One of the sure signs that the beginning of the end has begun for a Ponziesque scheme (and this term is intended here in its broadest possible sense) is the rattling, metal-on-metal scraping sound of a key turning clumsily in the outside lock, distinctly audible on the inside as it latches the only door leading out of the room in which your cash is stored. Once capital restrictions start to appear you know the end is nigh. Broadening the scope of that analysis, the failure mode checklist for the effort to control any capital system universally has restrictive capital controls (explicit or implicit) as one of the last items. What is surprising is that this effect is not more often recognized as a member of a larger class of problems: the effort to close (or, more accurately, to isolate) open systems- an effort doomed in the physical world by the laws of thermodynamics before it is even conceived. That it seems difficult to convince what may loosely be called "The Regulatori" that there are corollaries everywhere where systems interact is both unsurprising and sad.

It is important at the outset to distinguish between open systems, closed systems, and isolated systems. The term "closed system," at least in the realm of physics, is meant to refer to a system that can exchange energy (in the form of heat or "work") with its surroundings, but not matter. The more extreme "isolated system" is, as the name implies, one that exchanges nothing at all with its surroundings. An "open system," therefore, exchanges all three with its surroundings. Closed and isolated systems are, of course, more theoretical than anything else, but the concept is useful, particularly as a framework for thinking about the implications of system isolation, the conservation of mass, energy and information, and the viability of pipe dreams like perpetual motion machines.

This last point deserves some notice. There is a long and quite sordid history of human rebellion against the laws that make closed or isolated systems impossible on any practical scale. One sure-fire, never-fail investment over the generations has been betting against schemes that rely on the violability of the laws of thermodynamics (or the presupposition of the existence of closed or isolated systems). The unending string of wins such a strategy would have returned would make even the likes of Bernie Madoff green with envy. What is surprising is the number of schemes dependent exactly on these hitches that, even with so rich a history on the topic, keep cropping up.

Perhaps some explanation lies in the fact that the laws of thermodynamics (and their corollaries) are as unpopular as they seem to be inviolable. Who doesn't want a free lunch, after all? The unusually well-rounded individuals that compose the readership ranks of finem respice will have little trouble recognizing the tell-tale hallmarks of this futile rebellion in the bitter and embarrassing failures associated with names like the "Independent System Operator," though this is only one of the more obvious examples. In any event, it is trivial to notice that the unifying theme here is a crude attempt to close or isolate a naturally open system. Incentives to accomplish this bit of wizardry are significant. After all, annualized returns on "something for nothing" are huge.

Of course, markets are systems with similar properties to their physical counterparts. Though an imperfect analogy, the free flow of labor (work?), capital (heat?), information (entropy?) and goods (matter?) bears an almost alarming similarity to its physical counterparts- not least in the efforts inspired to close otherwise open systems to the passage of these market elements.

The two-stage pattern that tends to lead to these debacles is tauntingly similar in most cases. First is the attempt to extract unsustainable economic rents from the system, creating something akin to a false vacuum. Second, and far more frantic once it becomes obvious that the false vacuum is about to decay, is the desperate attempt to prevent the system from bleeding stability off and nucleating back into the true vacuum from whence it came. The familiar, if somewhat faded, specter of the California power crisis presents an intensely illustrative example.

The California Power Crisis

For the uninitiated, starting in May of 2000 California was subject to intense spikes in spot rates for electricity and natural gas culminating in a state of emergency, rolling blackouts and the financial ruin of wholesalers Southern California Edison and Pacific Gas & Electric.1

There are few entitlements held so dear, or with political flashpoint so low as the American public's belief in an inalienable right to cheap gasoline, insurance and electricity. So when Loretta Lynch, the then President of California's Public Utilities Commission, referring to the unseasonably hot day in California on May 22nd, says:

...I think it's pretty appalling that the folks who sell us power can charge whatever they want, and on that day they did, and on subsequent days they did, such that, last summer the price of power shot up from about 5 cents a kilowatt hour on average to about 18 cents per kilowatt hour on average.2

...we should probably be something less than surprised. Lynch refused for a time to hike retail rates and instead, true to form, turned the spotlight on the vague, difficult to substantiate, difficult to disprove and easily adopted as a rally cry by the closet conspiracy theorist lurking in the imaginations of all left-coast consumers, accusation of "price gouging" by the market makers in electricity.

