, but which were the subject of massive scholarship in the 1970s and 1980s which demonstrated the inefficiency of the existing regulatory structure: the experience in these industries post-deregulation strongly supported the scholarship that criticized existing regulations.

One interesting example is pharmaceutical regulation, something that exercises Romer quite greatly. Sam Peltzman showed in the 1970s that efficacy regulation under the 1962 Drug Act amendments did not result in a reduction in the amount of inefficacious drugs introduced, but did reduce the rate of introduction of new, valuable therapies. All pain, no gain.

Romer has nothing to say about this.

With respect to pharma regulation, Romer blames the opioid crisis on “pliant pretend economist[s]” who “assume[d] the role of the philosopher-king—someone willing to protect the firm’s reckless behavior from government interference and to do so with a veneer of objectivity and scientific expertise.”

He doesn’t quote any economist, pretend, real or otherwise, playing the role of philosopher-king/academic scribbler whose frenzy regulators or legislators distilled into opioids. Instead, he says:

By the 1990s, such arguments were out of bounds, because the language and elaborate concepts of economists left no opening for more practically minded people to express their values plainly. And when the Drug Enforcement Administration finally tried to limit the distribution of these painkillers, pharmaceutical companies launched a massive lobbying effort in favor of a bill in Congress that would strip the DEA of the power to freeze suspicious narcotics shipments by drug companies. It is a safe bet that these lobbyists made their arguments to Congress in the language of growth, incentives, and the danger of innovation-killing regulations. The push succeeded, and the DEA lost one of its most powerful tools for saving lives.

Of course, during earlier eras, regulators allowed many industries to profit massively from products known to be harmful; Big Tobacco is the most obvious example. But until the 1980s, the overarching trend was toward restrictions that reined in these abuses. Progress was painfully slow, but it was progress nonetheless, and life expectancy increased. The difference today is that the United States is going backward, and in many cases, economists—even those acting in good faith—have provided the intellectual cover for this retreat.

So apparently, by highjacking the language economists prevented rational debate, thereby rendering legislators and regulators defenseless against predatory corporations.

Or something.

That is, not only does Romer fail to show that deregulation was on the whole detrimental, he also fails to show that economists had anything much to do with making it happen. He asserts the Keynesian line, but does not come close to proving it.

Indeed, the reverse is true. Romer’s argument actually supports Stigler’s claim, which can be “distilled” thus: money talks. Or to use Keynes’ term: vested interests talk. What economists said or didn’t say or how they said it or what language they said it in (English, Yiddish, Aramaic) was nothing, compared to the lobbying might of the pharma industry. So not only does Romer fail to identify any actual economist who advocated the policy that infuriates him, he fails to show that what any economist said meant squat for the outcome.

Indeed, this is precisely why a certain species of economists (Stigler, and well, yours truly) was/is so skeptical about regulation: it tends to favor the interests of the regulated. It always has, and it always will. Economic efficiency is a secondary consideration, and what economists have to say on the matter has little (if any) bearing on the outcome. If anything, Romer’s piece is a case for Public Choice economics. But that has implications that Romer would no doubt find inimical.

Romer’s other big anecdote is from the financial industry, namely the infamous Goldman Abacus transaction in which Goldman served as the middleman between John Paulson (who wanted to short US real estate) and a hapless German bank.

The stand in for all economists in this anecdote is one sorta economist: Alan Greenspan. Apparently, Greenspan was the Representative Agent for the economics profession. This is beyond simplistic. Insultingly so.

Another bogeyman in Romer’s telling is Michael Jensen:

Michael Jensen, an economist who helped reshape the U.S. financial sector in the late twentieth century. Jensen rightly worried about several problems that bedeviled the market, including how to keep corporate executives from promoting their own interests at the expense of shareholders. His proposed solutions—hostile takeovers, debt, and executive bonuses that tracked the share price of a firm, among other changes—were widely adopted.

Corporate shareholders saw their earnings skyrocket, but the main effect of the changes was to empower the financial sector, which Greenspan, for his part, worked doggedly to unfetter. As Lemann writes, Jensen’s ideas also helped chip away at the power of the traditional Corporate Man—the sort of executive whose pursuit of profit was tempered somewhat by a commitment to noneconomic norms, among them a belief in the need to foster trust and build long-term relationships across company lines. Taking his place was Transaction Man, who focused on little more than driving up share prices by any means necessary.

There is so much wild generalization here that I am at a loss of where to begin. For one thing, Jensen’s heyday was the 1980s LBO and hostile takeover boom, which had been largely stymied by regulation by the early-1990s, long before the Financial Crisis. (So much for the power of Jensen’s advocacy! Jensen’s hero, Michael Milken, was in jail, FFS.)

I am at a real loss to trace the connection between Jensen’s advocacy of measures to control managerial agency costs and, say, the real estate securitization boom of the mid-2000s. Romer certainly doesn’t lay out the road map. Here merely cites Jensen’s views and asserts some connection with those of Greenspan, and proclaims QED! The South Park Underwear Gnomes’ argumentation was tighter.

And again, what economists said was almost certainly irrelevant here. There were powerful forces–political as well as economic forces–behind the real estate boom and crash. Homeownership became a totem for politicians of both parties in the 1990s and 2000s. Wall Street was on board, because it realized this could be an engine for profit. Main Street financial institutions were on board for the same reason.

So what if Alan Greenspan was cool with this? If he hadn’t been, he wouldn’t have been around long. Economic and political interests found a convenient mouthpiece: the mouthpiece didn’t create the economic and political forces. At the end of the day, economists would not have mattered, and the financial sector would have gotten the mouthpiece it wanted.

This part made me roll my eyes:

the traditional Corporate Man—the sort of executive whose pursuit of profit was tempered somewhat by a commitment to noneconomic norms, among them a belief in the need to foster trust and build long-term relationships across company lines. Taking his place was Transaction Man, who focused on little more than driving up share prices by any means necessary.

Evidence for this “commitment to noneconomic norms, among them a belief in the need to foster trust and build long-term relationships across company lines” among 1960s-1970s corporate executives? None whatsoever. This is an ex cathedra pronouncement that bears no relationship to the reality of self-serving corporate management during this era–management that a 1970s Romer probably would have inveighed against as venal and self-serving (as many criticisms of managerial capitalism did).

No, the issue here is not Corporate Man vs. Transaction Man. It is Straw Man (Romer’s, specifically) vs. Reality.

