Streetwise Professor

The tariff tremor has subsided, though the aftershocks linger. Again, most of the discussion is off-point because it is framed in strictly, or at least primarily, economic terms when in fact this policy is first and foremost an economic weapon in a much deeper great power conflict, one between the US and China/the CCP.

It is not correct to say that Trump started this war. The reality is that he has decided to fight back in a struggle for supremacy that China has been waging quite openly for years, especially during the Xi years. All the blather about Trump destroying the “American dominated rules based international order” is utterly ridiculous because China (seconded by Russia) has been quite blunt in its expressions of dissatisfaction with that order, and its intent to overturn it.

The genius behind the CCP strategy is that it has used, judo like, the order’s institutions against it. Most notably, it has ruthlessly exploited the WTO to advance its geopolitical objectives. It is quite sickening to read what the uniparty said about China’s ascension to the WTO. It was gonna make China all open and democratic, dontcha know. When admitted to the trading system, they would become just like us! Kumbaya! The End of History!

Wrong.

The desolation of industries outside of China, rampant IP theft, aggressive actions in Asia, Covid, and (if anything) an increase in domestic repression is what the gauzy sentiment about the “rules based international order” actually achieved. Perhaps too late, Trump is fighting back.

Then why not just tariffs on China then? Why impose punitive tariffs on the rest of the world, including our alleged allies, the Europeans?

Trump wants to isolate China and stem, and indeed reverse, the inroads it has made around the world, most notably Europe. The threatened tariffs on Europe (and other countries) are a way of forcing them to choose to cooperate in countering China, or kowtowing to it.

The Europeans, morons that they are, are leaning towards kowtowing. Even though they recognize that an avalanche of Chinese goods heretofore destined for the US will descend on Europe.

Lenin said that capitalists would sell communists the rope by which they will be hanged. The Europeans say: “That’s nothing! Watch this! We’ll buy from the communists the rope by which they hang us!”

All that said, I don’t think all of the measures Trump is adopting make sense. One about to go into effect is the special fee imposed on Chinese built and/or operated ships visiting US ports. The alleged purpose for this is to restore US commercial shipbuilding. As I wrote some weeks ago, this is a forlorn hope, and US efforts should focus on fixing its dysfunctional military shipbuilding rather than diffusing its resources with little (or no) chance of success.

Another downside of the monomaniacal focus on China is that it means that other areas that have greater potential to rejuvenate the American economy may be slighted. Two stand out.

The first is the T Rex in the living room–the budget and the national debt. The administration has made some encouraging moves in that direction, but those efforts appear to be slipping, and such as they were, they strike at the edges of the problem at best.

Musk promised that DOGE would save trillions. He has since faded those promises, and recent indications are that the realized savings will be 10 percent or so of those initially promised.

That’s so Elon. His business MO from Day 1 has been to overpromise and underdeliver. Remember the Solar Roof? Yes, Tesla eventually sort of caught up to his hype, but years after the promised delivery date. The lesson is–and I should have heeded it myself: always discount Elon’s promises.

I further remark that Musk’s prominence has faded noticeably in the last couple of weeks. No doubt there are multiple reasons for this. One is likely not wanting to be called out on his overpromising. Another is that his Face of DOGE routine unleashed hell on Tesla and he wants to tamp down those fires. Another is that he has no doubt tread on many toes and bruised many egos–including Trump’s.

Even a DOGE as promised would unlikely be enough to address the staggering budgetary issues confronting the country. Without confronting entitlements and effectively reversing the Covid spending splurge those issues will continue to pose an existential threat.

The second issue is regulation. One could reasonably argue that matastasizing regulation is one blade of a scissors that has cut American economic performance, China being the other.

Yes, the administration is making inroads here. Lee Zeldin’s zealousness at EPA is a particularly encouraging sign. As are Trump’s efforts to seize control of the “independent agencies” (a constitutional oxymoron). But these forays are being vigorously contesting in the courts, courts that harbor numerous intense Deep State/Administrative State partisans. Ultimately these battles will wind up in the Supreme Court, which is unlikely to resolve them definitively, let alone definitively against the bureaucracy. (Note that my prediction that the Court would dodge ruling on substance by deciding on narrow procedural grounds proved true in the first immigration case that reached it came true. Expect that to become a pattern).

The newest front in the battle for institutional control involves the Fed, with Trump ratcheting up his attacks on Chairman Jerome Powell. On the day that Trump announced the tariff salvo, I told a friend that he had to worry most about an internal foe–Powell and the Fed. My reasoning being that Trump is antithetical to the Powells of the world, and that the latter would therefore be highly likely to adopt policies that hurt the economy, just out of spite for Trump.

Powell’s remarks on Wednesday–which are what triggered Trump’s outburst about “terminating” him–confirm, or at least do not contradict, that suspicion.

Powell’s rationale for not cutting interest rates (something that the ECB has done and continues to do) is that Trump’s tariffs will be inflationary. That conclusion, if based on the simplistic reasoning that dominates discussion of this topic, is wrongheaded.

Tariffs affect the prices of imported goods relative to other goods. I repeat: they affect relative prices. Inflation relates to the level of prices. It is possible to have relative prices go up and the price level go down. Or the reverse. You cannot–I repeat, cannot–argue that there is a direct line between relative price changes and the price level.

Here I am reciting John Cochrane’s catechism about the sin of mistaking relative price shocks and price level shocks. I recommend reading the original in more detail: here is a good start.

There are causal channels that connect tariffs to the price level. But they are indirect. Both go through the effect of tariffs on real income.

The monetarist/neo-Keynesian channel is that tariffs reduce output, which reduces the demand for money, which leads to an increase in the price level.

The Fiscal Theory of the Price Level (my current preferred theory) is that tariffs reduce real income, which reduces tax receipts, which reduce primary surpluses, which causes an increase in the price level (since the real value of debt equals the present value of real primary surpluses). One wrinkle in this story is that tariff revenues affect primary surpluses, though I consider it likely that at least the punitive levels initially announced are not revenue maximizing, especially when taking into account their effect on income and corporate taxes.

