Now you might not think that a buck is a big deal, given that a T-note or crude oil contract has a nominal value of around $100 grand. But it is a big increment to the cost of executing a contract. For example, the bid-ask on a crude oil futures trade is usually about $10, and the brokerage commission adds on only a few bucks. So the tax would increase transactions costs on the order of 5 or 10 percent.
I note that the industry fought for years at efforts to impose a 15 cent futures transaction tax. What Johnson is proposing is substantially greater than that.
Now, if Johnson’s objective was actually to raise revenue, this would be an incredibly stupid idea. Rule one of taxation: tax what can’t move. Although in the floor days uprooting the exchange and taking it outside the city or the state would have been very difficult, that’s not the case in the electronic era.
Have servers, will travel. Yes, CME Group (and CBOE–which given recent developments might end up in CME) has corporate employees there, but if any city should understand that is no impediment to relocation, Chicago should given the exodus of several major corporate HQs from the Chicago area in recent years–Caterpillar, Boeing, and Tyson Foods being prominent examples.
Moreover, even before the CME says hasta la vista motherfuckers, it faces competition in some of its products from ICE, and a tax would shift business there.
Numerous trading firms (notably Citadel) have fled Chicago for reasons–namely the marked decay of the city. (And I do mean marked: even in the last two years the decline has accelerated dramatically.) The CME has certainly already put those factors on the scale when making its decision, and a sizable transaction tax would almost certainly tip the balance heavily in favor of joining the exodus.
Notice that I framed my analysis as a conditional statement: if Johnson’s objective was actually to raise revenue. One cannot be too sure these days. Mayors of city after city have taken actions, or failed to take actions, that seem designed to drive out all but the underclass and turn the polities they govern (I use the term loosely) into crime-ridden, drug infested wastelands. In fact, it’s hard to name a big city whose elected officials haven’t done that or aren’t doing it.
American Spectator writer Scott McKay calls it “weaponized government failure:” “deliberate refusal to perform the basic tasks of urban governance for a specific political purpose.” The “specific political purpose” being to drive out middle class voters who pose the main political threat to the Brandon Johnsons and their ilk.
Framed as a hypothesis, I’m hard pressed to come up with contrary evidence.
Whether that’s the true purpose behind Johnson’s transaction tax brainwave, if he moves forward with it it’s a near lock that CME will hit the road. An electronic exchange is footloose and fancy free and not beholden to any place. Where once there were “locals” whose physical presence was necessary to operate an exchange, there are now what may be called “globals” who can and do supply liquidity from anywhere.
And if it moves, Texas is a good place. No income tax for one thing. Reasonable housing costs. And as for the weather, as I told my late mom when she fought coming here: “Look, you spent four months a years indoors in Chicago. You’ll spend four months a year indoors in Houston. Just different months.”
So come on down, Terry Duffy. I’ll be here to greet you. With bells on.
In 2010, along with my UH colleagues Victor Flatt and Praveen Kumar, I taught what I believe was the first academic carbon trading course in the world. My lectures in the course related to the economic challenges of creating traded commodities, specifically the challenges of merely defining what the commodity is and monitoring adherence to the standards so established.
Now, this may seem trivial, but even something like “wheat” poses challenges due to heterogeneity related to quality (even within a given variety, such as soft red winter wheat) and monitoring whether the wheat traded under a contract adhered to the relevant terms agreed to by the parties. Indeed, as I noted in an early article of mine, the genesis and early development of commodity exchanges like the Chicago Board of Trade and the Liverpool Cotton Exchange was not driven by the desire to trade futures: these were cooperative, private efforts to define property rights and to create a mechanism to standardize commodities and to adjudicate contractual disputes primarily over quality. Only after these challenges were met was it possible to trade futures. Standards (and their enforcement) are obviously a necessary condition for trading standardized instruments like futures.
The major intended takeaway from my lectures in 2010-11 was that the problems of standard definition and especially standard enforcement were even more daunting in carbon than in traditional commodities like wheat or cotton, and that this was especially true with respect to carbon offsets–things like contracts to plant trees to capture carbon.
How do you define what is being bought and sold? How do you monitor whether the offset contracted for performs as agreed? How do you address contract performance failures? The Chicago Board of Trade struggled for years to overcome these issues in wheat and corn and oats in the post-Civil War era, even though the trade was relatively geographically concentrated, the contracts were of relatively short duration (typically for a single consignment), and the commodity was relatively simple.
All of these challenges are far greater for carbon, let alone for offsets. Sources of carbon emissions are numerous and diffuse and costly to monitor. With respect to offsets, they are highly heterogeneous; have very long lives; require continuous investment and upkeep; and have highly unpredictable performance (e.g., the forest that you plant may burn down, or be ravaged by insects). These contracts are far more complex than a deal to buy 10,000 bushels of SRW winter wheat for delivery in Chicago next month. Moreover, many offsets are located in countries with weak–and sometimes close to non-existent–legal systems.
Furthermore, the incentives of the parties to these agreements can be perverse, especially for “voluntary” offsets. A buyer who pumps its ESG score by purchasing offsets that turn out not to perform seldom suffers serious adverse consequences (although there is some backlash against “greenwashing”), and the seller has a strong incentive to collect the cash and not make the necessary expenditures to ensure that the offset performs as promised.
I taught the class in the immediate aftermath of the Global Financial Crisis, and I suggested that there were a lot of similarities between offsets and the kinds of deals that wreaked havoc in the banking system in 2008-2009, where bankers paid their bonuses upfront based on imagined profits predicted by highly speculative models to be realized over several years churned out garbage securities.
In 2010 I was therefore extremely skeptical about the viability of markets for offsets. And the defects that I talked about have been increasingly recognized in the last year or so.
I believe that the actions of Shell during the last week represent an authoritative recognition that these predictable–and predicted–problems have come to pass. Like other (especially European) energy firms. Shell made ambitious carbon reduction pledges that it intended to meet largely through the use of offsets. But reality has reared its ugly head, and Shell is all but abandoning this strategy. Other companies (e.g., Microsoft) say that they are still committed, but if they are even remotely interested in spending their shareholders’ money wisely, they will eventually have the same come to Jesus moment as Shell.
A Shell-funded mangrove restoration project in Senegal (Bloomberg).
This represents another grievous blow to the ambitions of the Net Zero fanatics. Offsets are a major component of Net Zero plans. Renewables are another part–and reality is catching up with that too (as the travails of Danish renewables developer Orsted and German turbine manufacturer Siemens demonstrate).
