Streetwise Professor

There have been several articles over the last couple of days regarding the implications of the CFTC’s and SEC’s inability to write the rules necessary to implement Dodd-Frank.  In a nutshell, Dodd-Frank repeals the Commodity Futures Modernization Act, which gave legal certainty to swaps.  When Dodd-Frank goes into effect, if the rules are not in place–a near inevitability–losing participants in derivatives deals–and remember boys and girls, there will be one in every deal!–may attempt to escape their losing OTC derivatives trades by claiming that the agreements are illegal off-exchange futures.

The CFTC’s Gary Gensler says “trust me on this.”  I’m with the WSJ on this one:

Commodity Futures Trading Commission Chairman Gary Gensler says his agency and the Securities and Exchange Commission are working on clarifications to guide derivatives markets for the period between July 16 and whenever regulators decide on new rules. He promises to post something on the CFTC website soon.

But not everyone is convinced that Gary’s web posting is going to defuse the bureaucratic bomb that Chris and Barney have programmed to detonate next month. Mr. Gensler can’t prevent private lawsuits if the law becomes murky. It doesn’t take too much imagination to see trial lawyers trolling the ranks of underachieving municipal finance officials who might want a do-over after some bad derivatives bets. We could immediately be talking about real money.

In other words, a CFTC web posting or Gary Gensler writing on his Facebook wall (and no, he hasn’t friended me!) or Tweeting that it’s all cool (and no, he doesn’t follow me nor I him!) of whatever won’t deter firms with big losses from taking a punt on a lawsuit.  Even if, in the end such lawsuits go nowhere, (a) uncertainty about this will chill some business, and (b) legal costs will be appreciable.

In other words, this is just another big screw up.  And it’s merely a procedural screw up–a problem that Congress in its infinite wisdom (for those who come for the sarcasm–there you go!) could have anticipated and addressed.  We haven’t even gotten to the potential substantive screw ups.  Screw ups that the financial world is now viewing with growing alarm.  People are starting to recognize that the unintended substantive consequences of Dodd-Frank–e.g., making CCPs too big to fail entities, the liquidity impacts of clearing mandates, to name just two of the biggies–could be the source of the next crisis.

So, as we venture into this brave new world, folks, don’t forget who brought the broomsticks to life but couldn’t control them:

At the Chicago Fed’s Financial Market Working Group meeting Tuesday afternoon–which included a very interesting talk about derivative collateralization by Mike Clark of UBS and ISDA.

No grass growing under my feet, I’m now in Lisbon for a commodities conference and some vacation, then off to London for some additional travel and another conference.

BP continues to maintain that the tie-up with Rosneft is just resting. But the Kremlin says that the deal is dead and will not be resurrected.

“The deal became a drag” in its previous form, Shmatko told reporters today in Moscow. “I don’t believe in the possibility of reincarnation for that particular deal.”

It is, in other words, a passed parrot.

The only real question is why, and in particular, why Sechin wasn’t able to pull it off–or perhaps more accurately, why Putin pulled the rug on Sechin. On those lines, I suggest you all check out Pahoben’s comment on the previous post (Igor Pyle). He provides additional detail as to why it is risible for Sechin or Putin or anybody else to claim “Surprise, surprise, surprise” at the TNK-BP shareholder agreement, and presents some plausible conjectures as to what killed this particular parrot.

Bart Chilton has been bolstering his case for position limits by touting a statistic that the amount of speculation in energy markets has increased by 64 percent since 2008. Several people sent me this very interesting deconstruction of Chilton’s number:

Critics say Chilton’s claim is grossly misleading for three reasons. [Emphasis added.]

First, the primary reason for the rise in futures-equivalent holdings was a collapse in natural gas prices, which fell 65% from June 2008 to January 2011 (see pie chart below on contributions to the rise in futures-equivalent index holdings).  Due to the price collapse, for a given notional value of natural gas exposure, more contracts are required now than in 2008.  But the dollar value of holdings did not rise per se.

Second, futures-equivalent does not represent open interest in futures markets, as some of the exposure index players have is netted against internal positions and therefore does not reflect open interest on futures markets.

Third, the notional value of index energy exposure, or the dollar amount on which periodic payments are calculated, shows holdings were 10% lower in January 2011 than in June 2008.  And among the energy contracts, only gasoline showed a notional increase.

