Streetwise Professor

Peter Klein and his colleagues at the excellent blog Organizations and Markets have graciously invited me to guest blog, and cross-post here.  Here’s the O&M link, and here’s the piece:

On the Border*

This is my inaugural post as guest blogger here at O&M.  I am grateful for the opportunity.

In his very gracious introduction, Peter Klein noted that my research is at the border of finance and industrial organization.  Quite true (and indeed, “borderer” is a good description of me overall.)

That border is very, very busy today.  Indeed, so much is happening there that it is difficult to keep up.  In the aftermath of the financial crisis, Congress and regulators are beavering away on laws and regulations that will completely reshape the organization and regulation of financial markets, and especially of the area of particular interest to me–derivatives.

I anticipate that many of my O&M blog posts will explore these issues, but I’ll start with something very topical.  Senator Chris Dodd just yesterday heaved up a 1136 page proposed financial regulation bill, and one proposal that is attracting considerable attention is his plan to consolidate banking regulators.  Dodd is not alone in thinking along these lines.  Even before the financial crisis, there were myriad proposals to consolidate various regulators, such as the Securities and Exchange Commission and the Commodity Futures Trading Commission.  These have only gained in popularity in light of the crisis.

In the modern financial markets, firms are big and complex, and operate in many markets (defined geographically, or by product).  It is difficult to fit a big financial firm into any box.  A Goldman Sachs deals in the securities markets and the derivatives markets.  So it doesn’t fit comfortably in a securities box, or a derivatives box, so in the current system for regulatory purposes the firm is split into pieces, some of which are put into the securities box and others into the derivatives box (and there are many other boxes too for a big firm like Goldman).

This leads to potential for conflicting regulations, jurisdictional disputes, regulatory arbitrage, and other problems.  So, the Dodd proposal–and most of the other consolidation proposals–advocate creating really big boxes, and in the extreme, one big box that regulates everything a financial firm does.

The problems of the seen are well known (though arguably exaggerated).  What concerns me are the largely unexamined problems of the as yet unseen big box alternative.

Economic theory can shed some light on these problems.  Specifically, any government agency multitasks.  The CFTC, for instance, regulates the financial health of futures brokerages and polices market manipulation.  The more expansive the agency, the more tasks it will perform.  Thus, regulatory consolidation exacerbates multi-tasking problems.

Moreover, any agency has multiple principals, including Congress and the White House.  Moreover, even within Congress there are multiple different constituencies that view themselves as principals.  The more expansive the regulatory agency, the more principals it will have; more Congressmen will perceive an interest in the activities of the agency because it will regulate a larger array of firms operating in more districts.

Agency theory tells us that multi-tasking agents working for multiple principals face serious incentive problems, and that given this, it is the interest of the principal(s) to subject the agent to very low powered incentives.  Indeed, assigning the agents more tasks and subordinating the agent to more principals generally requires (in a second best arrangement) a reduction in incentive power.  Weaker incentives, in fact, than those that regulators currently face.

Thus, Congress will find it in its interest to subject an uberagency that regulates everything that breathes (financially speaking) to very low powered incentives.  This translates into an agency that is highly bureaucratic, sluggish, unresponsive, (fill in additional pejoratives here).

Regulators hardly covered themselves with glory in the lead up to the crisis.  Does anyone really believe that a single, even less incentivized super regulator is likely to do any better?  Has anyone who matters even asked the question?

* With apologies to the Eagles.  And Taco Bell.

Sunday night I took my HS daughter and her best friend to the Social Distortion concert in beautiful downtown Sauget, Illinois.  (My idea, BTW.)  The venue, a club called Pop’s, is nestled on the banks of the broad Mississippi–and right between a Penthouse club and a Dream Girls establishment, and across the street from the Big River Zinc smelter.  When we got out of the car, my daughter said “What’s that smell?”  Damned if I knew.  Damned if I wanted to know.

Despite the rather seedy environs, the club was OK, although the crowd was not what my daughter and her friend were expecting.  Knowing the location of the venue, and the band (which had an album titled “White Lightning, White Heat, White Trash”) I had sort of an idea what it would be like, so I wore a “Heroes of the Confederacy” t-shirt that my Dad won at a Civil War Roundtable fundraiser–to blend in, dontcha know.  Good choice.  The guy in front of me had a shirt that said “White Trash and Proud of It!”

Funniest moment.  I went into the men’s room, where a kid–six years old, I’d guess–was washing his hands.  (There were more than a few kids younger, some a lot younger, than my charges.)  He had big, thick geek glasses–and full punk regalia.  Blue Mohawk.  (Gen-u-ine, real deal, Mohawk.)  Black t-shirt.  Metal-studded belt.  Straight-leg jeans.  Black Chuck Taylors.  When he turned to dry his hands, he noticed that the towel dispenser was about 5 feet off the ground.  I noticed his dilemma, pulled off some towels, and handed them to him.  He looked at me with that Mohawk, staring wide-eyed through those thick glasses, and said in this sweet six-year old voice: “Thanks, friend!”  I swear, it was like an episode of L’il Rascals Go Punk.

Perhaps not surprisingly, given that Social D’s heyday was in the mid-90s, the crowd had a strong forty-ish contingent, and was pretty well behaved.  Of course, there were a few knucklehead rowdies that security hustled off very quickly.  Half of those shown the door were women who looked like they outweighed the bouncers–and the bouncers, of course, were not small.  At the sight of these, er, ladies, being frog marched with their arms pinned behind their backs, exercising their salty vocabularies, my girls stared wide-eyed for a minute, and then began cracking up.  Quite educational, I do say.