But will the fanatics be deterred? Alas, it appears not. Indeed, they appear to be doubling down, as illustrated by lunatics like Michael Gove:
Michael Gove has insisted the UK needs 'big, hairy, audacious' environmental goals such as the ban on the sale of new petrol and diesel cars from 2030, during a live debate at #ftweekendfestivalhttps://t.co/jD1bEkY8c0
Net Zero and the policies intended to bring it about–including extensive reliance on renewables and offsets–are a guaranteed recipe for an impoverished future. This was predictable–and predicted–more than a decade ago. But when will the madness end? I am guessing not before these policies cause economic catastrophe.
The Biden administration, courtesy of the delusionally titled Inflation Reduction Act, has made a huge spending commitment on alternative fuels, and in particular “clean” hydrogen, i.e., hydrogen not produced from fossil fuels (such as methane). Most of the “green” hydrogen stimulus involves supply-side subsidies (especially a $3/kg production tax credit, but also loans to be doled out by the administrative state). The Infrastructure Law sets aside funds for hydrogen electrolysis and hydrogen “hubs” (like that just announced for Germany). The administration is also attempting to make “the economic case for demand-side support,” such power purchase agreements (PPAs), contracts-for-differences (CFDs), advanced market commitments (made by whom?), and prizes (funded by whom?).
It’s hard to know where to begin in criticizing this mess. The biggest problem is that it attempts to address the climate issue (which I will take as a given, focusing on means not ends) by picking technologies. This almost never ends well. First, there is the knowledge problem–bureaucratic governments do not possess the information to make these technology choices. Second, there is the rent seeking/corruption problem–which exacerbates the knowledge problem, as interested parties exploit the ignorance of bureaucrats and funders, and their political connections, to induce investments based not on their economic virtues but instead on political influence.
There are also serious doubts about whether hydrogen qua hydrogen is the right alternative fuel given that it poses numerous problems and costs. The first is that using renewable energy to produce green hydrogen is extremely expensive. The second is that, well, hydrogen is highly explosive: I distinctly remember my 8th grade science teacher, Mr. Fisch, using electrolysis to fill a test tube with hydrogen, putting in a piece of chalk, then lighting a match to set off an explosion that sent the chalk flying across the room. You didn’t have Mr. Fisch as a teacher, but perhaps you’ve heard of the Hindenberg:
Explosiveness creates hazards, of course, and mitigation of them is expensive. Hydrogen is also extremely expensive to transport and store and requires a new and distinct transportation and storage system.
We are talking trillions of dollars to create “the hydrogen economy”–something even its boosters admit. Hell, they brag about it.
Hydrogen “carried” with carbon, in the form of ammonia or methanol, pose fewer problems (although ammonia in particular is nasty stuff). They are also costly, and it is clearly uncertain whether “green” forms of these hydrogen carriers are economical ways to reduce carbon emissions from fuels for transportation and power generation.
But the administration (and Europe too) have gone all in on hydrogen. Why? Maybe because their extreme antipathy towards carbon leads them to disdain fuels with any carbon in them.
Having chosen its technology, for better or more likely worse, now the administration is focused on how to force its adoption. The supply-side incentives are clear enough, so now there is a pivot to the demand-side, as expressed in the appallingly shoddy Council of Economic Advisors document linked above.
According to the CEA–and not just the CEA, as will be seen shortly–the problem is that “[r]eal or perceived risks around clean energy projects can raise the cost of accessing capital, which could slow the rate at which projects like those in the hydrogen hubs program achieve commercialization..”
Well, I should hope so! That is, I should hope that risks are taken into account when allocating capital!
John Kerry flogged the risk issue on MSNBC (h/t Powerline):
“What’s preventing it is, to some degree, fear, uncertainty about the marketplace. People who manage very significant amounts of money have a fiduciary responsibility, an obligation to the people they manage it for not to lose the money, but to produce returns on that investment. Pension funds, many of them, are very careful about those investments in order to make certain they have the money to pay out to the pensioners who work for that money all their lives. So, there are tricky components of making sure that you have taken the risk away from these investments. And energy, which is what the climate crisis is all about, it’s about energy, it’s about how we fuel our homes, how we heat our homes, how we light our factories, how we drive and go from place to place.”
Damn those money managers for taking into account the risks and rewards of the money their investors entrust to them! Don’t they understand that John Effing Kerry knows what is right for humanity????? After all, he flies around the world in a private jet sharing his wisdom (and then dissembles about it before Congress).
I loved this part: “So, there are tricky components of making sure that you have taken the risk away from these investments.” Does John Kerry have a magic box into which he can make the risks disappear? Do tell!
Of course he doesn’t. What he means, clearly, is that the government must somehow absorb the risks inherent in the technology that they have already decided upon–apparently without analyzing those risks fully or carefully, or wondering whether maybe these damned investors might know something they don’t. (Of course they don’t wonder that! They are all knowing, right?)
At least the CEA attempts to put lipstick on the pig and raise some economic arguments to justify the need for demand-side support. There are market failures! Government never fails, but markets do, right?
In my experience the concept of market failure is most likely to be advanced when the market fails to do what someone thinks should be done, or wants to be done, based on their own vision. That is, when the market disagrees with someone, the market has failed! Especially when that someone is a member of what Thomas Sowell calls “The Anointed.”
The CEA basically cites to some theoretical possibilities. At the core of their argument is that learning by doing, including learning-by-doing that “spills over” among companies, can lead to inefficient investment. The CEA advances a couple of reasons.
One is a contracting failure. LBD–moving down the learning curve–reduces costs, meaning that prices are expected to fall. So, according the CEA, potential buyers are unwilling to enter into long term contracts for fear of agreeing to pay a price that will turn out to be too high: “if rapid declines in technology costs are expected, the willingness of private sector end-users to seek out such contracts with clean energy developers will be limited” (emphasis added). Without such contracts, hydrogen project developers can’t secure financing, so plants won’t get built, no learning takes place, and costs don’t fall. The Curly Equilibrium, in other words:
Really? If costs are expected to fall, market participants can enter contracts with de-escalator clauses, i.e., contractual prices that fall over time. Apparently the CEA only envisions contracts at a fixed price that extends through the life of the contract. But even then, given anticipated cost declines, the developer would be willing to sell at a price below the initial cost, basically, at the average cost expected over the life of the contract.
The CEA mentions the risks of of the magnitude of cost declines, but again, that should be a material consideration in any contracting and investment decision. Is the CEA arguing that the risk compensation demanded by borrowers will be excessive? They don’t say so explicitly, but that’s what you would need to argue that the prices in these contracts would be “too low” and thereby stymie investment.
I’d also note that indexed prices, widely used in a variety of commodity off-take agreements, eliminate the risk to buyers of locking in too high a price. They also address the asymmetric information problem that the CEA frets about. If the developer has better information about the likely trajectory of price declines, then yes, buyers looking at fixed price deals or deals with mechanical (non-market based) price de-escalators face a “winners’ curse” problem: the developer will agree to terms that overestimate his (better) forecast of future prices, and reject deals that underestimate.