But note: these causal stories are implicitly based on a projected final outcome in which the high tariffs persist for some time. That is by no means clear. The initial salvo is, as I opined at the very outset, likely a negotiating tactic that could result in reduced trade barriers, at least for countries other than China. The pause and announcements of numerous countries approaching the administration to negotiate certainly supports the art-of-the-deal interpretation.

And if it does, the same arguments that could be used to argue that the tariffs, if they remain in place, would be inflationary would be turned on their head: tariff threats that resulted in reduced trade barriers would be anti-inflationary.

Which brings me back to my earlier observation (which has achieved some resonance): tariff threats as a negotiating strategy don’t work unless there is uncertainty about whether they are a negotiating strategy. This creates uncertainty about the ultimate result, which creates uncertainty about ultimate effects on inflation.

Regardless, the legitimate potentially inflationary channels relate to the effects of tariffs on real incomes. And here perhaps the best analogy is with Fed policy responses to oil price shocks. An oil price shock is a relative price shock, just as tariffs are a relative price shock. As documented Bernanke et al, in the past the Fed has responded to this relative price shock by tightening policy, and that tightening has caused the recessions and stock market declines that Hamilton (and others) had documented previously.

Will Powell–unless Trump defenestrates him–follow the old–and discredited–Fed playbook of tightening in response to a relative price shock? I consider that likely, either because of intellectual error (compounded by institutional biases), political spite, or both.

If Trump indeed “terminates” Powell, it will have effects on the economic impact of tariffs, whatever they end up being, and will have potentially seismic consequences for America’s governing institutions (going well beyond the Fed). Thus, we are witnessing yet another game of chicken for high stakes. Does Powell think that his cause is so righteous that he will trigger this potentially cataclysmic collision?

Another imponderable that just compounds the uncertainty.

I was about to write that Europe has lost its mind, but I’m starting to wonder whether it had anything to lose. The meltdown over Trump having the audacity–the temerity!–to try to end the war in Ukraine (or at least bring a respite to the fighting) continues apace. Indeed, it seems to ramp up daily.

One common response to the US insistence that Europe put on its big boy pants and provide for its own defense is to say that well, if the US is going to abandon Europe, Europe should ally with China. Now, many of those saying so are just online midwits and dimwits, but not all of them. Indeed, the UK deep state’s preferred think tank, Chatham House, is flogging the idea:

Donald Trump’s approach to Ukraine is a test for Europe’s ability to adapt to a world of great power politics. To pass it, Europe should reach out to China. https://t.co/RAvcXmKprb

— Chatham House (@ChathamHouse) March 10, 2025

How is this supposed to work, actually? China is going to protect Europe against Russia? You know, the Russia that is in an alliance with China, and which China provides much of the support necessary to keep the war in Ukraine going on? That Russia? Will China base troops in Europe to defend against Russia? Oh, and is China going to put Europe under its nuclear umbrella . . . to deter a nuclear attack by Russia?

So please do tell: just how is China going to replace what the US has provided Europe for the past 80 years?

I’ve heard idiotic ideas in my time, but this is in the running for the most idiotic.

Because it’s not a rational response. Instead, it is adolescent petulance, along the lines of: “Daddy is forcing me to support myself. I’ll show him! I’ll go down on the local fentanyl dealer!”

Go for it. I’m sure that will be awesome, and that China will respect you in the morning!

Europe is also making moves to strengthen its military.

Shot:

The decision to unleash the power of the federal balance sheet to transform Germany’s military and revamp its infrastructure is a watershed moment https://t.co/MZJTtey2ZX

— Bloomberg (@business) March 15, 2025

As detailed by the invaluable Eugyppius, to achieve the “game-changing plan”, German crypto chancellor Merz made an insane deal with the Greens to change the constitution to permit breaking budgetary restrictions. This deal will do little to enhance actual German defense capability, but will throw €100 billion at more climate change unicorns, which will just go to dig Germany’s economic grave even deeper.

Chaser:

German army struggles to get Gen Z recruits ‘ready for war’ https://t.co/ox38cjqHE5

— Financial Times (@FT) March 15, 2025

So even if Germany does defy my expectations and buy some armaments, they won’t have anybody to fight using them. Maybe they’ll buy robots (from Tesla?) with voices like Arnold in Terminator to operate them.

France’s Henery Hawk, AKA Manny Macron, is acting very butch. He is flying the French version of AWACS over the Black Sea, pretending it can replace the intel the US is providing. A portion, boy, only a portion.

But Macron has inadvertently given away Europe’s real motive for not wanting the war in Ukraine to end:

??Europe can send troops to Ukraine without Russia's consent, French President Macron said.

"Ukraine is sovereign. If it asks to deploy allied troops on its territory, whether it accepts it or not is none of Russia's business. When Russia says that the ceasefire will be a… pic.twitter.com/PYklv3sboI

— ?MilitaryNewsUA?? (@front_ukrainian) March 16, 2025

That is, if fighting stops in Ukraine, Putin will move on to attack other countries, so the fighting must go on. In other words, Europe wants to fight to the last Ukrainian because they are petrified at their own impotence. All the while camouflaging their cynicism with lofty statements about protecting Ukrainian sovereignty.

The Baltics, in particular Estonia, have also been very vocal in their demands that “let’s you and him fight to protect me.”

Very revealing. Though as I’ve said repeatedly, if you look at capabilities, their fears are vastly overblown.

And as for the last Ukrainian, it is not hyperbole to say that Ukraine would be a dying nation even without this war. Europe as a whole is a demographic nightmare, and Ukraine is the most nightmarish country of them all:

That 23.8 million forecast decline represents 61 percent of Ukraine’s current population. 61 percent.

To put it bluntly: why should the US, or Europe for that matter, fight Putin over what will soon be a corpse? And why should the US, and the rest of Nato, shackle itself to what is soon to be a corpse, and promise to go to war (under Article 5) to protect it? That didn’t work out well for Germany in WWI with Austria-Hungary.

To me the most telling sign of Putin’s malignity is that he is willing to sacrifice hundreds of thousands of Russians to take control of a terminally ill nation. Especially in light of Russia’s own demographic train wreck, which looks good only in comparison with Ukraine (and some other eastern European nations, notably Poland).