Let’s break this down.  Chilton wants to exploit the recent rise in oil and gasoline prices to fuel (pun intended) his campaign for position limits.  He therefore needs to show, somehow, that speculation increased, driving the price increase.  But net long speculation in oil and refined products declined in dollar terms.  Futures equivalents increased somewhat (about 30 percent for crude).   But natural gas futures equivalents rose dramatically–186 percent–even though due to the collapse in gas prices the net dollar investment in natural gas declined 7 percent.  The dollar number doesn’t help to make his point for the crude complex.  The crude complex contract number doesn’t make a big point. So he combines contract positions for natural gas and the crude complex, and ties it to the recent rise in oil prices:

Hemingway said, if you really want to write, start with one true sentence, and from that sentence, you can form your opinion of the truth. Well, here is one true sentence: We have more speculative positions in commodities markets than we have ever had in the past—in fact, they are up 64 percent in the energy complex from June of 2008. You can draw your opinion of the truth, your own conclusions as to whether there is a cause-and-effect—looking at the price trends as these investors enter and exit markets. Read the studies, on both sides of the issue, and draw your own conclusions.

As for the tie:

I’ve said several times that I don’t think these investors are the cruise control of prices, but I do think they tap the gas pedal. I think they can have some effect on driving prices up when they are long in the markets, and I believe they can have some effect on declining prices when they exit.

Note how far Chilton has to stretch to get his headline-grabbing 64 percent number–he has to add in natural gas positions.  Yet he fails to mention that natural gas prices have fallen dramatically–65 percent!–over the period that what he portrays as a speculative splurge has occurred; doing so would completely undercut the “truth” he is trying to reveal.

It makes no sense whatsoever to lump natural gas and crude oil and refined products together.

Well, it makes no sense if you are trying to make a logical argument, and to support the argument by reference to legitimate empirical evidence.  It makes all the sense in the world if the true objective is to confuse the rubes with some sleight of hand.  Where’s the red lady?  (In the day, it was the black lady–maybe that’s not PC any more.)

As for me, I’m still waiting for that “one true sentence.”  That self-righteous reference to Hemingway only adds insult to deception.

Today it was the WSJ’s turn to run a long piece on the BP-Rosneft-AAR fiasco.  There’s nothing really new here.  But it is interesting to see the Russian spin–spin that makes more plausible the interpretation that BP was played all along..  A few samples:

The Rosneft deal was negotiated personally by Igor Sechin, a key ally of Mr. Putin and chairman of Rosneft, and publicly blessed by Mr. Putin. But when the tycoons complained about the new venture, the Kremlin didn’t shut them down. People close to AAR say they checked every major move against BP with President Dmitry Medvedev and Mr. Putin.

. . . .

A Kremlin spokesman declined to comment, saying the matter was one for the prime minister’s office. Dmitry Peskov, Mr. Putin’s spokesman, confirmed the prime minister discussed AAR’s plans to challenge the deal with Mr. Fridman in late January. “The government has neither the right nor the intention to intervene,” he said.

. . . .

Mr. Sechin had also warned BP’s Russian partners that an agreement was in the works. When Mr. Dudley met Mr. Fridman that evening, the Russian tycoon already knew of the planned meeting with Mr. Putin.

. . . .

Mr. Putin received the BP and Rosneft executives the next day at his official residence outside Moscow. Amid congratulations, he made his warning about the limits of Kremlin control. Mr. Putin’s spokesman said the comment was meant as a general one, not specific to BP’s partners.

So, Sechin is keeping AAR informed of his big deal.  Putin then, and his spokesman now, signal that their hands are tied.

Yeah, right.  The fact is that Putin has myriad levers to pull–if he wants to.  That’s what BP was counting on.  He is deciding, deliberately, purposefully, not to pull them.  It’s not a question of “can’t”: it’s a question of “won’t.”  Why won’t he?  A newfound fondness for contractual rights?  No, seriously.

Don’t buy the story that Putin’s hands are tied.  People should really be trying to figure out why he’s trying so hard to convince the world that’s so.  That’s the real story.  The real mystery.

Meanwhile, the clock is ticking on BP to salvage the deal.  Here, “salvage” means: “pay their reservation price, leaving all the benefit in Russian hands, and crumbs–at best–in its shareholders’ hands.”