I think in fact that the issue is that there is considerable uncertainty among all parties, developers and buyers alike, regarding what the future cost trajectory will look like. That is, there is a real risk here, and that risk should be taken into consideration when deciding whether hydrogen investments make sense. And market participants are far better at assessing the risks, and the pricing of those risks, than the government, which is clearly taking a “Damn the risks, full speed ahead!” Approach.
Sorry, but John Kerry et al don’t inspire confidence like Admiral Farragut at Mobile Bay.
One of the proposals under discussion is Contracts for Differences (“CFDs”) in which the government would (perhaps through a non-profit intermediary) provide a guaranteed revenue stream to a developer and absorb the price risk. To work, CFDs require indexing to some market price–and the market price for H2 hasn’t really been created. Further, they require some mechanism to set the guaranteed price, a non-trivial task given the very information asymmetries that the CEA worries about. The government-appointed third party (or the government for that matter) will certainly be the less informed party in any negotiations with developers, and will almost certainly overpay. (Not that they will mind–not their money!) Meaning that the asymmetric information problem the CEA frets about is present in spades in one of their preferred means of addressing it. Further, CFDs have already presented performance issues, with the sellers (those getting the guaranteed revenue stream) treating these contracts like options rather than forwards, and spurning their CFD commitments when market prices rise above the guaranteed price (as has happened with with generators in the UK when power prices spiked).
The CEA also invokes capital market imperfections also driven by asymmetric information that may impede financing if developers know more about the economics of projects than the financiers. This is a hoary old story that has been used to identify alleged market failures since time immemorial. So long ago, in fact, that when Stigler wrote “Imperfections in the Capital Market” (JPE) 56 years ago, he (in typical Stigler fashion) drolly started thus: “The adult economist, once the subject is called to his attention, will recall the frequency and variety of contexts in which he has encountered ‘imperfections-in-the-capital market.'” That is, “capital market imperfections” were an old joke decades ago.
Here’s another one, George! Based on long experience, George was a skeptic. Based on even longer experience, I am too, in this case in particular.
And let’s look at the empirical record. Learning by doing is a ubiquitous phenomenon. Dynamically declining costs in industries with potential information asymmetries abound. Yet industries have developed and thrived nonetheless.
Some examples.
I recently finished a piece describing extensive learning-by-doing in the shale industry, including evidence of learning spillovers and dynamic cost reductions. Yet, the shale sector has not faced problems getting capital or expanding rapidly. Hell, if anything, a common criticism is that shale drillers have obtained too much capital and drilled too much, not that they are starved for capital and drilled too little.
Does the CEA (or John Kerry!) believe the shale sector in the US is too small?
Insofar as spillovers is concerned, the fact that the costs of firm A decline when firm B produces more output is a necessary, but not a sufficient condition for an externality. One plausible outcome in oil (as identified in a paper on LBD in conventional drilling by Kellogg in the QJE) is that service firms are the ones that do the learning, and capture and internalize it.
LBD is well-documented for computer chips, which have seen relentless cost and price declines over the years. Yet computer chip factories have been built, and companies especially in the US and Asia have attracted the capital necessary to build these very expensive facilities and build new chip lines nonetheless. (In this industry too, there have been chronic complaints about overcapacity, rather than undercapacity. I am not commenting on the validity of those complaints, just noting that their existence contradicts the notion that dynamic scale economies and price declines due to LBD starve an industry of capital.)
The LNG industry has many of the characteristics that the CEA attributes to hydrogen. Yet this industry has expanded apace for well over 50 years now.
I viewed a presentation by DOE people today in which LNG was raised several times, and as an example not to be followed. DOE advisor Leslie Biddle (ex-Goldman) mentioned LNG several times (“I keep going back to the LNG analogy”), and in a negative way. LNG took 30 years to move to a traded market, dontcha know. And we don’t have that time! We need to create such a market in a year! (DOE’s Undersecretary for Infrastructure David Crane was more generous, giving us all of 5 years.) (Crane was also hyping the idea of hydrogen for everything, including home heating–apparently oblivious to the fact that even Net Zero fanatical Britain has just recently determined that H2 is too dangerous to heat homes.)
In the context of the discussion of a grand government plan to transform the energy system, I couldn’t help but think of Gosplan, or Stalin’s race to industrialization (e.g., the Magnitogorsk Steel Factory). We will inevitably–inevitably–meet the “Dizzy With Success” phase in hydrogen, mark my words.
I note that LNG production grew substantially before it became a traded market, which actually undercuts Biddle’s argument. Even though there was not a liquid traded market for LNG in the first decades of its growth and development, long term contracts, usually using crude (no pun intended) indexing features (like tying prices to Brent), contracts were agreed to, financing was obtained on the backs of these contracts, and liquefaction plants were built.
Oil refining faced many of the conditions that worries the CEA about hydrogen. Kerosene was a radical product early on, with a lot of uncertainty about market adoption. But Rockefeller dramatically expanded output and reduced costs: the cost of kerosene by 2/3rds in 10 years (1870-1880), in large part due to extensive learning and research on all aspects of the value chain. Standard Oil’s supposedly predatory acquisitions of were actually ways by which SO’s knowledge could be combined with physical assets to improve their efficiency.
The co-evolution of gasoline refining and the adoption of the automobile represents another example of investment and falling prices in a new market in a capital intensive industry.
I note that the early refining examples occurred when capital markets were far less developed than is currently the case. I further note that large energy firms (IOCs and NOCs like Aramco in particular) can potentially finance hydrogen (and other alternative energy projects) with cash flows generated by their legacy fossil fuel investments: this would largely eliminate any asymmetric information problem between developer and financier (because the developer is the financier) and developer and customer (because the developer could finance without securing a long term price commitment).
Another example. Electricity generation. Beginning with its inception in the early-1880s, electricity generation was highly technologically dynamic, with substantially declining costs. Yet in a few short years most urban areas in the US were electrified, with numerous private companies competing with government utilities. This was another industry in which overbuilding, rather than under-building, was widely discussed. The movement to price regulation occurred well after the industry developed, and was a reaction to intense price competition: regulation effectively cartelized electricity generation.
One more. Aircraft. LBD was first identified in the production of airframes. This phenomenon was first documented by Wright in 1936, and was subsequently observed in myriad other industries (e.g., Liberty Ship construction in WWII). LBD and the associated cost declines have continued in aircraft construction ever since. And aircraft have been built and aircraft manufacturers have been able to attract the capital to design and build new aircraft that benefit from these cost declines.
