Congestion pricing for security trades?

So the whole “banning shorts” thing was wearily predictable. The very politically-connected “good” investment banks had a little scare this week. Call it panic selling, call it a bear raid, whatever. Suddenly, it’s illegal to short financials. Go figure.

People like me are appalled. If it’s illegal to short in a “panic”, we ask, why isn’t it illegal to go long during obvious asset price bubbles? If you can tell a panic from a correction, then surely you can tell an asset bubble from a genuine boom, right Mr. Greenspan? Most people were perfectly aware of the housing and tech bubbles in real time. Only economists and idealists get confused.

Whatever. As I said, the whole dialog is tired, obvious, predictable.

But… Much as I’m an unapologetic short, I’m perfectly willing to concede that there’s such thing as irrational momentum selling, just as there is irrational momentum buying. Momentum buying is far more insidious and destructive in the long term, but both are bad. Banning short sales (or, in mirror image, restricting asset purchases to short covering) might help prevent momentum trades, but it’s a lousy way to address the problem. Decapitation is a perfectly effective cure for migraines, but that doesn’t make it good medicine.

Dean Baker frequently suggests a “Tobin tax” on securities trades, which, as reforms go, is not a terrible idea. What if we did put a small transaction tax on taking financial positions? Reduced liquidity means an increased commitment by investors to the underlying economics of their paper. That’s a good thing.

But what if we designed this tax so that, rather than being calculated as a constant fraction of transaction value, it was a function of both value and trading volume, so that it would be more expensive to trade when everyone else is also trading? Maybe it’d cost 0.02% of notional value to trade when daily transaction volume has been within 1 standard deviation of the trailing year’s mean, but the cost would increase as steeply rising function of any abnormal volume?

Such a tax would have lots of nice properties: First, it would be symmetrical, neutral between buyers and sellers. It would not harm transactors bringing new information into the market, since transaction volume would be normal while the information remains closely held. But it would bite transactors who react to widely known news or who pile on to price momentum. That is, “congestion taxing” wouldn’t much damage the information aggregation/price discovery of markets, but would tax the zero-to-negative sum rush into or out of positions once the information work is already done. “Me too” purchases would be expensive, and those that occur would be informative, because they would reflect conviction rather than copycatting. Low-conviction information cascades would be discouraged by a high cost of entry, rather than prevented outright by administrative fiat.

Is this a good idea? It’s Friday night, been a phukked up week, and I’m drinking right now (Kentucky Bourbon Ale, ya gotta try it), so maybe I’m slurring my thoughts. Just thought I’d toss this out into the world, and see where it lands.

Update: Jesse Eisinger has just published a nice column on the Tobin Tax in Portfolio.

Update History:
  • 22-Sept-2008, 9:45 p.m. EDT: Added link to Jesse Eisinger’s column.

To whom and for what?

I am sorry to go all AWOL lately. I’ll try to post something substantative over the weekend. My temporal balance sheet looks a great deal like Lehman’s financials. Plus, despite the generous antidotes provided by Yves Smith, the events of the past few weeks have me twitchy and disoriented, reading obsessively but barely capable of drooling. I think I speak for a lot of us who’ve been on the pessimistic side of the financial blogosphere these last few years in saying I wish we had been wrong. (I wish the mighty who are now falling had paid us some mind, too.)

Today’s big news is the hint of a bail-out to end all bail-outs. I often have mixed feelings about Robert Reich’s commentary, but I commend to you his piece today.

There is no question that we are going to spend a lot of public money to address the current crisis. We have already put a very extraordinary amount at risk. The question we should be asking is not whether or how much, but to whom and for what. The financial crisis we are facing is a symptom of a much larger economic and social crisis. Wall Street is not the source of the pain. On the contrary, the financial sector has been put this decade primarily in the service of hiding, literally of papering over, unsustainable trends in the current account, income distribution, human and physical capital deterioration, and the sectoral composition of the American economy. The conventional wisdom is that this is a financial crisis, and that so far “Main Street” has been largely insulated from the catastrophe. That is rubbish. The cancer is on Main Street, and the tumor has been growing there for years. Wall Street provided drugs to hide the pain and keep us going, palliative but not curative. What is happening now is those drugs are wearing off. The American economy is fundamentally unsound, and has been for some time. We would have noticed sooner, were it not for financial methamphetamine conjured by mad scientists in lower Manhattan from a whirlwind of foreign central bank money.

I think we’ll only get one shot to set things right by throwing a ton of money at the problem, so we’d better think carefully before we throw it at symptoms rather than causes. Trying to figure this out in a week before Congress goes off to reelect itself strikes me as ambitious. Broadly, my view is that if we are going to legislate, Congress should empower regulators to declare systemically important firms insolvent, write off existing common and preferred, fire incumbent management and unilaterally convert debt to equity as far up the capital structure as they need to go until the firms are unambiguously well-capitalized, with little or no public money involved. Going forward, investors should understand that firms that are too big to fail are too big to be debt-financed, and government enforcement of debt claims against such firms will be limited. If economies of scale are real, equityholders should be glad to reap them. Otherwise markets function better anyway when populated by small actors who compete rather than by behemoths who dominate. The government should not subsidize the many negative externalities of scale. Members of the Pigou Club might suggest that bigness should be taxed and diversity subsidized.

As far as the money is concerned, throw it at infrastructure. Increase worker bargaining power by offering Federally funded retraining sabbaticals for any worker over thirty who decides they want to retool. I’d rather see a new WPA than a new RTC. If it is true that during a debt deflation, the government can spend freely without fear of inflation, let’s spend in a way that balances the economy, not in a manner that tries to ratify the imbalances that brought us here in the first place.