As for the concert, it was very good, even though I couldn’t stay for the whole thing: being a very responsible parent and chaperone, I split at 11 to get the kids home at a reasonable hour on a school night.  Even the warmup bands (especially The Strangers) were good, and Social D was excellent.  Not quite as good as Rancid, but then I’m partial to Rancid.  It was interesting that the band was very faithful–almost to the note faithful–to their CDs in their live performance.  Very little improv or variation. That’s not bad, since I like the songs as they are on the albums.

I did really like the wall-of-sound feel of the band, and Mike Ness was an excellent entertainer.  Unlike Rancid, which showcases not just Tim Armstrong but Lars Fredrickson and Matt Freeman (their excellent bassist), Social D is really the Mike Ness Band.  It’s definitely his group, and his show.  You always wonder if somebody on a long tour is just going to dial it in, but Social D didn’t.  The entire band was working it, and Ness was definitely emotionally engaged with his edgy, gritty material.  Good show, and hopefully I’ll be able to see them again soon not on a school night;-)

Friday night, my college daughter and I go to Chicago (actually, DeKalb, about 60 miles west, near where my grandparents lived when I was growing up) to see our favorite band–the Smoking Popes.  And the Pixies are in Chicago in November.  Thinking about that one; always wanted to see them, and I’m a huge Frank Black fan.

Comment #3000 came in when I was in Hong Kong.  And the winner is . . . (pause for ironic effect):

rkka.  LOL.  Proof that I don’t play favorites.

Now, I tried to email him to inform him of the good news, but the message bounced with the error “Domain name not found.”  So, since rkka apparently guards his anonymity so jealously that he registers with a dummy email address, I doubt he’ll be stepping up to receive his SWP t-shirt.

Pretty funny.

And perhaps funnier, is that comment #3001 is from Steve J. Nelson.  Hey Steve . . . if you want your shirt, let me know via email at [email protected] –but remember I only promised to ship in North America 😉

Comments #3002 and #3003 were also Steve’s.

So, unless rkka or Steve come out . . . that means the winner with comment #3004 is R.  Step right up!

In all seriousness, folks, I’d just like to say thanks for all the interest and the comments.  The volume and intensity of the comments has been a surprise, and a pleasant one.  To put things in perspective, comment #1000 came in March, 2009, or more than three years after I started the blog.  Comment #3000 came in September, 2009–6 months after comment #1000.  It’s been a rollicking 6 months.

Sometimes things get testy and rough, but that’s the nature of the beast.  All I can say is, pace the Supersuckers: “I like it all, man.”

Thanks again, and I hope you all continue to visit in the months to come.

Dmitri Medvedev continues his split personality performance, sounding liberal on economic matters, but a chest-thumping Russian nationalist on foreign policy, especially on matters related to the near abroad.  The tragedy is that his economic pronouncements have virtually no possibility of being implemented, but that his foreign policy statements likely reflect the future course of Russian policy.

With respect to economics, Medvedev ordered a legal inquiry into Russian state corporations:

President Dmitry Medvedev ordered prosecutors to investigate Russia’s state corporations on Friday, questioning the need for the powerful institutions championed by Prime Minister Vladimir Putin.

The state corporations, which enjoy privileged legal status, are part of the economic vision Putin enacted during his two terms as president. He touted them as engines of Russia’s development that will eventually be sold to the private sector.

On Friday, the Kremlin released a brief and toughly worded statement in which Medvedev ordered an official probe into these firms. “The President ordered (prosecutors) to present their proposals including on whether there are reasons to further use … structures like state corporations.”

. . . .

Medvedev’s order to Prosecutor General Yury Chaika, who normally handles high-profile criminal probes, called on him “to pay special attention to general questions about how effectively (these firms) are using the state property transferred to them.”

. . . .

Some analysts suggested that Medvedev’s order on Friday was aimed at finding extra revenues amid the economic crisis rather than challenging the legacy of Putin, with whom Medvedev rules Russia in a so-called “tandem” power-sharing arrangement.

“When the state of the budget is one of the sore points for the Russian economy, such measures are directed at finding extra sources of financing in case oil prices fall,” said Yaroslav Lissovolik, chief strategist at Deutsche Bank in Russia.

Roland Nash, head of research at Renaissance Capital, Russia’s largest investment bank, said the order was part of Medvedev’s anti-corruption drive. “He has talked constantly about cleaning up Russia, and a very good place to start would be the state corporations,” Nash said.

Medvedev is right that the state corporations are a massive millstone around the neck of the Russian economy.  It is particularly laughable to think that such monstrosities, which have every incentive to throttle competition, can be the source of innovation.  They are, instead, far more likely to be means for the connected to tunnel state assets, as Mr. Nash states openly, and which Medvedev obliquely suggests with his statement about the “effectiveness” of the use of state property.

Medvedev also stressed his intention to curb burdens–including the burden of corruption–on small and medium-sized businesses:

Russian leader Dmitry Medvedev Wednesday attacked red tape and official extortion of  small businesses, a sector he wants to play a bigger role in the economy and provide more jobs in the economic downturn.

Modernizing the economy and reinforcing the rule of law are priorities for Medvedev, who took over last year from his ally and mentor Vladimir Putin, now his powerful prime minister.

“Experts say money spent by businessmen on overcoming red tape takes up a considerable part of (businesses’) annual revenues,” Medvedev told a meeting of officials gathered to discuss the issue in the town of Zvenigorod outside Moscow.