In the face of all these examples, the CEA and others making these market failure arguments should identify an industry that died aborning due to the alleged chicken-or-egg problem that makes demand side support of hydrogen investment necessary.
The CEA document has echoes of some rather common, but unpersuasive, arguments for government support of industry, such as the infant industry argument and the big push development literature. The latter has been demolished by practical experience: the list of its dismal failures is far too long. There are more than echoes of this discredited approach in the CEA document. It links to a paper that credulously recycles the old, bad, discredited theories.
What is amazing about the infant industry argument is how often it is invoked, and how little empirical evidence supports it. One of the few empirical papers, that of Krueger and Tuncer, rejects the argument in the case of Turkey.
A paper by Juhasz is often touted to support the theory. It shows that after the stimulus of the cotton spinning industry in France due to Napoleon’s Continental system, post-1815 the industry was competitive with the British, indicating that it had moved down the learning curve. Again, at most this identifies a necessary condition for protection–learning–but not a sufficient one. Even if LBD occurs, and even if there are spillovers, the cost of protection may exceed the benefits. A simple story demonstrates this. If the protected industry achieves cost parity with the first-mover (e.g., the UK in cotton), the protected firms merely displace firms in the first-mover country, leaving post-parity total costs unchanged. So in equilibrium, protection is costly but generates no benefits.
All in all, the CEA document reminds me of a rather conventional undergraduate econ paper, repeating textbook wisdom about externalities and market failures. It completely ignores the Coasean insight that market contracting methods are far more sophisticated than those in the textbooks, and that market participants have incentives to find clever ways to contract around what would be market failures if market transactions were limited to the forms considered in textbooks. It also ignores the historical record.
In other words, rather than writing off the difficulties of securing “bankable” contracts to secure funding for H2 developments to “market failures” or the excessive risk aversion of market participants, the government should step back and consider whether this alleged hesitation reflects a more sober and informed evaluation of risks than our betters in DC have undertaken.
I crack myself up sometimes.
In sum, the administration’s entire approach to hydrogen is utterly flawed. It attempts to pick technologies based on a pretense of knowledge it does not possess. It views flashing red lights warning of risks as signals to be suppressed rather than considered when making policy and investment choices. It engages in simplistic analyses of how real markets work, and how they have worked historically, to conclude that market failures requiring government intervention to fix abound in hydrogen.
All of these government failures could be eliminated by cutting the Gordion Knot, pricing carbon, and letting markets and private enterprise develop the technologies, products, contracting practices, and market mechanisms to trade off efficiently the benefits of reducing CO2 emissions. Decentralized mechanisms discover and utilize information, including information about new technologies, far more efficiently than governments. Decentralized mechanisms incentivize learning and innovation–including contracting and organizational innovations that can be instrumental in developing and adopting new technologies, products, and techniques.
In the case of hydrogen, pure or “contaminated” with carbon, priced carbon would address the problems that the CEA frets about, in particular the contracting problem. A carbon price would make it straightforward to index prices in contracts. A formula related to NG prices (because blue hydrogen is likely to drive the price of hydrogen at the margin, and because methane is likely to be the substitute at the margin for H2 in many applications) and the cost of carbon would send the appropriate signals and eliminate the need to fix prices in advance.
What the price of carbon should be and how it should be determined is a whole other question. But it would be far more productive, and not just in regards to hydrogen, to focus on that problem rather than leaving it to the John Kerrys of the world to pick technologies and then devise the coercive mechanisms necessary to force the adoption of those technologies.
Alas, we are on the latter path. And it will not take us to a good place. Probably figuratively, and perhaps literally, to the fate of the Hindenberg.
This is just an example of the inherent systemic risk created by margining, collateralization, and leverage. The issue is not a particular trade per se–it is an inherent feature of a large swathe of trades and instruments. What made the basis trade a big issue in March 2020 was its magnitude. And per the article, it has become big again.
This is not a surprise. Treasuries are a big market, and leveraging a small arb pickup is what hedge funds and other speculators do. It is a picking-up-nickels-in-front-of-a-steamroller kind of trade. It’s usually modestly profitable, but when it goes bad, it goes really bad.
All that said, the article is full of typical harum-scarum. It says the trade is “opaque and risky.” I just discussed the risks, and its not particularly opaque. That is, the “shadowy” of the title is an exaggeration. It has been a well-known part of the Treasury market since Treasury futures were born. Hell, there’s a book about it: first edition in 1989.
Although GiGi is not wrong that basis trades can pose a systemic risk, he too engages in harum-scarum, and flogs his usual nostrums–which ironically could make the situation worse:
“There’s a risk in our capital markets today about the availability of relatively low margin — or even zero margin — funding to large, macro hedge funds,” said Gensler, in response to a Bloomberg News inquiry about the rise of the investing style.
Zero margin? Really? Is there anyone–especially a hedge fund–that can repo Treasuries with zero haircut? (A haircut–borrowing say $99 on $100 in collateral is effectively margin). And how exactly do you trade Treasury futures without a margin?
As for nostrums, “The SEC has been seeking to push more hedge-fund Treasury trades into central clearinghouses.” Er, that would exacerbate the problem, not mitigate it.
Recall that it was the increase in margins and variation margins on Treasury futures, and the increased haircuts on Treasuries, that generated the liquidity shock that the Fed addressed by a massive increase in liquidity supply–the overhang of which lasted beyond the immediate crisis and laid the groundwork for both the inflationary surge and the problems at banks like SVB.
Central clearing of cash Treasuries layers on another potential source of liquidity demand–and liquidity demand shocks. That increases the potential for systemic shocks, rather than reduces it.
In other words, even after all these years, GiGi hasn’t grasped the systemic risks inherent in clearing, and still sees it as a systemic risk panacea.
In other words, even though I agree with Gensler (and the Fed) that basis trades are a source of systemic risk that warrant watching, I disagree enough with GiGi on this issue that the apocalypse that could result from our complete agreement on anything will be averted–without the intervention of the Fed.
For decades, Europe’s commodity traders have avoided being regulated on par with other financial firms. A new proposal currently working its way through the European Union legislative system could change that.
To close “loopholes,” dontcha know:
The loophole allows industrial companies like utilities and food processors — but also commodity trading houses — to take derivative positions without the scrutiny facing investment firms. Designed to reduce the burden of managing price risk, it also means that traders aren’t subject to rules on setting aside capital or limiting positions the same way banks and hedge funds are.
2022 certainly saw unprecedented liquidity pressures in the commodity trading sector, as firms that had sold derivatives (especially on gas and power) to hedge their exposures from supplying the European market saw huge margin calls that greatly strained credit lines and led a coalition of traders to request ECB support (which the ECB declined).