There’s no such thing as a choice-free bailout. The government’s largesse will go to some and not to others, and we have to decide. Don’t believe self-styled technocrats who claim that science or the market tells them who deserves the tax- (or inflation-) payers’ dollar. In a bail-out, there are winners and losers, and we get to pick. I think we should focus on a simple goal: Restructuring the economy so that the vast majority of Americans can afford a middle-class lifestyle with very little leverage on household or government balance sheets. That may be a radical suggestion in 2008, but our grandparents would have considered it only common sense.

Update History:
  • 19-Sept-2008, 8:30 a.m. EDT: Minor edits, added a missing “is”, replaced required with involved re public money.

Inequality and the Credit Crisis

It’s a clich&eacute, of course, that the 2000s are the new Gilded Age, that inequality in America is at levels not seen since the original Gilded Age, which you may recall was ended by a terrible depression.

During this decade’s tiresome debates about inequality, the don’t-worry-be-happy side of the argument frequently, and correctly, noted that income inequality statistics overstate the lived experience of inequality, since the poor spent more than they earn and the rich spent less.

Of course, the poor spend more than they earn primarily by taking on debt. In the halcyon days of 2006, that was no problem. Credit flowed like honey, and what could always be refinanced need never be repaid. It’s a wonder we didn’t do away with the whole “money” thing entirely. If you can spend all the way down to negative infinity, it hardly matters whether your starting wealth is one dollar or a billion dollars. Why keep track?

But, alas, people did keep track. They also stopped lending to people who might not be able to repay, people who, you know, spend more than they earn. Which means, even putting aside the terrible hardship of bankruptcy, or struggling to pay down old loans, all of a sudden the lived experience of inequality must come very much to resemble those unpleasant income inequality statistics. Are we cool with that?

In a way, the credit crisis comes out of a tension between the broad-middle-class America of our collective imagination and the economically polarized nation we have in fact come to be. We borrowed to finance an illusory Mayberry. The crisis won’t be over until this tension is resolved. Either we modify the facts of our economic relations, or we come to terms with a new America more comfortable with distinct and enduring social classes.

Tanta and Calculated Risk have popularized the notion that “We are all subprime now.” But that simply isn’t true. The vast majority may be subprime now, but not all of us. To use an old expression, as the easy money falls away, we are being left to “find our own level”. For many, it may be quite a bit lower than we had imagined.

I’m sure this is a bit polemic, but I don’t think it is much overstated. Credit was the means by which we reconciled the social ideals of America with an economic reality that increasingly resembles a “banana republic“. We are making a choice, in how we respond to this crisis, and so far I’d say we are making the wrong choice. We are bailing out creditors and going all personal-responsibility on debtors. We are coddling large institutions of prestige and power, despite their having made allocative errors that would put a Soviet 5-year plan to shame. We applaud the fact that “wage pressures are contained”, protecting the macroeconomy of the wealthy from the microeconomy of the middle class.

The credit crisis will end, and life in America will go on. What we have to decide now is, when the floodwaters clear, what kind of country will be revealed. Peering down through the murk, I don’t like what I am seeing.

Addendum: Tyler Cowen was prophetic on this point. He wrote in January, 2007 on income vs. consumption inequality:

People may be borrowing and accumulating large debts. Note that in this case, however, the comeuppance, however bad it may be, has yet to come. It could instead be argued that “inequality will (someday, when the debts come due) be a serious problem.”

Welcome to someday, Labor Day, 2008.

FD: I’m still very stagflation-oriented in my personal portfolio (precious metals, short long bonds and stocks), so the wage-price spiral demagoguing might be interpreted as self-interested. That said, no apologies. It astonishes me that even very liberal economists take comfort in the evisceration of wage-earners’ bargaining power. Yes, it means that Ben doesn’t need to hike, regardless of what commodities do. But what kind of economy are we building when we take the price of past mistakes out of future wage-earners’ pay packets, while protecting the accumulated wealth of those who profited by erring?

Why inflation?

In the more eschatological corners of the financial blogosphere, a debate has raged for centuries: Inflation or deflation?

I recommend Michael Shedlock as a thoughtful and passionate proponent of the deflationary view. (See e.g. here and here, but he’s been making the case for years and it’s worth searching the archives.) Also, Karl Denninger recently offered a nice deflationary tract.

I’m more certain of monetary and price volatility than I am of inflation or deflation. But on balance, even as commodities crash and the dollar rallies, my best guess is inflation.

Do read today’s excellent post by the always excellent Brad Setser, The changing balance of global financial power. Take a look at his graphs, showing the external official claims of “democracies” vs “autocracies”. You’ll notice that the autocracies are owed a great deal more money than the democracies are. Mostly, money is owed by the democracies to the autocracies in the form of debt denominated in the democracies’ currencies.

[Note: For the purpose of this piece, it matters only that policy in the “democracies” be sensitive to public pressure. The internals of the “autocracies”, and whether they are justly characterized as such, is not relevant to the argument, and not anything I want to get into here.]

Inflation helps debtors at the expense of creditors. In democracies where those who can vote are, on balance, debtors, one would expect collective indebtedness to favor inflation. Not all citizens are debtors, there would be domestic winners and losers. But on balance, voters gain by printing currency. If that’s a good argument for free trade, why should it not be an argument for weak money?

