Streetwise Professor

Here’s what I posted on the International Relations site:

Russian Energy Politics: Fuelling Power

The phrase “Russian energy politics” is dangerously close to a redundancy; in Russia, politics is energy and energy is politics. To be sure, energy is politicized in virtually every country, but nowhere is the nexus between petroleum and politics tighter than in the Russian Federation. After all, in what country is the Chairman of the Board of the state champion oil company (Rosneft) also the First Deputy Chief of the Russian Presidential Administration (Igor Sechin), while the Chairman of the Board of the natural gas monopoly (Gazprom) is also the Deputy Prime Minister and presumptive national president (Dmitri Medvedev)?

Energy exerts a decisive impact on every aspect of Russian politics, from the domestic to the geopolitical. Domestically, huge rents from energy have been conducive to the formation in Russia of what scholars Douglas North, John Wallis, and Barry Weingast call a “natural state.” As North, Wallis, and Weingast argue:

[a] natural state is a specific way of structuring political and economic systems so that the economic rents created by limited entry are available to secure credible commitments among politically powerful groups. Potential rivals in a natural state stop fighting (or fight less) when the economic rents they enjoy depend on continued existence of the sate and of social order. Natural states limit economic entry to create rents and then use those rents to credibly commit powerful groups to support the state. In other words, natural states use the economic system as a tool to solidify the stability of the ruling coalition.

They also note that to maintain the stability of the division of rents, natural states have an incentive to suppress civil society; undermine democracy in order to reduce the likelihood of a transfer of political power and limit citizen access and power; undermine the independence of the judiciary; and control or restrict entry into valuable economic activities. In a nutshell, stability among the ruling elite is a fetish in natural states, as instability can touch off devastating internecine conflicts over rents.

Rents and natural states go together, and Russia’s current energy bounty – driven by its physical endowment and an unprecedented spike in energy prices – has created a stream of rents beyond the wildest imaginings of Russians at the time of the collapse of the USSR. Events in Russia over the past several years support the main contours of the natural state thesis that increased potential for rent seeking markedly affects domestic political organization.

In Russia, this boom in energy rents has coincided with, and has quite plausibly been a major cause of, an undermining of Russia’s already weak civil society, judicial, and democratic institutions. Moreover, the late-Putin era has seen the fetishization of stability alongside the evolution of rival political clans, each with a strong cohort of violence specialists with roots in the security services, restively coexisting in a tenuous equilibrium. These clans are among the major beneficiaries of the rents flowing into Russian coffers, and securing their claims to these rents is their major preoccupation.

And that is where the North-Wallis-Weingast formulation can be misleading. They emphasize that rents can be the glue that keep a natural state together, but underappreciate that the stability of such arrangements can be tenuous indeed. Such tacit truces between rivals for rents can be supported under some circumstances, but can break down when conditions change. In particular, such “cartels” of rent seekers are sustainable when the rival parties have relatively long time horizons; with low discounting of the future, repeat interactions and the threat of defecting from tacit agreements to share rents support cooperation and suppresses conflict. However, shocks that increase uncertainty can truncate time horizons, and if these shocks are sufficiently severe, cooperation is no longer an equilibrium strategy. In these circumstances, stability can rapidly degenerate into chaos and violence. That is, natural states can be brittle, and their apparent stability chimerical.

The recent uncertainty over presidential succession has clearly shaken the Russian political elite. Indeed, there have been recent public outbreaks of struggles among the clans, and the many growls emanating from under the Kremlin carpet (to paraphrase Churchill) suggest that the public feuds are just battles in a much larger war. The main case for retaining Putin in power advanced by many elements of the elite (notably the Sechin clan) is that only Putin can keep the clans in check. Although Putin’s anointment of Medvedev has evidently eased some of the anxiety over succession, the combination of the uncertainty over the future division of power between Medvedev and Putin, the inherent ambiguity and volatility of any such division, and the billions in rents at stake (most of them energy derived) will conspire to make the months to March 2008 and far beyond fraught with peril.

In sum, in terms of domestic politics, huge resource rents—most notably, rents from energy—have transformed Russia into a natural state in which the dominant factor driving political and legal arrangements is the division of rents. As North et al suggest, such arrangements corrode civil society, and such corrosion is clearly evident in Russia. Contrary to their (relatively) sunny predictions that these arrangements also facilitate stability and lead to the suppression of political violence among the elite, however, this stability is very brittle. And again, this brittleness is clearly evident in current Russian politics.