The crucial part of the previous paragraph is “to hedge.” The danger of restricting or increasing the cost of such activities through regulation of the type that is apparently under consideration is that it will constrain hedging activities, thereby (a) making these firms more vulnerable to solvency, as opposed to liquidity problems, and (b) raising the costs of commodity intermediation.
Note that the companies that received state support that are mentioned in the article are not commodity traders qua commodity traders, e.g., Vitol or Trafigura or Gunvor. They are energy suppliers who were structurally short gas and did not hedge, and hence were facing serious solvency issues when gas prices exploded in late-2021 (before the Russian invasion) and winter and spring 2022 (when the invasion occurred). That is, firms that didn’t hedge were the ones that faced insolvency and received state support. (Curiously, Uniper is missing from the list of companies in the Bloomberg article, although Fortum Oyj was collateral damage from Uniper’s collapse.)
The relevant issue in determining whether commodity trading firms should be regulated like banks or hedge funds is not whether the traders can go bust: they can. It is whether (a) they are financially fragile like banks, and (b) whether they are systemically important.
These are exactly the same issue I addressed in my Trafigura white papers in 2013 and especially 2014. To summarize, commodity trading firms engage in completely different transformations than banks and many hedge funds. Commodity traders transform commodities in space, time, and form: banks engage in liquidity and maturity transformations. The difference is crucial.
Liquidity and maturity transformations are inherently fragile–they are the reasons that bank runs occur, as the recent failures of SVB, First Republic, and Signature Bank remind us. That is, the balance sheets of banks are fragile because they finance long term, illiquid assets with liquid short term liabilities.
Commodity traders’ balance sheets are completely different. The “pure” asset light traders especially: they fund short term (“self-liquidating”) relatively liquid assets (commodity inventories) with short term relatively liquid liabilities. Further, hedging is a crucial ingredient in this structure: banks are willing to finance the inventories because the price risks can be hedged.
This is not to say that commodity traders cannot fail–they can. But they do not face the same kinds of fragility (vulnerability to runs) that entities that engage in maturity and liquidity transformations do. It is this fragility that provides the rationale for bank capital requirements and limitations on the scope of their activities. This rationale is lacking for commodity trading firms. They are intermediaries, but not all intermediaries are alike.
Further, as I also pointed out almost a decade ago, major financial firms dwarf even the largest commodity trading firms. Even a Trafigura, say, is not remotely as large or systemically important as, say, Credit Suisse. Yes, a bankruptcy of a big trader would inflict losses on its lenders, but these losses would tend to be spread widely throughout the global banking sector given that most loans and credit lines to commodity traders are widely syndicated. And the potential for these kinds of losses are exactly reason that banks hold capital and that it is prudent to impose capital requirements on banks.
As I noted in the 2014 study, virtually the entire merchant energy sector in the United States imploded in 2002-3. Lenders ate losses, but the broader economic effect was minimal, the assets of the failed firms continued to operate, and the lights stayed on.
In sum, analogizing commodity traders to banks is seriously intellectually flawed, and what’s good or justified for one is not necessarily for the other because of the huge differences between them.
Pace Bloomberg, the events of 2021-2022 did not “expose” some new, unknown risk. The liquidity risk inherent in hedging has long been known, and I analyzed it in the white papers. Indeed, it’s been a focus of my research for years, and is the underlying reason for my criticism of clearing and collateral mandates–including those embraced enthusiastically by the EU.
Thus, a more constructive approach for Europe would be not to apply mindlessly regulatory restrictions found in banking to commodity firms, but to investigate ways to facilitate liquidity supply to commodity traders under extreme situations. Direct access of commodity traders to central bank funding is inadvisable, but central bank facilitation of bank supply of margin funding to commodity traders during such extraordinary circumstances worthy of investigation.
Recall that the Federal Reserve’s response to a funding crisis originating in the Treasury futures markets was instrumental in containing the systemic risks arising from COVID in March 2020 (as described in my Journal of Applied Corporate Finance article, “Apocalypse Averted“). The Fed’s actions were extemporized (just as they were during the 1987 Crash). The EU and ECB would do well to use that experience, and that of 2021-2022, to devise contingency arrangements in advance of future shocks. That would be a more constructive approach to the risks inherent in commodity risk management than to impose regulations that could impede risk management.
It is important to note that making hedging costlier instead of making it cheaper increases the risk of extreme price disruptions. Constraining risk management means that commodity traders will supply less intermediation especially during high risk periods. This will swell margins and make commodity supply less elastic, both of which will tend to exaggerate price movements during periods of stress.
I always wonder about the political economy of such regulatory proposals. Yes, no doubt regulatory reflex is a driver: “We have to do something. Let’s take something off the shelf and make it fit!” But my experience in 2012-2014 also motivates a more cynical take.
The genesis of the Trafigura white papers was an abortive white paper I wrote for the Global Financial Markets Association, a banking industry group. The GFMA approached me to investigate the systemic riskiness of commodity trading firms, and I came up with the wrong answer, so they spiked the study. Somehow or another Trafigura got wind of this, and that was the genesis of the influential (if I do say so myself) papers I wrote for the firm.
The point being that in 2012 the banks were pushing to regulate commodity trading firms with capital requirements and the like in order to raise the costs of competitors, and were looking for intellectual cover for that endeavor–cover I did not provide after a deep dive into the commodity trading sector.
Hence, I wonder if this reprise of the ideas that were largely shelved in the mid-2010s is an example of “let no crisis go to waste,” i.e., whether there are interests in Europe pressing to regulate commodity firms for shall we say less than public spirited reasons.
The proposals are apparently very protean at this stage. But it will be interesting to see where they progress from here. And I’ll weigh in accordingly.
“Equity” is one of the three legs of the iniquitous DIE gallows. It is a driving force behind a variety of policy proposals, two of which have surfaced in recent weeks. They illustrate the fundamental depravity of such “equitable” policies generally.
In other words, it is a purely redistributive policy. And excuse me, but where have I seen this movie before? Oh, that’s right. During the last financial crisis, which was in large part the consequence of policies designed to, well, “increase pricing support for purchase borrowers limited by income or by wealth.”
It isn’t rocket science to figure out where this will go. More low credit quality households will buy houses they can’t afford. A loss of a job, or a downturn in the real estate market, or one of myriad of other things means that they won’t be able to repay the loan, resulting in default, foreclosure, and a credit loss to the lender. Most likely followed by class action law suits alleging predatory lending.
Wealth redistribution via housing policy and housing finance policy has always been a bad idea plagued by unintended–but totally predictable–consequences. But it’s like a bad drug, and one that the United States government just can’t quit for long.
The other policy, smaller in scale but similar in design comes from California. There the three major state regulated utilities have proposed implement two part tariffs, consisting of a fixed monthly fee and a per unit usage charge. The fixed fee will be based on income, with low income households paying $15/month and higher income households paying as much as seven times that amount. Further, the utilities will reduce the rate per kwh.