There are, of course, institutional constraints, “independent” central banks and all. It is one thing for a nation’s central bank to stand above the fray with respect to competing domestic interests, but quite another for the bank to put foreign interests or economic ideals above a collective national interest. That’s especially true if the alternative to devaluation is deflation. Under a deflation, American workers (those who remain employed!) would have to work more to pay off their fixed dollar debts. Individuals can declare bankruptcy and default, but collectively we cannot default on official debt (pace Felix Salmon, whose heretical idea I adore). One way or another, as reckless debtors or noble taxpayers, Americans would have to work harder under a deflation than they had signed on for when they took on the debt. Americans are having a hard time coming to grips with their nominal debt burden, public and private. I think it implausible that they would accept a large increase in the real interest rate they must pay. Officially it is the policy of the American central bank to maintain price stability and full employment regardless of the external value of the dollar. If the Fed faces a choice between deflation and high unemployment, or tolerating a significant inflation (with or without high unemployment), I’m pretty certain it would choose the latter as the less-bad option.

Japan’s experience in the 1990s and the US’ in the 1930s are often cited to suggest the inevitability of deflation, despite monetary policy heroics. But in both cases, the deflating country had a large, positive international asset position. To the degree money was owed by foreigners in domestic or pegged currency, the “national interest”, looking past winners and losers, was to tolerate deflation.

All of this ignores the secondary consequences of a partial default through inflation and devaluation. A wise polity would weigh the immediate collective benefit of reduced debt load against costs including higher future interest rates (foreign creditors get spooked), more expensive tradables, and a nationalistic backlash by creditor states. Of course, it would also have to consider the secondary effects of tolerating deflation, such as a spike in bankruptcies combined with a large tax spike to avoid a sovereign default. It seems to me that the adverse consequences of deflation would be sharp and domestic, while high prices and interest rates can be billed as “facts of nature” in a market economy, and other people’s hostile nationalism often helps domestic politicians, who can provoke some hostile nationalism of their own.

It is not impossible that the Fed will square the circle, maintaining something close to price stability while the US gears up its tradables economy and foreign creditors silently ease our debt burden via real appreciation. Obviously, that’s the best outcome (at least for the United States). But if deflationary winds do blow, if the Fed is faced with the choice of tolerating a spiraling credit contraction, falling prices, and bankruptcies or overshooting with “quantitive easing” into inflation, well, as Ben Bernanke famously put it

[T]he U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

FD: My investment portfolio includes inflation hedges such as precious metals and short positions on long bonds. My portfolio return over the past several weeks has been large and negative, and if you take anything here as investment advice please expect a similar outcome.

Too much risk?

One of the more depressing bits of emerging conventional wisdom is the notion that the financial system took on “too much risk” in recent years. I think it is equally accurate to suggest that the financial system took on too little risk.

Consider the risks that were not taken during the recent credit and “investment” boom. While hundreds of billions of dollars were poured into new suburbs, very little capital was devoted to the alternative energy sector that is suddenly all the rage. Despite a “global savings glut” and record-breaking levels of “investment” in the United States between 2005 and 2007, capital was withdrawn from a variety of industries deemed “uncompetitive” in large part due to obviously unsustainable capital flows. Very few brave capitalists took the risk of mothballing rather than dismantling factories and maintaining critical human capital through the temporary downspike. Under the two to five year time horizon of our most far-sighted managers, whatever is temporarily unprofitable must be permanently destroyed. To gamble on recovery is far too great a risk.

I don’t pretend to know where all that capital, that incredible swell of human energy and physical resources, ought to have gone. But it doesn’t take an Einstein to know that it probably should not have gone into building Foxboro Court. Sure, hindsight is 20/20. But lack of foresight really wasn’t the problem here. In 2005, how many macroeconomists or big-picture thinkers were arguing that the US economy lacked suburban housing stock of sufficient size and luxury? We gave the building boom the benefit of the doubt because it was a “market outcome”. But the shape of that outcome was more matter of institutional idiosyncrasies than textbook theories of optimal choice. It resulted as much from people shirking risk as it did from people taking big bets.

The big central banks, whose investment largely drove the credit boom, were (and still are) seeking safety, not risk. The banks and SIVs that bought up “super-senior AAA” tranches of CDOs were looking for safe assets, not risky assets. We had a housing boom, rather than a Pez dispenser bubble, because housing collateral is (well, was) the preferred raw material for fabricating safe paper. Investors were never enthusiastic about cul-de-sacs and McMansions. They wanted safe assets, never mind what backed ’em, and mortgages are what Wall Street knew how to lipstick into safe assets. The housing boom was born less from inordinate risk-taking than from the unwillingness of investors to take and bear considered risks. Agencies, asset-backed securities, it was all just AAA paper. It was “safe”, so who cared what it was funding?

Finance is not a closed system, a zoology of exotic contracts and rocket scientist equations. The job of a financial system is to make real-world decisions, “What should we do?” A good investment is a simple answer to that question, with clear consequences for getting it right or wrong. Mom and Pop can have FDIC insured bank accounts, and imagine that there is such thing as a “risk-free return”. But that’s a lie, a sugarcoated subsidy. Foregone consumption does not automatically convert itself into future abundance. People have to make smart decisions about what to do with today’s capital. If they don’t, no amount of regulation or insurance will prevent all those savings accounts from going worthless. When huge institutions treat the financial system like a bank, depositing trillions in generic “safe” instruments and expecting wealth to somehow appear, they are delegating the economic substance of aggregate investment to middlemen in it for the fees, and politicians in it for whatever politicians are in it for. And we are surprised when that doesn’t work out?