Moreover, the ramifications of energy rents extend far beyond Russia’s borders, and not only to the extent that regional and international stability is affected by the internal stability of a former superpower possessed of a massive nuclear arsenal and a UN Security Council veto.

Russia’s energy rents will be larger, the more that competing suppliers of energy restrict output. This fact sheds light on much recent Russian foreign policy. In Central Asia in particular, Russia has engaged in a diplomatic full court press to wall off that region’s energy resources from European and American countries. Gazprom in particular benefits greatly from limited competition for Turkmen gas, and the company and the Russian government (as if one can distinguish them) have acted aggressively to forestall the development of pipelines that could divert this gas from Russian, which is to say Gazprom’s, pipes. The new Great Game in Central Asia revolves around energy, and involves not just Russia and Europe, but Turkey, Azerbaijan, Iran, the US, and notably for the future, China.

But Central Asia is not the only area in which Russia is maneuvering to control or coordinate production of energy in a way that will enhance Russian energy rents. Russian initiatives with countries as diverse as Qatar, Algeria, and now Nigeria are all driven by Russia’s desire to restrict competition in the international trade of energy. These efforts focus primarily on natural gas because that commodity’s particular infrastructure needs make it particularly vulnerable to such anti-competitive efforts.

Moreover, it should be noted that uncertainty and the potential for supply disruption can drive energy prices higher. This undermines Russia’s interest in promoting stability in major energy producing regions, such as the Gulf, Nigeria, or South America. Indeed, it may provide an incentive to sow instability in these regions. As a result, there is a reasonable basis for suspicion over the motives behind its policies regarding Iran, as well as other energy producing nations.

Energy is also an instrument that Russia uses to advance other geopolitical objectives. Energy is the primary tool that Russia employs to reassert its influence the “Near Abroad.” Moreover, Russia repeatedly attempts to utilize energy to drive a wedge between European regions and individual countries, and between Europe and the US. These efforts are undertaken in service of the desire by some elements in Russia who believe their nation is in conflict with Western and “Atlanticist” blocs.

In brief, one cannot understand Russian domestic politics or Russian foreign policy without understanding the role of energy. At present, the resurgence of Russian state power both domestically and internationally is figuratively fueled by high energy prices.

And in this there is a cautionary tale. The influence of the USSR in the world during the 1970s was financed by the windfall of the last oil shock; without such a windfall, the Soviets would not have been able to overcome their severe structural weaknesses in industry, and especially agriculture. The end of this windfall precipitated the collapse of the USSR. Current Russian assertiveness is similarly dependent on an energy windfall.

Although it would be rash to predict a modest, let alone precipitous, decline in energy prices occurring in the near future, it would have been similarly rash to do so in 1985. As a much more open, market oriented economy, Russia is far better positioned to weather a decline in oil prices than the Soviets were, but Russia would still suffer terribly from a decline in energy prices. But perhaps the most disturbing realization is that high oil prices are no blessing to Russian civil society, democracy, and political stability, or its non-resource economy, or to the stability of the world outside of Russia’s borders. High energy prices or low, there is much room for pessimism about Russia. The “devil’s excrement,” indeed.

Apropos my last post re Rosneft, yesterday’s London Times reports:

Mounting disquiet among Western investors surfaced in the City last month in a backlash against plans for a $10 billion ( £5.4 billion) flotation on the London Stock Exchange of Rosneft. Some Western institutions might be have been content that this Russian oil giant was created mainly through the controversial state seizure of the assets of Yukos, the energy group once controlled by Mikhail Khodorkovsky, the jailed oligarch. Others were not so sure.

F&C, a leading UK fund manager, delivered a bold denunciation of Russia’s dubious corporate governance regime. So long as this remained opaque and incomprehensible, investors ought to steer clear of the unacceptable risks posed by taking any stake in Rosneft, F&C said. George Soros, the billionaire investor, weighed in with a warning that the float would “raise serious ethical and energy security issues” and risked legitimising Moscow’s expropriation of key parts of Russia’s oil and gas industry.

