Streetwise Professor

I have only had time to skim press coverage of the new Mifid & Mifir promulgated by the European Commission, but on my initial read, that appears to be a fair description.  All of the bad ingredients of Frankendodd made worse, with some special Euro accents of a decidedly dirigiste flavor.  The same deep suspicion of markets, the same cartoonish view of why market structures have evolved as they have, the same conceit of knowledge and control, the same breezy disregard for unintended consequences.

Sorcerer’s apprentices run amok, again.  Led by a French apprentice no less.

After July 21, 2010, who woulda thunk that regulatory arbitrage would have thrown business in the US’s direction?  If Mifid and Mifir go through anything like what Barnier et al propose, that could well happen.

There has been a lot of hyperventilating over this Bloomberg story about the transfer of derivatives positions from Merrill Lynch to Bank of America.  Much of the commentary, most notably by Felix Salmon, has expressed outrage at dumping risk on the deposit insurance fund.

The Bloomberg story focuses on the fact that FDIC and the Fed are at odds over the transfer. This tells you a lot, and what it should tell you is not comforting.  Both sides are talking their book, and what the Fed is saying reveals its concerns about stresses in the market, and particularly on dealer firms.

FDIC is obviously and justifiably concerned about the contingent liability it assumes as a result of the transfer.  Presumably the Fed is not oblivious to this.  So why would it favor the transfer?

I think it speaks volumes about the Fed’s concerns over the condition of dealer firms.  In the current environment, the most worrisome ones would be Merrill, Morgan Stanley, and perhaps to a lesser degree Goldman.  All of these have seen their credit spreads widen recently.  Concerns about creditworthiness of these firms can lead to runs.

I don’t think that runs on derivatives per se are the issue: yes, counterparties can seek to novate, or find other ways to get cash out of their dealers with whom they have in-the-money positions (although that’s not as much of an issue with standard interdealer CSAs in which no credit is extended.)  But counterparties, customers, and lenders of/to dealer firms who are concerned about the derivatives exposure of a dealer of questionable creditworthiness have an incentive to reduce their exposure to the dodgy firm.

This, ironically, illustrates the systemic danger associated bankruptcy rules that give derivatives trades priority: it gives ostensibly junior claimants who can pull their money an incentive to get out first. You can’t evaluate the systemic risks of derivatives without considering capital structure more generally.

And there are reports that big non-dealer counterparties are getting nervous about dealer creditworthiness.  Novation inquiries are increasing as dealer credit spreads have gapped.

[Black humor moment in linked article:

“We’ve not experienced clients moving away from us. On the contrary, we’ve seen more clients come to us as a result of our strong positioning in the equity derivatives markets,” said a source close to one French bank.

Sure.  Remember that the French have claimed their banks have “no toxic assets.”  Which presumably explains why Sarkozy is running around like his head is on fire and his a** is catching it (h/t Charlie Daniels) trying to get the Germans to recapitalize French banks.]

Thus, my interpretation of the Fed’s action is this.  It sees the conditions are ripe for a customer and funder run on Merrill.  It wants to reduce the risk that customers and lenders perceive.  The less risk in ML, the lower the likelihood that customers and lenders will get the urge to go for a jog–or a sprint.  Reducing ML’s derivative exposure reduces its risk, and makes a destabilizing run less likely.  Not that BAC is in great shape, but it is less vulnerable to what the Fed fears than Merrill is, and less vulnerable to a depositor run precisely because of deposit insurance.

So that’s the real story here, IMO: the Fed’s encouragement of the move of ML’s derivatives to BAC reveals its nervousness about the vulnerability of ML, and some dealer firms generally, to a run.  From its perspective, moving the derivatives risk to BAC is the least bad option. If you believe that runs are an inefficient equilibrium outcome–and that is a reasonable belief–doing something to reduce the likelihood of a jump to that equilibrium makes sense.  And that’s what the Fed appears to be doing.

And no, that shouldn’t give you the warm and fuzzies.

During this week’s bus tour, Obama repeatedly asserted that it was necessary to pass the “jobs bill” in order to save the jobs of teachers, firemen, and the like.  Biden joined in, and predicted that failure to pass the jobs bill would lead to more rapes and murders, due to layoffs of police.  And it just ain’t Crazy Joe: Jay-the-most-aptly-named-man-in-DC-Carney said that Obama “absolutely” agrees with Biden.  Harry Reid weighed in, claiming that public employment was the priority, because “it’s very clear that private-sector jobs have been doing just fine.”