Lynch later told PBS's Frontline:

You and I have to buy electricity every day. And we can't store it. So the people who make electricity know that they have a fundamental economic necessity that people will buy at any price. And so they charge any price they want."3

One assumes no reader with even the most rudimentary familiarity with an Economics textbook can fail to see the almost comic absurdity of Ms. Lynch's worldview. One assumes this because it is otherwise impossible to traverse from day to day without falling into a deep and despair that all rationality is dead.

Lynch is, unfortunately, no isolated case in this matter. The 1935 Federal Power Act, requiring that rates be "just and reasonable"4 (with virtually no guidance on the meaning of those terms) has been ample excuse for regulatory tampering in power markets since Roosevelt pushed the bill through- with somewhat predictable consequences. The underlying argument justifying interference seems to be that price fluctuation for electricity is a "bad thing" because the commodity itself is of such an essential and necessary nature.

The reality in California was that new supply was effectively impossible to build, that clean air requirements often caused existing generation capacity dips as providers converted to cleaner equipment, that long-term contracts or forward markets were effectively impossible, regulatorily, to create and that accordingly, not only did the utilities have to purchase one of the most volatile commodities on the planet, electricity, on the spot market while selling it into retail price-freezes, but that the powers that be would not, except under the greatest of pressures, raise retail rates and alter the low-cost electricity style to which the retail California energy consumer had grown accustomed. When California utilities were just shocked to be paying $0.18 per kilowatt-hour when prices spiked on high-demand days, some communities in the Northeast had been quietly chewing on $0.20-$0.25 per kilowatt-hour costs every day, day in and day out for months or even years.

On the retail side, just as California was patting itself on the back for "deregulating" in 1996 (via a bill that Pete Wilson created with complexities and exceptions for e.g., San Diego that make the special interest game in Washington look tame by comparison), it froze, just after reducing, retail electricity rates for five years. Add to this the fact that California had long depended on supplies from, e.g., the Northwest, which, for years, enjoyed a hydroelectric power generation surplus. As the surplus vanished with droughts and increased demand in the Pacific Northwest, so did the supply buffer California was so used to, and that it leaned on most heavily over the years to avoid building new generating capacity (new capacity being the bane of the progressively green environmental utopian-paradise that was (is) California energy politics). All this conspired to spike rates. Who is surprised?

It is somewhat unfortunate that Enron's shrewd manipulation of California's badly flawed and outright schizophrenic market scheme was so flagrant, and that unrelated accounting scandals at the company permitted the story to become one of deregulation evils and free market greed rather than the core issue: the political spinelessness exhibited by California officials and their ongoing attempt to insulate voters from anything resembling market prices for electricity. Even the Federal Regulatory Commission's report on the matter summarized this part of their findings thus:

...supply-demand imbalance, flawed market design and inconsistent rules made possible significant market manipulation as delineated in final investigation report. Without underlying market dysfunction, attempts to manipulate the market would not be successful.5

The California Power Crisis is so useful to cite because it almost perfectly encapsulates many of the features one sees in attempts to close open systems. These include:

