Streetwise Professor

June 9, 2010

Vladimir Putin, Transaction Cost Economist: Part II

Filed under: Commodities,Derivatives,Economics,Exchanges,Politics,Russia — The Professor @ 3:57 pm

Yesterday Putin did his best King Canute impression, and ordered a group of financial regulators, including the finance ministry, to draft plans for an exchange to trade steel, coal, coking coal, and other metals.  By 1 August.  Putin believes the exchange will, in the words of the Moscow Times article just linked to, “avert price rows between producers and industry.”

In other words, even though no exchange anywhere has created successful spot or futures markets for steel and coking coal, and really for thermal coal either, in the 150 odd years since the advent of modern futures trading, Putin has commanded that Russia, which has never really created a successful commodity exchange for anything ever, do it in less than 2 months.

Yeah.  Right.

My reference to Canute was a slight to Canute, of course.  The Danish (English/Norwegian/Swedish) king knew that he couldn’t make the waves cease their beating: he just wanted to make the point to court sycophants.  Putin, by contrast, apparently thinks that his command will make it so.  I can just imagine the furtive and panicked looks between those in Putin’s audience charged with implementing the (impossible) task.  I can also imagine the “jump? how high boss?” responses to his command.

This is another case of Putin, Man in a Hurry, as I dubbed him soon after I began this blog.  It is clear that he has tired of the squabbling between the upstream and downstream firms in the Russian ferrous metals sector.  He evidently believes (or at least hopes) that a command that a market magically appear will relieve him of mediating this conflict to maintain the equilibrium in the natural state.

Ain’t gonna happen.  Markets don’t just magically appear.  As has been documented in the academic literature, most notably by Dennis Carlton, auction type futures markets are devilishly hard to start.  Far more contracts fail than succeed, despite the concerted efforts of experienced exchanges to identify the most promising candidates, to work to design contracts that will suit the needs of the target industry, and to build industry support through favorable fees, liquidity support programs, etc.

Steel and coking coal are particularly challenging for a variety of reasons.  “Steel” is not a homogeneous product, but consists of a dizzying array of differing physical types and shapes.  Some kinds of steel, e.g., scrap, are fairly standardized and traded, but its prices don’t necessarily track the prices and values of other types of steel.  Coking coal is also characterized by substantial differences in grades and uses.  Moreover, for coal in particular, location matters because it is relatively expensive to ship.

Industry structure matters too.  Futures markets tend to work best with relatively disaggregated value chains, where the same product is often bought and sold repeatedly, and where there is relatively little concentration on either the buy or sell sides.  (Structure is not independent of product characteristics, of course.  Relatively homogeneous goods tend to have a larger number of buyers and sellers, and greater turnover, than more specialized goods unique to one producer or tailored to fit the needs of a particular consumer.)

Firms in an industry will not necessarily support the introduction of more transparent pricing mechanisms, either, as Carlton points out in another paper.  The steel industry has been quite outspoken in criticizing plans for steel and iron ore derivatives markets.  (India’s Tata Group is a good example of this.)

I would imagine all these factors go double in Russia–if not more than double.  With central planning, the absence of a free pricing mechanism, and a preference for giganticism, Soviet firms tended to be few in number and dependent on a small number of suppliers and customers.  Moreover, just as was the case with the US electricity business prior to deregulation, integration and price regulation led to patterns of investment in plant and equipment that tended to create holdup problems; Steel plant S was highly dependent on coking coal from mine M because the lack of freely negotiated prices meant that outside options weren’t that valuable in constraining opportunism.  (In US electricity, firms that supplied both generation and transmission didn’t worry about holdups between these two stages of the value chain, and hence created generation and transmission infrastructures that were subject to bilateral monopoly problems when the products were unbundled in deregulation.)  Russia inherited this structure, but then eliminated the central planning and price control that was necessary to keep transaction costs  in check.  Hence Putin’s pricing problems.

In Russia, the holdup problems inherent in the mismatch between the pattern of capital investments made when government control over prices suppressed (but didn’t eliminate) pricing disputes, and the pattern that firms would choose if they had to worry about opportunism problems, has exacerbated the price conflicts that are vexing Putin.  But the problem is that saying “presto, change0, make me an exchange-0” doesn’t make these fundamental problems go away.  Indeed, they are antithetical to the effective operation of a centralized spot or futures market.  And what’s more, the prices for the stuff not traded on exchange–which would be most of the steel and coal products actually produced and consumed in Russia–would still have to be negotiated between the parties.  Yes, centralized market prices would provide some information about the underlying fundamentals that affect the values of steel, etc., but there would still be considerable room for dispute about the price relationships between the standardized and non-standardized products.  As a result, there would still be considerable potential for holdup.