BP has until Wednesday to make a deal with AAR.  This reminds me of a story about a former colleague, now passed, sadly.  He’d totaled a car in an accident, and needed to buy a new one stat to take his family on a long planned vacation.  So he walks into the dealer and says: this is the car I want, and I need it by noon today.

Needless to say, he paid sticker.

BP’s Dudley could only wish he’s bargaining with a car salesman.  The whole world knows his bargaining position–or lack thereof.  The only plausible cover he has in dealing with AAR is to claim he can’t take too bad a deal or his shareholders will revolt.  But he and the board are so invested in the Rosneft deal that the credibility of that representation is pretty thin.  So Fridman et al have nearly carte blanche to name their own price. Somehow I don’t think they’ll need William Shatner to provide instructions.

The Journal article reports one BP insider’s take on the situation: “We’re kind of in a predicament.”

You don’t say.  Wow.  I wonder how much that guy gets paid to come up with such blinding insights.

There are additional calls for Robert Gates to resign, including here at CFR (a post by Elliott Abrams) and here at Information Dissemination (a good Navy blog).  The argument is the conventional one.  Gates is undermining the authority of the elected commander-in-chief.  QED.

Understandable and understood.  But Gates knows this.  He is no MacArthur.  He has been a very conventional, very loyal, civil servant for over 30 years.  He is more apparatchik than maverick.  He has never gone off the reservation.  Never.  He would, no doubt, agree with the conventional arguments–in conventional circumstances.

But by applying conventional templates to Gates’s behavior, his critics are completely overlooking the fact that when such a conventional man does something so uncharacteristic, there are reasons–and the reasons are likely to be quite disturbing.  I can conjecture what those reasons are, but that’s not really my point here.  Instead, the point is that the critics should take note of the extraordinary nature of what Gates has said, and try to determine why he said it.  What is going on behind the scenes that would compel Gates to do something that you have to know he would agree would be a firing offense in normal times?

The analogy that comes to my mind is that of US Navy Commander Jeremiah Denton, who blinked out “T-O-R-T-U-R-E” in Morse Code when being questioned by his North Vietnamese captors in 1966. Like Denton, Gates is signaling that something very wrong is going on off camera.

Update: If, as is plausible, this New Republic explication (by Steven Metz) of the alleged logic behind the administration’s policy is correct, then Gates’s insurrection is quite understandable:

Clearly the Obama strategy is designed to find the middle ground between disengagement and domination. The idea seems to be to maximize flexibility by keeping all options open as long as possible. This is a good idea in a highly fluid situation. [Yes, keeping options open is sensible–but the essence of military force is imposing your choices on the enemy, and denying him options.]

. . . .

In a broader sense, President Obama is struggling to transcend American history. For two centuries, Americans have believed that any use of military power is war, and the objective in war is victory over the enemy. They have little tolerance for military operations that deviate from this pattern, such as the limited use of force in support of diplomacy or armed action leading to something other than decisive victory. [That’s Jacksonian America.]  After a foray into “limited war” from Korea to Vietnam, the United States walked away from the idea. What became known as the Weinberger-Powell principles argued that the U.S. military should never be committed unless vital interests are at stake—and then, only with the intention of clear victory. This became inculcated into the American strategic culture. And, since World War II, Americans have also come to expect that the United States will dominate any military operations in which it participates. The normal state of affairs, Americans believe, is for the United States to be is the senior partner in a coalition.

The Obama strategy represents a step away from the Weinberger-Powell principles and the notion that the United States must dominate any operation where its military is involved. Whether it works will be determined by the unpredictable whims of Muammar Qaddafi, the willingness of other states to take some or all of the burden off of America’s hands, and the president’s ability to sell the American public and its elected leaders on a strategy that runs counter to their tradition and inclinations. While Obama’s Libya strategy has a distinct logic, its success thus remains in the balance.  [We are ceding the initiative to Khaddafy?  This is a good thing? Really?  This is a “strategy”?]

“After a foray into ‘limited war’ from Korea to Viet Nam.”  Seriously.  Metz wrote that.  Thirty-five years and 100,000 dead Americans is a “foray”?

Here’s another way to put it: the Obama administration isn’t “transcending American history.”  It is failing to learn from it.  It is revisiting the failed policies of the past–as even it’s own defenders (e.g., Metz) are admitting, but claiming it is a feature not a bug.  It is doing its best to prove Marx right, re-enacting a tragedy as a farce.