An aside. First: what planet is Reid living on?  (NB: not the first time I’ve asked this question to myself.)  Second: can you imagine the hue-and-cry, the gnashing of teeth, the rending of garments, had any Republican said anything remotely similar to what Reid did?  S/he would have been labeled the second coming of Marie Antoinette* for her/his callousness, insensitivity, lack of compassion, condescension, etc., etc.

But on to my substantive point.  Since when, in the nearly 225 years of this Republic, has the employment of firemen, policemen and teachers been the responsibility of the Federal government?  Indeed, the entire concept is a mockery of the idea of a “federal” system.

I know that the Constitution is a sad shadow of its former self, primarily the result of a relentless centralizing assault beginning in the Progressive era.  (The Progressives being arch-foes of many things in the Constitution, federalism among them.)  But the idea that it is somehow the responsibility of Washington to secure the employment of teachers, etc., represents a complete mockery of the most basic ideas of the Constitution.

Brought to you, ironically, by a former lecturer in Constitutional Law.  (Not professor.  Professors at least attempt to engage in original thought and scholarship.  Obama just lectured a few classes then: he lectures the world now.)

Public education, and police and fire protection are quintessentially local activities.  Local communities internalize the benefits of these activities, and should bear the costs.  It is fundamentally defective as an economic matter, even ignoring Constitutional constraints, to shift the costs of providing these services to people who do not realize the benefits.  That just leads to waste and inefficiency.

But this isn’t about the Constitution, or economic efficiency.  This is about paying off Obama’s (and Reid’s, etc.) constituencies.

Sadly, I have looked in vain to find any relatively prominent person in politics object to the Obama-Biden-Reid efforts on principled Constitutional grounds–which in turn are based on a solid political and economic principle of delegating decision making authority to those who are directly impacted by said decisions.  Which suggests that disrespect or indifference to the most basic Constitutional tenets is a bi-partisan affair.

Not that this is news, but seldom is it so blatantly on display.

*Yes, I know Marie Antoinette’s “let them eat cake” is a fabrication, first found in Rousseau.  Just another reason to pay no attention to Rousseau.  But for worse or for worse, Marie is the poster girl for callous indifference to human suffering.  In contrast, Harry Reid’s comment is fully documented, yet he is getting a pass.  Particularly from the intellectual heirs of Rousseau.

I’m in New York.  No, I’m not joining OWS down in Zuccotti Park.  Quite the opposite.  I was speaking at event sponsored by the object of their ire, at the JP Morgan Chase Commodity Forum.

I spoke about Dodd-Frank and commodity trading.  I did my shtick, and it went over pretty well: I was surprised that “Frank-n-Dodd” was something most hadn’t heard before.  The audience found the phrase amusing, and more than a few people remarked on the phrase afterwards.

Substantively, the most interesting thing I heard was said by Morgan’s head of commodities, Blythe Masters.  She noted that F-n-D imposed huge compliance and administrative burdens.  Huge.  Moreover, these are fixed costs.  So Frank-n-Dodd increases economies of scale in banking, which will favor the big over the small, and encourage the big to get bigger and the small to go away.

In other words, something ostensibly intended to address too big to fail will encourage big banks to get bigger through regulation-induced scale economies. The effect will be the exact opposite of the intent.

The road to hell is paved with good intentions.  Frank-n-Dodd just well may be the world’s largest paving company.

The CFTC voted out two rules today, one on position limits, the other on clearing.  I’ve beaten both issues to a bloody pulp over the last couple of years, so I don’t have too much to add.  Just a couple of high level comments.

Bottom line: Both rules are highly ill-advised.

Regarding position limits, some of the most inane provisions of the original proposal are gone, notably the “class” limits that constrained netting across the futures and OTC swaps.  This was a hidden constraint on market making by dealers, and made no economic sense.  Fortunately it is gone.  Also gone–for the most part–is the conditional spot month limit that treated cash-settled and delivery-settled contracts differently.  This made zero economic sense too, and it is also gone.  The one exception is that there are different limits for cash- and delivery-settled contracts for Henry Hub nat gas.  This makes zero economic sense too, and is a blatant political compromise by the Commission intended to throw a bone to ICE that lost on the conditional limit issue generally.  Laws, sausages–and CFTC rules.

My comment letter on position limits criticized both stricken provisions.  But other provisions I inveighed against, particularly those that constrain ETFs like USO and US Nat Gas funds, remain.

The partisan rancor on this issue came through loud and clear at the meeting, as this piece by Jeremy Grant makes clear.  Jill Sommers and Scott O’Malia were very outspoken:

“We went beyond the statute” by doing things like narrowing the bona fide hedge exemption, Sommers told Reuters. “Those are the things that people can use for a legal challenge.