Of course we should regulate and manage the risks that were the proximate cause of the credit crisis. Anything too big to fail should be no more leveraged than a teddy bear, and fragile, poorly designed markets should be fixed. But that won’t be enough. We’ve trained a generation of professionals to forget that investing is precisely the art of taking economic risks, then delivering the goods or eating the losses. The exotica of modern finance is fascinating, and I’ve nothing against any acronym that you care to name. But until owners of capital stop hiding behind cleverness and diversification and take responsibility for the resources they steward, finance will remain a shell game, a tournament in evading responsibility for poor outcomes.

Investors’ childlike demand for safety has made the financial world terribly risky. As we rebuild our broken financial system, we must not pretend that risk can be regulated or innovated away. We must demand that investors choose risks and bear consequences. We need more, and more creative, risk-taking, not false promises of safety that taxpayers will inevitably be called upon to keep.

Financial system failure and the paradox of thrift

Over the weekend, Paul McCulley offered a thought-provoking piece (ht Justin Fox, Brad DeLong), which starts with a discussion of the “paradox of thrift”:

For those of you who might not recall, the paradox of thrift posits that if we all individually cut our spending in an attempt to increase individual savings, then our collective savings will paradoxically fall because one person’s spending is another’s income – the fountain from which savings flow.

There’s a hidden assumption in the “paradox of thrift” that really ought to get teased out more often. It is true that one person’s spending is another person’s income. But it does not follow that an increase in saving translates to a decrease in aggregate income. There are two kinds of spending, consumption and investment. Laying a subway line adds to somebody’s income as surely as buying a Ferrari does. Ordinarily, nearly all savings are actually spent on investment goods, and there is no “paradox of thrift”. What is “saved” is really spent on current production of future capacity, and there are plenty of paychecks to go around. There is no “fallacy of composition“: individually and in aggregate, today’s thrift lays the groundwork for tomorrow’s abundant consumption.

However, for this to work out, two things must be true: Today’s savings must be invested in projects that will actually generate future wealth, and savers must believe they will retain a stake in the increased wealth commensurate with the size and wisdom of their investments. We have a financial system in order to make these facts true. If the investment industry is capable of finding or initiating projects likely to satisfy future wants, and if financial claims are predictable and stable stores of value, we need not trouble ourselves over the paradox of thrift. The issue only arises when the financial system breaks down. When investors lose faith in the quality of available investments or their ability to collect the proceeds (in real terms), they pull out savers’ Plan B: precautionary storage. They buy gold, or oil, or art, or whatever, and they keep it, generating scarcity rents for those who can offer perceived value stores, but very little in the way of general income and employment. Precautionary storage, not thrift itself, is the villain of the tale.

The vulgar Keynesian prescription is to encourage consumption, when a dynamic of precautionary storage takes hold. And in extremis that might be a good idea, because if all everyone does is hoard, it’s hard to figure what to invest in, except maybe storage tanks. But it’s much better to develop a financial system that actually performs, that identifies fruitful projects and allocates claims fairly. Storage eats wealth, while productive enterprise creates it. People know this. No one “invests” in gold or oil when a financial system is working. They do so when it is broken. Like now.

Encouraging people to go shopping in order to help the economy is not “second best” policy. It’s a desperate last resort. We’re not at a point where there’s so little economic activity that we can’t foresee future wants. We’re at a point where people are beginning to shift from investment to storage because of a well-deserved loss of confidence in the financial system. Encouraging consumption now is nihilistic. It feeds into a vibe (I feel it personally, do you?) that saving is so uncertain and money so volatile that one might as well spend, ‘cuz who knows what tomorrow might bring. The right way to sustain aggregate demand and maintain current income is to figure out what we should be investing in — not stocks, bonds, or CDOs, but factories, windmills, or schools — and then to put current resources to work. Our financial system is failing spectacularly because it erred grievously. It built homes and roads and sewers that oughtn’t have been built, it “invested” in vacations and plasma televisions, and it paid itself handsomely for doing so. That’s not a problem we can spend our way out of. To fix the financial system we have to change it, not rally to its support. We will know we’ve put things right when thrift is something we can celebrate, when we save because we are excited about what we are creating rather than frightened by what we might lose.

Covered by whom? Bonds on what?

When you’re abducted by aliens, there’s little cause to be cynical. The sucktitude of a painful probe is straightforward. There’s no sugarcoating to see past, things are exactly as bad as they seem. Between the screams you realize that, in a way, you have been offered a kind of innocence. When you are abducted by aliens, you savor the silver linings.

After such an ordeal it’s a bit depressing to be dropped off on the Planet of the Covered Bonds. Cynicism levels are off the tricorder here as, alas, they should be. [See Yves Smith, Michael Shedlock, Maxed Out Mama. Less cynically, David Merkel offers a very nice description of what covered bonds are and how they work.]

Covered bonds sound nifty. They’re designer drugs. They’re just like the mortgage-backed securities that gave us such a fine party, except the nasty hangover inducing components have been engineered away. They are on-balance sheet loans, look Ma, no Enron! (finally…) Covered bond issuers have “skin in the game”, skin, bone, and sinew actually, as they guarantee the loans. That problem of “misaligned incentives” is solved, ‘alleleujah! (…though intrafirm agency problems are not addressed.) These are old-fashioned, full recourse, secured and overcollateralized loans, just packaged into tradable securities. What could possibly go wrong?