As distasteful as it is to agree with George Soros, he’s right. (I prefer to think that he is actually agreeing with me–which he would also probably also find distasteful if he knew me from Adam’s Off Ox.) In any event, it is gratifying to note that there is increasing recognition that it is imprudent to plunk down good money in the Russian energy sector. Further, yesterday’s WSJ contained another article indicating that western investors are becoming somewhat chary of plunging into Russian equities due to concerns about transparency and buying a lemon.

Investor disquiet is playing out against a background of growing tension between the US, eastern Europe, and Russia. VP Cheney gave a blistering speech in Vilnius castigating the Russian use of energy as a weapon. Poland has expressed considerable unease at the Russian stance–and is clearly dismayed at German participation in a gas pipeline project that will bypass Poland, thereby ensuring German gas supplies while making Poland (and other EE countries) more vulnerable to Russian extortion. It brings to mind the words of the wise old Pole, Joseph Conrad, who in his perspicacious essay, Autocracy and War, wrote: “The common guilt of the two Empires [Germany and Russia] is defined precisely by their frontier line running through the Polish provinces.” Given the grim history of Poland since the early 17th century, it is not surprising that the Poles are nervous as cats when the Germans and Russians get together and pointedly leave the Poles out.

The western Europeans are also slowly coming to the realization that it is one thing to be an energy importer, but quite another to be an energy importer increasingly beholden to a state monopoly that is as much a political entity as an economic one. Gazprom is attempting to gain ownership and control of gas distribution networks in western Europe. This would put them in a position to impede entry of competitive sources of gas into western Europe, thereby enhancing Gazprom’s market power. Now of course this would also make Gazprom vulnerable to expropriation if it were to act too clumsily–those pipes in Italy and Germany are not going anywhere. It is a safe bet, however, that Gazprom investments in the EU are much less vulnerable to expropriation than western investments in Russia. The EU legal system would (rightly) make it difficult for European states to expropriate. Moreover, it is to be doubted whether any European government would have the stones to act in this way. Thus, the threat of future expropriation is not a credible response to any future attempt by Gazprom to squeeze the Europeans. To keep their strategic options open, Europe should be very leery about creeping Gazprom access and influence today–as they are unlikely to be able to resist it tomorrow. (It probably grates on them, but Ronald Reagan warned them of energy dependence on Russia in the 1980s!)

This said, it is worthwhile to remember something else that Conrad emphasized in Autocracy and War: Russia is never as strong as she looks. Right now, Putin has one card–energy–and he is playing it to the hilt. Sad to say for the many fine Russian people (friends and colleagues) that I know, Russia is painfully weak on every other dimension. It is living a demographic nightmare. Its birthrate is extremely low, and its death rate is astronomically high. Although the former may–emphasize may, as birth rates have remained low in many western European countries (e.g., Spain) despite robust growth–increase in response to the country’s emergence from the calamity of the 1990s, the latter problem appears intractible. The death rate among men in particular is beyond belief–and far outside historical experience for any developed country. The eastern part of the country–the heart of energy production–is depopulating rapidly. Overall, population is contracting at about .5 percent per year. Most economic growth is in the energy sector alone. Energy now accounts for 30 pct of GDP, and this fraction is growing. The rest of the economy is stagnating. The energy boom enriches the state and a few favored oligarchs, but has only limited benefits for the remainder of the populace. The Russian military is a hollow shell.

Putin is playing very aggressively right now, but his hand is not a strong one. Perhaps he can bluff his way to winning a big pot–the western Europeans are particularly likely victims of a bluff. But if they exhibit a modicum of backbone, and the US stands forthrightly by the eastern Europeans and facilitates the development of stronger energy ties with the central Asian republics, Putin and Russia risk another epic humiliation if they continue this strategy.

And another thing. Energy prices go both ways. Things now are similar to circumstances in the early 80s, when everyone predicted that energy prices would only rise. Within a very few years, they had collapsed. Fundamentals are different now, and I don’t forsee an imminent price collapse, but markets do correct. High prices induce entry. They may actually provide a welcome jolt of reality to nitwit Congressmen and parlimentarians and get them to remove self-imposed obstacles to enhancing energy supplies. With such an inelastically demanded commodity, every little bit can have an appreciable price effect. Betting everything on high and rising prices –as Russia is doing–is a sucker’s wager.