Metz’s interpretation makes Obama’s policy appear very post-modern, making military action and victory and defeat all matters of semantics.  Post-modernism is heavy on the irony, and that’s here too as well.  For this administration–and its defenders–is chock-full of people who were strident in their criticism of the Viet Nam “foray”.

Weinberger-Powell was a reaction to Viet Nam.  It was the product of the military’s agonizing appraisal of what had gone wrong and how to avoid the repetition of these errors.  By casting Weinberger-Powell aside–consciously, if Metz is to be believed–Obama runs the grave risk of making the same mistakes that gave rise to it.  Gates is likely representing the views of the uniformed military that are grounded in this appraisal of Viet Nam, as updated and reinforced by the experiences in Iraq.  That is, most likely, the root of the SecDef’s insurrection.

I wrote my Regulation piece expressing skepticism at arguments blaming speculation for commodity price spikes–“No Theory? No Evidence? No Problem!“–with the US Congress and certain folks at the CFTC in mind.   But commodity Know-Nothingism has gone global.

French President Sarkozy and European Commissioner Michael Barnier have both been demonizing speculation of late, and placing blame for recent commodity price spikes on speculators.  Sarkozy has announced that controlling commodity speculation will be one of his priorities during his chairmanship of the G20, and Barnier has been right behind him giving his full support.

And in carrying out their vendetta, Sarkozy and Barnier are doing a Gallic imitation of Alphonso Bedoya: “We don’t need to show you any steekin’ evidence!”

Indeed, Sarkozy and Barnier are pointedly and almost mockingly ignoring the evidence:

So it is quite a surprise to find the European Commission has censored its own research into food prices under pressure from President Sarkozy. As Andrew Peaple discussed in a Heard column last week, there is no evidence speculation is responsible for the current high food prices. A new E.U. study came to exactly the same conclusion, finding no evidence of “a correlation between the substantial increase in index fund positions and commodity futures prices.” But curiously, the draft report containing this conclusion was first delayed and then finally published today with the offending sentence removed.

Mr. Sarkozy has admirably decided to make tackling high food prices a priority for France’s presidency of the G20 this year. Less admirably, he has clearly already made up his mind to blame speculators regardless of the evidence. As my Dow Jones colleague Caroline Henshaw reports, he even joked about this at a press conference last month saying: “I will recommend a date for the publication of a study showing that speculation does not result in global price rises of raw materials: 1 April.”

In the end, Mr. Sarkozy didn’t need to delay publication because he had an ally in Michael Barnier, the French European Commissioner in charge of markets regulation who saw to it the report contained no mention of speculators either good or bad, thereby ensuring Mr. Sarkozy wasn’t embarassed. Mr. Barnier bizarrely then went on to tell the post-publication press conference that: “Agricultural products are turning into financial assets, which is why we want to share with you our concern about this,” ignoring the fact his own directorate’s report expressed no such concern.

“Don’t bother me with the facts” is not a recipe for good policy. But that probably doesn’t bother Sarkozy and Barnier (and their fellow travelers) because this is about the politics rather than the policy. There is a major problem–spiking commodity prices. Their are no policy tools at hand that will truly address the problem–or those that would have an impact are out of Sarkozy’s hands (and in Ben Bernanke’s), or are politically unpalatable (e.g., reforming EU agriculture, or eliminating ethanol subsidies).

So Sarkozy does the policy equivalent of kicking the dog after a bad day. It does nothing, but it makes him feel better. Or something.

More to the point, it is a demagogic tactic that has wide appeal and resonance.

And it won’t create an additional kernel of corn or drop of oil. Nor will it affect the demand for either. So it won’t have any effect on price. Moreover, by focusing on a non-issue, it distracts attention from devising practical, effective policies.

Sarkozy is one of the most difficult national leaders to peg. He is insightful and cunningly realistic on some issues, and foolish and demagogic on others.

But perhaps not so difficult: you just need to know the code.

Though of Hungarian origin, he is in many ways quintessentially French (perhaps not surprising as this is necessary to get to the top of the French political ladder). On foreign policy matters he is unromantic and realistic and pretty ruthless in his pursuit of French–not European–interests. On matters relating to markets, he is not a socialist, but he is definitely French in his deep suspicion of markets and his fondness for dirigisme. His anti-speculation fulminations are a manifestation of this.