Romer gives economists both too much credit, and too little. By painting all economists who criticized regulation (based on empirical evidence and theory) as stooges, he gives them too little credit. By blaming them for massive public policy failures, he gives them too much. If only we had such influence.

Does economics matter? Yes. Do economists matter? Not really. And the reason for these answers is the same. Economic considerations–distributive considerations in particular, as they operate through the political and regulatory system–drive political and regulatory outcomes. Economists can comment on this, analyze it, and even advocate particular outcomes. But their participation has as much effect on the outcome as a sportscaster’s does on who wins the Super Bowl.

A recent RFS paper by Brogaard, Riggenberg, and Sovich purports to show that the rise of commodity index investing has had adverse effects on the real economy. Like most of the papers that analyze index investing, this one is seriously flawed and does not support the broad conclusions it asserts.

Like virtually all of the papers in this literature, it relies on crude before-after comparisons based on some magic year (2004? 2005? 2006?) during which commodity index investing became important. Even assuming that the rise in index investing was a sort of exogenous shock, this crude method of attributing causation has problems. After all, a lot of other stuff happened after, say, 2004. The rise of China as the predominate force in commodity markets, for instance.

Perhaps this problem would be less troublesome were commodities assigned randomly to “treatment” (part of an index) and “non-treatment” (non-index) groups. But this is definitely not the case. There are systematic differences between index and non-index commodities, so it is difficult to know whether the effects documented in Brogaard et al are due to a correlation between these systematic differences and the performance measures they utilize.

Ah. The performance measures. That raises yet more issues. The paper claims that firms with exposure to index commodities experienced lower returns on assets (i.e., operational income/assets) post-indexation than their non-index-exposed counterparts.

So what is the implicit model of the market in which these firms operate? If the presumption is that the markets are relatively competitive, why would you expect profit margins to change over a period of several years? Even assuming that indexation increased costs via the channels posited by the authors, in equilibrium this would lead to (a) an initial decline in profits, (b) exit (meaning fewer assets and lower output), and (c) a return of profits to the competitive level. Meaning that actually looking at assets or output would be a better measure of how indexation affects cost than profit margins.

If, conversely, the presumption is that these markets were imperfectly competitive prior to the indexation shock, the fall in profit rates could be a good thing, rather than a bad thing. It could indicate that indexation resulted in more intense competition/lower market power.

This is particularly interesting, given that this was a period in which measured profit rates were rising generally in the economy, a phenomenon which some (not I, but some) attribute to declining competition. Now, there are big problems with that literature (problems that the late great Harold Demsetz identified in the 1970s, but which modern scholars have forgotten), but take it at face value. Declining profits/margins could be interpreted as a signal of increased competitiveness and efficiency. A feature, not a bug.

And via a channel exactly contrary to that posited by Brogaard et al. They posit that indexation reduced the informational efficiency of commodity prices. But an increase in informational efficiency would tend to reduce market power–and reduce margins/profits. Note that many firms HATE the introduction of futures, or increased trading of futures, of their main inputs or outputs. Precisely because futures trading increases the informational content of prices which undermines an information asymmetry that generates profits for major producers and consumers.

Which brings me to that information channel. Brogaard et al measure informativeness using the autocorrelation in commodity returns.

Really?

They basically find that autocorrelations went up, which they interpret to mean that commodity futures markets became weak form inefficient (or further from weak form efficiency).

Again: really?

Taking their argument literally, it means that speculators were able to eliminate predictable movements in prices prior to indexation, but weren’t able to do so afterwards. This stretches credulity to its limits. After all, “financialization” of commodities also saw the entry of banks and hedge funds into commodity trading. We’re supposed to believe they left easy money on the table?

This purported reduction in price efficiency raises another issue. When I read about return autocorrelations I think time-varying expected returns. So the Brogaard et al result suggests that index commodity returns became more time-varying after indexation became a thing.

Arguably the primary impact of indexation was to integrate more closely commodity prices and stock and bond prices, and in particular, ensure that systematic risk was priced more consistently across commodities and financials. We know that equities and bonds have time varying returns. It is plausible that the documented increase in time variation in expected commodity returns reflects this integration, and is yet another feature rather than a bug.

If so, commodity prices that more accurately reflect the pricing of risk should lead to better investment decisions, not worse decisions. Further, these better investment decisions need not be associated, over several years, the operational performance measures they employ.

Indeed, along the lines of a paper that I wrote a few years back, indexation improves the allocation of risk and reduces the cost of commodity price risk to firms. In equilibrium, this would lead to lower rates of return. Which is exactly what Brogaard et al find.

Pursuing this further, I note that the authors do not use sensitivity to commodity prices as a means of determining whether firms are exposed to commodity prices, on the basis that hedging can reduce price exposure. Yes, but consider the following. Hedging is costly. Hedgers frequently pay a risk premium to speculators. This leads them to hedge less, which leads to high exposure. If indexation reduces hedging cost (as my paper implies), at the margin, firms will hedge more, and bear less risk. This reduces expected profits (which incorporate compensation for risk).

This has at least two implications. First, the average profit rate of firms exposed to hedgeable commodity prices (which are precisely the commodities that are included in indices) should decline post-indexation: this is consistent with the Brogaard et al finding. Second, firms should hedge more–leading to lower exposure to commodity prices. Brogaard et al do not test this latter implication. (Admittedly, this raises complications. Firms may limit commodity exposure in ways other than hedging, and a lower cost of hedging can lead to a substitution of hedging for these other means, leading to offsetting effects which reduce the commodity exposure impact of cheaper hedging.)

The upshot of all this is that the conclusions that the authors advance–namely, that indexation resulted in poorer real outcomes in terms of performance and investment–are not supported by their empirical findings. That is, there are alternative hypotheses that are consistent with the empirical findings that are diametrically opposed to their hypothesis.

This paper is well done within the analytical confines that its authors select. But that’s exactly the problem with this literature. The analytical confines exclude important channels of cause and effect. Most importantly, these confines make implicit assumptions about the degree and nature of competition that either make their results problematic, or mean that their results have diametrically opposed implications to those of the chosen analytical framework.

Meaning that the debate on the effects of indexation are still very much open, and that finance and economics scholars have largely failed to devise reliable tests to distinguish indexation-is-bad hypotheses from indexation-is-good hypotheses. Which is precisely why the debate is still open.