“Straightforward extortion of money (by officials) also exists, and that is simply disgusting,” he said.

Promoting small and medium-sized businesses is a major part of Medvedev’s plans to modernize Russia, whose wealth remains heavily reliant on the export of oil, gas and minerals. Those sectors, along with heavy industry, continue to employ large numbers of people in Russia.

Again, these statements are exactly correct.  The rate of business formation, and the proportion of output produced by small firms, is far less in Russia than eastern Europe, for instance, and corruption is a major reason.

But if you search “medvedev state corporations” you will see that the President has been saying these things throughout his term, and nothing happens.  Indeed, the more he speaks, the more you get the impression that he is in fact powerless to change things.  Moreover, that makes me wonder whether Putin actually prefers it that way.  The disconnect between word and deed makes Medvedev’s impotence plain, which in turn reinforces perceptions that Putin is actually in charge.

Moreover, when it comes deeds, they often don’t match his words.  Indeed, there is a sort of zig-zag nature to Medvedev’s actions regarding the economy and state corporations.  For instance, last month he signed legislation creating a state corporation to build tollways.  (Road building, it might be added, is outrageously corrupt, even by Russian standards, contributing to the appalling quality and astronomical costs per kilometer of road built.)  He also signed a decree transferring the assets of 426 state companies to Russian Technologies, the poster child for bloated state corporations:

In a presidential decree signed on July 10 and announced on July 14, Medvedev approved the transfer of the state’s assets in 426 companies to Russian Technologies, the giant state corporation that was formed on the basis of the state arms trader Rosoboronexport and already controls titanium maker VSMPO-AVISMA and automobile manufacturer AvtoVAZ (Reuters, July 14; Moscow Times, July 15). Russian Technologies is headed by Sergei Chemezov, who served with Vladimir Putin, the former Russian president and current prime minister, in the KGB in Dresden, East Germany, in the 1980s.

Commenting on Medvedev’s decree handing over state assets to Russian Technologies, Mikhail Fishman and Konstantin Gaaze wrote in the Russian edition of Newsweek: “Now Medvedev finds himself in an embarrassing situation. He signs a controversial decree that violates, in the opinion of experts, his own statements about liberalizing the economy.” Fishman and Gaaze quoted experts as saying that while Medvedev’s campaign to replace officials with independent directors on the boards of directors of state companies has “symbolic meaning,” what is needed in practice is “to lower barriers to small businesses and limit the role of state corporations in competitive economic spheres.” Medvedev’s decree moves things in the opposite direction.

Fishman and Gaaze also noted that in signing the decree granting state assets to Russian Technologies, Medvedev has greatly strengthened the position of Chemezov, who, as they wrote, is a key member of the group of siloviki hardliners who continue to surround Vladimir Putin. It remains to be seen whether the continued influence of the siloviki is compatible with Medvedev’s stated goals of fighting corruption and liberalizing the Russian economy.

But he also ousted silovik Chemezov from a presidential commission on modernizing the economy, and the investigations of state corporations may also be aimed at Putin’s pal:

The timing of Medvedev’s order suggests the investigation may be targeted at least in part at Russian Technologies, which is headed by longtime Putin ally Sergei Chemezov, who has recently come under criticism for his management of military plants and AvtoVAZ.

Medvedev on Thursday ousted Chemezov from a presidential commission on modernizing the economy. The Kremlin offered no explanation, but Chemezov reportedly had missed several meetings.

What’s the message? You can be corrupt, but don’t miss a meeting?

On foreign policy, though, Medvedev has been the epitome of consistency, and adherence to the siloviki hard line, on Georgia in the days surrounding the anniversary of the war, and now on Ukraine:

President Dmitry Medvedev launched a Kremlin drive to bring Ukraine into its fold on Tuesday as he waded into the country’s presidential elections with a call for a new leader to break with the “anti-Russian” policies of the incumbent and to co-operate with Moscow.

In an open letter to Viktor Yushchenko, neighbouring Ukraine’s pro-western president, the Russian leader refused to renew diplomatic ties by saying he was postponing the dispatch of a new ambassador to Kiev until there was a change in relations.

Mr Medvedev criticised Mr Yushchenko for pursuing anti-Russian policies that include arming Georgia in its war against Russia last year and pursuing Ukraine’s entry into Nato while “ignoring the opinion of your country’s citizens”. In his strongest attack yet against Mr Yushchenko, Mr Medvedev accused him of putting gas supplies to Europe at risk and departing “from the principles of friendship and partnership with Russia”.

“We have the impression that Kiev consistently seeks to break traditional economic ties with Russia, first and foremost in the energy sector,” said Mr Medvedev. “Russia hopes a new Ukrainian leadership will be ready to build ties between our countries, ties that will indeed answer the true hopes of our peoples in the interests of strengthening European security.”

Here’s more:

Russian President Dmitry Medvedev waded into neighbouring Ukraine’s presidential election campaign on Tuesday, attacking the incumbent as “anti-Russian” and urging the next leader to cooperate with Moscow.

In an open letter to Ukraine’s pro-Western President Viktor Yushchenko, Medvedev said he would postpone sending a new ambassador to Kiev, and accused Yushchenko of putting gas supplies to Europe at risk by disrupting ties with Moscow.

. . . .

“This is a tough diplomatic demarche,” said Vladimir Fisenko, head of the Ukrainian think-tank Penta. “This is a signal for the presidential campaign, aimed against Yushchenko.”

“It is also a signal to all Ukrainian politicians that it’s time for Kiev to change its course.”