Whatever the origin, the Sarkozy-Barnier approach is intellectually bankrupt. The almost smirking refusal to consider seriously the evidence–indeed, the open willingness to suppress evidence–makes that plain. And makes it plain that they really don’t give a damn.

Today the CFTC voted out its position limit proposal for public comment.  Even though the vote was 4-1 (with Jill Sommers the lone nay), the ultimate fate of the initiative is still in doubt.  Indeed, its fate is even cloudier that previously thought.  That’s because of the most newsworthy aspect of today’s meeting: Commissioner Michael Dunn expressed skepticism about the need for limits.

This is newsworthy because (a) Dunn is a Democrat who is widely viewed as a swing vote on the Commission, but more importantly (b) is (as Reuters correspondents  Roberta Rampton and Sarah Lynch put it) a “circumspect senior commissioner who rarely airs his personal views in public.”

Dunn has a very, very solid basis for his skepticism.  Indeed, he echoed a theme I have hammered on for a long time: the lack of any evidence that speculation has actually distorted prices:

An important swing vote on the five-member Commodity Futures Trading Commission expressed skepticism about whether curbs on their trades would prevent a large run-up in prices.
. . . .

“To date, CFTC staff has been unable to find any reliable economic analysis to support either the contention that excessive speculation is affecting the markets we regulate or that position limits will prevent excessive
speculation.

“The test then is for the CFTC staff to determine whether position limits are appropriate. With such a lack of concrete evidence, my fear is that, at best, position limits are a cure for a disease that does not exist or at worst,
a placebo for one that does.”
. . . .

“If there is more than anecdotal evidence that there is excessive speculation distorting the prices in our markets, we need to see it. If there is statistical or economic analysis that shows that excessive speculation exists and that position limits will lower the price that we pay for gas, milk and steak … we need to see it.”

“Only after all these questions have been answered will I be able to determine whether or not position limits are appropriate.”

Nothing to criticize (a shocker, I’m sure): Nothing much to add.  I have pointed out repeatedly that the theoretical and empirical basis for the proposition that speculation has distorted prices is lacking (as suggested by the title of my piece on limits in Regulation: “No Theory? No Evidence? No Problem!“) So it’s encouraging to see Commissioner Dunn see that the lack of evidence is indeed a problem. It’s particularly encouraging to see him do so on a day when a group of eight senators put out an evidence-free statement demanding that the commission act to impose limits.

If actual, you know, evidence and data demonstrating the distortive effects of speculation asserted by the senators is required for position limits to move forward, they ain’t moving forward.

And speaking of not moving forward (yet, anyways), the rule limiting ownership and regulating governance of contract markets, SEFs, and clearinghouses was not put to a vote today, as had been anticipated.  There are apparently deep divisions within the commission, with some thinking what’s currently on offer goes too far, and others, not far enough.  These restrictions could have even more pernicious effects than position limits, so I can only hope that they too do not advance.

The CFTC’s Proposed Rule on Core Principles for Designated Contract Markets (DCMs) contains something that has escaped comment (but not the sharp eyes of Jerry, who brought it to my attention).

Specifically, it states:

A DCM can satisfy the requirement that membership and participation criteria are impartial, transparent, and non-discriminatory by establishing clear and impartial guidelines and procedures for granting access  to its facilities and publishing such guidelines and procedures on its Web site. Such requirements may  establish different categories of market participants, but may not discriminate within a particular category. Fee structures may differ among categories if such fee structures are reasonably related to the cost of providing access or services to a particular category. For example, if a certain category requires greater information technology or administrative expenses on the part of the DCM, then a DCM may recoup those costs in establishing fees for that category of member or market participant (p. 80579, emphasis added).

So, it appears the CFTC is adopting its own version of net neutrality for DCMs (exchanges, in everyday, non-legalese parlance).  Specifically, it is asserting regulatory authority over the pricing of exchange services.  Just like the FCC’s net neutrality rule (as proposed) would regulate the terms on which the operators of internet services can offer and price access to their systems, the CFTC’s access principle (Core Principle Two) imposes constraints on the terms on which operators of exchanges can offer access to their trading facilities.

The principle is that (a) within a category of users, all must be offered access on the same terms at the same prices, and (b) across categories, access fees can differ on a cost basis.

