Asymmetrical Information

From the desk of Jane Galt:

KrugmanWatch An old joke: A

KrugmanWatch

An old joke: A farmer hears suspicious noises in his henhouse. "Who's there?" he calls out. "Nobody here but us chickens," replies the thief. Satisfied, the farmer goes back to bed.

That about sums up the behavior of federal regulators during California's electricity crisis. As I've been pointing out for more than a year, there is powerful circumstantial evidence that market manipulation played a key role in that crisis. Energy companies had the motive, the means and the opportunity to drive prices sky-high. And the crisis exhibited exactly the features you would expect if market manipulation was playing a big role: much of the state's generating capacity stood idle even as wholesale electricity prices went to 50 times normal levels.

An old joke: an engineer, a chemist, and an economist are stranded on a desert island with no food source but the ton of canned goods sitting on the beach. (Where'd it come from? I don't know. Doesn't matter to the story.) They are trying to figure out how to open it using only the sparse vegetation found around the island.

The engineer gets to work making a complicated catapault device to burst the cans on impact with the sagebrush.

The chemist gets to work trying to extract acid from the local plants.

The economist, meanwhile, sits on the beach. When the other two ask him what he's doing, he says. "The problem's very simple. First, we assume a can opener. . . "

That about sums up Paul Krugman's behavior in the California energy crisis. He's assuming the Bush Administration is guilty. He'll get around to finding the actual proof some other time.

"Energy companies had the motive, the means and the opportunity to drive prices sky-high"? This is evidence? Paul Krugman had the means, the motive, and the opportunity to plot the assasination of Andrew Sullivan, but I misdoubt he's put them into action. As for that idle capacity, unless I missed a memo, I'm assuming he's referring to the plants that went down for routine maintenance. Probably that generators were not particularly eager to get that capacity back online; I'm sure that they weren't after the state refused to pay. But the maintenance, was, in fact utterly neccessary; as the internet boom fueled consumption, the generators had run their plants flat out the previous summer without breaking for routine maintenance. Or so I'm told by people who ought to know. I'm also told that to the extent that plants were held idle, it was because there was insufficient transmission capacity for the power they could have generated. It was not part of some vast conspiracy to defraud the public -- if refusing to sell people something they want at the price they want to pay can be called "fraud".

Yet federal officials, from George W. Bush on down, offered California nothing but sermons on the virtues of the free market. The Federal Energy Regulatory Commission, which is supposed to police these things, found no evidence of foul play. Essentially, FERC asked energy companies whether they were manipulating the market. "Who, us?" they replied — and that was that. My favorite FERC study found that power companies had the ability to exercise "market power," and that it would have been profitable for them to do so, but that there was no evidence that they actually had. Those power executives must be swell guys!

Amusingly, Krugman fails to mention that there's nothing FERC could have done, because all of this was legal. At least I'm amused.

The significance of the "smoking gun" Enron memos that came to light a few days ago is that they show exactly how swell those power executives really were. It turns out that Enron was indeed rigging the markets, with schemes that had smart-alecky nicknames like Fat Boy, Death Star and Get Shorty. Who said business isn't fun?

So the big problem with all this is that traders are wiseasses. If they'd just named their trading strategies after the 12 apostles, we could live with it, but movie titles -- can we give them the death penalty for transgressing on the sacred name of Tarantino?

These memos came to light despite FERC's evident determination to see no evil. (We now know that the Bush administration in effect allowed Enron to choose the commission's members.) As one California official put it: "FERC is like a parent who doesn't want to believe their teenager has gone bad. The memos are significant because they are like finding a diary in the kid's backpack saying, `I robbed the liquor store.' "

Physical reality: Ken Lay threatened one guy, who was subsequently axed. This guy was the head of the body. While this looks bad, I'm also seen enough firings to know that often what seems like a smoking gun is just a coincidence inflamed by an acrimonious imagination. What woman hasn't had at least one female colleague tell them that the reason she got the axe was clearly sexual discrimination -- rather than the gross incompetence we knew to be the actual cause?