Formally, the only way anything could go wrong would be if the issuing bank fails and the pledged assets turn out to be worth less than originally estimated. Do you think those two events might be correlated? Covered bonds can certainly be no worse, from an investor standpoint, than the nonrecourse asset pools they are intended to replace. A guarantee by the issuing bank has gotta be worth something. If it were 2002 again and the banking industry had adopted this originate and guarantee model (rather than the originate and forget model they chose), perhaps we wouldn’t be in the current mess. But it is not 2002. These bonds will be offered by banks that would already have collapsed without vast support to the financial system by the Fed and the US Treasury. Guarantees by money-center banks are no longer bonds of confidence in the prudence or skill of bank managers. The value of such guarantees comes from a different place, from the notion that it is unthinkable the state would permit these banks to fail. A covered bond offered by Citi or Bank of America would only default if a titan collapsed. Investors might reasonably believe that would not be permitted to happen. If they are right, then these bonds are indeed covered. They are covered by you, dear taxpayer.

The great credit crisis of 2007-2008 is slouching towards its Bethlehem, a full faith and credit crisis for the United States of America. This die was cast at the first TAF auction, when the Fed chose to pull private credit risk onto taxpayers’ already strained balance sheet, rather than endure any unpleasantness. Covered bonds may prove to be a success with investors. But, careful what you wish for. The more banks sell, the more we’re all on the hook, if the loans go bad. Covered bonds issued by “too big to fail” banks are basically equivalent to mortgage backed securities guaranteed by Fannie and Freddie. It’s just another way of putting private-sector bells and whistles on a public sector assumption of risk.

These bonds are seen as a way of “unfreezing the housing market”. The housing market seems frozen because in many areas, relationships between home prices, rents, and incomes are still out of whack. Assuming relatively stable rents and incomes (bad assumption, I know), mortgages in “stuck” markets made at or near current asking prices are likely bad investments. That suggests the implicit taxpayer guarantee won’t expire unused. The more covered bonds are sold, the more extreme measures or hidden subsidies will be required to prevent household names from failing.

The committee to save the world is you, and we will be grateful for your contribution, although we will never thank you, or admit that anything other than the skill of our red knuckled, fabulously wealthy financiers had anything to do with the eventual recovery. That period of commodity inflation and steep yield curves was just a market outcome, a fact of nature. Of course our proud financial institutions were always going to weather the storm. They are the best and most sophisticated in the world. Thank goodness for private enterprise.

[HT Yves Smith on the slouching towards Bethlehem thing. BTW, my use of the term “taxpayer” is imprecise, state guarantees are really backed by “taxpayers and/or those most vulnerable to inflation (low bargaining power workers and those on fixed incomes)”. My guess is that we will use tradables inflation more than outright taxation to save the whales. FD, I’m short long-term Treasury futures and long precious metals, going with that whole full faith and credit crisis scenario. As always, this ain’t investment advice, I frequently lose my shirt so go copy Warren Buffett or something.]

Update: Felix Salmon directs us to an excellent new blog on which John Hempton writes:

[I]f you have lent to people in a currency where interest rates suddenly go to 50 percent (as happens in some devaluation crises), your funding cost (deposits) will rapidly go to 50%. However if you pass that on to your borrowers they will fail. You will suffer credit risk and possibly go insolvent. If however you have offered fixed loans to your borrowers you will wind up with huge funding mismatches – and possibly go insolvent. For small moves there is a difference between credit risk and interest rate risk. For large moves there is no effective difference. The same analysis applies to currency and credit risks.

This goes some way towards adressing Tyler Cowen’s demurral

I cannot see that the credit of the United States government is in danger. There is a) the printing press, and b) our location on the left side of the Laffer Curve.

I agree with Tyler that the US government is more likely to print than default outrught, if those are the alternatives (though do recall this from the generally levelheaded Accrued Interest). But, for large moves, I think the distinction between credit risk, inflation risk, and currency risk is largely academic. (Regarding Tyler’s second point, Robert Olson hits the nail on the head in a Marginal Revolution comment, “Being on the left-side of the Laffer Curve doesn’t matter much if the political situation makes it impossible to raise taxes.”)

Update History:
  • 29-July-2008, 11:09 a.m. EDT: Fixed misspelling of Warren Buffett’s name. Thx Nemo.
  • 31-July-2008, 3:03 a.m. EDT: Added the word “by” somewhere where it was needed. Added the update regarding credit risk vs inflation/currency risk.


Err… is this thing on? Am I back?

I think I’m back.

I am periodically abducted by aliens, who do unspeakable things the details of which I can only guess from various aches and irritations.

In my absence, the comments on the previous more-than-a-month-ago post were remarkably good. The blog is better, actually, when I disappear. Smarter voices chatter.

The whole oil thing seems so, like, last month, although I notice there was some kind of deadhead revival in SoCal a couple of days ago. Some quick, crude thoughts: the whole “fundamental” vs “speculative” debate is terribly miscast, as emphasized most recently by Jeff Frankel (via Mark Thoma), but also by Tyler Cowen, and me too. What I liked best about the Thoma / Krugman model is that it gave us four lines to think about, two kinds of demanders (people who want to burn oil vs people who want to store it) and two kinds of suppliers (people who suck oil from the ground vs people who drain their tanks). An imbalance of speculation on futures (more longs than shorts) creates incentives for people with tanks to fill them, potentially shoving up one of the two demand lines (the one on the left-hand panel of the Thoma/Krugman graphs). But four lines iz a lot of moving parts. I think the really interesting line is the right-panel supply line. Rather than “speculation” vs “fundamentals”, I wonder whether discretionary oil producers are flat-out producing as much as they are able, given the infrastructure currently in place, and whether over the past few years they have held back on developing capacity, or whether they are in fact eager to pump but hitting “peak oil” limits. Either story is consistent with James Hamilton’s fundamentals, although one might call unenthusiastic production “speculative” in a certain sense. In the end, I think Paul Krugman wins the debate he started, if it was the left-panel demand line driving prices, the only piece futures-buyers can influence, we should observe storage in tanks. As both Robert Waldmann and Alea’s jck (in a comment) point out, paper speculators only persuade oil producers to leave the stuff in the ground when they drive futures into something close to strict contango, because producers enjoy less of a convenience yield than people with tanks. Inventory should build in tanks before it builds underground, if increased stock demand is driving the story.

