Repent! Repent! Before the Inferno Consumes You!
Yesterday I was exchanging emails with a couple of folks about CFTC Chair Gary Gensler’s increasingly apocalyptic jeremiads against OTC derivatives. (Indeed, I think I’ll start referring to him as “Jeremiah.”) I offhandedly wrote “Pretty soon he’ll be saying that OTC derivatives cause cancer.” Lo and behold, what do I read in today’s FT:
US taxpayers bailed out AIG with $180bn when that company’s ineffectively regulated $2,000bn derivatives portfolio, managed from London and cancerously interconnected to other financial institutions, nearly brought down the financial system.
I personally find it very disturbing that I can channel Gensler’s thinking.
The substance of the oped is more Gensler same-old, same-old. Clearing is again the deus ex machina of his sermon:
Clearing houses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. Transactions are moved off the books of derivatives dealers, which are part of financial institutions that may be both “too big to fail” and “too interconnected to fail”, and on to those of well-regulated central counter-parties. Centralised clearing has helped to lower risk in futures markets for more than a century.
Uhm, just who backs that guarantee, Jeremiah? Could it be the very same derivatives dealers? Meaning that the risk really isn’t moved off their books, and that they’re still interconnected?
Arguendo ad AIG makes its stock appearance (see the first quotation). George Stigler once wrote that data is not the plural of anecdote. What’s unbelievable is that Gensler (and Geithner and others) can’t even find multiple anecdotes, let alone anything rising close to the level of data. What’s even more unbelievable is that his use of the AIG anecdote is deeply misleading–so deeply, that Gensler is either very dishonest or very badly informed. First, although OTC derivatives deals were one source of AIG’s loss, they were not responsible for anything near the entire $180 billion bailout, but Gensler insinuates that they were. Second, since it is unlikely that the AIG deals were clearable then, or would be today, it is misleading to use them to advocate clearing. Third, Gensler doesn’t address the counterfactual question of what would have happened if AIG hadn’t written protection on mortgage CDOs; arguably, the crisis would have been worse.
Gensler also asserts that OTC derivatives were the underlying cause of the financial crisis. He provides no evidence whatsoever–other than the tired AIG trope. This is a complete misreading of the history of the crisis. If you don’t believe me, I suggest you read Rene Stulz’s piece on derivatives and the crisis in the most recent issue of the Journal of Economic Perspectives.
Gensler also makes some assertions that are categorically incorrect. For instance, he says: “The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk.” It is, in fact, well known that excessive transparency can reduce liquidity. There is NOT a monotonic relation between transparency and liquidity, as Gensler asserts.
More generally, on the transparency and exchange trading arguments, Gensler implies that market participants that willingly choose to trade on OTC markets instead of readily-available exchange alternatives don’t know their business.
I could go on and on, but I’ll let it rest here for now.
If the substance is tiresomely familiar, Gensler’s rhetoric reaches new heights. He pegs the metaphor meter with his lurid comparison of the role of OTC derivatives in the financial crisis to the Chicago Fire, and the banks to the cow in Mrs. O’Leary’s barn that kicked over the lantern that ignited the fire. (At least he spares us the apple story.) (The reference to Mrs. O’Leary’s cow is actually quite fitting here, as that poor creature is almost certainly the least plausible cause of the Chicago fire; the editor of the Chicago Republican admitted he made up the story for its entertainment value. He’d be more accurate talking about meteorites or Pegleg Sullivan–he should check out the Alkaline Trio song about old Pegleg. But accuracy is merely an obstacle, it appears, in Gensler’s shrill attacks.)
(And another parenthetical about the metaphor overload: is cancer “interconnected”? Usually cancer is used as a symbol of something maliciously that spreads, which is somewhat different from interconnection.)
Perhaps this remarkable performance is actually good news. Gensler apparently believes that he has to ramp up the rhetoric in order to achieve his (defective) policy goals; that’s usually a sign of desperation, and a lack of success in previous efforts to persuade.
And that lack of success is not surprising. Yes, it might have something to do with the fact that incumbents don’t want major changes in the ways they do business. But it’s also due to the fact that faulty analysis unsupported by reliable facts or data is usually unpersuasive.
But perhaps there’s an upside; we have a new entry in the Bulwer-Lytton fiction contest: it qualifies both because it is fiction, and because of its overwrought writing.
[…] Pirrong, a Professor of Finance at the University of Houston who blogs at the Streetwise Professor, replied (in equally inflammatory fashion): Gensler also asserts that OTC derivatives were the underlying […]
Pingback by FT Alphaville » Craig Pirrong v Gary Gensler: who’s right on OTC derivatives? — February 25, 2010 @ 3:50 pm
A completely unrelated question: why do you feel that cornering markets and ‘squeezing’ should be a punished? You argued that here http://agriculture.house.gov/testimony/110/h80710/pirrong.pdf
I’m seriously interested in the argument. Thanks.
Comment by dc — February 25, 2010 @ 6:34 pm
hey, dc; thanks for the question. manipulation is a pet issue of mine. when it comes to manipulation, I remind myself of what Churchill said about fanatics: can’t change my mind and won’t change the subject.
I’ve written a lot about the subject, inc. 7 journal articles and a book, but I’ll try to summarize the gist of the argument briefly.