On an intellectual level, this demonstrates yet again a point I’ve harped about for years: financial markets, especially electronic ones, raise many of the same issues that have been staples of analysis, argument, and regulation for years in what are traditionally considered network industries, such as telecoms and electricity transmission.  (A point that will be one of the themes in my next book, tentatively titled Market Macrostructure: The Organization of Securities and Derivatives Markets.)   Financial regulators are just waking up to that fact, but unfortunately all too often it appears that they are reinventing the wheel, and not taking advantage of all the work that has been done on network industry pricing and regulation.

On a practical level, this is yet another troubling example of the expansion of the CFTC’s authority.  It is becoming the new regulatory Blob*.  Its capacity and competence are already challenged by its existing responsibilities.  Dodd-Frank added massive new ones, and here the agency is claiming even more.

The experience in network industries is that regulating access prices is beset by conceptual difficulties, impeded by the lack of data to quantify cost differences, and mired in politics and rent seeking.  Some regulatory agencies, notably the FCC and FERC, have developed vast apparatuses to deal with these complications.  In contrast, CFTC has no real experience in this area.  It is miles away from its normal bailiwick.  There is no reason whatsoever to believe that it has the competence to regulate the pricing of access services.  Yes, it allows cost based differences, but pray tell what expertise does the agency have to measure these cost differences?  And with the proliferation of SEFs, which will almost certainly be subject to similar constraints at some future date, just think of all the disputes that could arise.

Even beyond the issue of competence and resources, the proposed rule poses conceptual difficulties.  Any system of categorizing users will result in heterogeneity within categories.  Due to this heterogeneity, some customers within a category will be costlier to serve than others in the same category.  The proposed rule would suppress any price differences across entities in a particular category.  Which will mean that those subject to the regulation will attempt to create more, narrower categories.  Which will mean that these decisions will likely be subject to legal challenge.

On the other hand, lawyers will be happy.

One other quick comment on the Core Principles rulemaking.  To show that a derivatives contract that can be settled by delivery is not subject to manipulation, the Commission requires a DCM to ensure the deliverable supply for the contract is adequate.  This makes sense as a means of reducing the frequency of market power manipulation.  In contrast, the criteria that the Commission uses to determine whether cash-settled contracts are subject to manipulation does not impose any requirements relating to deliverable supply.

You might say: of course not!  Because there’s no delivery, you don’t need to worry about a delivery squeeze.  But you’d be wrong.  As I show in my 2000 JOB piece on manipulation of cash-settled derivatives contracts, one can manipulate a cash-settled derivatives contract by buying or selling large quantities of the physical in the cash market.  Indeed, the very same factors that determine the susceptibility of a delivery settled contract to a squeeze or corner determine the susceptibility of a cash-settled contract on that commodity to manipulation by buying or selling large quantities of the physical commodities used to determine the settlement price.  Thus, the size of the cash market, deliverable supply if you will, is relevant for these contracts as well.

Appendix C of the Proposed Rule does mention the “size and liquidity of the cash market” and “the volume of cash
market transactions and/or the number of participants contacted in determining the cash-settlement price” but these don’t get at the kind of manipulation I discuss in the JOB piece.  Particularly, the volume of cash market transactions doesn’t correspond even remotely to the relevant measure of the size of the deliverable supply.  I would also note that whereas CFTC goes into great detail prescribing what DCOs must do to document that the deliverable supply for a delivery-settled contract is adequate, it imposes no comparable requirement for cash-settled ones.

Instead, the appendix focuses on manipulations that could arise from false reports, or settlement indices based on a small number of cash market transactions.  These are relevant to the susceptibility of a cash-settled contract to one kind of manipulation, but are irrelevant to determining its susceptibility to market power manipulation, where the market power is exercised in the cash market.

A small point, perhaps.  But given that manipulation is an offense that has been under the CFTC’s jurisdiction, or that of its predecessor agencies since 1922, and which has in fact been its primary responsibility since that date, it does raise questions about the agency’s qualifications to regulate new, arcane, and inherently complex areas, such as the pricing of access.

Beware the Blob.

* Steve McQueen is one of my favorites.  A hero to sinewy blond guys everywhere.  I also like this:

The Khodorkovsky verdict was announced Monday.  I don’t have much to say about the verdict itself that hasn’t been said already.  What I do find interesting is the Russian response to the near-universal foreign criticism of the outcome of the “trial.” 