Now you can make an economic case for a two part pricing structure in an industry (like electricity) with high fixed costs, but that doesn’t appear to be the motive here: instead, it is an attempt to use electricity tariffs to redistribute income and wealth. It is also somewhat ironic that California, which faces chronic electricity shortages and constantly strives to reduce consumption because climate change is introducing a policy that encourages consumption. I am sure that will work out swell.
If you believe in redistribution, there are better and worse ways to achieve that objective. The better ways are through lump sum transfers or something like the negative income tax. The worse ways are through messing with prices. It’s fair to say that the worst ways are through messing with prices.
And that’s exactly what these two policies will do. The FHFA policy messes with the price of credit. The California electricity policy messes with the price of power.
Messing with prices distorts decisions on a variety of margins.
For example, distorting the price of credit (i.e., charging borrowers rates and fees that do not reflect default costs) encourages overborrowing by those with poor credit and underborrowing by those with better credit. As we saw in 2006-8, such policies can have systemic consequences. Even absent systemic consequences, they will lead to greater financial distress costs, deadweight bankruptcy costs, reduction in housing values due to the effects of foreclosure, etc.
Both policies also increase effective marginal tax rates, which distort labor supply decisions. In California’s case, the redistributive policies represent one more straw on the camel’s back of those debating where to locate, and due both to the direct effects and the signal sent regarding the extractive nature of California policies will add to the exodus of the middle class from the state.
The means by which these redistributive policies are being imposed is also pernicious. This is redistribution via regulatory fiat. The administrative state is already too large and too unaccountable. Giving it a license to redistribute income and wealth–or to engage in more such redistributive schemes–in the name of “equity” will result in a proliferation of such ghastly schemes, and the deadweight costs they entail due to their distortions of prices. Make elected politicians make the case for and take responsibility for redistributive schemes rather than delegating them to the unelected and the unaccountable. Especially those who can only implement redistributive policies through destructive distortions in the prices of the goods and services they regulate.
The United States desperately needs pro-growth policies, not redistributive ones–not least because growth is essential to prevent a debt crisis. These redistributive policies are decidedly anti-growth.
They are also divisive, and are being implemented at a time where social divisions are already acute.
I wish I could say that these two policies were outliers. They are not. They are representative of today’s strongest policy current: the Biden administration’s “whole of government” plan for “environmental justice” is another. Such policies are a recipe for stagnation, and taken collectively and together with lavish government spending bear the seeds of future economic crises. And not far into the future either.
The Texas legislature meets every other year, meaning that 2023 is the first session in which legislation to address the issues that became apparent with the near death experience of the Texas power grid during Winter Storm Uri in February 2021 can be considered. The Texas Senate has passed two bills. Senate Bill 6 mandates the building of 10,000 MW of thermal generation (with on-site fuel storage), to be paid for via an “insurance” mechanism that guarantees a 10 percent rate of return to be funded by uplift charges to transportation and distribution utilities. Senate Bill 7 effectively creates an ancillary services market that allows dispatchable generation to sell reserves (e.g., spinning reserves) on a day ahead basis.
Opponents immediately created the false narrative that the Texas bills are proof that Texas politicians “no longer have faith that competitive markets can adequately and economically satisfy the electricity need of Texas citizens,” said Beth Garza, a consultant for the think tank “R Street Institute.”
Well, the bills do represent major departures from Texas’ “energy only” market design. But this raises the question of what undermined the energy only market in the first place. And the answer to that is clear: subsidies for renewables. Past subsidies have wreaked havoc for years. Future subsidies, especially those in the Green New Deal in Drag, AKA the Inflation Reduction Act, threaten to wreak even more havoc in the future.
As I’ve written, this problem was evident years ago, in the mid-2000s. Even then, the penetration of renewables was undermining the economics of thermal generation, leading to exit of such capacity, thereby pressuring reserve margins and compromising–seriously–reliability. The process has continued inexorably in the past 15 years or so, leading to the precarious situation that culminated with Uri–and which has led to chronic concerns about blackouts during every cold snap and heat wave since.
The upshot of the process is an electricity system with a decidedly suboptimal generation mix. Too much intermittent, non-dispatchable renewables, too little dispatchable thermal. The Senate bills are attempts to address that distortion.
This is a great example of the “theory of the second best,” in which one policy that would be suboptimal in the absence of any distortions is welfare-improving in the presence of other distortions. The massive past, present, and prospective subsidies for renewables have distorted the operation of an energy only market. The past subsidies cannot be undone, and the future subsidies are also largely out of the control of Texas and ERCOT. So subsidies for thermal generation that would otherwise be objectionable can improve economic efficiency because they counterbalance the effects of these other subsidies.
It is clear that persisting with the EO market would be a recipe for future disaster. Subsidy to offset subsidy is a second best approach, but the first best is unattainable due to the renewable subsidy induced distortion.
Are there other policies that might be preferable? The only real alternative I can see is a capacity market (another departure from energy only), with capacity obligations clearly directed at dispatchable resources. I am skeptical about the credibility of capacity commitments, and the ability to tailor them to address reliability concerns in particular. Furthermore, political economy considerations threaten capacity markets: renewables operators will lobby to qualify for capacity payments.
SB6 is focused on encouraging investment in dispatchable, reliable capacity. It is likely the MW will be forthcoming. The main challenge is whether the MWh will be there when needed, that is to ensure that the new generation is maintained so as to be able to supply surge demand with a high probability. To provide the incentive to make it so the EO market has to allow generators to earn high prices when supplies are tight. Political economy may again be the main obstacle to this. The new generation will earn high returns–perhaps well above 10 percent–during the periods they are most needed. This will create political pressure to claw back these profits: “windfall profits tax,” anyone? The prospect for clawback undermines the incentive of the new generation to be optimized to supply power in times of short supply.
In sum, renewable subsidies distorted the EO market. Some second best measure (the first best being no renewable subsidies) is necessary. These must effectively subsidize investment in reliable, dispatchable, thermal generation. Between the two main alternatives on offer–guaranteeing a return on investment on such generation, or a capacity market–the former seems superior. But regardless of which is chosen, it is essential to keep in mind what requires the choice: the distortion that compromised the reliability of the Texas grid in the first place, namely, renewables subsidies.
A brief follow-up on SVB (which kinds of sounds like a venereal disease, which is kind of apropos I guess).
During the GFC I wrote about how bank capital requirements were like price controls. A regulator can never set the “right” prices–in this case, the shadow costs of assets with different risks. It will underprice some risks, and overprice others. Banks will hold too many of the assets where risk is underpriced, and too little of the assets where the risk is overpriced.