• The basic attempt to create an isolated or closed system. In the present case, insulating consumers from market pricing for electricity. As an aside it should be noted that, in the present case, this also decreased the price elasticity of demand. Since price fluctuations do not reach the ultimate consumers, changes in wholesale pricing have little effect on demand. The argument often offered in support of the exceptional nature of electricity as some kind of "protected necessity commodity," that California electricity demand is inelastic, is hard to understand given that California power consumers have almost never been exposed to anything like real pricing for electricity.
• As obviously exists here, a near certain connection with some short-term political gain (in cases of regulation). In the present case, (re)election rewards for preserving artificially low prices for energy in the state where it is used most gluttonously.
• A complex pricing ruleset that replaces market-based price discovery. More than complex, these tend to be unduly complex to cope with the many interests and differing levels of political power and influence among market actors affected by the regime. In the present case, the wildly conflicting schizophrenia of Pete Wilson's 1996 "deregulation" legislation fits the bill nicely.
• Panicked pandemonium at the sudden realization that things are headed south. This particular brand of chaos almost uniformly focuses on piling on more regulation, more price caps and more controls to reign in the now decaying false vacuum. (Loretta Lynch's desperate efforts to impose wholesale price caps, ban "price gouging," anything at all to avoid the obvious: raise rates to consumers).
• Finger pointing and scapegoating, almost universally directed at those who "gamed the system." While much is made of the famous "trader tapes" that emerged from the Enron scandal, certainly, the casual conversation of any trading floor would bear fruit for eager plaintiffs attorneys and many of the routine, profanity-laden exclamations of traders preserved for the record reflect a sentiment, albeit testosterone injected, that seems to be properly appropriate for an absurd and byzantine system of regulation so markedly divorced from reality as to be worthy of more than a modicum of contempt. To wit:

McGowan: There was a guy he was yesterday, he’s – he’s some consultant for some fuckin’ other business we’re supposed to be starting or whatever.

Badeer: Right.

McGowan: He came in, he- and I wasn't- I didn't even meet the guy. I was sittin' here, he was talking to George McLellan and George’s desk, he’s like, yeah, you know, I’m in California now and my small consulting business, my energy costs have gone from 100 to 500 dollars a month. It's unbelievable, I don't know what to do. I just turned from my desk, I just looked at him, I said, "Move." [laughter] The guy was like horrified. I go, look, don't take it the wrong way: "Move; it isn't getting fixed any time soon."

Badeer: You know man, it's unbelievable, it's like at that – that’s the – that’s the best thing that [inaudible] about it. That’s so beautiful. [laughter]

McGowan: Oh best thing that could happen is fuckin’ an earthquake, let that thing float out to the Pacific and put ‘em fuckin’ candles.

Badeer: I know. Those guys – just cut ‘em off.

McGowan: They’re so fucked and they’re so, like totally.

Badeer: They are so fucked.6

Indeed. In retrospect, "move" might have been the best advice anyone could have given in the situation.

Once this template is used, it becomes trivial to overlay it on any number of idiotic schemes that will be familiar to the typically well rounded and well read finem respice reader.

Florida Insurance Rates7

• Closed System: Maintain low insurance rates in the state that accounts for 60-70% of weather related insurance risk in the country. Insulate insured from actual risk-adjusted insurance rates.
• Short Term Political Gain: Election or re-election of Florida's political class on the strength of insurance reform and low rates for the widest demographic of voters.
• Complex Pricing Ruleset: Cap all rates. Provide exemptions for politically connected beggars in the insurance industry and a byzantine morass of pricing regulation.
• Panicked Pandemonium: Mandate the use of state-approved risk models that artificially depress rates. As national insurers flee once their increases in auto and business insurance can no longer cover their losses in weather related insurance, the state drafts Citizen's Insurance (the state owned firm) to pick up the slack. Citizen's quickly engorges itself with 70% of the market in the highest risk hurricane, wind and flood policies and later desperately attempts to offload the risk on reinsurers with mixed results.
• Finger pointing: To come with the next moderate storm. Stay tuned.