It is widely agreed that the real issue here is gas:

Alexei Mukhin, the head of the independent Russian think-tank Centre for Political Technologies, said gas was the Kremlin’s main source of concern.

“Russia is preparing for delays in gas payments in December and January,” Mukhin said. “Many in Ukraine are likely to try and use the gas card in their election campaign.”

Yushchenko has criticised a deal on gas prices and transit that Tymoshenko struck with Russian Prime Minister Vladimir Putin in January.

An EU-Ukraine deal on rebuilding Ukraine’s gas network infuriated Moscow because Russia was not involved, and Medvedev mentioned this again in a posting on his website.

“The supreme Ukrainian leadership is negotiating the supplies of gas — Russian gas — with the European Union, bypassing Russia, and is signing a document contradicting the Russian-Ukrainian deals of January,” he wrote.

This is not surprising at all.  And to be honest, I’m actually pleased by the elfin Medvedev’s attempt to play tough guy.  (But, Please!  No shirtless photos!)  Why?  Well, because it worked out soooooo well for Russia last time that it interfered in the Ukrainian Presidential election.  That  was decisive in sparking the Orange Revolution.  (Funny, nobody seems to mention that particular triumph of Putin.  Sort of down there with Beslan, Nord Ost, the Kursk.)

You’d think they’d learn.  Well, no actually.  And heavy-handedness would go over particularly badly if it appears that the main objective is gas.  Even the heretofore supine Europeans are increasingly aware of the effects that Russian dominance of Ukraine would have for their energy security.  They made the first tentative steps towards providing support for the Ukrainians on gas, and although they seem reluctant to get to deeply involved in dysfunctional Ukrainian politics, they may have little choice if Russia reverts to form.  And Medvedev’s broadside suggests that they have every intention of doing so, thus setting up a confrontation between Russia and Europe.  A confrontation that would reach its peak in the depths of winter, nearly on the anniversary of the 2009 gas war.  Would Russia spark another gas war in a gambit to  swing the election?  Would a desperate Yuschenko or Timoshenko do so in order to stoke a nationalist surge in the hopes that this would prevent the election of Russian ally Yanukovych?  I imagine something spectacular will happen, as both sides have a predilection for brinksmanship.

The months leading up to the Ukrainian election will be very interesting indeed.

In the early-1990s Exxon entered into a deal with the Russian government to develop the Sakhalin I project.  As part of the deal, Exxon received an exemption from Gazprom’s legal monopoly on exports of gas from Russia.  Now, in a shocking development (irony alert), it seems that the exemption is under threat:

The government will step up pressure on U.S. major Exxon Mobil to sell cheap gas from Sakhalin, analysts said Thursday, a day before construction begins on a new gas link to the Pacific.Prime Minister Vladimir Putin will travel to the far eastern city of Khabarovsk on Friday to inaugurate the start of the pipeline to the Pacific port of Vladivostok, which will ultimately liquefy gas from Sakhalin Island for export to Asia.

“I think Exxon Mobil knows that they will twist their arm. It is pure pressure,” said Mikhail Krutikhin, an analyst with RusEnergy.

. . . .

Valery Nesterov, analyst at Troika Dialog, said that despite a growing belief among investors that the government’s grip over resources is easing after deals with Total and Shell in recent months, foreign firms will often remain under pressure.

“Exxon does not have a free choice. Past experience shows that if [Moscow] has a strong desire, the foreign partner has to agree,” he said.

The Khabarovsk-Vladivostok pipeline will run 1,460 kilometers, and Nesterov estimates its cost at $2.9 billion to $4.4 billion.

Sakhalin is already connected to Khabarovsk with a gas link, which is supplying local consumers.

Krutikhin said that even if Exxon is forced to sell all its gas from Sakhalin-1 to Gazprom, volumes will not exceed 7 billion to 8 billion cubic meters per year, while Gazprom is eyeing a peak capacity of up to 47 bcm a year.

“So to fill the pipeline, you need to discover new fields or build a pipeline from Yakutia,” he said.

Bloomberg adds some details:

OAO Gazprom, Russia’s state-owned natural-gas exporter, started building a pipeline in the Pacific Ocean that may damage  Exxon Mobil Corp.‘s plans to export the fuel to China.

Workers welded the first joint on the initial 1,350 kilometers (840 miles) of the pipeline at a ceremony attended by Prime Minister  Vladimir Putin and Gazprom Deputy Chief Executive Officer  Alexander Ananenkov. The pipeline will link Sakhalin Island with the mainland city of Vladivostok.

“The development of gas transportation infrastructure in the east will let us diversify our exports,” Putin said today at the event in Khabarovsk, which is on the pipeline’s route. “But I would like to stress that the domestic market will be a priority for the Far East and eastern Siberia.”

I repeat: “The domestic market will be a priority for the Far East and eastern Siberia.”  To translate: If XOM has a deal that allows them to export the gas, well, that’s just its tough luck.

So how will Putin bludgeon ExxonMobil into moving the gas to the domestic market–and likely at controlled domestic prices–rather than to a more lucrative export market?

With apologies to Elizabeth Barrett Browning: “How can I screw thee?  Let me count the ways.”

There’s environmental laws (Sakhalin II); licensing (BP, various mining firms, and perhaps now MOL); taxes (Yukos, and myriad others); blowing stuff up (Turkmenistan); legal harassment of employees, including accusations of espionage (TNK-BP); legal fraud and theft (Heritage Capital); abusive lawsuits in pocket courts (Telenor).  I could go on, but you get the picture.  If they want it, they will take it.  The only question is what they’ll pull out their bag of tricks.