So will hostilities cease soon despite Europe’s wish that they continue? I don’t know, but I can say that Europe’s desires matter not at all, except if they feed Zelensky’s delusions sufficiently to make him to reject reality and refuse any compromise.

Zelensky has–after being reminded through the limited withdrawal of US support of his dependence on America–agreed to the cease fire plan offered by Trump. Putin has publicly said that he will agree too . . . with conditions. In response to which the cry has gone up “See–he isn’t interested! It was dumb to expect otherwise! Why does Trump even bother? It must be because he’s Putin’s poodle!”

Said by people who apparently don’t understand that public statements–especially by the likes of Putin–must be discounted heavily. What matters is what transpires out of view. Trump and Putin will supposedly speak this week. That’s what matters, though the usual bedwetters are saying that this only proves that Trump is Putin’s stooge.

Methinks their real fear is that Trump will bring the fighting to an end, at least for a while.

Putin needs a deal, for many reasons. But he has proven that he is willing to expend lives to gain some concessions. Europe and the foreign policy establishment in the US refuse to countenance any such concessions, including in particular a denial of Nato membership for Ukraine.

But that is a price that the US should be more than willing to pay: indeed, Biden should have offered it in 2021 or 2022, in which case the war might well never have begun in the first place. Again, shackling the US to a Ukrainian corpse-to-be would be all pain and no gain for the US.

If that’s a hill the Europeans want to die on (or more accurately, want the Ukrainians to die on), so be it. The US should not be party to their folly, and their selfish cynicism.

The travails of Disney’s latest attempt at suicide-by-woke, the Snow White reboot, brings to mind one of the spawn of Frankendodd–the ban on movie box office futures.

In 2008, Howard Lutnick’s Cantor Fitzgerald filed to create the CX Futures Exchange to trade futures on movie box office receipts. Hollywood lost its mind, and in the post-GFC anti-derivatives hysteria and the resulting legislative response, succeeded in getting Congress to include a ban on such futures as one of the many pieces stitched together to create Frankendodd. Thus, such futures joined onions as the only thing that was otherwise legal on which it was illegal to trade futures.

Why was Hollywood so hot and bothered about box office futures? That’s what brings me back to Snow White.

Disney is in a panic because it is widely predicted that the movie will bomb epically at the box office, and in particular since it is Peak Woke, with the wokiest of actresses in the title role. As of now, those predictions are merely conjectures bandied about in the press or in online conversations, and don’t involve anyone putting their money where their mouths are.

But, if there were futures, all of that diffuse information about how bad the movie is, and how badly it will perform, would be crystalized into one number for all the world to see. And the number would have credibility, because the people behind it would have skin in the game. And it would have credibility because the futures would incentivize those with information about the picture to communicate that information to the market via their trades.

Futures would have been a box office bomb detection device.

Without futures, Disney can hope that many people won’t have heard the Hollywood chatter, or will discount it and give the movie a chance. And they can hope that woke reviewers will pump the movie.

Futures would have been a box office bomb detection device. If there were futures, there would be a hard number to communicate objective information about how bad Snow White is. Nobody would attend, and the movie would bomb.

Absent futures, Hollywood can fool enough of the people enough of the time with marketing and propaganda to at least mitigate the revenue disaster of a bad film. With futures, that would be much, much harder. Which is why they successfully importuned the authors of Dodd-Frank to strangle movie box office futures in their crib.

Trump’s version of Operation Bagration has started bagging rats. Or, more exactly, sacking bureaucrats.

First to feel the blow are the staff at USAID. Musk’s DOGE landed there with two big feet and released a stream of information regarding the agency’s profligate, inappropriate, and frankly un-American spending. One that attracted a lot of attention is the amount of money USAID showered on media organizations, including–get this–the BBC, which admitted receiving 8 percent of its funding from USAID. Yes, USAID NOT UKAID. Apparently license fees coercively extracted from Brits are not enough to fund the Beeb, so it had to suckle at the American teat. Sorry, old chum, but weaning time is nigh.

Another beneficiary was Politico, AKA Tiger Beat for the political class. In a huff, Politico (in a “note to our readers“) said “this is not funding. It is a transaction.”

So is prostitution. (The analogy is exact).

Hard on the heels of these disclosures, newly installed Secretary of State Marco Rubio (a) defenestrated the head of USAID, (b) installed himself as head, and (c) (and this is the best part) fired 9000 USAID staffers, leaving a rump of 600, which is probably more than enough to do what USAID is supposed to do, whereas the 9000 were engaged in what it shouldn’t do.

I am sure the choice of USAID was no coincidence, comrades. First, it almost certainly represents the most egregious examples of spending abuse, and especially of the type that drive people mental (e.g., condoms for Gaza). Second, this is an indirect attack (a la Liddell-Hart or JFC Fuller) on the NGO-Think Tank-Deep State nexus, which is the center of gravity for the anti-Trump axis. What DOGE has revealed is that USAID is a massive money laundering operation with layers of cutouts that directs money to subversion efforts abroad and at home (e.g., through facilitation of illegal immigration). Its ostensible purpose of feeding starving waifs and fighting contagious diseases in benighted regions is merely a cover for its real purpose.

Next on the agenda? Apparently the Department of Education. And academia generally, as this Musk post signals:

Can you believe that universities with tens of billions in endowments were siphoning off 60% of research award money for “overhead”?

What a ripoff! https://t.co/RRTIMKTVYN

— Elon Musk (@elonmusk) February 8, 2025

Man, can I relate. More than 30 years ago I secured a grant–$100K, a huge amount at the time. (NB: Private grantor, not the government). The University of Michigan sucked up every dime. Every single dime. I saw nothing. Lesson learned. I said fuck that. Never again. I’m not going to be a chump for university bureaucracy. But the US taxpayers have been for years.

These “indirect cost” allocations have subsidized the grotesque administrative bloat that I have witnessed during my years in academia. As recently as last week I have seen what this metastasizing academic administrative state does: make it more difficult to do beneficial things, not easier.

So chop away!

Other agencies are feeling the knife. EPA staffers are supposedly upset that 1000 are to be let go.

I’m upset too! Why only 1000?