On Thursday, the CFTC voted along party lines to approve a proposal on position limits. The party line vote reveals a salient fact: the proposal represents a virtual abandonment of the Commission’s earlier proposals (2011, 2013, 2016). Indeed, virtually all of the features that I criticized in the earlier proposals are gone, and the current proposal largely mirrors the recommendations of the Energy and Environmental Markets Advisory Committee that I served on (before being uninvited by current EEMAC chair Dan Berkovitz). (More on EEMAC below.)

Most importantly, limits outside the “spot month” (which is actually just a few days for some commodities) for energy and metals commodities are gone. Good riddance. They remain for nine legacy ag futures contracts (corn, cotton, and the like), but the any-and-all limits have been expanded substantially.

The rule expands hedging exemptions beyond the prior proposals, and in doing so meets the objections of companies like Vitol. Interestingly, the proposal tidies up the definition of a “bona fide hedge” and makes explicit, rather than implicit, the principle that bona fide hedges are solely for the reduction of price risk.

The Commission did eliminate the “risk management” hedging exemption for swaps dealers, based on an interpretation of Congressional intent and a reading of statute that limits hedging to the management of risk of physical commodity positions. On principled grounds, I object to this. A swap dealer buying an oil swap from an E&P firm facilitates the hedging of a physical position, and hedging that swap via the futures markets serves a classical risk transfer function. A dealer selling an index swap to a pension fund isn’t hedging a physical risk, but it is still serving a risk transfer function and the distinction between physical commodity hedges and non-physical hedges is rather Talmudic.

The practical effect is unknown. In terms of index swaps, most swap dealers are out of the nearby contract when an index (e.g., GSCI) rolls, which is well before the spot month for energy and metals that make up the bulk of most indices. Hedges of the ag portion of these swaps could be affected by the any-and-all limits and the elimination of the risk management exemption, but the dramatic increase in the size of these limits may well greatly reduce any impact. A dealer hedging a swap with payments based on final settlement prices of say NYMEX crude or natural gas could be impacted by the elimination of the exemption, but the spot month limits may be large enough to cushion the impact here as well.

The most interesting feature of the proposal is its rather tortured attempt to address the “necessity” issue that derailed previous proposals in court.

The most important aspect of this is that it appears that the Commission has essentially conceded that a necessity finding is, well, necessary. That raises the issue of the criteria for establishing necessity.

One criterion could be that a limit is necessary only if the risk of speculation causing unwarranted price fluctuations is sufficiently great.

An alternative criterion is that a limit is necessary as long as the risk of unwarranted price fluctuations exists at all, if the contract is important enough.

The Commission took the latter approach, and limited its limits to commodities it deemed were sufficiently important (measured by volume and open interest) so that any unwarranted price fluctuation could lead to impairment of price discovery and risk transfer on a large scale. The closest that the Commission came to taking likelihood of disruption into account is its restriction of the limits to physical delivery contracts that could be cornered or squeezed. This is a logical problem (cash-settled contracts give rise to manipulation too) but this is of secondary importance. But it could be read to limit the Commission’s interpretation as to the source of unwarranted fluctuations to market power manipulation, which would be a good limitation indeed.

A sufficient statistic to infer that the Commission conceded much in its necessity finding is Dan Berkovitz’s freak out on the issue in his dissent.

As a manipulation-related aside, I will note that the spot month limits are justified by the notion that a position in excess of deliverable supply is necessary to execute a market power manipulation (i.e., a corner or squeeze). I have some recent research (which I’ll post and write about soon) showing that this may be a sufficient condition, but not a necessary one. Meaning that the limits will not be sufficient to eliminate market power manipulation.

The recent proposal, assuming it is finally approved as a rule in something resembling its current form, represents the end of a saga that has had a major influence on my life. I began writing about the speculation issue when it became a source of renewed political controversy in 2006. I wrote my first major post in response to a Senate Permanent Subcommittee Report (large authored by Dan Berkovitz) on oil speculation in August 2006.

As oil prices spiraled upwards in 2007 and 2008, I wrote more about the issue, and gained more notoriety. This resulted in my testifying before the House Ag Committee in July 2008 (a day or two before oil prices reached their all time high) and led to a WSJ oped.

Then the Financial Crisis happened, and I focused more on clearing issues, with periodic forays into the speculation debate. But Frankendodd included a provision on speculative position limits in commodities, and the CFTC rolled out a proposal in 2011.

I wrote a comment letter on the proposal. That letter (and others I wrote subsequently) were sufficiently important that in the final rulemaking and in later proposals it or other things I’ve written were cited dozens of times (my name gets 50 hits in the 2016 proposal).

But the impact of the letter on my life went beyond that. Gene Scalia–son of Justice Antonin Scalia, and now Secretary of Labor–retained me to write a declaration criticizing the inadequate cost-benefit analysis in the proposal (it being something required under the law.)

Perhaps most importantly, Blythe Masters at J. P. Morgan liked it, and called to tell me so. She then proposed that I write an analysis of the systemic risk of commodity trading firms for SIFMA. I did–and came up with the wrong answer. So SIFMA spiked the report. But word leaked out, which prompted Trafigura to retain me to write a study (with a subsequent follow-on study) of the economics of commodity trading firms.

I don’t think I’m exaggerating to say that this study proved to be very influential, perhaps because of the lack of competition: writing on the sector was, and remains, very sparse. I have traveled, lectured, and taught around the world based on people wanting to hear what I wrote about in that piece.

The study was also the hook for the New York Times hit piece on me in December, 2013. See! I took money from evil speculators while writing in opposition to limits on speculation! Never mind that I had been consistently opposed to limits years before, and never mind that Trafigura (and other oil traders) are not speculators and use the futures markets mainly for hedging.

(As an aside, I am convinced, but cannot prove, that Gary Gensler was the moving force behind the piece. After all, why else would the NYT devote front page space to an obscure academic? And under the theory of there-are-no-coincidences-comrade, comments on the 2013 revised proposal were due in January, 2014. So December 2013 was the perfect time to kneecap a gadfly. By the way, Gary, how’s that gig as Treasury Secretary working out. Oh. Right. Well maybe you can chair Hillary’s legal defense fund.)

Asides aside, other than frightening my aged parents this article actually was all for the good. It validated me as an influential voice. It also got many very reputable people to rush to my defense, including Thomas Sowell, one of my long-time heroes.

The article raised its head a few years later when I was serving on EEMAC, and was asked to write the (Frankendodd-mandated) report on the committee’s deliberations. I was the dutiful scribe, and honestly recorded the committee’s adamant opposition to the then-outstanding proposal (which included all the bad features jettisoned in the new proposal).