I would imagine this plan will go nowhere, as it is as futile as commanding the tides to stop.  It is futile because it ignores all of the transaction- and product-specific features of the products in question, and the necessity of structuring transactions in ways that respect these features.  Putin is apparently like Gary Gensler, who thinks that auction markets should be good for everything, when experience (and economics) shows that they are really good for very few things indeed and pretty much unworkable for everything else.

Putin’s heavy metal headache is a fitting curse for a Sovietophile who is enamored with raw materials and basic industries and who has been the enemy of property rights and the rule of law.  He is suffering this malady in large part because of (a) an industrial structure inherited from Soviet times, and (b) the inability of Russia to move beyond its resource focused development, which (c) which reflects in no small part the fact that the precariousness of property and legal rights in Putin’s natural state is an anathema to entrepreneurship and tends to favor the persistence of oligarchic structures because oligarchs can bargain with the state on relatively equal terms, and can thereby protect themselves against expropriation without having to rely on courts.  Putin’s problem, then, is inherent in Putinism.

Irony can be a real b*tch.

So, good luck with that steel exchange thing, VV.  And don’t say I didn’t tell you so.

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  1. […] This post was mentioned on Twitter by Craig pirrong and Craig pirrong, Craig pirrong. Craig pirrong said: Updated my SWP blog post: Vladimir Putin, Transaction Cost Economist: Part II ( ) […]

    Pingback by Tweets that mention Streetwise Professor » Vladimir Putin, Transaction Cost Economist: Part II -- — June 9, 2010 @ 4:13 pm

  2. For anyone interested in the topic, a 1966 article by Roger Gray on success and failure of futures markets is still the classic work on the subject IMHO:

    Comment by Scott Irwin — June 10, 2010 @ 9:40 am

  3. Does anybody see any significant difference between Putin as described here and Stalin? After all, Putin has plenty of time to get just as carried away.

    Horrifying. What must it feel like to be a Russian with no chance of leaving the country watching this crap unfold day after day?

    Comment by La Russophobe — June 10, 2010 @ 5:14 pm

  4. Let’s not insult Stalin.

    Comment by So? — June 10, 2010 @ 9:02 pm

  5. Excellent post perfesser. I expect this whole ‘exchange’ idea will get walked back in short order. “Oh no no. I didn’t mean an exchange per se. What I really meant was…blah blah Yeltsin bad, blah blah West bad, blah blah Georgia’s fault”. Must avoid the appearance of impotence at all costs. He’ll have to have at least two shirt-optional photo shoots to reclaim his mojo after this. Hmm. Isn’t the annual harp seal whacking coming up? No…wait…they don’t do that anymore.

    Why the short fuse on the notional exchange I wonder? Putin and Medvedev love to order perpetual studies and investigations, why not order a few up here? Is the steel industry really in that dire need of a heavy hand?

    Comment by Swaggler — June 10, 2010 @ 9:05 pm

  6. Putin jumped the shark in ’07 with that shirtless shtick.

    Comment by So? — June 11, 2010 @ 12:25 am

  7. Craig, Please stop before you (inadvertently, of course) give transaction cost economists a bad name by association!

    Comment by Scott — June 11, 2010 @ 7:41 am

  8. Can you explain the thought behind the 2011 budget, and why they increased by 25%?

    Comment by NinaIvanovna — June 11, 2010 @ 11:04 am

  9. Cheers Prof Irwin – that article is hysterical.

    Would one of you gents (Irwin, Pirrong) venture a guess why the normal backwardation hypothesis is still with us, and still features prominently in every (intro) course on the subject? It is an honest mystery to me.

    Comment by DTH — June 11, 2010 @ 11:21 pm

  10. DTH–mystery to me too. I teach about it for historical background reasons, and as a foil to more serious treatments of risk premium. My thesis advisor, Lester Telser, cast empirical doubt on the normal backwardation theory in HIS PhD thesis in the late-1950s; bad ideas are hard to kill. (As many Keynesian ideas demonstrate.) It also annoys me no end that Keynes appropriated the market term “backwardation” and used it in a completely different way. That has been a source of confusion ever since.

    Scott–LOL. I have one more post to write about the subject. Then I’ll stop. Maybe you should write Putin and tell HIM to stop 🙂

    The ProfessorComment by The Professor — June 12, 2010 @ 2:23 pm

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