DC is in an uproar. All of the legacy news outlets are running stories about the terror stalking the corridors of administrative power.

It’s kind of funny actually. They act as if it’s a bad thing, and that we beyond the Beltway feel their pain. LOL.

“We at OPM are just as frustrated, confused, and traumatized as the rest of America.”

Sorry to break it to you, but the rest of America isn't traumatized. Giddy is more like it. https://t.co/4HprQdmerH

— streetwiseprof (@streetwiseprof) February 8, 2025

Among the shrieks are “NOBODY ELECTED ELON MUSK!” and “THIS IS UNCONSTITUTIONAL.”

Well, nobody elected any of these bureaucrats. Musk and his DOGE minions are the designated agents of the man who was elected as chief executive.

Which gets to the nub of the issue of constitutionality. The real constitutional issue is how is it remotely possible that employees of the executive branch are independent of the chief executive, who by the Constitution exclusively wields executive authority. The whole idea of a bureaucracy independent of the chief executive is at best a constitutional deformity, and really a constitutional monstrosity.

One issue is the president’s authority to direct spending, or more precisely, to stop spending on, say, queer studies in the 3rd World. Here the Government Party is hoist on its own petard. Trump is going after expenditures not explicitly authorized by Congress. In essence, shirking its responsibility, Congress has shoveled money at agencies like USAID and said “knock yourselves out! Go to town! Have a spree!”, which the agencies obliged like a drunken sailor who found a wad of $100s lying on the sidewalk.

Yes, Congress appropriated money for the agencies. And yes, there will be a court challenge to Trump’s actions. But he has a strong case: you gave money to these agencies with no strings attached, that is, with discretion on how it is to be spent. Fine. I will exercise my discretion by not spending it. And certainly not on funding NGOs (whom nobody elected, BTW).

This is a fight he wants. It is a fight we should want. And it is a fight he can win, both in the courts and politically.

Another reason that Trump started with USAID is no doubt the fact that it is the creation of an executive order by JFK. So it is different than the Department of Education, or the Department of Energy, and the like. He’s saying, in effect, what the executive giveth, the executive can taketh away.

There is no doubt panic in the streets of London and Birmingham.

And there is definitely panic in the streets of DC. (I’ve read that housing prices have fallen by about 1/7th). Which, like napalm in the morning, I love . . . because it smells like victory.

Cocoa has been on a wild ride for the past year.

So wild that Bloomberg has a separate category for “The Cocoa Crisis.” Contributing to the recent hysteria is news that Hershey has requested “special permission to buy over 90,000 tons of cocoa.” Evidently the chocolate manufacturer has requested a position limit exemption from the CFTC. (Links to the “Cocoa Crisis” coverage are in the article).

Note that exemptions, specifically for hedging, are explicitly recognized in the relevant regulations, and are granted routinely, so this is not really exceptional. Not knowing the exemptions granted to Hershey in the past it is difficult to know whether the magnitude of the exemption is extraordinary.

The article is confusingly written. In commodities subject to limits, there are different kinds of limits. These include single month and all month limits outside the “spot month” and “spot month” limits. Spot month limits kick in sometime prior to expiration. In cocoa, it is my understanding that the spot month limit kicks in on First Notice Day, which for the next ICE Cocoa contract (“CC”), March 2025 (“CCH5”) is 24 February, 2025.

The article implies that the exemption requested is for the spot month:

The maker of Reese’s Peanut Butter Cups wants to take a position that will allow it to purchase more than 90,000 metric tons of cocoa on ICE Futures US, said the people, who asked not to be identified because the information is private. The request to the Commodity Futures Trading Commission equates to about 5,000 20-foot containers and is more than nine times the amount the exchange currently allows.

The spot month limit is 1,000 lots, so 9,000 contracts would be 9x the spot limit. The single month/all month limit is 4,900 contracts, so the requested exemption would be less than 2x the single/all month limit.

I am somewhat skeptical that the exemption request is related to the spot month given that spot exemption requests can occur closer to FND, and the magnitude is so large relative to ICE cocoa certified stocks (currently only 1,604 lots) that granting such an exemption would be problematic. Particularly problematic would be “purchas[ing] more than 90,000 metric tons of cocoa on ICE Futures US” if that means acquiring that much physical cocoa via the delivery process.

But Hershey did that in 2020, and exchange cocoa is supposedly at a discount to the cash market. The cash market discount begs the question: why? Are apples being compared to apples in terms of quality, location, etc.?

Acquiring 90,000 tons–or 25 percent of that amount– would require bringing in large amounts of cocoa to exchange warehouses. That in turn would require acquiring cocoa on the cash market (at a supposed premium), getting it to ICE warehouses, grading it, etc. So it’s hard to believe that cert cocoa is an economical source of supply for Hershey in the quantities mentioned in the Bloomberg article.

The price movement in 2020 sure as hell looks like a squeeze, but neither ICE nor the CFTC took action, so maybe Hershey figures it can do it again.

Unlike 2020, this time the spread didn’t take off:

The March-May 2025 spread did spike in mid-December, but only narrowed slightly after the publication of the Bloomberg article on 8 January. (Perhaps somewhat confusingly, an increase in the spread is referred to as “narrowing”. “Wider” means a bigger carry: “narrower” means less carry or more backwardation).

Here’s 2020 for comparison:

I certainly believe that big commercials can sometimes bamboozle ICE and the CFTC, especially when it comes to telling just so stories about how its economical to take delivery. So it’s not inconceivable that Hershey is trying to do that here, and that they will succeed.

The are other curious things in the article. For example: “A spokesperson for the Pennsylvania-based company said Hershey has a ‘rigorous’ procurement process and that it is ‘well covered’ on its cocoa needs for 2025.” If “well covered” means that Hershey has supply contracts sufficient to meet its anticipated physical needs, why would it need to take delivery? If “well covered” means that they supply contracts are fixed price, Hershey wouldn’t need to hedge using futures. So the company’s statement obfuscates rather than informs if it is intended to ease fears that the company could be hammered by a high and rising cocoa price in 2025.

As I noted before, the epic price rally has put cocoa in the news frequently. Another example is this Reuters article from last month. In brief, the high and volatile cocoa prices have driven speculators from the market, leading to thinner, less liquid markets.