So why does anyone invest there, let alone go back after getting bashed around before (Shell, most notably).  When I gave a talk to some Foreign Service and Civil Service officers with energy-related responsibilities who visited Houston earlier this week, the analogy that came to mind was battered spouse syndrome.  Hopefully Exxon will fight this hard, and won’t succumb to the same syndrome.

As I said in an earlier post, I expect that this will all be a prelim to big confrontations between China and Russia on energy.  Note that the China angle plays into the Sakhalin I issue.  Moreover, China is becoming increasingly aggressive, and successful, in areas that Russia considers its fiefdoms, notably Central Asia (especially Turkmenistan) and now Moldova, of all places.  And finally, the big one: the Rosneft/Tatneft-China oil pipeline/loan deal.  That one will turn very interesting once the pipeline is done, especially if oil prices are well above those at the time of the signing of the deal.  And absent another world economic catastrophe, that’s almost a given.

h/t R

Pressure is at near record lows in that vortex of stupidity, Washington, DC.  Noted financial wizard Maxine Waters proposes to ban credit default swaps. Financial prude Colin Peterson doesn’t want to go that far–he just wants to ban naked ones.  The Senate holds hearings on puzzling developments in the wheat market, and instead of making inquiries regarding the true mysteries, continues its monomaniacal campaign against the least likely culprit, passive index funds.  Regulators testify in front of Congress, and offer pearls like this:

“Regulators would be able to see (the clearinghouses) and rigorously oversee them,” Gensler said. “I believe over time you might see a consolidation and a concentration in this, but initially the statute would allow for more than one.”

Gary, there you go, making me break out the Ginsu again.*

Yeah, maybe the statute would allow for more than one, but it is well known that there are strong scale and scope economies in clearing.  (I’ve written on this before, and if you don’t believe me, take a look at Darrell Duffie’s paper on the subject.)  It is almost certainly most efficient to have only one clearinghouse that clears pretty much everything.  Having multiple clearinghouses in fact undermines the main benefits of clearing.  Moreover, due to these very same scale and scope economies, natural economic forces are likely to lead to consolidation resulting in the survival of a single big clearinghouse.  Where huge risk will be concentrated.  Too big to fail on steroids.  Worried about the interconnection of big financial players?  Well, this clearinghouse will be a single entity connecting all major financial intermediaries.  So, if you mandate clearing, you are mandating an extreme concentration of risk.

So, it is deeply irresponsible of Gensler to recognize, on the one hand that there might be (understatement alert!) concentration and consolidation, and then blow off the serious systemic risk questions this implies with a lame statement about what statutes would allow–but couldn’t mandate.

The lack of thought over these extremely important and complex issues is endemic.  Here’s Peterson:

“Barney and I are going to have mandatory clearing,” said Peterson. Under that approach, all contracts would go to central counterparties. If a clearinghouse rejected a contract as being specialized, the SEC or CFTC would set the margin and collateral requirements for it.

“I imagine SEC and CFTC will set higher margins” and reserves, said Peterson.

The Agriculture Committee bill passed in February would allow the CFTC to suspend trading of “naked” credit default swaps (CDS). The reform bill would go a step farther, said Peterson — “We’ll probably ban naked credit default swaps.”

“I imagine SEC and CFTC will set higher margins.”  (Cue John Lennon.)  OK, pick a number.  Tell me the methodology for picking the number.  What cosmic wisdom will inform the SEC and the CFTC when they determine what the right margin level is?  Will the agencies just pick a nice round number, like 50 percent, and then keep it there, for I dunno, 35 odd years?  Will this number be the same for all firms, regardless of their creditworthiness?  What information will the agencies have?  Can they possibly have better information than sophisticated market participants?  Will their choice of margin be uncontaminated by political pressure?  (Clearing operators, for example, will lobby the agency to raise OTC margins in order to impede competition from the OTC markets.)  In brief why should we believe for a minute that the CFTC, the SEC, or their future spawn have the knowledge or the incentive to determine the appropriate margin levels more effectively than market participants?

We are talking about trillions of dollars here.   The largest financial markets in the world.  And this is the level of thought that is going into to completely re-engineering them.  One hopes that Bismarck was right, and there is indeed a special Providence for fools, children, drunkards, and the United States of America.  We’ll need it.

*In a recent newsletter, futures industry maven John Lothian made this comment about one of my earlier posts on Gensler: “Gary Gensler gets the ginsu knife treatment (figuratively) from the Streetwise Professor, Craig Pirrong.”

Frequent commentor, not to say gadfly, S/O, has suggested that American aircraft carriers are obsolete due to the development of new anti-ship weapons, such as hypersonic missiles and conventional ballistic missiles.  Information Dissemination (a Navy geek website) links to a Navy Times article on the US development of a new anti-ship missile that addresses S/O’s arguments head on:

I particularly enjoyed, and agree completely, with the response by Norman Friedman.

U.S. commanders became wary of ship-launched anti-ship missiles in exercises in the 1980s, during which they missed or hit neutral ships about as often as they found their targets, naval weapons expert Norman Friedman said. The weapons suffered from the classic problem of needing good information about their targets.

Friedman said he was skeptical about the prospects for DARPA and ONR’s new missile. Although sensors have gotten better in the age of unmanned aerial vehicles and higher-tech satellites, the classic target-finding problem still remains, he said.

“There are constant efforts to make hypersonic missiles — you see claims about them — but they don’t seem to go anywhere.”