It’s important to note that, just because futures buying / speculative storage probably did not drive the great oil price boom of early 2008, doesn’t mean it could not affect prices. Imagine, in Mark Thoma’s discussion, that rather than a parallel outward shift in demand, the slope of the stock demand curve flattens as well. The “flatness” of stock demand maps to speculators’ conviction that prices will rise. If speculators are absolutely certain that (the present value of) future prices will be higher than the current price, then they would persistently buy as much as would be necessary to pull the flow market price to the expected future price. In Mark’s scenario, speculators effectively choose a quantity they are willing to buy at above the spot clearing price, and prices revert once their appetite has been sated. But speculators might choose price rather than quantity. (Still, if they do, we should see inventory build.)

Of course, explaining the rise in oil prices is passé. Now it’s all about explaining the fall. Is it demand destruction? an incipient long run? declining inventories? increased production? a speculative bubble going “pop”? I dunno. Do you? (Maybe it’s those evil short-sellers.)

In the month-ago discussion, Arnold Kling was the first to point out the connection between option values and the convenience yield. That theme was developed quite extensively by commenters, especially anon and MG, and is common in the academic literature as well. The kind of option a convenience yield represents is fun to think about. It is an option whose underlying is fluctuating calendar spreads, rather than prices. There is a lovely symmetry, in that there is a positive convenience yield both on having the commodity available, and on not having the commodity (but having an place to efficiently store it). If that seems weird, recall how same-strike call and put options both have positive value, even though when one is in the money, the other cannot be. We can even derive a relationship between the expected value of these two convenience yields somewhat analogous to put/call parity.

This all seems very retro now, a month is a long time, in the blogosphere and in financial markets. If I can avoid the lights in the sky, perhaps I’ll come up with something more exciting to write about soon.

Oh! Speaking of exciting, welcome Gabriel!

The convenience yield

If a commodity is in “backwardization”, that is, if futures prices are lower than current prices, does that imply that futures markets are discouraging storage (encouraging disgorgement)? Paul Krugman makes the case, here and here.

I’m going to challenge him with a low-down, dastardly kind of argument. The gentleman keeps asking for evidence, evidence, and in response I’m going to offer an unfalsifiable hypothesis. Krugman says that futures prices are too low to cause people to withhold physical oil and sell forward, as required to affect spot prices. But whatever forward price curve he shows me, I can posit an invisible “convenience yield” large enough to make hoarding oil worthwhile. I don’t even have to be unreasonable about it. Extrapolating from historical data, we see that gently “backwardized” futures prices might be quite sufficient to encourage storage when convenience yields are taken into account.

Despite all of this, I agree with Krugman that futures markets can’t explain the recent skyrocketing oil prices. Not unusually, he’s been a voice of sanity and reason. But just as speculation in futures need not affect spot prices (if it is balanced long and short), speculative withdrawal of physical supply need not affect the shape of the future price curve. Futures market “signatures” can’t be relied upon to distinguish speculative from fundamental demand, and inventory may be unmeasurable, especially if it is offshore or takes the form of withheld production. Further, both futures in contango and measured inventory build can signify known fundamental demand as well as speculation. (Suppose entrepreneurs are planning to fire up many new factories over the next few months. If they buy forward to hedge their exposure to energy prices, that would push futures into contango and promote storage with no one speculating on anything.)

But this isn’t about that. This is a disquisition, and ode, a homage and a tribute to the marvelous, mysterious, misunderstood and maligned convenience yield:

The bedrock principle of futures markets is “no arbitrage”, that is prices should be set such that there is no investment strategy that yields a risk-free profit higher than the risk-free rate of interest. For a physical commodity, this seems to imply that the forward price should equal the present price plus the risk-free rate of interest and any storage costs. Interest rates are never negative, and storing stuff always costs something, so you’d expect future prices of storable commodities to always be higher than current (“spot”) prices. But check out the following graph of the four month “forward yield” of crude oil. (Data courtesy of the EIA, hat tip Krugman, calculations and errors are mine, click for a bigger version).

The “forward yield” is just the percentage by which the future price is higher than the spot price. I’m using four month futures, but I’ve converted the yield an annual rate. If the forward yield is 10% and the interest rate is 4%, an oil man would profit from buying oil now and selling it forward, as long as his storage costs are less than 6% per year. Tycoons would start buying spot and selling forward until yield dropped to interest + storage.