This caused Elizabeth Warren to lose her [insert vulgar metaphor of your choosing here]. This article in particular cracked me up (and still cracks me up): Why Elizabeth Warren Is On the Warpath This Week.

Well, why was she on “the warpath”? Well–me, now that you ask:

The committee, which was established by Dodd-Frank, has nine members. Though it is supposed to express a “wide diversity of opinion” and “a broad spectrum of interests,” eight of the nine members represent companies or industries with a financial interest in killing the position limits rule, or have a personal financial interest themselves. 

. . . .

The recent inclusion of Craig Pirrong on the committee is perhaps the most flagrant example. Pirrong, who co-wrote the first draft of the report with James Allison, is a professor of finance at the University of Houston, who has been paid by several industry participants and trade groups for his research into commodity speculation. He was also a paid research consultant for the International Swaps and Derivatives Association, the very group that got the initial rule overturned by the courts.

The CFTC report relies mostly on Pirrong’s research and a presentation he made to the committee last year, which did not include the opinion of anyone who believes in the dangers of excessive commodity speculation. In fact, 10 of the 13 witnesses at EEMAC meetings came from industry, two were representatives of CFTC, and the other was Pirrong. The meetings never mentioned that there would even be a final report. [Er, it’s in the law, you knobs.]

As Public Citizen’s Tyson Slocum, the only non-industry committee member and the only one to dissent from the recommendation, points out, Pirrong was not on the committee until after he co-authored the report. Pirrong “is so new to the EEMAC,” Slocum wrote in a minority dissent, “that I only learned he was a member when he was listed as a co-author.” 

This kerfuffle warranted another mention in the NYT, and I’ve been told that Warren used it (and me) in a fundraising pitch.

I’m so proud. One’s enemies are the best comment on one’s character.

What cracks me up is that it wasn’t a right-wing snarkmeister like me that included “Warpath” in the title of an article about Liz Warren. It was the (by then) far-left New Republic. Freudian slip? Whatever, it’s hilarious.

Alas, understandably but not commendably, Commissioner and EEMAC chair Christopher Giancarlo buckled under the political pressure and withdrew the report. But this was almost certainly a non-event: the proposal was dead in the water, and was only salvaged by saving major pieces overboard. And I’ve sailed on.

What a long strange trip it’s been. The speculation debate has had a first-order impact on the arc of my life for more than a decade. Although the Commission proposal will likely put an end to one chapter of that debate, as I wrote in my first piece in 2006, speculation controversy is a hardy perennial, and will no doubt recur the next time some major commodity price spikes or craters. And maybe I’ll be around to draw more fire–and deliver some–when that happens. And until then, I’ll keep Truckin’ on whatever fits my fancy.

Nota bene: I’m not a Dead Head by any means. But if the song fits . . . Well, not the drugs part!

The BIS included a box on the September USD repo spike in a chapter to its Quarterly Review titled “Easing Trade Tensions Support Risky Assets.” The piece lays out many damning dots, but does not connect them. Let me give it a try.

In a nutshell, the BIS report says that as a result of the wind down of the extraordinary post-crisis monetary policy measures there has been a dramatic change in the funding structure in US markets. In particular, the “big four [US] banks” (which the BIS delicately–or is it cravenly?–doesn’t name) have flipped from being suppliers of repo collateral (and hence cash borrowers) to being suppliers of cash (and hence collateral borrowers). Further, other US banks are not viable competitors to the big four, nor are other potential cash suppliers such as money market funds because they have hit counterparty credit limits which have constrained their lending capacity. According to the BIS, these events has made The Big Four Banks Who Shall Not Be Named the “marginal lenders” in the repo market. And mark well: prices are set at the margin.

Further, “leveraged players (eg hedge funds) were increasing their demand for Treasury repos to fund arbitrage trades between cash bonds and derivatives.”

So here are the dots. Recent structural changes have given the Big Four Banks Who Shall Not Be Named a dominant position in the repo market. Their main potential competitors as suppliers of funds are constrained by size or regulation. There has been a large increase in demand for repo funding.

Not even being willing to name the banks (as if their identities are unknown), the BIS does not even draw the blindingly obvious implication of its analysis–that the Four Repo Horsemen have market power. A lot of market power. Are we supposed to believe that (out of the goodness of their hearts, perhaps) they did not exercise it? I didn’t just fall off the turnip truck.

Even the euphemism Big Four is deceptive, for in reality this group is dominated by one bank–Morgan. And of course Morgan has been loudest in its protestations that it really wanted to lend more, but just couldn’t, dammit, because of those cursed liquidity regulations.

The BIS attempts to run cover, and provide some rather lame excuses for the failure to lend more despite the high rates:

Besides these shifts in market structure and balance sheet composition, other factors may help to explain why banks did not lend into the repo market, despite attractive profit opportunities. A reduction in money market activity is a natural by-product of central bank balance sheet expansion. If it persists for a prolonged period, it may result in hysteresis effects that hamper market functioning. For instance, the internal processes and knowledge that banks need to ensure prompt and smooth market operations may start to decay. This could take the form of staff inexperience and fewer market-makers, slowing internal processes. Moreover, for regulatory requirements – the liquidity coverage ratio – reserves and Treasuries are high-quality liquid assets (HQLA) of equivalent standing. But in practice, especially when managing internal intraday liquidity needs, banks prefer to keep reserves for their superior availability.

Hysterisis? Decaying internal processes and knowledge? Staff inexperience? Complete and utter argle bargle. We’re talking overnight secured lending here, not rocket science structured finance. It’s about as vanilla a banking transaction one could imagine. And LCR provides convenient cover.

The BIS lays out a compelling case that four major institutions have market power in repo. September events in particular are consistent with the exercise of market power, and the alternative explanations are beyond lame. Yet none dare speak its name, or even raise it as a possibility. Not the BIS. Not the Fed. Not the Treasury. Despite the systemic risks this poses.

The Financial Crisis supposedly changed everything. It apparently changed nothing.

It’s impossible to turn around these days without being beset by control freaks.

Exhibit 1. Michael Bloomberg, who is running for president. Bloomberg is infamous for his desire to control everything, from what you eat to what you drive to how you defend yourself. Bloomberg thinks taxing “sugary drinks” (among other things) is a great thing, despite the regressivity of this tax, because it’s good for the poor:

And if you buy a gun do defend yourself, you’re pretty stupid–so he will take them away:

“And if you want to have a gun in your house, I think you’re pretty stupid…” – Michael Bloomberg, 2014
https://t.co/XWmcPjP4V6

— John Cardillo (@johncardillo) November 29, 2019

Pretty sure his security detail is heavily armed. But that’s the credo of his ilk: for me, but not for thee.