A recent Wall Street Journal article (subscription required) discusses growing unease among brokerage firms over rising trading fees at NASDAQ and NYSE. European traders have expressed similar disquiet at rising fees on European bourses. The heady valuations of publicly traded exchanges, such as the CME and CBT, are predicated in part on the belief that they have pricing power that they will be able to raise fees in the future.

Is it plausible that exchanges have market power, and therefore can charge supercompetitive prices? In a nutshell: hell yes. There is little doubt that exchanges have considerable market power. Over the years I’ve written several articles on the subject setting out the arguments and evidence, but the essence of the story is rather straightforward. (This article sets out the argument in a non-mathematical way.) When some traders have better information than others, the relatively uninformed are better off when they concentrate their trading in a single marketplace. This creates a network effect. Traders like to trade where others trade. There are therefore natural monopoly elements to trading. (In the future I plan to blog about things that weaken the network effect and therefore facilitate competition between trading venues.) Moreover, it is hard to contest an incumbent monopolist’s position. (Cf., Eurex’s not-so-excellent US adventure, ditto EuroNextLIFFE.) Attracting liquidity to a new platform requires the simultaneous defection of numerous traders from the incumbent. This is a daunting coordination problem.

Hence, DTB/Eurex’s victory over LIFFE in Bund futures in 1998 is the exception rather than the rule. As I’ve shown in a working paper , moreover, that was something of a fluke for two reasons. First, DTB/Eurex had a less severe coordination problem because the German banks that were the source of large order flows also owned the exchange, so it was easier to build a base order flow to challenge LIFFE. Second, when DTB/Eurex had attracted enough volume to reduce the price impact disparity with LIFFE, it cut fees aggressively and LIFFE did not respond. If LIFFE had responded in kind rather than dilly-dallying for 3 crucial months, it might have hung on to a big chunk of the Bund business.

The CBT and CME learned from LIFFE’s errors and cut prices aggressively when faced with the prospect of entry; it’s always much more satisfying to learn from others’ screw ups than one’s own. Moreover, neither challenger could tap a block of affiliated order flow to build liquidity in contracts offered by the incumbent exchanges. As a result, the entrants weren’t able to repeat the Eurex coup on this side of the big pond.

When evaluating the prospect—or reality—of rising exchange fees, its important to remember that exchanges have always had market power, but they just exercised it in different ways. The traditional member-owned, not-for-profit exchanges did not exploit their market power by charging supercompetitive transaction fees. That would have cut into their members’ ability to make money by reducing the derived demand for brokerage and market making services. Instead, traditional exchanges exploited market power by limiting entry. With a few exceptions (primarily resulting from legislation and regulation rather than exchange choice) traditional member-owned exchanges limited the number of members. They also had rules that advantaged floor traders at the expense of others. These measures allowed the members to earn rents. As I’ve shown in a couple of articles, network effects make it possible for an exchange to choose a suboptimally small membership, raise trading costs, and yet face no credible competitive threat. Thus, exchange customers have historically paid supercompetitive prices for floor brokerage and floor market making services rather than supercompetitive exchange transaction fees.

Things are changing now that exchanges are moving away from the mutual non-profit (“MNP”) form. Investor-owned exchanges in particular have a new clientele to serve. Rather than catering to the interests of exchange members (typically floor traders or those who leased floor trading rights), some exchanges now respond to the interests of investors. For profit investor owned (“FPIO”) exchanges have no incentive to do things that inflate liquidity or brokerage costs. Indeed, they have the very opposite incentive. Higher profits to brokers and market makers reduce the derived demand for the services exchanges offer (namely, access to the trading engine.) As a result, they want to minimize barriers to entry by liquidity suppliers and suppliers of brokerage services. Exchanges will exploit the market power conferred by network effects by charging supercompetitive transaction fees.

High exchange fees are a more transparent way of exploiting market power. Market power wasn’t a secret to savvy folks in the old regime; I’ve talked to many upstairs traders, including some very successful ones, who routinely complained of being “robbed by the floor.” However, I imagine a lot of folks were unaware how limitations on entry and trading rules inflated trading costs. In-your-face increases in trading fees attract more attention, but the bottom line is that it’s just a different way of taking advantage of network effect-induced market power.