But didn’t we say future prices should be higher than spot prices? Look at the average (the yellow line in the graph). It at -3.4%, well below zero! The yield is negative more often than it is positive. Whenever the yield is anything less than interest + storage, you’d expect oilmen to sell crude from storage and buy it back forward. He earns interest on his cash and saves the storage costs that way, which is better than the profit he’d make storing and selling forward. When the forward yield is negative, Texans should be selling physical and buying forward like mad. By doing so, they earn interest on cash, save storage costs, and lock-in an easy profit buying back their oil for less than than what they sold it for. Very quickly, all the selling should create a glut of physical oil, driving down spot prices, while the buying forward drives up future prices, until the yield is positive and sanity is restored. But negative forward yields for oil have persisted, sometimes for years at a time! We must be missing something. Hmmm…

Suppose someone offered to buy your vacuum cleaner today for $100, and sell it back to you next week for $80, with no risk of wear or breakage. Would you? It would depend how much you value the use of your snorter. If you refuse, we might infer that a week’s access to the pleasures of vacuuming is worth 20 bucks to you. We call that value of temporary use a “convenience yield”. It’s as if having the vacuum cleaner around pays you $20, even if no cash changes hands. Maybe we observe negative forward yields on oil because the smell of oil in the morning is priceless to guys in cowboy hats. (Or not… see below for a more plausible account of oil’s “convenience yield”.)

Let’s eliminate wandering interest rates, and take a look at the storage cost / convenience yield of oil historically. Below is a graph of a three-month forward yield (calculated from the first to the fourth month forward, because futures prices are more trustworthy than spot) with the concurrent 3-month T-bill rate backed out of it, leaving only storage costs. When storage costs are negative, that reflects, by definition, a convenience yield. (Again EIA monthly data, T-bill rates courtesy of FRED, my calculations)

From Jan 1986 through May 2008, oil futures have reflected a convenience yield of 8% per year on average. (This is in rough agreement with the overall mean of 0.021% per day calculated here by Milonas and Henker, see Table 3.)

Suppose that the current convenience yield is about 8% and three month interest rates are about 2%. Then a one-year futures contract should be about 6% cheaper than spot, and a four-month-out contract should be about 1.4% cheaper than a one-month-out contract (reflecting 3 months of storage). At the end of May, the 4-month-out contract was in “backwardation”, but was only 0.5% cheaper than the 1-month, still too expensive given the convenience yield. Oil dudes could have earned (on an annualized basis) about 3.6% more than the risk free rate (about 5.6% overall) buying high and selling low, but enjoying the privilege of storage. Now that oil is in gentle contango (as of June 17, the 4 month contract costs about 1% more than the 1 month), buying forward and storing looks like a really fantastic deal.

What is this “convenience yield”? Is it real? It seems like it must be, the economics of an 8% return aren’t subtle in the data. But when I first encountered this idea, it baffled me. So instead of talking oil, let’s talk hotels.

Suppose you have a hotel, it’s morning, and you’ve got a room that isn’t yet booked for tonight. Empty rooms end up costing you about $10 a night, considering your rent, maintenance, utilities, etc. But, you estimate there’s about a 50% chance that a weary last-minute traveler will come by and pay your walk-in rate of $150 for the room. So, the risk-neutral expected value of your empty room is $65 [(150 ÷ 2) – 10]. You’re risk-averse, not risk neutral, though. You’d accept a certain $60 rather than a 50-50 chance of losing $10 or earning $140. That $60 is the “convenience yield” on your empty room, it’s what having a room empty, in case opportunity strikes, is worth to you.

Oil is a “spiky” commodity. Every once in a while, someone really needs it, now, and will pay a premium for immediacy. The market for oil in Cushing, Oklahoma might be reasonably efficient, but what happens when someone in Peoria needs oil today? Opportunity! Instead of running a hotel, you build an oil tank in Peoria. Suppose that every month, there’s a 10% chance a desperate client will offer a 5% premium for immediate delivery of all your oil, and that interest and storage cost you 0.2% per month. Then on average, you’d earn 0.5% (10% x 5%) each month from desperate clients, and pay 0.2% in expenses. You don’t want to bear the risk of fluctuating oil prices, so you sell your oil forward. If you were risk neutral, you’d be willing to sell it for a discount of up to 0.3% less than you bought it for at the beginning of the month, at which price you’d just break even. But you’re not risk-neutral: You attach a “certainty-equivalent” value of only 0.4% to the unpredictable income from needy customers, and would offer no more than a 0.2% discount on month-forward oil sales. In the end, you earn a risk-adjusted 0.4% per month “convenience yield” from desperate polluters, and pay 0.2% in interest and expenses, and 0.2% in hedging costs. If one-month oil futures pay more than 0.2%-less-than-spot, or (golden days!) if they are in contango, you’d buy as much oil as you could and sell it all forward, because every new barrel that you promise to buy high and sell not-so-low represents certain (well, “certainty equivalent”) profit.

Putting aside Peoria and our artificial needy customer, sometimes oil spikes even on the wider market, so that anybody with physical oil can sell at a high price and while locking in low-priced near future purchases to replenish their stock quickly enough to meet any other contractual obligation to sell. If you estimate the profit you’d to earn from these occasional opportunities, and subtract a bit to come up with a “certainty-equivalent” value for this uncertain income stream, you’ll have determined a convenience yield. It shouldn’t be surprising that convenience yields are especially high for volatile commodities subject to frequent shortages and price spikes.

When futures markets are well-arbitraged (which might not always be the case!), the future price of a storable commodity is determined by the spot price plus the total cost of storage, defined as foregone interest, plus storage costs, minus any benefit of temporary ownership &mdash the convenience yield! When a storable commodity like oil is in backwardation, that doesn’t mean that the markets are predicting that its price will fall. It means there is a convenience yield. And in order to decide whether futures markets are creating incentives to store or to sell physical stuff, you have to estimate the convenience yield.

Postscript: While I was writing…

Mark Thoma offers a nice extension of Krugman’s model, showing how monetary policy, by affecting interest rates, would be expected to affect storage.

Yves Smith offers very pointed commentary on futures markets, speculation, and inventory (here and here).