Bloomberg also sucks up to the world’s leading control freaks, the Chinese Communist Party. When (amazingly) confronted about this by (amazingly) a PBS interviewer, Mikey totally flacked for them:

.@MikeBloomberg tells @FiringLineShow that China's leader is addressing pollution to satisfy constituents & secure his political future.
"The Communist Party wants to stay in power in China and they listen to the public," he says. pic.twitter.com/B9SoAXJwrM

— Firing Line with Margaret Hoover (@FiringLineShow) September 27, 2019

And behold the stunning dishonesty here–the lengths to which he goes to avoid criticizing the CCP. Bloomberg wants to control the entire energy system in order to reduce the emissions of global greenhouse gases (GHG). The Chinese are building coal plants at a frenzied pace, yet when confronted on this, Bloomberg treats the Chinese coal plants as merely an issue of local particulate pollution in places like Beijing.

As an aside on this issue: the silence of the Davos Douches (control freaks all) who sucked up to Xi on this issue, and so many others involving China, is deafening.

Exhibit 2. Elizabeth Warren, reprising her “you didn’t earn that” bullshit:

It's a point I've made since my very first campaign: Nobody in this country got rich on their own. They relied on infrastructure we all paid for, employees we all paid to educate. So if you're successful, good for you—now pay it forward so everyone has a chance at success. pic.twitter.com/FAuZhggAGk

— Elizabeth Warren (@ewarren) November 29, 2019

What pretzel logic. Because you might have benefited from some public goods, you are obligated to let Lizzie decide what she will take from you in order to pay for all the non-public goods that she wants.

I have a better idea: I’ll gladly pay taxes for public goods that earn a return in excess of the cost of capital, and Lizzie can STFU.

Exhibit 3. Angela Merkel. Zere vill be NO free speech for you!:

https://twitter.com/marceldirsus/status/1199666529413062656

Nice hand gestures there. Wonder where she picked those up?

Such a good little Ostie, ain’t she?

Exhibit 4: “Scientists”:

About 11,000 scientists call for population control in mass climate alarm https://t.co/jX7uJ5gKUv

— Bloomberg (@business) November 30, 2019

The irony of this is that those so wise in the ways of science

are obviously lecturing the developed world, which in their wisdom they apparently haven’t recognized is depopulating. Population growth is overwhelmingly concentrated in very low income Africa, the Middle East, Asia, and the Subcontinent, whose peoples (a) will never hear what these scientists are demanding, and (b) would ignore it in any event.

So what are these scientists proposing? What coercive powers will they deploy against brown people in order to achieve their vision?

No doubt Bloomberg has the answer: if they don’t submit voluntarily, kill them. You know, for their own good.

Elizabeth Warren, among other Democratic candidates, have promised to eliminate fracking in the US. The WSJ has a dialog between pro-ban and anti-ban advocates. It demonstrates just how unmoored from reality the fracking ban side is.

The anti-ban participant, Sam Ori, executive director of the Energy Policy Institute at the University of Chicago, points out that as a result of the fracking revolution, US production accounts for 8 percent of the world total, and eliminating this would dramatically increase prices:

One year after the implementation of a ban, shale-oil production would be down by more than a third. After two years, production would be down 55%. You’re talking about triple-digit oil prices and a possible global economic shock

To which the ban supporter, Kassie Siegel, director of the Climate Law Institute at the nonprofit Center for Biological Diversity, replied: What? Me worry? My magical thinking will save the day!

I think an oil-price prediction is largely a red herring, because I am not talking about banning fracking in a vacuum. My organization and others propose a fracking ban along with other smartly designed programs to speed the development and deployment of clean technologies, support local communities, and offset oil and gas price increases. Government policies that drive a rapid just transition to clean-energy technology can create the largest economic stimulus since World War II.

I’m talking about policies like accelerated clean car and truck standards that rapidly decrease oil consumption in the transport sector and moving the power sector to 100% renewable energy. Other policies like reinstating the crude-oil export ban would also counteract price increases from banning fracking and restricting the supply of oil and gas.

Well-designed government policy in other areas, like tobacco and asbestos, addresses both supply and demand. Climate policy must do the same. The barrier to this is opposition from the fossil-fuel industry, not any insurmountable economic or policy problem.

And don’t you think we need to be a little bit skeptical of anyone’s ability to accurately predict oil prices?

Unpacking this idiocy in its entirety would exhaust my time and my patience. So just a few comments.

“Well-designed government policy” and “smartly designed programs.” Such a comedian! Because we know government programs are always well-designed and smartly designed. Did I say “always”? Sorry. I meant “never.”

Case in point. The brilliant European strategy to reduce CO2 by forcing the replacement of gasoline engines with diesel. Whoops! Not only was it colossally expensive, it was a major mistake because (a) it barely affected emissions of CO2, and (b) greatly increased auto emissions of harmful particulates.

Further, since China is the largest emitter, and the largest growing emitter, of CO2, Ms. Siegel is relying upon the wise beneficence of the CCP to achieve her goals.

Need I say more?

“Accelerated clean car and truck standards that rapidly decrease oil consumption in the transport sector.” First, this is costly, not just directly in terms of replacing a huge stock of existing capital, but indirectly by forcing people to drive lower-quality automobiles. How do we know they are lower quality? Because people don’t buy them voluntarily: they have to be compelled.

Second, auto emissions are a drop in the CO2 bucket.

“Moving the power sector to 100% renewable energy.”

Excuse me a minute. I have to walk my unicorn.

OK. I’m back. One-hundred percent renewables is utterly unrealistic and enormously costly, including in terms of reliability and transmission–and fires started (in places by California) by transmission needed to support renewables generation. Fires which, by the way, emit massive amounts of CO2.

Look at Germany, which I wrote about a few days ago. They are running into a renewables wall well short of 100 percent, and have incurred massive costs (imposed on energy consumers) to get this far.

I note that Ms. Siegel doesn’t mention cement, or steel, or other industrial emitters (which put autos in the shade, btw).

Not to mention that fracking oil has f-all to do with power generation, and fracking gas that supplants coal reduces CO2 emissions.