A couple of comments.

First, the exit of hedgies has not caused prices to decline, which implies that they were not the ones that caused the high prices in the first place as has been frequently claimed (as is usually the case when prices move a lot–“round up the usual suspects”).

Second, the reduction in speculative capital makes the price more sensitive to bigfooting by commercials. Like Hershey. Just sayin’.

Third, this demonstrates clearly the effects of clearing and margining. Volatility and high flat prices increase margins and thereby the cash needed to maintain positions. Since cash liquidity can be costly, this raises the cost of providing both long term and short term market liquidity, which leads to the exit of speculative capital that has occurred in cocoa. This in turn increases volatility all things equal. That is, the margining mechanism creates a positive feedback loop that can be detrimental to market performance.

Not to say that the credit risk mitigation benefits of margining don’t outweigh these market liquidity costs. Just pointing out that mitigating credit risk is not cost free.

Given the decline of liquidity and the possibility that a large commercial may lean on the delivery process, the cocoa market is worth keeping an eye on.

As an aside, some years back there were squeezes in cocoa in March. I used to teach my commodity trading course in Geneva in March, and I joked to my students that I should buy CC calendar spreads before heading to Geneva. (I now teach there in April). This March might be particularly interesting.

And of course there was the big Armajaro corner in cocoa in July 2011.

All in all, cocoa can be a source of material for those interested in how er “technical factors” affect pricing. Including me. So I guess you could say I’m coo coo for cocoa:

(A flashback to my youth).

Until I read this post by Nasdaq chief economist Phil Mackintosh I was unaware that the SEC wants stock exchanges to adopt cost-based pricing. Even by regulator standards–and Gensler-era SEC standards in particular–this pegs the Dumb-o-Meter.

It is dumb on many levels. Full spectrum dumb.

For one thing, why would the SEC want cost-based pricing? Presumably because it believes that exchange prices are too high. Why would that be? Market power presumably.

But in the electronic era, and ironically especially in the post-RegNMS era, there is substantial competition between exchanges, and between exchanges and the OTC market. Here’s a chart of trading volume and shares by venue for the last 5 days (found here).

Note that exchanges account for less than half of total volume, with a majority of trading taking place on the OTC market. Even among exchanges, volume is fairly well split, with the NYSE having the biggest share (roughly 1/3 of exchange volumes).

This volume split reflects the competition that resulted from RegNMS in an electronic environment. Given this competition, excessive exchange profits should be the least of the SEC’s worries.

Even if market power was a concern, the idea of cost-based pricing would be inane. Exchanges have fixed and variable costs. Price structures must cover both, but average cost pricing leads to inefficiencies: the price of the marginal trade should equal marginal cost, but marginal cost is virtually impossible to measure. And with fixed costs, it can be efficient to utilize variants of Ramsey Pricing in which prices deviate from marginal costs, and for multi-product firms the deviations between price and marginal cost vary by product. (Exchanges are multi-product firms, offering transaction services, data, listing, and other services). (The SEC might also want to catch up with the economics literature, starting with Coase’s The Marginal Cost Controversy, which is only 78 years old).

Moreover, as Mackintosh notes, exchanges are platforms–though he doesn’t explicitly point out the key fact that they are two sided platforms, as most matching systems are. A crude taxonomy of the two sides in the exchange context is liquidity suppliers and liquidity demanders.

As has been known since two sided platforms became a thing (post-Internet, basically) optimal platform pricing structures can be very complex, and optimal pricing structures are not cost-based. To generate the mix of customers that maximizes platform value it is typically the case that one side pays below cost prices (and may indeed pay a zero price or receive a subsidy). In the exchange context, this is most readily seen in maker-taker or taker-maker pricing structures where the exchange fee differs depending on whether you are the active or the passive side of a transaction.

One aspect of inter-exchange competition is that they compete on price structures in order to optimize platform value. Some exchanges even offer different platforms with different pricing structures. This differentiation accommodates the heterogeneity of traders, some who prefer one structure and others who prefer another. In essence, the platforms are competing for different clienteles.

The idea of imposing a cost-based cookie cutter pricing structure on exchanges is therefore beyond absurd. Not only is it unnecessary to constrain market power, any cost-based structure would be wildly inefficient and completely at odds with the basic economics of exchanges as two-sided platforms.

But I guess that’s what you should expect from an agency dominated by lawyers and accountants.

It is ironic that the SEC apparently doesn’t recognize the benefits of one of its major regulatory initiatives of the past two decades–RegNMS. That regulation led to substantial inter-exchange and inter-platform (exchange-exchange, exchange-OTC) competition. One result of that competition is non-cost-based pricing that reflects the fundamental nature of trading venues as two-sided platforms. Thus, exchange pricing is something that the SEC doesn’t have to worry its pretty little head about.

There is a bigger lesson here, relevant to our DOGE era. Parkinson’s Law says that in a bureaucracy work expands to fill the time available. An agency that has the time to pursue such daft initiatives is obviously over-resourced and over-staffed.

Put differently, idle regulator hands are the Devil’s workshop.

Apropos an earlier post scourging Tyler Cowen’s lament that cutting regulator headcount would harm businesses who rely on regulators’ guidance, there have been numerous articles appearing in the post-election days similarly arguing that regulators are really businesses’ friends. They’re from the government, and there to help you! Really!

But as I noted in that post, much of that “help” is necessary only because regulators create the need for helpers by implementing wasteful, complicated, and intricate rules. Cost-based pricing of exchange services could be a poster child for that. It would be economically unnecessary (because competition constrains pricing) and inherently result in absurdities that would have the regulated running to the regulators for guidance and clarification. Regulators creating jobs for regulators, and justifying their existence thereby.

The structure of financial market regulation has been a source of dissatisfaction since at least the time of the birth of the SEC in the 1930s, and maybe even dating back to the first regulation of futures markets in 1922. Don Wilson of DRW is only the latest of those to express this dissatisfaction.