Krugman Reality Lite (1/3 less facts than regular reality): Enron was allowed to choose the staff of the entire regulatory body, which we may infer was staffed entirely by the layabout cousins, ex-drug-dealing buddies, and third grade Sunday school teachers of Ken Lay.

The great risk now is that this will be treated purely as an Enron story.

. . . because though the New York Times staff has said Enron and Bush together so many times that they now sound like one word when they say it at cocktail parties, people seem to be curiously stubborn about waiting for evidence before they indict Bush along with Ken Lay.

That's wrong; Enron was mainly a trader rather than a power producer, and as such could have only limited impact on electricity prices. The bigger story involves market manipulation by a number of producers. The circumstantial evidence for that manipulation is overwhelming. And if no smoking-gun memos have yet come to light, what do you expect? The Enron story shows just how easy it is for companies to cover their tracks, especially when the regulators are in their corner. If Enron hadn't lost its clout by going bankrupt, you can be sure that we would never have heard about Fat Boy and Death Star.

What's the circumstantial evidence? That prices went high, even as capacity was offline. Well, a shrinkage in the supply would naturally cause a rise in price. . . oh, he means that the generators were manipulating things? But I thought this article was about how we should indict the traders, who had little generating capacity. . . Tarzan confused. Should we indict the traders because the generators took their capacity offline, and is making up obnoxious nicknames a felony or a misdemeanor? Or should we indict the generators because utility expert Paul Krugman thinks that their maintenance took too long?

But he does make a point I've been screaming about for days: Enron may have profited from the shortage of supply in the energy market, but they didn't raise prices (they conspired to sell above the price caps on in-state power, raising total cost, but not the actual price) and they didn't cut supply. That was due to a number of factors, all, I argue below, due to government's thinking it was smarter than the free market.

There is, however, one specific Enron angle here. I may have done Thomas White, secretary of the Army, an injustice. He ran Enron Energy Services, a division that — or so I thought — was mainly used as a way to generate phony profits, inflating Enron's stock price. But the division turns out to have had another role: to create phony energy transactions, inflating Enron's actual profits at the expense of the state of California. Why, exactly, is Mr. White still in office?

No idea, but to be honest, I'm not really that concerned that he's going to start arbitrage operations with the 7th cavalry.

What really annoys me in this story, however, isn't the behavior of the energy companies. It isn't even the behavior of the Bush administration — though the administration not only stood idly by while California was robbed of around $30 billion, it also shamelessly exploited the state's misery to promote its own, utterly irrelevant energy plan. (Now, of course, that same energy plan is essential to the war on terrorism.)

After reading Paul Krugman's column for months, his psychic powers are rubbing off on me. To wit: after I read the first paragraph, I knew that somehow, this was all going to be the fault of the Bush administration. I didn't know how, exactly: whether we'd find that George Bush was sneaking out of the White House at night to throw wrenches in the turbines down at Calpine, or whether maybe he and Ken had come up with the Nicknames of Evil while they were taking a break from figuring out how to run Enron into the ground. Of course, back then, at the beginning of the article, I couldn't have known how shamelessly evil the Bush Administration would turn out to be, shamelessly refusing to force other states in the area to sell power they needed for their own citizens to California, or nationalize the power companies. But I knew it was somehow the fault of the Bush administration.

No, what bothers me is the position taken by so many business and political commentators: that the California catastrophe says nothing about the risks of deregulation and the dangers of loving free markets too much. It was California's own fault, they say, for creating a "flawed" system — a wonderfully vague term that evades the necessity of explaining what really happened. In fact, the main flaw was that the system contained no safeguards against market-rigging.

And I'm sure that there will be a determined effort to ignore even these latest revelations. After all, why let facts get in the way of a beautiful, and politically convenient, theory?

It certainly says something about the risks of deregulation. It says that if people want to imagine that they can get something for free, they'll be in for a rude shock somewhere down the line.