If policymakers want to “do something” about commodity speculation, they should really start investigating passivity on the short side of the market rather than enthusiasm on the long. Given what’s before them, I hope they ignore Michael Masters (ugh!) and Thomas Palley (whom I often like, but yuk), and go with Dean Baker’s suggestion of a Tobin Tax (ht Mark Thoma).

Market power, asset allocation, and oil prices

In response to a (somewhat ridiculous) proposal that we “sue OPEC” over high oil prices, Mark Thoma writes:

[I]t’s unlikely that [monopoly power] is the factor behind the run-up in prices. Monopoly power explains the level of prices, i.e. why price is $8 rather than $5, but it doesn’t explain the change in prices, i.e. why the price would change from $8 to $12. There are ways to tell this story, e.g. a war or some other event giving a cartel the cover it needs to raise prices and blame it on external factors, but I don’t think that’s what’s going on in oil markets today, at least I don’t think this is a significant factor behind the oil price increases.

I think there may have been a change over the last few years in the market power of oil producers, for structural reasons. Traditionally, OPEC has suffered from the usual problem that makes large cartels unwieldy: Under agreements to restrain production, members individually have an incentive to cheat and sell larger-than-agreed upon quantities at still artificially high prices. But that assumes that the production quotas are significantly beneath the capacity of most members to produce. More subtly, it also assumes that each country gains by producing more rather than less oil, if cartel prices are maintained. Both of those assumptions may no longer hold.

As the global oil market has grown, demand may have outpaced individual countries’ capacity to supply, either because investment in new projects has not kept pace, or because nations have hit domestic “peak oil”. (See Indonesia for an extreme example.) Other countries may desperately need money in order to fund current spending, so it is widely known they will produce as much as they can, regardless of quotas. Ironically, as long as the total capacity of sure-fire cheaters and constrained suppliers is well below global demand at the cartel’s target price, the certainty of their output may enhance the ability of discretionary producers to control the quantity produced.

It’d always be easier for a cartel of five or six producers to exercise market power than a cartel of, say, thirteen. But that’s especially true when cartel members have little incentive to cheat. Normally, we think of governments as spendthrifts, always eager to spend an extra dime unless constrained by tax revenues or debt markets. That’s obviously a mischaracterization of today’s most important oil producers, whose governments spend far less than the oil revenue they receive. For Saudi Arabia, selling a barrel more of oil is a portfolio choice: revenue from the marginal barrel will be saved, not spent, so the question becomes whether it is wise to shift some of the Kingdom’s current allocation out of oil and into some asset that can be purchased with currency. For countries that have very little non-oil savings, mere diversification would encourage oil sales. It is unwise to have all ones eggs in one basket, and oil producers remember all too well that world prices can go down as well as up. They’d want to store their national wealth in an “efficient portfolio”, one that maximizes their return on risk by including a variety of investments.

But as oil producing nations have accumulated vast reserves of financial assets, switching from oil-in-the ground to stocks, bonds, or bank accounts is no longer so sure a bet. Real interest rates on “safe” dollar assets are currently negative, both in US and home country terms, and the outlook for safe euro assets is uncertain at best. Central banks and sovereign wealth funds of oil-producing nations already hold hundreds of billions of dollars worth of Western financial assets. They might already have reached or exceeded what they view as an optimal allocation of their national wealth into these securities. Of course, producers are still not well diversified, and it’s pretty clear that sovereign wealth funds are looking for alternative assets that might hedge their exposure both to oil and Western paper. But allocating into less liquid, unfamiliar categories of assets is slow work if you want to do it well. Perhaps current oil revenues outstrip oil producers’ capacity to find good investment opportunities, and they view oil-in-the-ground as a better second-best asset than dollars in the bank.

Ten years ago, oil producers did not have vast hoards of dollars and euros, and required oil revenue to meet budgetary needs. World demand was low enough that cheating by OPEC members could corrode producer pricing. It was hard to exercise market power. Now, cheaters don’t matter, and discretionary producers may be indifferent or worse to the prospect of selling a barrel more of oil at current prices.

(In a sense you might not call this market power at all, as price equals marginal cost, that is to oil producers, the assets they can buy for the dollar price of a barrel of oil are worth no more to them than a barrel of oil left in the ground.)

Brad Setser recently noted that…

[T]here are two clear paths that could end the current “oil up, dollar down” pattern.

Weakness in the US economy could drag down global oil demand, pulling both the dollar and oil down. Asia’s 1997-98 crisis led both Asian currencies and the price of oil.

Or a rebound in the US economy could push up the dollar while adding to oil demand. In 2000, a booming US pushed up oil prices and the dollar.

Ironically, a strong, healthy US economy might also push oil prices down, even while increasing US and world demand for oil! The price of oil to discretionary producers is not measured in dollars, but in the future purchasing power of the assets dollars can buy. If oil producers expected US financial assets to appreciate in value more quickly than oil (in terms of what they want to buy), President Bush wouldn’t have to look anyone in they eye to get the producers to invest in new wells. However, if that’s not the case, then the rate of production might be determined more by the political costs of failing to produce than by world demand or current-dollar prices.

But… for US dollar assets to appreciate faster in oil-producer purchasing power than oil itself, those assets would have to represent claims (direct or indirect) on future goods that producers want to buy, that is investment in tradable goods and services. Unfortunately, Brad is probably right to suggest that a “rebound” in the US economy would drive oil prices up, since we’ve come to believe that more GDP is always better, sectoral composition doesn’t matter, and producing tradables is for the little people. Federal stimulus checks might give a zetz to GDP, but in and of themselves they do nothing to make claims on American assets worth buying.