Scouting, Scouting, Scouting. My favorite paragraph in Wayne P. Hughes book  Fleet Tactics and Coastal Combat covers the problem perfectly.

It seems pedestrian to say that scouting has always been an important constant in war. Perhaps the way to put it is this: winners have outscouted the enemy in detection, in tracking, and in targeting. At sea better scouting – more important than maneuver, as much as weapon range, and oftentimes as much as anything else – has determined who would attack not merely effectively, but who would attack decisively first.

While I have no problems with the development of a new anti-ship weapon system, particularly considering this is a weapon system that doesn’t seem to get much attention in the US Navy anymore; I still say the challenge for the US Navy is improving the capabilities in scouting. I could be wrong, but I don’t see any evidence that delivering firepower is a problem for any service branch of the armed forces.

But developing effective maritime domain awareness of the battlefield… I see that as a major issue emerging in the 21st century, particularly with hybrid threats emerging that look and act exactly like the normal maritime traffic seen globally every day.

But if the United States, which has the most advanced, extensive, and capable surveillance resources in the world has difficulties finding maritime targets, any potential challenger will have even more daunting challenges.  This is especially true inasmuch as the US also has the greatest capability to deny any enemy of the ability to use these resources.

This is no reason for complacency by the United States Navy.  It is just to say that some seeming wonder weapons have Achilles Heels that make them far less threatening than their specs would suggest.

Several posts discussing ongoing controversies about the Soviet role in World War II have resulted in extended discussions in the comment section about the Molotov-Ribbentrop Pact, also known as the Nazi-Soviet Non-Aggression Pact.  One line of thought, expressed most cogently by Cutie Pie, is that Stalin entered into this agreement with Hitler because the French and the British had left the USSR hanging by conceding Czechoslovakia to Germany; that the USSR was willing to go to war to defend the Czechs, but that France and Britain had undermined such an effort at collective security.  Given this evidence of Western pusillanimity, the argument goes, Stalin had no choice but to treat with Hitler to protect Soviet security.

I’ve responded that this doesn’t fully account for a good deal of Stalin’s motivation for entering the Pact; excuse Soviet behavior in the aftermath of the Pact; or recognize that the Pact actually turned out to be quite detrimental to Soviet interests because it freed Hitler to attack Poland, and then turn west to dispose of France and drive Britain to the brink, thereby leaving the USSR to fight Hitler almost alone.

Here’s a few things that speak to this debate.  The Encyclopedia of the Second World War gives a fairly balanced overview:

Aware of Russia’s enormous weaknesses . . . Stalin watched Hitler’s moves to rearm German and the success of his armed diplomacy in the Rhineland (1936), Austria (1938), and the Sudetenland (1939) with increasing nervousness.

Nonetheless, Stalin’s suspicion of all the imperialist powers, combined with marked Anglo-French reluctance to accommodate Soviet political and strategic interests in eastern Europe or to commit themselves to multilateral treaties with the Soviet Union, lent increasing weight to the idea of some rapprochement with Germany.

The crude Anglo-French assumption that Russia’s ideological incompatibility with Nazi Germany guaranteed Stalin’s de facto partnership with the West without a formal alliance was not shared by Stalin, who noted the widespread conservative sympathy for German expansionism in Britain and France . . . . Employing his own style of appeasement with some skill, Stalin . . . signaled his preparedness to treat with Hitler by replacing Litvinov with Molotov in May 1939. . . .

In August, with the German attack on Poland set for 1 September, it became imperative for Hitler to have an assurance of non-interference from Russia. . . . Ribbentrop’s overtures to Molotov on 15 August stressed the urgency of negotiations but were at first stalled by Moscow.  Requesting a  trade and credit agreement as a preliminary to the signing of the pact, Molotov also referred to the need for a special ‘protocol’ with respect to mutual interests in the Baltic states.  Impatient with the progress of negotiations, Hitler intervened on 20 August with a personal telegram to Stalin.  The resulting meeting in Moscow on 23 August produced an agreement in 24 hours. . . .

Despite the undoubted triumph of diplomacy for Russia, the signing of the pact contributed directly to the exercise of Nazi aggression, to which the Soviet Union would in its turn would fall victim in June 1941.

Contrary to the narrative outlined above, in which a desperate USSR, abandoned by France and Britain, attempted to secure its own safety by treating with Hitler, this account makes it clear that a nervous and impatient Hitler initiated the agreement, after receiving signals of Moscow’s willingness to bargain.

Henry Kissinger’s  Diplomacy  discusses the Pact in considerable detail.  It is far to long to quote extensively, but the name of the chapter that sets out the analysis–“Stalin’s Bazaar”–captures well Kissinger’s verdict.  He is scathing in his assessment of the British and French, condemning their dreamy unrealism.  He clearly admires Stalin’s diplomatic skills.  But his ultimate judgment does not support the Cutie Pie Hypothesis.

The entire chapter is obviously too long to quote in its entirety, but here are some salient parts:

“Only extremely wishful thinking on the part of the democracies’ leaders could have led to the widespread belief that Stalin–the original Bolshevik and a staunch believer in so called objective, material factors–could have converted to the juridical and moral doctrine of collective security.  For Stalin and his colleagues had reasons other than ideology to be unenthusiastic about the established international order.  After all, the Soviet frontiers with Poland had been imposed by force and Romania had seized Bessarabia, which the Soviets considered their own.  

Nor did the potential German victims in Eastern Europe desire Soviet help.  The combination of the Versailles settlement [which created many small states] and the Russian Revolution had created an insoluble problem for any system of collective security in Eastern Europe: without the Soviet Union, it could not work militarily;  with it, it could not work politically.”