Bank capital requirements focus primarily on credit risk, rather than interest rate risk. SVB incurred very little if any capital charge to hold Treasuries and agency debt, because they are viewed as “safe” from a credit risk perspective. But they did allow SVB (and other banks) to take on interest rate risk.
Very low or zero capital charges on Treasuries fall into the there-are-no-coincidences-comrade category. The government wants to encourage holding of Treasuries and agencies. Big deficits to finance, after all. As Niall Ferguson, Charlie Calomiris, and others have pointed out, governments regulate and structure banking systems first and foremost to facilitate government finance, not private capital markets.
Related to this is the issue of stress tests. The relaxation of regulation passed in 2018 meant that banks of SVB’s size no longer had to undergo stress tests. But the recent government stress tests would not have really stressed SVB: they only tested for a 200 basis point increase in interest rates, not the 400+ increase we have experienced. So SVB would have passed anyways.
In the immediate aftermath of the GFC I expressed skepticism about stress tests. I called the Tinker Bell Economics–“We believe! We believe!” That is, they are intended to assure everyone about the safety of the banking system, rather than to actually test the safety of the banking system.
The unstressful interest rate stress scenarios also plays into the idea that the Fed and Treasury don’t want to do anything to dampen banks’ appetite for government bonds.
One last comment. Many historical banking system crises are the result of yield chasing in low interest rate environments. Low yields (a) allows banks to borrow cheap, and (b) induces banks to chase yield by taking on more risk.
We obviously operated for years in a low rate environment, courtesy of the Fed. Yield chasing was an inevitable. SVB chased yield.
In sum, yes, SVB’s execs were rats. But the government designed the maze (capital requirements, low interest rates) and baited it with cheese. So when the government says that they are going to fix the problem, don’t believe them. But believe this: especially given the United States’ huge debt and deficits, any “fixes” will be rigged to protect the Treasury market, and the devil take the hindmost. Which would be you.
Bank failures tend to come in waves, and we are experiencing at least a mini-wave now.
Banks fail for three basic reasons: 1. Credit transformation: deterioration in borrower creditworthiness, usually due to an adverse economic shock (e.g., a real estate bust). 2. Maturity transformation: borrowing short, lending long, and then getting hammered when interest rates rise. 3. Liquidity transformation combined with an exogenous liquidity shock, a la Diamond-Dybvig, where idiosyncratic depositor needs for cash lead to withdrawals that exceed liquid assets and therefore trigger fire sales of illiquid assets.
The two most notable failures of late–Silicon Valley Bank and Silvergate–are examples of 2 and 3 respectively.
In some respects, SVB is the most astounding. Not because a bank failed in the old fashioned way, but because it was funded primarily by the deposits of supposed financial sophisticates–and because of the disgusting policy response of the Treasury and the Fed.
SVB took in oodles of cash, especially in the past couple of years. The cashcade was so immense that SVB could not find enough traditional banking business (loans) to soak it up, so they bought lots of Treasuries. And long duration Treasuries to boot.
And then Powell and the Fed applied the boot, jacking up rates. Bonds have cratered in the last year, and took SVB’s balance sheet with it.
Again, an old story. And hardly a harbinger of systemic risk–unless such reckless maturity mismatches are systemic.
SVB was the Banker to the Silicon Valley Stars, notably VCs and tech firms. These firms are the ones who deposited immense sums in exchange for a pittance of return. Case in point, Roku, put almost $500 million–yes, you read that right, 9 figures led with a 5–into SVB!!!
I mean: WTFF? Was the Treasurer a moron? For who other than a moron would hold that much in cash in a single institution? (Roku claims its devices “make your home a smarter.” Maybe they should have hired a smarter treasurer and CFO, or replaced them with one of its devices). Hell, why is a company holding that much in cash period?
A few of these alleged masters of the universe (like Palantir) saw the writing on the wall and yanked their deposits: deposits fell by a quarter on Friday alone, sealing the bank’s doom. Those who were slow to run howled to the high heavens over the weekend that if there was not a bailout there would be a holocaust in the tech sector.
Even though the systemic risk posed by SVB’s failure is nil (or if not, then every bank is systemically important), the Treasury Department and the Fed responded to these howls and guaranteed all the deposits–even though the FDIC’s formal deposit insurance limit is $250,000. You know, .05 percent of Roku’s deposit.
When evaluating this, one cannot ignore the reality that the Democratic Party is completely beholden to Silicon Valley. This is beyond scandalous.
Occupy Silicon Valley, anyone?
Treasury Secretary Janet Yellen insulted our intelligence by assuring us this is not a bailout. Well, it’s not a taxpayer bailout, strictly speaking, because the Treasury is not providing the backstop. Instead, it is being funded by a “special assessment” on solvent banks. Which are owned and funded by people who also pay taxes. And such an “assessment” is a tax in everything but name–because it is a contribution by private entities compelled by the government.
The policy implications of this are disastrous. The whole problem with such bailouts is moral hazard. What is to stop banks from engaging in such reckless behavior as SVB did if they can obtain seemingly unlimited funding from those who know that they will be bailed out if things go pear-shaped?
And the regulatory failure here demonstrates that bank regulation–despite the supposed “reforms” of Frankendodd–can’t even catch or constrain the oldest bet-the-bank strategy in the book. Free banking–no deposit insurance, no bailing out of depositors–couldn’t do worse, and would likely do better.
No, the failure of SVB is not the scandal here. The scandal is the political response to it. This reveals yet again how captured the government is. This time not by Wall Street, but by tech companies and oligarchs that are currently the primary source of Democratic political funding.
A couple of weeks ago the Silvergate story looked juicy, but SVB has put it in the shade. Silvergate also grew dramatically, but on the back of crypto rather than SV tech. It became the main banker for many crypto firms and entrepreneurs. The crypto meltdown did not affect Silvergate directly, but it did crush its depositors, the aforesaid crypto firms and entrepreneurs. They withdrew a lot of funding, and an old fashioned liquidity mismatch did it in.
In traditional banks, deposit funding is “sticky.” Banks that rely on wholesale funding (“hot money”) are more vulnerable to runs. Silvergate’s funding was not traditional sticky deposit funding, nor was it hot money per se. It was money that was pretty cool as long as crypto was cool, and became hot once crypto melted down.
A run started, but the run was precipitated by a liquidity shock. Simple story, really.
Silvergate’s failure was not a scandal. SVB’s failure per se was not a scandal (except to the extent that our vaunted banking regulators failed to prevent the most prosaic type of failure).
Again–the scandal is the politically tainted response that will have baleful consequences in the future, as the response virtually guarantees that there will be more SVBs in the future.