Mortgage Crisis

• Closed System: Maintain low interest rates for the widest range of voters possible. Insulate voters from actual risk-adjusted mortgage rates.
• Short Term Political Gain: Election or re-election of the country's political class on the strength of their deep commitment to "The American Dream of Home Ownership."
• Complex Pricing Ruleset: Inject massive amounts of capital via GSEs (carrot) and fear of the wrath of an angry legislator (loan, loan loan!- stick). Complex regulatory exceptions for off-balance sheet liabilities. Variable reserve and capital ratio requirements depending on the character of balance sheet assets (favor given to MBS securities with AAA ratings). Repeatedly raise capital limits for GSEs. High level of securitization as legislatively sanctioned regulatory arbitrage. Explicit loan and MBS origination targets. Capital requirements linked to securities ratings.
• Panicked Pandemonium: Pour capital into rescue of damaged institutions. Pump up the debt machine (again) to fill lending gap/reflate assets. Ban short selling. TARP, TALF, PPIP, TWIT, stress tests, suspend mark-to-market and (stay tuned).
• Finger pointing: Bad market. No bone.

Try It At Home

• The Music Industry
• Defined Benefit Pension Plans
• Big Auto
• Big Auto Parts
• Newspapers
• Health Care

Cost Cartels

There are also a number of cute catchphrases and concepts used to support legislation or proposed regulatory schema not yet developed enough to template that, none the less, fail to pass the sniff test when wafted under this nose. A current favorite of these farces is "energy independence," the concept that, somehow, if the United States can just produce enough energy locally, we can forget about all those bothersome, sandy places in the world.8 The reality, of course, is much dimer. Unless the legislature proposes a total ban on export or import of any energy products at all (food for oil anyone?) prices in the United States will still remain quite strongly coupled with the rest of the world. Cheap crude here presents an irresistible trade opportunity if supply elsewhere becomes expensive. Expensive extraction here will be awfully hard to justify if it comes at a 20% premium to international sources, wherever those may be located. Is the mantra of "energy independence" worth a 20% premium to world prices? Perhaps. Even if so, how could one possibly expect to enforce the separation- if one could isolate, in effect, the United States from the open system of global energy markets?

Even if the United States were somehow to become a net exporter of energy (perhaps a sudden breakthrough in fusion power, with highly capital intensive up-front costs, and cheap, plentiful energy thereafter?) dreams of "energy independence" are but fantasy.

Accepting that the present proposals to tax carbon emissions (effectively the first universal taxation on energy) are primarily motivated by the altruistic desire to prevent anthropomorphic climate change requires a suspension of disbelief of such magnitude, particularly with respect to the required levels of cooperation and gaming forbearance expected of actors on a global scale, that one feels almost overwhelmed by a novel, practically hypnotic sense of looking-glass transcendence. No wonder this is an issue that is almost never even raised, much less discussed, when the topic of "climate revenue," is introduced.

After nearly fifty years, OPEC, composed primarily of culturally similar extraction economies with governing systems characterized by highly concentrated political power and extremely high levels of state control with respect to industrial policy, actually enjoys terribly low historic quota compliance (around 60%),9 and, in what will be recognized as the "cartel paradox" compliance grows lower the more desperately it is needed.

It takes precious little analysis to realize that compliance rates in a much more complex system with a much wider group of members, virtually no commonality of political system, none of the direct short or medium-term economic benefits a supply fixing cartel like OPEC provides, and significant short or medium-term direct and indirect costs for complying members, will be abysmal. As a means for regulating anthropomorphic climate change a global carbon trading or carbon cap regime is a non-starter.

It stands to reason, therefore, that the actual purposes of such a regulatory regime are quite distinct from the stated, and naively altruistic "save the planet" rhetoric commonly touted. It is not hard to suspect that the twin features of $120 billion in new "climate revenues" (read: taxes)10 and the prospect of an overarching regulatory mechanism with a reach akin to the breadth of the Commerce Clause, but, this time, conveniently concentrated in an Executive Branch agency, might actually make better candidates for the actual motives. Of course, "climate revenues" will be probably be the result of a complex transaction morass resembling the spectrum auctions occasionally run for the benefit of this week's politically valued firm by the Federal Communications Commission. This should send shudders down the spine of anyone even marginally appreciative of trivial matters like efficiency.