“Other policies like reinstating the crude-oil export ban would also counteract price increases from banning fracking and restricting the supply of oil and gas.”

Yo. Einstein. We have oil and gas to export because of fracking. If we ban fracking, we’ll have no exports, and the export ban will have zero, zip, nada impact on prices.

Further, export bans reduce the price in the exporting country, but raise prices in the importing country. So I guess Ms. Siegel is an economic nationalist. I bet she looks stunning in her MAGA hat.

“And don’t you think we need to be a little bit skeptical of anyone’s ability to accurately predict oil prices?”

Yo. Von Neuman. This has nothing to do with predicting the level of oil prices. Demand curves slope down. You reduce production, prices go up. In fact, oil demand curves slope very steeply, so if you reduce production a little prices go up a lot.

Not rocket science. Just the law of demand.

And these are the brainiacs who are going to make sure that we have “well-designed” and “smartly designed” government policies.

God save us.

In the ongoing evaluation of what has been happening in the repo market, market participants have identified post-crisis regulations as a potential source of the problem. In particular, these regulations (including the Liquidity Coverage Ratio) require behemoth banks like JP Morgan and Citi to hold large amounts of reserves, and makes them reluctant to lend them out even when repo rates spike.

Having long said that the various liquidity regulations intended to prevent a recurrence of the last crisis could be the cause of a new one, I am certainly quite sympathetic to this view. However, information that is coming out now suggests another potentially complementary and aggravating factor.

In particular, reserve holdings are very concentrated:

Fed data show large banks are keeping a disproportionate amount in reserves, relative to their assets. The 25 largest US banks held an average of 8 per cent of their total assets in reserves at the end of the second quarter, versus 6 per cent for all other banks. 

Meanwhile, the four largest US banks — JPMorgan Chase, Bank of America, Citigroup and Wells Fargo — together held $377bn in cash reserves at the end of the second quarter this year, far more than the remaining 21 banks in the top 25

Moreover, the big banks have been reducing their reserves:

Analysts and bank rivals said big changes JPMorgan made in its balance sheet played a role in the spike in the repo market, which is an important adjunct to the Fed Funds market and used by the Fed to influence interest rates.
Without reliable sources of loans through the repo market, the financial system risks losing a valuable source of liquidity. Hedge funds, for example, use it to finance investments in U.S. Treasury securities and banks turn to it as option for raising suddenly-needed cash for clients.
Publicly-filed data shows JPMorgan reduced the cash it has on deposit at the Federal Reserve, from which it might have lent, by $158 billion in the year through June, a 57% decline.

Although JPMorgan’s moves appear to have been logical responses to interest rate trends and post-crisis banking regulations, which have limited it more than other banks, the data shows its switch accounted for about a third of the drop in all banking reserves at the Fed during the period.
“It was a very big move,” said one person who watches bank positions at the Fed but did not want to be named. An executive at a competing bank called the shift “massive”.
Other banks brought down their cash, too, but by only half the percentage, on average.
For example, Bank of America Corp (BAC.N), the second-biggest U.S. bank by assets, with a $2.4 trillion balance sheet, took down 30% of its deposits, a $29 billion reduction.

So . . . substantial concentrations of reserves, and declining levels of reserves. Yes, these are all potential consequences of Frankendodd. But they also are potentially symptomatic of market power and the exercise thereof.

This triggered a synapse, which led me to recall a 1993 article from the Journal of Monetary Economics by R. Glen Donaldson. Donaldson’s article was motivated by a study of the Panic of 1907, when a “cash syndicate” (led by . . . J.P. Morgan, in person and through his eponymous bank) lent to cash strapped trust companies facing depositor runs at very high rates.

Donaldson presents a model in which a spike in the need for cash by a set of market participants (trust companies facing depositor outflow, in his model) makes the funds held by a group of other institutions pivotal: these institutions face a downward sloping demand curve for their funds because of constraints on competitive suppliers of funds. The pivotal institutions supply funds (through a repo-like transaction in which they buy securities from the trusts) at a supercompetitive price (by buying the trusts’ securities at subcompetitive prices). In his model, collusion between the pivotal institutions exacerbates the rate spike.

The main implication of the model is that spikes in the demand for funds lead to spikes in interest rates that are bigger than would prevail in competitive conditions.

There is an element of non-linearity in the model, because the big suppliers’ funds are not pivotal in normal conditions, but become so when the demand becomes sufficiently large. This leads to a switch from competitive to monopoly pricing, which in turn causes a spike in rates.

I should note that the regulatory and market power stories are not mutually exclusive, and are indeed complementary. Regulatory constraints can increase the demand for funds (making it more likely that the big suppliers will be pivotal) and can reduce the supply of funds from the smaller suppliers (which lowers the threshold for the switch from competitive to monopoly pricing, and makes the demand curves for the big suppliers funds steeper, leading to a higher monopoly rate).

I therefore consider it a plausible hypothesis that market power contributed to the repo market spike, and that one channel by which regulations contributed to the spike was through its effect on market power.

How can this hypothesis be tested? Conceptually, if regulatory constraints alone caused the spike, then those in possession of large quantities of reserves (e.g., Morgan) were absolutely constrained in their ability to lend additional reserves: the difference between the repo rate and the Fed Funds rate would represent the shadow price on this regulatory constraint.

If a big bank or banks exercised market power, this constraint would not be binding.

Operationalizing this test is likely to be complex, however. Big holders of reserves will inevitably make all sorts of arguments to say that they couldn’t have lent more.

This brings to mind the California electricity crisis in 1999-2000, when generators operated below various capacity measures, but pleaded that constraints (by unplanned outages, or NOX regulations, etc.) reduced their effective capacity below these nominal capacity measures. Given the complexity of operating a power plant, it was very difficult to determine whether the generators were withholding capacity, or in fact offered as much as they were capable of doing.

Despite the difficulty of operationalizing the test, I think it is something for regulators to attempt. There is a colorable case that the repo rate rise was exacerbated by market power, and given the importance of this market, this possibility should be investigated rigorously.

As an aside, the Donaldson model appeared only a few months before my Journal of Business article on market power manipulation. The two articles have a lot in common, despite the fact that they were developed totally independently, and seemingly involve completely unrelated markets (money vs. physical commodities). However, the core arguments are similar: economic frictions can periodically create market power in markets that are usually competitive.

Hannah Arendt once wrote that “one of the greatest advantages of the totalitarian elite in the twenties and thirties was to turn any statement of fact into a question of motive.” This quote came to mind when reading Matt Stoller’s hit piece on Aaron Director on the Stigler Center’s Pro-Market blog.