O’Malia said: “over-reached in interpreting its statutory mandate to set position limits.”  O’Malia also emphasized the lack of empirical evidence of a need for limits, echoing my “No Theory? No Evidence? No Problem!” refrain.

As I was quoted saying in the Reuters piece, this statutory overreaching will be the basis for a legal challenge.  Not just on the hedge exemption issue, but on the more fundamental issue of whether it is necessary for the Commission to find that “excessive speculation” has indeed caused “unwarranted” fluctuations in prices, i.e., the “no evidence” point.  I would not be surprised if the cost-benefit analysis, such as it is, is not challenged as well.

The disappointing guy was Dunn, who blasted the idea of position limits, but voted for them anyways.  Not exactly a profile in courage or conviction by a retiring commissioner.

The other rule would require CCPs to admit firms with a minimum of $50 million in capital.  I think this is a terrible idea.  I understand that CCPs could potentially use excessively onerous admission requirements to reduce competition: hell, I’ve been making that point for well over a decade.  But I also understand that undercapitalized members, and members who cannot contribute constructively to the auctioning of a defaulter’s position, can undermine the effectiveness and even the safety of the clearinghouse.

There is a tension between encouraging competition, and making CCPs secure: Gensler and the majority focused on competition, and I think that is a major mistake, particularly given the fact that the clearing mandate in Dodd-Frank is intended to reduce systemic risk. Micromanaging CCP operations is a horrible, horrible idea.

Grounds for challenge?  Maybe.

No surprises here, really. Gensler is hell-bent on ramrodding through his agenda.  And that’s probably the best way to phrase it: the agenda is pretty bent, and will create some regulatory hell.

This long Zero Hedge post recapitulates William Buiter’s analysis of the leveraged EFSF “bazooka.”  It is a very detailed exposition of why this mechanism is not credible.  As Buiter lays out, it is not credible primarily because it is laden with wrong way risk.  Good object lesson in what can go wrong with a CCP, by the way.

The things I don’t go through for you all.  I forced myself to watch some video of the the King of the Korporatists, Jeff Immelt.  He declares “President Obama has been a great partner.”  No doubt he has.  For Immelt and his ilk.

But that’s just the problem.  The symbiosis between government and particular corporations is the disease, not the cure as Immelt would have it.  It helps the GEs of the world, and the Berkshire Hathaways, and others who have access and who can influence the process.

As Adam Smith pointed out, and as Friedman emphasized repeatedly, there is a difference between supporting the free enterprise system, and supporting particular enterprises–businesses.  Supporting an open access order with a rule of law that treats all equally, or at least strives for that outcome is very different from gaining business support in exchange for some quid pro quo. A vibrant open access order promotes creative destruction–in which the old and established are ruthlessly supplanted by the new and dynamic.  The corporatist order stifles the emergence of the new in order to protect the interests of the old.

A picture is worth 1000 words.  If you want to see the portrait of American corporatism, cast your eyes on the video at about the 10 or 12 second mark.  Left to right: Immelt; Obama; Daley; Trumka.  Not a creator among them.  Rent seekers the lot of them.  That tells you everything you need to know.

In another video, Immelt says “look out for Russia!” (Those aren’t his exact words, but the title on the video.)  That’s what I say too, but definitely not in the way Immelt means it.  Quite the opposite, in fact.  Although he laughs about how tough it is to do business there, I’m sure that is a place where the likes of him can do business.  It is “business” based on political transactions.  That’s what makes Immelt comfortable with Obama, and what should make you uncomfortable with Immelt et al.

It seems like forever ago, but it was only 2010.  That year I wrote about the Citizens United case, in which the Supreme Court established that corporations–like individuals–had speech rights.  The post responded to criticisms of the decision, notably in the Stevens dissent, that cited the Founders trenchant criticism of corporations.  I noted that the corporations that the Founders–and Adam Smith–criticized were a far different thing than the modern corporation.  They were established by the crown–political favors to the politically connected.  They were a part of a “closed order” in which only a select few had access to power and wealth.  I further noted that as John Wallis has pointed out (in his work with North and Weingast on the natural state), the idea of the corporation was fundamentally transformed in the mid-19th century.  In particular, states ceased making corporations special privileges awarded to the few.  Instead, states created an “open order” in which anybody could incorporate.  Corporations in an open access system are fundamentally different than those in a closed access one.