Since derivatives markets first emerged from their niche in the commodities, and especially agricultural commodities, a lot of the criticism has focused on the bifurcated nature of US regulation, with separate securities and derivatives regulators, the SEC and the CFTC respectively. Why not just have one regulator given the substantial overlaps between securities and derivatives markets? Whereas previous “reform” proposals have been to merge the agencies, Wilson suggests scrapping them both and creating a new unified regulator.

This idea is a hardy perennial and has always struck me as mere org chart shuffling, or furniture rearranging. And that’s the best case. Worse outcomes are very possible.

For one thing, the relevant laws–the Securities and Exchange Acts, and the Commodity Exchange Act–would remain in place, with one commission in charge of implementing both. Many of the conflicts, tensions, and contradictions involving the SEC and the CFTC are rooted in the underlying laws, and would remain post-merger (or replacement with a super agency). The conflicts would become intramural rather than intermural as it were, but would not go away.

For another, I generally favor functional regulation and given the myriad functions of financial markets and institutions subsuming all regulatory oversight to a single agency may well impede functional specialization.

The SEC already represents a good example. In broad strokes the Securities Act relates to securities issuers (e.g., disclosures) and the Exchange Act relates to the trading of securities. Those are two very different functions and only tangentially related. Yet a single regulator oversees both.

The CFTC also has authority over trading per se on some venues.

Both agencies have authority over intermediaries (e.g., broker-dealers, FCMs) and clearing.

Maybe there would be some reasonable rationale for splitting off regulation of issuers from regulation of trading, trading intermediaries, and clearing, and putting these last three in a single silo. But even that is problematic due to path dependence.

We are not starting with a blank slate. The pre-existing statutory division is one historic fact. Another is that derivatives and securities markets have evolved very differently, and that could very much reflect the longstanding regulatory bifurcation.

Is it desirable to move toward uniformity in how derivatives and securities markets are organized and governed, and in essence ignore the historical process that created the current market structures? That’s not immediately obvious given how wrenching and unpredictable the process of achieving uniformity would be–and how rife the unexpected consequences would be.

Moreover, how would the political economy work? There’s no guarantee that the politics of a unified regulator would lead to a more efficient regulatory structure.

Indeed, to me it’s more likely that that rent seeking would rule, and efficiency would be damned. There’s actually a strong argument to be made that competition between regulatory agencies disciplines the rent seeking to some degree. And it can also discipline the ideological fervor of someone like Gary Gensler.

The ongoing drama over crypto regulation is an example. I’m not a crypto evangelist by any means but overall I favor letting market processes determine the outcome. If GiGi was king, or even merely the sole regulator of crypto, that would never happen. Regulatory competition (with the CFTC) constrained Gensler and the SEC, so the market will have the chance to have the final vote.

Indeed, one of Don Wilson’s beefs is very specifically with Gary Gensler. (And oh boy, do I get that!) A regulatory structure with one regulator would make some future GiGi far more dangerous.

Why should regulatory monopoly be looked upon more favorably than private monopoly? Indeed, regulatory monopoly is more dangerous because it cannot be disciplined or undermined by entry. Only the naive who believe in the public interest theory of regulation (and regulators) could believe that a single regulator would act to enhance efficiency rather than exploit its power for often malign reasons.

I have often written that there is a multitude of ways for executing financial transactions that have some common elements because transactors and transactions are heterogeneous. One size does not fit all. (Gensler was something of a one size fits all fanatic at the CFTC). Even though any division will lead to anomalies, conflicts, and regulatory arbitrage, there is enough distinctiveness between say derivatives markets on the one hand and security markets on the other to make separate regulators a better outcome. The division of labor is limited by the extent of the market. The scope of financial markets is so huge that there is considerable division of labor in them, and a division of regulatory labor makes considerable sense too.

Further, although the term “regulatory arbitrage” is typically used as a pejorative, it is not necessarily a bad thing. Indeed, it can be a good thing when market participants use regulatory fragmentation to introduce beneficial innovations that a particular regulator would prevent.

It should also not be forgotten that the SEC and the CFTC are not the only regulatory players in this game. The banking regulators and the Fed are also quite involved, especially on issues relating to intermediaries (who are banks or deeply enmeshed in the banking system) and clearing. Some regulatory fragmentation is inevitable as a result. Just mashing together the SEC and the CFTC will not make the fragmentation disappear.

I say only slightly facetiously that the best effect of regulatory consolidation is that reduced specialization would increase the cost of regulation, leading to less of it. There are no economies of scale, and are in fact diseconomies of scale, at the commissioner level. The bandwidth of the commissioners who are the final arbiters of rules is limited. As a rough estimate, a single commission responsible for double the statutes will have the capacity to produce half the rules as two commissions would. Sounds good to me!

(And no, doubling the number of commissioners would not help. Each commissioner has to weigh in on each proposed rule).

(Less factiously, doubling the workload would empower staff as commissioners would be more reliant on staff to craft rules, and explain them, so rule “output” might not decline that much as the commissioners just end up spending less time on each proposal).

Proposing agency merger or creation of a super agency is almost always a symptom of overall dissatisfaction with regulatory outcomes. But those bad outcomes are usually the result of bad regulators or bad underlying statutes. As noted above, consolidating regulators would increase the power of the bad regulators who will inevitably come along, so be careful what you ask for. And redrawing the regulatory org chart won’t address the statutory problems.

So if you don’t like current regulatory outcomes, don’t focus on the number of agencies and the names on the buildings they occupy: focus on the laws that determine what regulators can do and how they can do it.

Frankendodd was full of bad things, so start with that. Go to a slimmer legal framework that focuses on force and fraud rather than one that attempts to micromanage market macrostructure. Work towards a framework that disempowers would be Gary Genslers rather than the reverse.

Recent Supreme Court decisions, especially Loper, will help by constraining the ability of regulators to go beyond the authority explicitly delegated to regulators by statute. But many of the delegated powers are already too broad, so that needs to be addressed too.

In sum, to fix regulation it is necessary to get to its roots. Its roots are in legislation. Shuffling around who implements the legislative mandates is a superficial response to a deeper problem that originates in the Capitol.

PS. My friend Jeff Carter has a Substack on the same issue. Check it out.