As an aside, I’ve been surprised for years at how little academic commentary and regulatory scrutiny has been directed at exchange membership limits. Economists since Friedman (in his dissertation on the medical profession) and Stigler (and probably before—I just learned it from Stigler and Sam Peltzman) have noted that entry restrictions are the most straightforward way for regulators or professional organizations (e.g,. the AMA) to cartelize an industry and create rents for producers. To most economists, the use of entry restrictions is prima facie evidence of the inefficiency of a regulatory policy. Yet although I’ve read pretty much all I can get my hands on about exchanges, I can’t recall seeing anyone level similar criticisms against exchanges despite the fact that they have almost universally imposed such limits. Indeed, it’s not uncommon to hear exchanges lauded as the exemplars of perfect competition. ‘Tis a puzzlement. (Hat tip to anybody who can provide a cite contradicting my assertion regarding the absence of academic criticism of entry limits at exchanges.)

Is there any way of comparing the relative efficiencies of the old and new monopolies? Looking at output—trading volume—may provide some evidence. IPE experienced an appreciable volume jump when it closed the floor, which would suggest that the new model is more efficient than the old. Other comparisons of this type could be illuminating.

The moral of the story is that exchange market power inheres in the fundamental nature of trading, but that the means by which an exchange reaps the rents of market power depend on its organizational and ownership form.

It may be the case that the transparency of exchange fees has regulatory and anti-trust consequences. As exchanges become more like traditional firms, they may draw more anti-trust scrutiny. That will be, as Arte Johnson used to say, verrry interesting.

Here begins yet another blog–which immediately raises the question: Why? A blog is a peculiarly 21st century vanity, and I set out with no expectations that I will amass a large readership. The field is so crowded, and many of the subjects that I will discuss are so arcane, that it would be foolish to expect otherwise. Indeed, I imagine that this blog is as likely to be read as the greeting plaque on the Viking space probe.

So why bother? In all modesty I think I can claim a decent reputation in a few specialized areas of economics and finance, notably the economics of exchanges and commodity markets. I have written about these subjects in academic publications for over two score years, and plan to continue to do so. However, traditional academic forms–journal articles, and to a lesser degree, books–are highly structured and highly limiting. There are many interesting subjects and ideas that do not fit comfortably in these traditional academic genres. Some ideas are too small in and of themselves to warrant publication in a journal–even a minor one–but too important to be ignored altogether. Some ideas are promising but insufficiently developed. Perhaps most important, traditional academic publication is inimical to discussion and analyis of current and topical subjects.

The blog is a more immediate, fluid, dynamic, and contemporaneously interactive medium. It is conducive to the communication of the small truth and the protean idea. It permits immediate analysis of the day’s topical issues. It is a way of reaching people outside the academic community–people who have valuable knowledge and insights, and who have vocational or avocational interests in a variety of subjects. So in a nutshell, this blog is the continuation of research by other means.

What about the name, you ask. The “Professor” part is pretty obvious–that’s what I am/do. The “Street” part echoes the colloquial use of the term “The Street” to refer to the financial markets. Around the world, “the Street” is synonymous with Wall Street. In Chicago, “the Street” refers to the LaSalle Street financial district dominated by the Board of Trade. (As a native Chicagoan, I am partial to the latter of course–hence the background graphic of a 1920s view down LaSalle Street to the famous CBOT building.) Since this blog will focus on financial issues, especially as they pertain to financial exchanges and markets around the world, the “Street” in “Streetwise” accurately describes the subject matter. As for the “Wise” part, well, that is a goal to strive for: I hope that I can express through this blog some wisdom accumulated through years of study and work. In the end, my readers will judge whether I achieve that goal.

The title is also somewhat ironic, and related to my (somewhat arrested) musical tastes. A complementary hat tip awaits the first person to make the connection. (A small reward, you might say, but in the world of Google the cost of obtaining such information is commensurately small.)

Although this blog will focus on financial and commodity markets, I will explore other interests as well. In particular, from time to time I will comment on military and political matters that engage my attention.

So for those of you that have somehow made it through the increasingly dense web to this site–Welcome. I hope you find it of interest. I encourage you to participate actively through comments, as I hope to learn from my readers too.