I agree with Professor Bainbridge that in the open order system, corporations have become incredible engines for the creation of wealth.  But that very success has had perverse political economy consequences.  Large, powerful, and wealthy  corporations can undermine the open order, and use their wealth and influence to receive benefits like those conferred by crowns on the corporations they created.  That is, a true open order may be unsustainable.  It bears within it the seeds of its own destruction.

Andrei Shleifer argues that regulation was adopted in the late-19th and 20th centuries precisely because the power of corporations had undermined the independence and impartiality of the courts.  Large corporations could suborn justice, and Progressives believed that the countervailing power of the regulatory state could restrain this process: the view was that the state was harder to suborn than a judge.

But regulation is not immune from being suborned.  Indeed this is the essence of the Chicago/Friedman/Stigler critique of regulation: regardless of its original or stated intentions, regulation typically confers a benefit on a powerful entity, more often than not a corporation or group of corporations. Progressive intentions to tame corporations led to an expansion of government power that was used to benefit them.  The master became servant.

This classical liberal (libertarian) critique is all the more compelling today: corporatism has grown apace with the growth of the power of the state that began in the Progressive era.  The classical liberal/libertarian response to the suborning of the regulatory state is quite straightforward: sharply limit the power of the government to regulate, thereby constraining its ability to confer rewards on the powerful.   As I said in the previous Occupy This post, corporatism requires two to play: corporations and the government.  The libertarian remedy for corporatism is not to constrain corporations in the economic sphere, but to constrain government in its ability to aid corporations (often in the guise of “public interest”).  In the classical liberal/libertarian view, this preserves the open access order, and permits corporations to achieve the economic benefits that Professor Bainbridge lays out so nicely.

But there is a nagging question: are constraints on the power of the state to confer rewards credible?  The economic benefits to concentrated interests from government intervention can be immense.  How is it possible to constrain credibility the ability of these interests to “buy” these benefits from politicians and regulators?  They are willing to pay so much, and the diffuse interests who are victimized cannot outbid them: politicians go to the highest bidder. Is it possible to prevent the auction from occurring at all?

A Stigler, or a Mancur Olson, would probably say no: it is like trying to prevent water from flowing downhill.  It will work relentlessly, and eventually erode or circumvent anything in its way.  There is not a political system that empowers the government to provide public goods or to exercise police powers that is immune to having those powers seized by rent seekers.

So what is the alternative?  Increasing government powers–the Progressive/progressive/Occupy This prescription–is completely counterproductive.  The idea of the state as countervailing power is completely chimerical, because the state is suborned by private interest: increasing its powers will only exacerbate the problems of corporatism.  A Constitution of Liberty (to appropriate Hayek’s phrase) is attractive, but likely unsustainable.

So what is a practical political program?  Perhaps the only real alternative is to wage a continuing war against the ceaseless action of the waves, like the Dutch battling the seas with their dykes and dams, knowing that some water will seep through, and that sometimes the dykes will give way.  A Constitution of Liberty is a leaky bulwark, but it is better than the alternative: to follow the progressive prescription would be to open the sluices, unleashing the deluge.

Not a happy conclusion, but methinks a soberly realistic one.

Update.  Here’s another way to state this.  I pretty much agree with Mark Pennington’s defense of classical liberalism against “market failure” arguments, communitarianism, and egalitarianism.  I am skeptical, however, about the real prospects for a “robust political economy” (the title of his book) on classical liberal lines.

The Occupy [Insert Location Here] crowd has to be the most inarticulate, inchoate, and incoherent protest movement in history.  A decidedly motley collection of progressive types, heavily laden with aging Boomers pining for their Glory Days of the ’60s protests and younger clueless wannabes.  Hard-core leftists are disproportionately represented.  Its basic messages, to the extent that it is possible to distill any, are that banks are bad and people should get more free stuff paid for by The Rich 1 Percent. The cluelessness about the way this stuff is actually created is breathtaking.

There is definitely reason to criticize and protest the unseemly nexus between business (and finance particularly) and government, but for the most part the #OWS types seem to be completely unaware of the fact that their calls to enhance government power will only strengthen and deepen the nexus.   Corporatism needs two players: corporations and the government.  Because of its monomaniacal focus on corporations, and its call for increasing the power of government, if it were actually to succeed Occupy Whatever would actually bolster the corporatism its members deplore.  Libertarian and even anarchist criticisms of the prevailing system are largely coherent and internally consistent: Occupy is notable for the complete disconnect between its diagnosis and proposed cure.

What is most interesting is that the entire Obama administration–starting at the top–is aligning itself  with this movement.  The Washington Post reports that “President Obama and his team have decided to turn public anger at Wall Street into a central tenet of their reelection strategy.” But this is particularly cynical, given the joined-at-the-hip relationship between the administration between the administration and companies like GE and Monsanto.