Paul Krugman has railed against the "spot market". I assume he is not, in fact, proposing eliminating the spot market, as that would make the system -- well, let's just say, unless he's got an innovative plan I don't know about it, it would eliminate liquidity and make the system highly unstable. But the madhouse plan to buy all power on the spot market was the brainchild of the de-regulators, and Governor Davis could have eliminated the problem any time he chose by permitting long-term contracts. But no, Davis had to step in and do it himself, and being totally clueless about how to negotiate a power contract, stuck the state with permanently higher prices. California's woes are due to grandstanding, not the traders.

But what about the memos? Arnold Kling has actually read them, which is more than 99% of the people yelling about them have bothered to do. (Note for a later rant: my experience in actually reading The Bell Curve and then having long arguments about it with people who hadn't read the book.) And if you actually read them, he says, what they describe is rather commonplace arbitrage operations with rather lurid names.

Certainly, Enron profited from California; all the traders did. But the power suppliers, you notice, went broke, not the people of California who are still, last time I looked, refusing to pay for all the power they used. And though the market structure was brutally flawed, that says more about government than it does about Enron. Which is to say, that when government has the power to hand out goodies or declare what companies live or die, those companies will invariably try to influence the process in their favor.

Nor would you really want it any other way. If you're a responsible citizen who actually knows how a business works (and doesn't, let's not forget that; corporations are finely tuned machines only in comparison to their governmental alternative) you know that to actually let the labor, environmental, and consumer groups that want to set the rules for business to make those rules without any input from the firms involved would be a total disaster. So you have to let both sides be involved.

But we are not a perfect species. Think of all the different businesses that every state legislator is expected to know how to run: bakeries, foundries, steel makers, technology firms, gas stations, beauty salons, nightclubs, construction companies, car rental firms, oil refineries, insurance companies, chemical manufacturers, doctors, lawyers, dentists, airlines. . . and that's just a small fraction of highly regulated businesses that came to my head. Your legislator is expected to divine what regulations will work and which will be disastrous, and to know exactly how every line of the law he just wrote will be executed in practice. It's not possible. Sometimes he errs in favor of the activist groups; sometimes in favor of the business groups. But no matter how well intentioned he is he won't get it right every time, because that's not in human nature.

So you can't take the business influence out of making laws, you say; that's why we have regulatory agencies.

But regulatory agencies are no less prone to corruption than lawmakers. Look at where regulators go when they aren't being regulators any more: they go to work for the companies they regulate. This is utterly natural; if you've just spent 10 years being a utility regulator, that's what you know. It's go to work for the companies, or apply to air-conditioner repair school, and those schools often have waiting lists.

I had an interesting correspondance about this with one of my left-leaning readers. So make it illegal to work for those companies, said he.

I think that a permanent ban would violate the constitution, I pointed out. But anyway, if you did this, then no one but incompetents will work for the state; regulatory jobs don't pay well enough to attract top flight talent without the access to the private sector.

So raise the salaries, he said.

But most regulatory employees are civil service, I pointed out. You can't raise their salaries without raising the salaries of every other employee at their level in the state. And the ones that aren't would have to make more than the Governor to compete with private sector salaries. It would never get passed.

His response: change the civil service rules. And (I am not making this up) put the corrupt or incompetent regulators in place and then hope that at some undefined point in the future, the public would realize that they need to pay their regulators more to get good ones.

He's well meaning. But he's gotten so focused on his goal that he's ignoring all the other costs. If you know anything about government, you know that ripping out the civil service structure would be more expensive than giving everyone in the state their own generator and unlimited diesel to fuel it. And if you know that the regime you're proposing is going to be corrupt or incompetent, but you propose it anyway because of a dogmatic desire for regulation, how can we take that seriously?

Now, to be fair, Paul Krugman isn't a regulatory specialist and I'm not either; what I know I know through my dad, who deals with such issues as part of his job. And Paul Krugman certainly has better access to all sorts of journals and documents written by top-flight economists that I can't afford and don't have time to go to the library to look up. So there may be better economic arguments against deregulation than he's making. But that's my point: he's not making them. He's using scary names like Fat Boy and what have you. He occasionally throws in a technical term. But he doesn't actually explain the underlying economics. I know (Lord how I know) how hard it is to explain even basic concepts to a general audience. Nonetheless, this is inadequate. I was looking for the underlying facts on which he bases his argument; I found one. The capacity was idle while prices were high. Which has an explanation, the credibility of which neither I nor Krugman are qualified to check. He offers no other backup, such as statistical analysis, on which he would be qualified to comment. If he wants to hang this scandal on Bush, Enron, or the free market, where's the beef?