Director was one of the major moving forces behind the Chicago revolution in antitrust scholarship in the 1950s and 1960s. Although he published little himself, through his teaching, and his interactions with other faculty in economics, law, and business at Chicago, Director challenged the consensus on antitrust, especially in areas like vertical restraints. The challenge that he inspired pretty much overturned this consensus, and it is fair to say that the Chicago became the replacement paradigm. A good portion of the industrial organization and antitrust scholarship of the past 50 years has been aimed at challenging the Chicago view, but nonetheless, many of its key insights remain regnant.

Stoller does not mount a serious attempt to critique Director’s actual contributions, or to explain them, as Sam Peltzman does in his two posts on Director. Rather than challenging Director and his followers on the facts, or on the analysis, Stoller instead questions Director’s motives. It is attack by ad hominem.

In Stoller’s telling, for much of his life, Director was a good progressive, and a devotee of Henry Simons. As such, he was an antimonopolist who favored aggressive antitrust enforcement. But then Simons died, and Director “suddenly” converted to a right-wing pro-business fanatic in order to appease a major funder who according to Stoller was an “extreme right-wing[er]” and quasi-fascist:

Director suddenly decided that conservative ideas were compatible with corporatism after all. Monopolies, apparently, were always created by government. At this moment, Director broke with the conservative tradition and birthed neoliberalism, the anti-government, pro-monopoly philosophy that now dominates policymaking globally. Director convinced George Stigler and Milton Friedman of the new creed. Both had opposed corporate monopolies, but flipped to support Director’s new movement. The Chicago School was born.

Thus, Director was nothing but an intellectual Judas, who sold out his firm convictions for a few pieces of silver.

This begs so many questions it isn’t funny. Take Stoller’s premise as fact. How, pray tell, did Director convince such notoriously strong minded people like Stigler and Friedman? Did he pay them off? No really–how did he persuade them?

And how did he persuade others, such as Bork, who was a major force in reshaping antitrust law? And how did the Chicago school antitrust/industrial organization ideas midwifed by Director have such a profound effect on the economics and legal academy outside of Hyde Park, and then the courts? Especially since they were initially so contrary to the professional consensus, and indeed attracted substantial (and often hysterical) opposition?

There must have been something to the ideas, eh? But not in Stoller’s telling. Instead, according to him, Harold Luhnow got his money’s worth by getting Director to turn from anti-monopolist to pro-monopolist, and somehow (mesmerism?) Director convinced myriad intellectuals (and judges) to go along.

The closest that Stoller comes to addressing any of the scholarship that Director inspired is a drive by shooting on John McGee’s Journal of Law and Economics (1958) paper that contended that, contrary to the overwhelming conventional wisdom, Rockefeller’s Standard Oil did NOT engage in predatory pricing.

Stoller refers to a paper which disputes McGee’s findings. Fine. But he is presented with the problem that, as shown by Joshua Wright, McGee’s article had far less of an impact on academic and legal thinking on predatory pricing than the 1975 Areeda-Turner article. But no problem! Just turn this question of fact into one of motive: “It didn’t hurt [Areeda-Turner’s] motivations, of course, that they were both on the payroll of IBM, which was at that moment in a bitter series of antitrust lawsuits which included, you guessed it, predatory pricing claims.”

Disgusting.

Stoller writes: “With support on the right and the left, courts soon accepted Director’s ideas, laundered through McGee, Turner, and Areeda.” Again: through what powers of mind control did Director get “liberal Democrats” from Harvard to launder his dirty ideas? Inquiring minds want to know!

But Stoller’s distortion of history doesn’t end here. His explanation for the rationality of predatory pricing goes like this:

Contra Director’s logic, predatory pricing is quite rational. A competitor to a corporate goliath can’t borrow an infinite amount of money to lose until prices come back, nor can a competitor just shut down until prices go back up. No bank would lend to a competitor of Standard Oil, just as no one today will lend to a retailer competing to lose money against Amazon. 

Wow. That logic sounds familiar! Yes, I remember now: in 1966 one of my thesis advisors, Lester Telser (a contemporary of McGee’s in the PhD program at Chicago), published an article titled “Cutthroat Competition and the Long Purse” which explored that very same logic.

It gets better.

Lester’s article was published in what Stoller portrays as the main vehicle for Director’s malign influence: the Journal of Law and Economics. Better yet, Telser thanks Director for his input. Better yet: Telser’s article was published in an issue honoring Director, on the occasion of his retirement from Chicago and editorship of the JLE.

Of course, you would never know this, if you read Stoller. Stoller also fails to mention that Sam Peltzman told an anecdote regarding Director and predatory pricing in a JLE article on “Aaron Director’s Influence on Antitrust Policy,” published as a sort of obituary at the time of Director’s death in 2004. In Sam’s telling, Director, in his typical Socratic style, led his students through an analysis of predatory pricing . . . in which he concluded that the defendant in a predatory pricing case “most likely was guilty as charged.”

It is particularly astounding that Stoller should overlook this anecdote, given that it was republished on the very same Pro-Market website. So it’s not like Stoller had to, I dunno, get onto JStor and do some real research on whom he was supposedly analyzing.

Stoller also fails to acknowledge that Director’s alleged ability to mesmerize did not even extend to nearby offices at the University of Chicago Law School: Richard Posner, for example, acknowledged that predation could occur.

Stoller also evidently has no clue as to how academia works. Provocative articles like McGee’s inevitably spur others to challenge it. And indeed, there have been numerous articles over the years that identify conditions in which predation can work. As it turns out, however, the conditions are much more fragile than Stoller lets on.

In sum, Stoller’s post on Director is an appalling piece of work. It fails to join Director’s actual work, and relies on vicious ad hominem to discredit the work which he does not like by attempting to discredit the motives of the person.

I don’t really give a damn about Matt Stoller. What I do find especially disgusting is that the Stigler Center at the Booth School of Business would lend its imprimatur to a piece that violates the fundamental norms and ethics of scholarship. If Pro-Market wanted to provide a critical view of Director, the Chicago School of antitrust has a lot of serious critics who could analyze his work and the work that he inspired. Instead, Pro-Market provides a platform for an intellectually disreputable attack on alleged motives, and one that provides no substantial evidence for its central claim, and which begs so many questions as to be self-refuting.

Appalling, and an affront to the long tradition of economics and law at Chicago.