Moreover, key figures in the administration have come out and expressed their sympathies with the movement.

Figures like Timmy! Geithner. You know, the former head of the NY Fed, which just happens to be deeply enmeshed in the Wall Street banking establishment which Occupy identifies as the locus of evil in the universe, and formerly of the IMF, which is also a linchpin in the current finance-government web. 

Or like Bill Daley, Chicago corruptocrat extraordinare, famous intermediary between big corporations (like JP Morgan and SBC and Merck and Fannie Mae) and the government: note well that his corporate jobs have been with companies that are heavily regulated.  Not a creator.  A rent seeker: the operator of a protection racket.

One’s jaw drops at the chutzpah of people like Daley and Geithner going all populist given that they are made men in the corporatist system.  They are avatars of the incestuous relationship between government and government regulated corporations.

So what explains Obama’s decision to align himself with such a cretinous assemblage?  I can think of several, not mutually exclusive, alternatives:

• Given the objective economic conditions, Obama feels desperate politically, and knows that he cannot win using a conventional campaign.  So he is throwing in with a disruptive force that could upset conventional political dynamics and calculations.  A go-for-broke, put himself at the head of the mob strategy.  These strategies can work, but they are very risky–and often end up devouring the would-be leaders–for once destablizing forces are unleashed, they are extremely difficult to control. [Update: I note that the pivotal moment in Obama’s 2008 victory was the Lehman collapse and subsequent panic. He was fading before that, but the crisis propelled him to victory.   He benefited from chaos in 2008: why not create his own in 2011-2012?]
• A realization that the ultimate result of a success of this movement would be to strengthen the government’s power–and not coincidentally strengthen the corporatism from which the Daleys etc. profit.
• A recognition that this is a way to shakedown Wall Street for campaign contributions which have been less forthcoming than in 2008.  Remember Obama’s “my administration is the only thing standing between you and the pitchforks” remark in 2009?   Translated: pay up or I’ll get out of the way.

2012 was already shaping up to be an ugly and angry campaign.  By going all in for a class warfare, us against them, strategy, Obama is making it all the uglier.  One interpretation is that he is choosing the Sampson option:  If I go down, I’ll bring everything down with me.

There will be immediate economic consequences of this as well.  Just as FDR’s attacks against “malefactors of great wealth” contributed to the regime uncertainty that retarded recovery in the Great Depression, Obama’s strategy will contribute to intense volatility over the next 13 months, and this volatility will hardly be conducive to hiring and investment.

For the past three years, I’ve wondered aloud whether we are going to relive the ’70s or the ’30s.  It’s looking more like the ’30s all the time.  And as bad as the ’70s were, that’s not a good thing.

Update.  UH student Steven Ray Christopher wrote a very similar analysis in the Daily Cougar last week.  Very nicely done: give Steve’s piece a read.

Igor Yurgens discusses what Russia needs to do to address its capital flight:

Although the Russian economy is the 10th largest in the world, it is regulated in a way that does not suit investors’ preferences. That is why the regulation issue outweighs the potential advantages that a speculative portfolio investor could have given the high oil prices we’re seeing. In addition, in order to attract short-term direct investment, the country needs investors to be confident in their future, property rights, simple relations with the state, as well as a number of investment factors. We lack some of them, like a predictable tax burden. The absence of quality human capital and skilled labor has also depressed investment.

Investors seek more politically stable havens and financial markets in periods of panic or plain old anxiety. Nor do investors enter a market until they completely understand the country’s foreign investment strategy.

Do you think that the capital outflow we’ve seen since the beginning of the year can give way to capital inflow?

Yes, once all the factors I mentioned change, once Russia becomes investment-friendly for both domestic and foreign investors, once we carry out a sort of regulatory revolution, and neither small or medium-sized businesses are assaulted by law enforcement and raiders.

In other words, pretty much everything must change.  Things that have remained largely unchanged for 20 years.  The prospects for a “regulatory revolution” that protected property rights and stamped out raiding were dim enough under Medvedev’s presidency, and while there was a chance that he might actually proceed with something resembling modernization: these return of Putin–who has never shown the slightest interest in any of these things, and who has actually worked against them in crucial instances–means that the prospects are now non-existent.

So if Yurgens has in fact identified the necessary conditions for vibrant foreign and domestic investment in Russia–and his list is a reasonable one–the only conclusion is that the prospects for vibrant foreign and domestic investment in Russia are pretty much non-existent.