Nina Khan’s FTC has indicated that it will outlaw non-compete clauses in labor contracts. Be skeptical. Be very skeptical.
My priors are that such restrictions are unwarranted, especially when originating in the Khan FTC.
For one thing, this brings to mind Coase’s dictum that the knee jerk response to any non-standard contracting practice is that it is the result of monopoly (or in this instance monopsony) power. Coase argued that instead most such practices economize on transactions costs. Research dating back more than a half century reveals that many practices frequently branded as monopolistic, such as resale price maintenance, exclusive dealing, and exclusive territories, reduce transaction costs associated with free riding on information. Non-compete clauses can obviously serve this function by preventing an employee who obtains proprietary information at company X from supplying that information to company Y. Eliminating this protection on property rights to information will result in less investment in this information.
Furthermore, although the monopoly/monopsony explanations that Coase belittled at least involve the application of economics, the Khan FTC has basically thrown economics out the window. (It has definitely thrown Chicago School economics–which provided efficiency rationales for RPM, etc.–out the window.) Instead, her FTC has embraced Brandeisian big-is-bad, unconventional-is-bad antitrust. The Khan Theory of Antitrust Enforcement is akin to Potter Stewart’s theory of pornography: she knows an antitrust violation when she sees it. It is a very subjective approach completely contingent on her non-economics-based subjectivity.
Moreover, the process at the Khan FTC is highly dubious. The Chairwoman is alleged to run roughshod over staff and other commissioners–as epitomized by the resignation of the FTC’s Republican Custer, Christine Wilson. This furthers suspicions that this proposed rule is purely the product of Khan’s uneconomic, idiosyncratic mind and prejudices, rather than on sober analysis.
So my priors are that anything that comes out of the Khan FTC is likely bilge.
But priors can be modified by evidence! So let’s look at the economics of a ban.
So as not to keep you in suspense: this analysis provides no reason for me to change my priors. To the contrary.
Evidently the rationale for this ban is that non-competes are a means of exercising monopsony power. Where to begin?
First, given the plethora of participants on both sides of labor markets–including markets for fairly specialized labor–there is considerable room to be skeptical that monopsony power is severe. This is particularly true for information workers for whom non-competes are most likely used.
This is especially the case today, when the reduced cost of remote work sharply mitigates one of the factors that could conceivably create a quasi rent that an employer could extract, the cost of moving.
Not that this would be a major issue for a lot of information workers anyways. Due to well-understood agglomeration effects (that have been operating since, say, the heyday of New England cotton milling in the antebellum US!) firms of a particular type, and hence employees of this type of firm, tend to be geographically concentrated. So an employee with valuable information can find work at another firm that can use that information without having to move, or move far.
Indeed, this can explain why non-competes exist in the first place. Employers in industries with a high degree of spatial agglomeration cannot rely on the costs of relocation to prevent competitors from poaching employees. Thus, I would predict that non-competes are more likely in industries where agglomeration effects operate, whereas the monopsony power theory would predict the opposite.
To make it more specific: I predict non-competes would be more prevalent in places like Silicon Valley, whereas the monopsony theory would predict that they would be less prevalent there (because employers would have less market power when relocation costs and hence quasi rents are low).
Second, although non-competes can potentially create quasi rents ex post, ex ante potential employees can negotiate contract terms (or at least reject terms offered by a potential employer). Employers can attract employees only if the other terms of the contract (including pay, but also other terms) compensate for the restriction on the employees ex post options. As long as the ex ante employment market is largely competitive, contractual terms will compensate (or more than compensate) for the employee’s ex post loss of freedom. If (due, for instance, to information disclosure problem) non-competes are wealth enhancing, the Coase Theorem comes into play. Employers and employees will negotiate other terms that make both better off.
Third, even granting arguendo that non-competes are a way of exercising market power ex ante (a dubious proposition), eliminating non-competes does not eliminate the market power, so it is by no means clear that eliminating non-competes will make employees better off. Rapacious, monopsonistic employers will just find some other way to exploit their market power. And that could make employees worse off. Eliminating an efficient way of exercising market power makes the pie smaller, and it is likely that both employers and employees would both suffer as a result.
This raises the issue of why monopsonists would prefer to use non-competes to exercise (ex ante) market power, rather than just paying lower wages/salaries, or offering fewer benefits. Perhaps you could view it as a form of price discrimination where employers exploit differences among employees by offering a menu of contracts with different pay and non-pay terms (including non-competes, or not) to extract rents. Even if that’s what’s going on, it is well known that the welfare effects of price discrimination–and hence of its restriction–are highly ambiguous.
That is, even if non-competes are a way of exercising market power, eliminating this particular way of doing so does not necessarily mean that market power will decrease: firms may instead utilize less efficient ways of exercising it.
One Chicago School staple is that a monopolist has no incentive to engage in things like exclusive dealing in order to extend market power: it can extract the maximum profit by just charging the monopoly price. Hence, there is likely some non-monopoly leveraging explanation for such contracting practices. Similar logic applies to exercise of monopsony power.
The pushback against Chicago resulted in the creation of a lot of highly stylized, not to say contrived, models in which such monopoly leveraging can occur. Nice models! Never seen one that applies to a real world situation.
I therefore surmise that even if employers have ex ante market power, it is unlikely that non-competes enhance that market power, and that eliminating them will make employees better off–because the elimination does not reduce the ex ante market power.
The empirical evidence that supposedly supports the ban is that elimination of non-competes is associated with higher wages. Even putting aside my skepticism that wages are a sufficient statistic for employee welfare (since so many other terms of employment can be varied), it must be recognized that there are reasons why elimination of non-competes in competitive labor markets could boost wages for some.
Elimination of non-competes essentially gives employees property rights in valuable information. Absent non-competes they can effectively sell this information, whereas they cannot do so (or are limited in their ability to do so) when non-competes are in place. Since the information cannot be sold separately, it is bundled with the other services supplied by the employee. All else equal, employers (including an individuals current employer and potential employers) are willing to pay more for the information-service bundle than the service alone. That means higher compensation.
As Coase and subsequent scholars (including prominently my thesis advisor Lester Telser) noted, contractual restrictions can be ways of creating or protecting property rights in information. It is highly likely that’s the role that non-competes play, especially given their widespread use in tech and other information industries. Therefore, be skeptical indeed about the FTC proposal. Indeed, even if you believe that instead non-competes are in part a means of exercising market power, you should not conclude that their elimination will make employees better off because the market power remains even after one means of exercising it is constrained.
We should all fear the Wrath of Khan generally, given her economic ignorance, and indeed her hostility to economic reasoning. We should especially fear it in her latest attempt to reshape private contracting in what is arguably the largest market in the United States–the market for labor, and for information intensive labor in particular.