Donald Trump’s post-election blitzkrieg (see! He is Hitler!) has shocked and awed the ruling class. One of his moves that has attracted the most attention is his announcement of a “Department of Governmental Efficiency” (“DOGE”) to be headed by Elon Musk and Vivek Ramaswamy.

Musk has promised to use the yet-to-be-formally-established non-department department to trim trillions of dollars from federal spending (although it is somewhat unclear if this is an annual number or a cumulative total over some period).

The mechanism by which this laudable goal can be accomplished is unclear, given Congress’ power of the purse, and previous Supreme Court rulings regarding things like impoundment by which the president can thwart Congressional appropriations. Various stratagems have been floated, but these will set up a Constitutional clash, which, ironically, will get bogged down in the political and judicial quagmire that is the source of much inefficiency.

Moreover, it must be recognized that the room for budgetary maneuver is quite limited. Entitlements plus interest (including spending on veterans in entitlements) consume about 53 percent of federal spending. Discretionary spending accounts for “only” $1.6 trillion, half of which is for the Pentagon. Even axing entire departments, like the Department of Education, would only free up modest sums: Department of Education spending accounts for 4 percent of the budget, and no doubt closing down the entire monstrosity would result in a lot of that spending being shuffled elsewhere. (The case for eliminating Education rests–and rests quite firmly–on non-budgetary grounds, namely its destructive effects on American education at all levels).

Looking at trends, the Covid spending spikes (which added appreciably to debt and per the Fiscal Theory of the Price Level were a major contributor to inflation) stand out, but so does the increase in the growth rate of federal spending under Biden.

Notably, Federal spending plateaued during the post-2010 period of divided government, then ticked up under Trump (no budget hawk he), and accelerated markedly under Biden.

Therefore, the best outcome is to try to recapture the (relative) budget discipline that prevailed post-GFC, and post-Republican capture of the House in 2010. This is something that will have to come from Congress, and from Trump. Not from Elon and Vivek.

This is not to say that DOGE is futile. It can–and should–focus on non-spending sources of government inefficiency, but particularly on the inefficiencies that the government inflicts on the private sector through regulation. Especially during the Biden administration, the administrative agencies have run amok in imposing new rules, interpreting existing ones in pernicious ways, and regulating by enforcement. The new administration has considerable–though not untrammeled–power to cut back on this thicket, and pretty much complete discretion at not adding to it.

This is exactly the domain which exercised Musk most, as epitomized by his Parable of the Sharks and Whales:

Gulliver Musk’s SpaceX in particular (but Tesla too) has been attacked by regulatory Lilliputians. And X would clearly have been in a Harris administration’s regulatory cross hairs.

Here DOGE can perform yeoman’s service to propose, but it will still be up to the agencies to dispose. And those efforts will also trigger protracted legal battles. But there are battles that must be waged, and DOGE can perform a vital role of identifying the most egregious problems, the fixing of which would generate the most benefits.

This is also the area where the name-and-shame aspect of DOGE can work best. Lacking any real authority, DOGE can best serve as a bully pulpit (and hopefully a bullying pulpit) to galvanize public support for anti-regulatory efforts. As a strategy guide, I recommend Alinsky’s Rules for Radicals. Virtually all of them could be quite useful to DOGE, including “ridicule is man’s most potent weapon” and “pick the target, freeze it, personalize it, and polarize it.”

Back in the day, Senator William Proxmire had his Golden Fleece Award that ridiculed particularly absurd examples of government spending. DOGE should initiate something like that, perhaps even on a weekly basis. It could echo Proxmire’s focus on spending, but it should especially focus on regulatory outrages and absurdities.

It could also serve as a clearinghouse for complaints about regulatory abuse. You know, sort of like from the days when the doges ruled Venice:

No doubt the most useful information would come from within the agencies themselves, as many of the apparatchiks within said agencies will no doubt be waging guerrilla war against de-regulatory efforts and only their peers will be able to expose them.

There are two ways to rescue the United States from its parlous fiscal circumstances: cut spending, or increase growth. I doubt DOGE can do much regarding the first, but can contribute materially to the second. Attacking regulation-induced economic sclerosis would provide a much needed fillip to the American economy, which would spur federal revenues and help boost primary surpluses. This would also have salutary effects on inflation, again per the Fiscal Theory of the Price Level.

I wish Musk and Ramaswamy and those they attract to DOGE the best. They have set for themselves the Herculean task of cleaning the Augean Stables in DC. The best way to perform it is to prioritize and to optimize the use of the tools at hand. Given the numerous obstacles to tackling spending directly, this dictates a focus on regulation, and the mobilization through transparency of popular awareness of its myriad perversities.

Note. According to Wikipedia, the word “doge” “originally referring to any military leader, becoming in the Late Roman Empire the title for a leader of an expeditionary force formed by detachments (vexillationes) from the frontier army (limitanei), separate from, but subject to, the governor of a province, authorized to conduct operations beyond provincial boundaries.” That actually seems quite appropriate here, especially the authorization to conduct operations beyond boundaries.

There is a bit of a kerfuffle in futures world about the CME winning approval from the Natinoal Futures Association (NFA) to operate its own brokerage firm (futures commission merchant “FCM”). The industry is pretty unified in its opposition to this “vertical integration” by the CME that will put it into competition with some of its customers.

(Once upon a time I worked on the 15th floor of the tower on the left).

I think this will turn out to be much ado about nothing. Yes, CME has the right to open an FCM, but whether it will, or how big it will be if it does, is very much open to doubt.

Recall that the CME launched this initiative in response to FTX’s adoption of this model. (The fact that the CME obtained approval almost exactly 2 years after FTX went kaput tells you a lot about the speed at which regulators work). FTX is no more, and no other exchange, crypto or otherwise, has adopted the model. So there’s no perceived competitive threat from an integrated exchange, which reduces (and perhaps eliminates) the CME’s need to bring the FCM to life. It likely pursued the application after FTX’s demise as a precautionary measure.

If that’s right, the FCM will remain on the shelf.

And I think it will because it’s hard to make a business case for it. Let’s consider the various economic rationales for such integration.