The most contentious battle in American securities markets right now is being waged over exchange pricing of data, in particular over proprietary order book feeds. The battle pits the exchanges against market users (e.g., HFT firms, institutional traders) with the latter claiming that the prices charged by the former border on the extortionate.

The critics actually have a very good point. The economics of the situation imply that the prices the competing exchanges charge are ABOVE the price a monopoly would charge.

No. Really.

So how could competing firms charge a supra-monopoly, let alone supra-competitive, price? The answer to this question is something pointed out by the first true mathematical economist, Augustin Cournot, in his Principes Mathematique, published in 1838. In that book, Cournot laid out “the problem of complements.” Cournot showed that imperfectly competitive firms overprice complementary goods. (Cournot’s example involved zinc and copper in the production of brass. They are complements used in fixed proportion.)

The basic issue is that when goods are complements, if firm A raises its price firm B that produces a complement to A’s good cannot steal sales from A by cutting its price (as would be the case of A’s and B’s goods were substitutes). This reduces the incentive to cut price, and actually provides an incentive to increase prices in order to get a bigger piece of the surplus that is generated when the consumer buys both goods.

This situation fits the stock market case perfectly. Execution services on US exchanges (e.g., NYSE, BATS) are substitutes, but data services are complements.

Consider an HFT firm. One source of profits for this firm is to exploit price discrepancies across exchanges. This requires having near immediate and simultaneous access to prices across all exchanges. Or consider a buyside firm that is trying to minimize execution costs by a clever order routing strategy. Optimizing the allocation of orders across exchanges requires knowing the order book on all the exchanges.

In other words, there are many market participants who have to collect the entire set (of exchange data). This makes the data provided by competing exchanges complements, which by the Cournot logic, forces prices above the competitive level, and indeed, above the monopoly level.

Furthermore, the problem becomes worse, the larger number of exchanges. This is a situation in which lower concentration leads to less competitive outcomes. (Robin Hansen made a similar point recently.)

This is yet another example of the only law that is never repealed: the law of unintended consequences. The intent of RegNMS was to increase competition in the execution of stock trades, and it has done a marvelous job of that. However, the unintended effect of this “fragmentation” (i.e., the increase in the number of execution venues and decline in concentration across exchanges) has been to create and exacerbate a complements problem in data.

A couple of final points. Perhaps one could make a second-best argument here: low execution fees and high data fees may be a good way of covering the fixed costs of operating exchanges (a la Ramsey pricing). Perhaps, but unproven.

What is the right regulatory response? Not clear. I addressed similar conundrums in my 2002 Market Macrostructure article. Natural monopoly-style/pricing regulation could mitigate the overpricing problem, but entails its own costs (e.g., undermining incentives to innovate). The issue is particularly challenging here because efficiency-enhancing competition on one dimension (execution) leads to inefficient problems-of-complements competition on another (data).

As I argued in Market Macrostructure, it really comes down to an issue of property rights. Should exchanges have exclusive ownership of their data? Should this ownership be attenuated in some way, such as limitation on prices, or a required pooling of data that would be sold by a monopolist, with revenues shared by the exchanges? Here is a case where a monopoly would actually improve outcomes.

Maybe that is the way to split the baby, politically. Exchanges would get rents, but efficiency would be improved. Not a first-best solution, but maybe a second best one, and one that could represent a Coasean bargain between exchanges and their customers. And perhaps the regulator–the SEC–could help facilitate and coordinate that deal.

In the Gilded Age, American financial crises (“panics,” in the lexicon of the day) tended to occur in the fall. Agriculture played a predominant role in the economy, and marketing of the new crop in the fall led to a spike in the demand for cash and credit. In that era, however, the supply of cash and credit was not particularly elastic, and these demand spikes sometimes turned into panics when supply did not (or could not) respond accordingly.

The entire point of the Fed, which was created in the aftermath of one of these fall panics (the Panic of 1907, which occurred in October), was to make currency supply more elastic and thereby reduce the potential for panics. In essence, the Fed had one job: lender of last resort to ensure a match of supply and demand for currency/credit, when the latter was quite volatile.

This week’s repospasm is redolent of those bygone days. Now, the spikes in demand for liquidity are not driven by the crop cycle, but by the tax and corporate reporting cycles. But they recur, and several have occurred in the autumn, or on the cusp thereof (this being the last week of summer).

One of my mantras in teaching about commodities is that spreads price bottlenecks. Bottlenecks can occur in the financial markets too. The periodic spikes in repo rates–not just this week, but in December, and March–relative to other short term rates scream “bottleneck.” Many candidates have been offered, but regardless of the ultimate source of the clog in the plumbing, the evidence from the repo market is that there are indeed clogs, and they recur periodically.

The Fed’s rather belated and stumbling response suggests that it is not fully prepared to respond to these bottlenecks, despite the fact that their regularity suggests that the clogs are chronic. As the saying goes, “you had one job . . . ” and the Fed fell down on this one.

And maybe the problem is that the Fed no longer just has one job, and it has shunted the job that was the reason for its creation to the back of the priority list. Nowadays, the Fed has statutory obligations to control employment and inflation, and views its main job as managing aggregate demand, rather than tending to the financial system’s plumbing.

This is concerning, as dislocations in short-term funding markets can destabilize the system. These markets are systemically important, and failure to ensure their smooth operation can result in crises–panics–that undermine the ability of the Fed to perform its prioritized macroeconomic management task.

One of the salutary developments post-crisis has been the reduced reliance of banks and investment banks on flighty short-term funding. The repo markets are far smaller than they were pre-2008, and the unsecured interbank market has all but disappeared (representing only about .3 percent of bank assets, as compared to around 6 percent in 2006). But this is not to say that these markets are unimportant, or that bottlenecks in these markets cannot have systemic consequences. For the want of a nail . . . .

Moreover, the post-crisis restructuring of the financial system and financial regulation has created new potential sources of liquidity shocks, namely a supersizing of potential demands for liquidity to pay variation margin. When you have a market shock (e.g., the oil price shock) occurring simultaneously with the other sources of increased demand for liquidity, the bottlenecks can have very perverse consequences. We should be thankful that the shock wasn’t a Big One, like October, 1987.

Hopefully this week’s tumult will rejuvenate the Fed’s focus on mitigating bottlenecks in funding markets. Maybe the Fed doesn’t have just one job now, but this is an important job and is one that it should be able to do in a fairly routine fashion. After all, that job is what it was created to perform. So perform it.