This is particularly germane to the discussion of the realism of conjectures that the USSR would have defended Czechoslovakia militarily if the British and French hadn’t have folded at Munich:

One can only speculate what Stalin might have intended at the time of Munich.  Yet his least likely course at the moment when he was convulsing his country with purge after purge  would have been automatic and suicidal implementation of a mutual assistance treaty.  Since the treaty with Czechoslovakia committed the Soviet Union only after France was at war, it left Stalin with a number of options.  For instance, he could demand passage through Romania and Poland and use the nearly certain refusal of  those countries as an alibi to await the outcome of battles in Central and Western Europe.  Or else, depending on his assessment of the consequences, he could recapture the Russian territories lost to Poland and Romania in the aftermath of the Russian Revolution, much as he did a year later.    The most unlikely outcome was one in which the Soviet Union would mount the barricades as the last defender of the Versailles territorial settlement in the name of collective security.  

No doubt, Munich confirmed Stalin’s suspicions about the democracies.  Yet nothing could fundamentally deflect him from seeking to fulfill, at nearly any cost, what he considered his Bolshevik duty–pitting the capitalists against each other and keeping the Soviet Union from becoming a victim of their wars.  The effect of Munich, therefore, was primarily to alter Stalin’s tactics.  For he now opened up a bazaar for bids–one which the democracies had no hope of winning if Hitler was prepared to make a serious offer.

On the distrust of the British, and the difficulties of Britain and France in dealing with the USSR on Stalin’s terms:

[I]f Great Britain concentrated on a Soviet pact, Stalin was sure to demand his pound of flesh for helping the Poles by pushing the Soviet border westward, toward the Curzon line.

Spurred on by public outrage and convinced that retreat would further weaken Great Britain’s position, the British Cabinet refused to sacrifice any more countries, whatever the dictates of geopolitics . . . . Above all, the British leaders distrusted the Soviet Union: “I must confess,” Chamberlain wrote, “to the very most profound distrust of Russia.  I have no belief whatever in her ability to maintain an effective offensive, even if she wanted to.  And I distrust her motives, which seem to me to have little connection with our ideas of liberty, and to be concerned only with getting everyone else by the ears.”

On the calculating nature of Stalin’s diplomacy post-Munich:

The Soviets’  interest in preserving the status quo in Eastern Europe ended with the Eighteenth Party Congress . . . . Crucially, Stalin did in fact have the option of turning to Hitler and, after the British guarantee of Poland, could play his Nazi card with considerable safety. . . . his strategy . . . . was to make certain that the Soviet Union was the last major power to commit itself, thereby achieving the freedom of action for a bazaar in which either Soviet cooperation or Soviet neutrality would be offered to the highest bidder.  

More on the virtual impossibility of Britain (and France) dealing with the USSR on Stalin’s terms:

Yet it was not Great Britain’s clumsy diplomatic conduct that led to the Nazi-Soviet pact.  The real problem was that Great Britain could not meet Stalin’s terms without abandoning every principle it had stood for since the end of the First World War.  There was no point in drawing a line against the rape of small countries by Germany if that implied having to grant the same privilege to the Soviet Union.  A more cynical British leadership might have drawn the line at the Soviet border instead of Poland’s, thereby greatly improving Great Britain’s bargaining position with the Soviet Union and giving Stalin a serious incentive to negotiate about protecting Poland.  To their moral credit, the democracies could not bring themselves to consecrate another set of aggressions, not even on behalf of their own security. . . . Stalin had a strategy but no principles; the democracies defended principle without ever developing a strategy.

This last point emphasizes the importance of avoiding, to the extent possible, the error of interpreting decisions in light of what transpired afterwards.  From the British and French perspective, in 1939, it was not a trivial task to determine who was the greatest enemy to peace, Hitler or Stalin’s USSR.  The USSR was a committed enemy to capitalism and democracy, that had a longstanding policy of aiming to overthrow the western democracies.  It had a demonstrated record of mass murder and atrocity–more in fact, in 1939, than Hitler.  It had obvious designs on Eastern Europe–as did Hitler.  It could be expected to act brutally if it did move in to that region.  It is understandable that the British and French declined to deal with Stalin.
In the light of events, it is very plausible to assert that Hitler was in fact the greater threat, due Hitler’s unique psychology, in combination with Germany’s military and geographic characteristics.  From this perspective, it is possible to argue that the Allies misjudged.  

But Stalin clearly misjudged too.  He calculated that Germany would become bogged down in a war with France and Britain, and that this would give him the time he needed to prepare the USSR to defend against a German onslaught.  He calculated incorrectly.  The rapid German victory in the west, made possible by the Nazi-Soviet pact and the consequent securing of Hitler’s rear, left the USSR to face Hitler alone.

Here’s Kissinger’s final judgment:

Russia played a decisive role in the outbreak of both [World Wars].  In 1914, Russia had contributed to the start of the war by rigidly adhering to its alliance with Serbia and to an inflexible mobilization schedule; in 1939, when Stalin relieved Hitler of the fear of a two-front war, he must have known that he was making a general war inevitable.  In 1914, Russia had gone to war to preserve its honor; in 1939, it encouraged war to share in the spoils of Hitler’s conquests.

This seems to be a balanced judgment.  In this assessment, although Munich affected Stalin’s calculations, the Nazi-Soviet pact cannot be seen as primarily a response to it.  Instead, Stalin had territorial ambitions in Eastern Europe, and dealt with Hitler because that was the most effective way, in his view, to advance those ambitions.  Deflecting Hitler westwards also, in Stalin’s view, created the possibility of a vast Capitalist War that would destroy the USSR’s main rivals, Britain, France, and Germany, leaving the USSR dominant not only in Eastern Europe, but Europe more generally.  