On the other hand, deregulation can work; Pennsylvania's is. So he clearly cannot say, unless he offers proof that the people in Pennsylvania are wrong and their deregulation isn't working, that it just doesn't work. California's was clearly FUBAR, but that would seem to me an opportunity to learn what doesn't work than to declare that deregulation is a failure. That's the whole point of de-regulation: you experiment, and then when you get it wrong, you do something better.

And at root, in my eyes, that was where California had a disaster, rather than a bump in the road to free markets. They thought they could get something for free. There were three basic ingredients for California's crisis which could have caused the crisis all by themselves, even if the traders hadn't profited, and they were all due to California's abandonning the principles of TANSTAAFL.

First, inadequate generating capacity. California is a huge importer of power, much of it from Canada (oops, Paul Krugman forgot to go after the evil Chretien administration for not stepping in to help California). California's peak loads are very close to total generating capacity in the area; if something goes wrong, (like the low reservoir levels that resulted in inadequate hydro supply in the Northwest) they are vulnerable. This insufficient redundancy has not been resolved, and long term contracts or no, if California doesn't get more capacity in the area, it will continue to be vulnerable to blackouts.

Second, consumer price caps. Electricity is inelastic, but not that inelastic. San Diego saw a nice decrease in power usage because they raised the price to consumers. Remember, power is priced on marginal cost: the cost of the last (most expensive) unit generated to cover demand. Lowering demand even slightly can lower price greatly because the power company doesn't have to buy any more from the very high cost emergency sources they use to cover excess demand. In the rest of the state, meanwhile, people continued to run their air conditioners until the power went off. Why? It's the tragedy of the commons. If you don't run your air conditioner, and everyone else does, you're hot and miserable and the power still goes off. That's why the price signal is vital. But Gray Davis didn't want that price signal to go out -- so consumers got blackouts instead.

Incidentally, perhaps you should meditate on the fact that Krugman disbelieves every word from the energy traders and generators, while simultaneously swallowing everything said by the people from the Davis administration, who are every bit as desperate, if not more, to cover their asses.

And third, the insane plan to buy everything on the spot market. Why is this there? At the behest of the evil Enron lobbyists? Gosh, I have no idea -- I don't work for a California state legislator, and am not privy to their gossip. But Krugman doesn't know either. And I do know enough about government to know that if the legislators who passed the bill had had any inkling about what was going to happen, they wouldn't have passed it; they aren't that venal, and even if they were, they have a keen eye to their own interest, which does not include being ridden out of town on a rail by a crowd of angry power users. I know why they thought it would work: because they thought that power prices would continue to fall, even though they didn't understand too clearly the market forces that had made it fall in the first place, and could certainly have looked around and noticed that all the environmental and consumer regulations they were busy passing had left the state a little short on generating capacity. They wanted to make sure that the utilities would keep getting the best price; hence, the spot market, where the price would always be the freshest on the market. In other words, they thought they knew better than the free market, where no company tries to meet its full demand for any vital commodity on the spot market.

Blaming deregulation for California's woes is like blaming painting for Thomas Kincade. The way in which the deregulation was done was faulty; it allowed interest seeking traders to take advantage to their own profit. But if you think that the state will find a way to outlaw people and businesses seeking their own interest -- well, I refer you to every single worker's paradise. The best we can hope for is to harness that interest, and the best way we know how to do that is, yes, the free market. To paraphrase a famous quote: in California, deregulation was not tried and found wanting; it was found unpopular and left untried.

Update If you want to hear what a regulatory economist does have to say about California, check out testimony from Bill Hogan, who designed the Pennsylvania/Maryland/New Jersey scheme.

Posted by Jane Galt at May 11, 2002 06:06 AM | TrackBack | Technorati inbound links