Specifically, Foreign Minister Sergei (“The Spider”) Lavrov scuttled out to tell everybody (foreign everybodies in particular) to mind their own business.

Be careful what you ask for, Sergei, because as a result of the verdict, and the conditions that it epitomizes, foreign investors will be minding their own businesses thank you very much, and will be minding it somewhere other than in Russia–or at least not at the scale that the apparent opportunities would seem to justify. 

Yes, there will be exceptions, especially in retail and consumer products (as in the Pepsi deal for Wimm-Dann).  But even there the recent decision of Walmart to abandon plans for Russia, and the ongoing IKEA saga, demonstrate the trepidations that even heavy hitters have about investing in Russian retail/consumer markets.  Similarly, just because a politically connected behemoth like GE thinks that it has the heft and the influence to navigate the treacherous shoals of Putinland don’t conclude that others less hefty and less influential will have the same confidence.  Pepsi and GE are more the newsworthy exception than the unremarkable rule. 

And far more importantly, many Russians will conclude that minding a business is not worth the risks.  The Khodorkovsky prosecution, with its attendant absurdities, symbolizes quite graphically the arbitrariness of the system and the contingency of wealth and ownership in Russia.  This is a country where Putin has a call option on a business or a share of its profits; and where Putin deems a business to be unworthy of his attention, some local satrap has the call option.  And so it goes down the line, with the smaller the business, the smaller the thug (or thugs) with an option over the action.  But in the land of the raiders, every entrepreneur knows that his/her hard work–and his/her freedom or his/her life–is at risk to the depredations of some official or some mafiosi (to the extent that these are distinct classes, which too often they are not). 

The low rate of entrepreneurship and business formation in Russia is well known.  The reasons for it are not hard to find.  The Khodorkovsky saga is just the most notorious, larger-than-life, epitomization of a systemic problem.

It should be recognized, though, that this systemic problem is not easily addressed, because its roots are not merely political but cultural and historical: put differently, the political system is consistent with, rather than antithetical to, the beliefs of large numbers of Russians.  If there is anything to Deirdre McCloskey’s “Bourgeois Dignity” hypothesis–and I think there is, although I am not totally convinced–Russia is not fertile soil for modernization because of the widespread hostility towards entrepreneurial–“bourgeois”–values and enterprise. 

Indeed, Russia is McCloskey’s poster child for anti-bourgeois hostility and its corrosive effects on economic growth.  (McCloskey, nee Donald, I might add, was a student of Russian-born Alexander Gerschenkron at Harvard.)  This is not a new thing, but a very old thing, and hence quite difficult to change.

McCloskey points out that historically it was the outcast Old Believers that made up the bulk of the entrepreneurial class in Russia, to the extent it existed at all (and that many of the rest were Jews, also outcast).  Se further points to the zero-sum mindset that is characteristically Russian (and if you have doubts about that look at Russian foreign policy which oozes this mindset).  It is (was) widely believed in Russia that if anyone makes money, he made it by theft.  (Not that such beliefs are alien elsewhere, just that they are modal in Russia.) 

Sadly, there are many examples that support that belief.  (Arguably, Khodorkovsky himself for one, once upon a time.)  But that’s just a manifestation of a vicious circle, in McCloskey’s view.  To her, the cultural devaluation of bourgeois striving gives rise to a sort of Gresham’s Law, whereby the bad actors drive out the good.  If it is widely held that no respectable person goes into commerce, no respectable person will go into commerce.  Only a change in values–or the value placed on commercial activity–can make it possible to escape this fixed point.

So yes, the Khodorkovsky verdict is a bad omen.  But if McCloskey is right–and again, I think there’s a lot to what she has to say–Russia’s deeper challenges in achieving modernization would still remain even in the highly unlikely event that Medvedev were to rebel against the system that created him, realize his airy words about modernization and the ill effects of legal nihilism, and pardon Khodorkovsky tomorrow.  The Russian government and the Putin system are consonant with a set of beliefs that is deeply suspicious of people who mind their own businesses.  This set of beliefs is broadly held and long-established.  The system reinforces the beliefs and the beliefs reinforce the system.  This results in an equilibrium that will be hard to change, at least anytime soon.