One commonly asserted one is to leverage monopoly power. Commonly asserted, and wrong. The one monopoly rent theorem implies that except under very special (and usually quite contrived) circumstances, a monopolist (which CME arguable is in most of its products, and in clearing) can extract all the rents from its market power by pricing its own product, and cannot increase profit be obtaining market power upstream or downstream.

Regulated monopolists have sometimes integrated to circumvent rate regulation. For example, ATT owned its equipment supplier Western Electric. ATT operated under rate of return regulation, but could circumvent that by purchasing equipment from its subsidiary at inflated prices.

That doesn’t apply to CME. It is a regulated monopolist but not subject to rate of return regulation.

Integration can also be a way of circumventing price controls. That’s also not an issue here.

Vertical integration can mitigate transactions costs when there are bilateral monopolies (at least after the “fundamental transformation” that occurs when the upstream and downstream firms make relationship specific investments). The FCM sector is pretty fragmented and competitive, and does not fit this “scorpions in.a bottle” template.

Another reason for vertical integration is double marginalization. This occurs when both the upstream and downstream firms have some market power. Each charges a price above marginal cost, and in general the all in price exceeds the joint profit maximizing price.

Again, the FCM sector, though more concentrated than it was historically, is still highly competitive. It’s not impossible that FCM prices (commissions and data charges) exceed marginal cost, but not by much.

But it is not outside the realm of possibility that CME believes that the more concentrated FCM industry could use a little price competition. An exec at Interactive Brokers apparently thinks so: “If they’re going to undercut our pricing and offer cheaper market data then that will be a problem.” (It’s quite interesting that market data is mentioned. That’s a big deal in the modern electronic world).

Pro tip: “we don’t like the fact that they may compete with us on price” is not a public spirited rationale for opposing a competitor’s or potential competitor’s action.

I consider this to be the most likely reason for CME to activate an FCM and operate it seriously. And that would not be a bad thing. Although the impact on the ultimate customer is likely to be modest because lower FCM prices would permit CME to jack up its price. But the combined CME+FCM price would be lower if there is indeed double marginalization going on. That would benefit the ultimate customer.

Another reason for integration would be for the CME to secure better information on the costs of supply and the demand for FCM services. This could help it optimize its pricing.

The one potential real concern about CME’s move is that it is a self-regulatory organization that polices FCMs, and that it might favor its own or try to raise its rivals’ costs through exercise of its oversight facilities. But note that the NFA, which granted approval, regulates FCMs (under CFTC auspices).

In sum, absent competition from a new integrated FTX copycat, I don’t see a compelling business case for the CME to turn on the lights to its newly approved FCM, or at least to operate one at a scale that would compete seriously with the bank-owned big boys. (Funny how that form of integration gets little comment or scrutiny, eh?). The reason that it might–to stimulate price competition in the FCM space and mitigate double marginalization–would benefit customers, though perhaps not by much. The self-dealing issue is ameliorated considerably by the fact that the NFA regulates FCMs. (Indeed, political economy considerations, namely pressure from other NFA members, might make the NFA be harder on the CME).

So all in all, nothing to get hot and bothered about.

As a small example of the joys of Californication that would spread to the entire US under a Harris administration, a couple of days ago Gavin Newsom signed legislation that would empower the state’s Clean Air Board to require California refiners to hold certain levels of. inventory. The objective of this legislation is to prevent the price spikes that periodically occur in the state.

Implicit in this legislation is the idea that inventories are too low. Why would that be? What market failure is there that induces such allegedly suboptimal behavior? None has been provided.

And no, the existence of price spikes is not evidence of inefficiency, and in particular inefficiently low inventories. In fact, in an efficient market for a storable commodity, price spikes should occur periodically: their absence would be evidence of excessive inventory holding.

The intuition is straightforward. Spikes occur when there are stockouts–when inventories fall to low levels due to supply and demand shocks. But it is optimal to have stockouts. If you didn’t, that would mean that you have produced something that is never consumed, which is obviously wasteful. So inventories should be drawn down to low levels periodically, and prices should spike then. Therefore, prices should spike periodically.

The cover of my book on commodity price dynamics based on the theory of storage has a graph of a simulated efficient, competitive market price for a storable commodity. It has spikes.

Forcing excessive stockholding is inefficient. Moreover, it tends to raise prices on average even if it reduces the frequency of price spikes. The only way to increase inventories that are consumed in certain periods is by reducing consumption during other periods. That requires higher prices in these other periods.

But spikes are politically salient, whereas higher prices most of the time get treated as the baseline, as being normal. The fact that those baseline prices are higher than they would be absent the mandated stockholding is hidden from most voters. So politicians can claim credit for shaving off some of the highly visible spikes, and aren’t blamed for the hidden cost (i.e., higher everyday prices).

That’s all assuming the legislation has the intended (if inefficient) effect of raising inventories. But it might not. As I understand it, the mandate applies to refiners. But non-refiners–traders in particular–hold stocks too. Indeed, those are most likely to be the “speculative stocks” that are used to smooth out supply and demand fluctuations, thereby reducing price volatility.

Mandating higher refiner stocks is likely to result in a reduction in these speculative stocks, thereby reducing the effect of the regulation. Given that holding excessive inventories is inefficient, this offsetting is a good thing. Indeed, it is possible that the offset will be 100 percent, meaning that every increase in refiner stocks is offset exactly by a decline in non-refiner stocks, thereby vitiating entirely the effect of the law.

So, the possibilities are: (a) the regulation will increase what consumers pay for gasoline, or (b) it will have no effect. Making consumers better off is not one of the possibilities.

Newsom has used the legislation to demonize oil companies, whom he claims make too much money, as evidenced by the high prices Californians pay for fuel, relative to those who live elsewhere.

Riddle me this, Gavin: if being in the refining business in the Golden State is so damned lucrative, why have 7 refineries in the state shut down in the last decade? Indeed, hot on the heels of Newsom’s crowing over the law, Phillips66 announced it is closing its refinery in California.

Note to the slow learners (and no learners): exit is not a sign of excess profits. Quite the contrary.

But this is the type of deep economic thinking that infests progressives, and which they want to inflict on all of us. Oh, if what happens in California were to stay in California, what happiness there would be for the rest of us. But the Democratic party wants to Californicate all of America instead.