Corners and squeezes are the result of the exercise of market power; that’s why my book title has “market power manipulation” in it. This exercise of market power causes the usual deadweight losses. There are excessive deliveries which distort spatial and temporal consumption patterns. Moreover, in derivatives markets manipulation can have even more perverse effects that strike at the very purpose of the markets. Manipulation–and even the possibility of manipulation–adds noise to prices and to the basis. The latter effect reduces the effectiveness of derivatives contracts as hedges. Moreover, the noise reduces the value of the derivatives price as a price discovery mechanism. Thus, corners/squeezes interfere with the two most important functions of derivatives markets.
In addition, as Tullock/Posner and others noted about the deadweight costs of market power long ago, deadweight losses arise not only from the traditional welfare triangles, but from rent seeking. People expend real resources to engage in trading strategies intended to capture a rent. Moreover, the potential victims of corners/squeezes expend real resources to reduce their probability of being squeezed. They invest in commercial intelligence gathering, for instance, that is not socially valuable, but is privately valuable to the extent that it allows someone to reduce the losses they suffer as the result of market power.
Anyways, those are the arguments in a nutshell. WIll be interested to read your response.
Tullock…
you mean Tullock, Gordon. “The Welfare Costs of Tariffs, Monopolies, and Theft.” Western Economic Journal (now Economic Inquiry) 5.11 (1974): 224-32. Yes?
Interesting. That’s the one where he argues that he argues that there is no fundamental difference between entrepreneurs trying to become monopolists by offering newer and better goods and services to consumers with the thief’s continuous development of new methods of stealing…
very odd you would accept that argument, considering you are basically an Austrian economist…
Do you also believe in the Natural Monopoly Theory?
Comment by dc — February 26, 2010 @ 2:24 pm
In any case, I don’t buy the market power theory, simply because it is too static, it cannot be properly defined, whether you use Pindyck or Lerner, and completely ignores competition at the margins. Though my main beef really is the whole aggregation that is needed to establish it. Too much of a Misesian to have any patience for it.
My real beef with bans on ‘cornering’ or such things is this: people have the right to use their own property as they see fit, as long as they don’t engage in physical violence against others. Why should it be illegal for me to buy every last bit of copper on the market and dump it onto a big pile because I like looking at it? And if I’m tired of it, why should i not be allowed to sell it in small amounts to the highest bidder? What if I buy all the copper in the world with no intent to sell it, then I die, and my heirs sell it a piece at a time? Should it be illegal because somebody would like to have it more cheaply? Seriously?
Again, you are an odd Austrian economist….
Comment by dc — February 26, 2010 @ 2:40 pm
I disagree completely with you on your analysis of market power theory. It can be defined, measured, and tested in this context, without going anywhere near Lerner or Pindyck. In fact, virtually no aggregation is required. Many of the aggregation issues that arise in standard anti-trust cases are absent in this context.
I am generally sympathetic to your thoughts re property, but rent seeking of this sort is costly, and to the extent it can be reduced/mitigated at sufficiently low cost, there are gains to be captured. In many antitrust cases, the definitional, measurement, aggregation, and dynamic/static issues are far too complex, and I would generally agree with your skepticism. In a derivatives market, the dynamic considerations are typically irrelevant, and the other issues can be addressed quite readily.
Should be clear–disagree with analysis of market power theory as applied to corners.
Here’s my personal litmus test for these things: is it conceivable that such behavior could be successfully sanctioned without the state? In other words, would actors in a purely market based system have the incentives/ability to develop regulations to punish market cornering? If yes, at least conceptually, than I can see your case. I haven’t analyzed it that way yet, so I don’t know the answer. Any thoughts?
Comment by dc — February 27, 2010 @ 3:14 pm
I will read up on your writings on the issue, haven’t really dealt with this systematically since grad school.
Comment by dc — February 27, 2010 @ 3:15 pm
dc–
Re the private sanction, I wrote an article published in the J. Law and Econ. (1995) on this very subject. It documents the difficulties that private organizations (e.g., exchanges) had in sanctioning corners. A related article appeared in the J. Legal Studies (1994). The latter wasn’t on cornering per se, but on the factors that determine the effectiveness of private, cooperative efforts to reduce the frequency and severity of opportunistic conduct in commodity and financial markets.
I personally favor the use of private rights of action to deter, rather than state involvement. That is, treating cornering as a common law-type offense.
Thank you. It does not happen often that I meet people who actually understand what I’m trying to say. I’ll look up that article as well.
Cheers.
Comment by dc — February 27, 2010 @ 10:56 pm
dc–No problem. I think our basic worldviews are actually quite similar.
Re your earlier comment re odd Austrian economist. First, some people would say that the last two words are superfluous: odd covers it;-) Second, I have some Austrian tendencies, and value highly some Austrian insights, but I’m not a card carrying Austrian. I think Sherwin Rosen’s take on Austrian economics, and the potential gains from trade between Austrians and neoclassicists (in his JEP article of some years back) has it about right. (Full disclosure: Sherwin was on my PhD committee at Chicago.)
As regards to corners in particular, I think that many of the aspects of the Austrian critique of government intervention are not particularly forceful in that context. Indeed, if you think of the price system in an Austrian way as providing and aggregating valuable dispersed private information, you can conclude that opportunistic abuse of the price system to gain a rent is detrimental. Moreover, if you look at the methods I advocate for identifying corners as part of a system for sanctioning this conduct, you’ll see that they rely extensively on the informational properties of prices and price relations. (I even cite Hayek in this context.) What I’ve advocated does not make anything even close to the socialist calculation error. Indeed, the kinds of regulations that I have vociferously opposed–position limits, for instance–are the things that embody this error.