In other words, the Nazi-Soviet Pact was the result of a bloody-minded calculation–or, in the event miscalculation.  Although French and British diplomacy in 1936-1939 was a disaster, to blame it for the Nazi-Soviet Pact is mistake.  The responsibility for this Pact lies squarely with its principals, Hitler and Stalin.  The consequences of the Pact–a World War that commenced in Poland on 1 September, 1939, and also, tens of millions of Soviet losses– therefore lie squarely with its principals as well.  The OSCE resolution that lays blame for the war on both Hitler and Stalin is therefore well grounded.

Seeking Alpha has picked up SWP as one of its regular contributors, for which I am appreciative.  I join a select group of 400;-) including (ironically) Bill Gross.  It will be interesting to see how it affects traffic, which set a (very modest) record in June: maybe I should leave the country more often.

Posting may be somewhat irregular in the coming three weeks, because I will be traveling in Europe for a conference and family vacation time. But, thanks (?) to a flight cancellation I have a few extra minutes to write a post.

And, luckily, it is on one of my favorite subjects–Gazprom and Turkmenistan. Today’s MT has a priceless article that says it all on Gazprom’s view that contracts are options, not obligations:

Gazprom has demanded that Turkmenistan cut either the price or the volume of its gas, Interfax reported Monday, sounding another harsh note in an escalating dispute between the energy giants.

The two have been in talks since April over how to resume the flow of gas after it was severed by a gas pipeline explosion, which Turkmenistan says Russia caused.

Russia, which no longer needs to buy Turkmen gas because of a sharp drop in global demand, denies any wrongdoing and says it hopes to resolve the situation through talks.

“Either we change the price or the volumes,” Valery Golubev, the deputy chief executive of the Russian gas export monopoly, told reporters on Monday, Interfax reported.

“Change the price or the volumes.” Sounds like an ultimatum. However, the Russians signed a take-or-pay contract that committed it to specific prices and volumes. They did so apparently thinking it was a good deal. They thought they needed the gas, and wanted to lock in Turkmen supplies. It seemed like a good idea at the time, and I remember the crowing of Gazprom management, Putin, and Medvedev.

You enter into a commitment, you take the upside AND the downside. Gazprom really likes the upside, but apparently thinks the downside is optional.

Without mentioning the explosion, he said Europe had slashed its gas imports from Russia, so Turkmenistan must help shoulder the burden of falling demand.

“Since Europe is not taking the gas anymore, we said, ‘Dear colleagues, there is no market for your gas at such a price,'” Golubev said.

“We have suggested to our Turkmen colleagues that they limit the gas supply volumes, just as Gazprom and other Russian producers have had to do,” he said.

Gazprom supplies a quarter of Europe’s gas. Part of these supplies are bought from Turkmenistan and other Central Asian states and resold to the Europeans.

But as the global financial crisis hammers European industries, demand for the fuel has fallen, forcing Gazprom to lower its gas output by a quarter in recent months. The demand that is left can be more profitably met using Gazprom’s own gas without buying extra from Turkmenistan, analysts said.

No. What about the concept of a forward contractual commitment don’t these clowns get? Turkmenistan doesn’t have to share the burden, because it entered into a contract whereby Gazprom willingly accepted the risk of such a burden falling on it.

Apparently the company didn’t think that as going to happen. Oh well. The whole world has been living a continuous “sh*t happens” moment for the last 9 plus months. Unless there is a sh*t happens clause in the contract that lets it off the hook when it hits the fan, Gazprom is committed, even if (as it is no doubt true) that it is more profitable to meet dwindling demand out of its own resources.

The silver lining for the world here is that this move–which smacks of desperation–may prove one and for all that Gazprom (and Russian companies generally) are unreliable contracting parties. Perhaps this will finally galvanize the will in the ‘Stans and Europe to outflank Russia. For the ‘Stans to deal directly with Europe (and China), and for parties to cut the shilly-shally and build the infrastructure needed to make this happen.

And this reinforces my more general point about the outlawry that masquerades as commercial conduct in Russia. Gazprom is a normal company only by the Russian definition of normal–which is highly abnormal by the standards of commercial conduct that have evolved in Europe and the Anglosphere and large swaths of Asia (Japan and even China) over the past millennia. Gazprom behaves more like a reckless sovereign of medieval Europe, entering into contracts and commitments, and then disregarding them hen it became inconvenient to adhere to them.

Commitments to purchase are not options. When you punt, as Gazprom did on European gas demand and the adequacy of its own supplies, you have to eat your losses when you figure it wrong. I hope the Turkmen take Gazprom to arbitration, and secure a settlement that involves both full payment for full volumes, and punitive damages as wel.

And I can’t wait for the next sanctimonious Gazprom/Putin/Medevev statement about Ukraine’s unreliability. I say this not in defense of Ukraine, which as I wrote during the gas war was also behaving in a highly disreputable way. But as a middleman, a buyer and a seller, Gazprom has no business slagging the reliability of Ukrainians as buyers when its behavior as a buyer is just as disreputable, if not more so. After all, Ukraine’s actions didn’t result in pipeline explosions, and reflected national bankruptcy.

In other words, the next time Gazprom squeals about Ukraine’s conduct in the gas market, even if that squealing is legitimate, I say: shut the hell up and look in the mirror.