The Politics Of Gaming

Key to understanding the potential for gaming such systems either at the arbitrary and yearly carbon cap allocation level, the initial auction stage or the subsequent trading in the "secondary market," is recognizing that "fraud expands to meet the envelope." More generally here, "gaming expands to meet the envelope." The two factors that favor gaming are present in thermodynamic-ignorant schemes in force. Specifically:

• Opportunity (fostered by complex rules).
• Motive (the presence of inefficient pricing mechanisms).

It is probably no coincidence that the creators of these schemes have at least learned to include vague "anti-gaming" or "just and reasonable" type clauses to permit them to impose arbitrary penalties when "fraud" of the "I know it when I see it" variety appears (imagine that) as market actors game the complex rule system. This begs the question: is gaming such systems even unethical?

The mere existence of a complex wealth of language determining a series of interlocking rules for pricing implies the intention to provide an all-encompassing framework of rules. Taking advantage of vagaries or outright omissions in such a framework can hardly be blamed on the gamesmen. The classic example, of course, is the tax code of the United States, where the very specificity and complexity of the system itself implies a certain indulgence towards gaming. It is difficult to come to another conclusion after observing that the United States Tax Court is dedicated entirely to drawing the line between "gaming" and "tax evasion" (fraud) in this particular and complex pricing system.

In the meantime, as long as The Regulatori persist in their misguided belief that a system characterized by marked susceptibility to gaming, requiring intricate complexities mandated by interest group politics (this last is likely considered a feature rather than a bug by designers) and resulting in the concentration of control in the hands of would-be central planners, somehow delivers efficiency gains when set against a market pricing system, plenty of examples of false vacuums will continue to exist and be created. But now, given the current fiscal crisis and the debts we will, doubtless, be enjoying for decades to come, the surplus of clay available to plug holes in the system's isolation walls is conspicuous primarily for its absence. Clever finem respice readers are likely already looking up intently into their eyebrows, counting the shorting opportunities as they come to mind.

Ponder for a painfully fleeting moment how singularly unique and brilliant it might be to hear a legislator instead say:

You know, I'd love to make that cheaper for you this year, but if I do, in ten years time "cheaper" will be so fucking expensive it will make your current outlays look like the uncontested auction purchase of a marked-to-market, twice-regifted fruitcake in the off-season.

That would, however, require on the legislator's part some reflections on consequences (intended and otherwise).

And for this last, I am not holding my breath.

1. 1. See Generally: Lisa Royan, "The California Power Crisis 2000-2001, An ERisk Case Study" ERisk.com (August, 2001). See Also Generally: Federal Energy Regulatory Commission, "Western Energy Crisis, Chronology at a Glance," Federal Energy Regulatory Commission (2009).
2. 2. Loretta Lynch interview with PBS's Frontline for "Blackout," (first aired June 5, 2001).
3. 3. Ibid.
4. 4. 16 USC 12 § 824(d)(a) reads "All rates and charges made, demanded, or received by any public utility for or in connection with the transmission or sale of electric energy subject to the jurisdiction of the Commission, and all rules and regulations affecting or pertaining to such rates or charges shall be just and reasonable, and any such rate or charge that is not just and reasonable is hereby declared to be unlawful." It is interesting to note that the party for which rates must be "just and reasonable" is not defined, and though the language "made, demanded or received by any public utility" (emphasis added) suggests a certain bi-lateralism, I am uncertain of the frequency with which the seller of electricity invokes the language to support price hikes.
5. 5. The Federal Energy Regulatory Commission "Price Manipulation In Western Markets (Summary of Findings)," (March 2003).
6. 6. From the transcript of conversations between Enron traders Bob Badeer (Enron, Portland, California) and Kevin McGowan (Enron, Houston, Texas).
7. 7. See also: Equity Private, "There's No Such Thing As A Risk Free Lunch," Going Private (February 11, 2008).
8. 8. c.f. Venezuela, Canada, Brazil, Mexico, etc.
9. 9. "...OPEC-11 compliance was 79% in February 2009, compared to an historical average compliance rate of 60% for the cartel, with the performance of all eleven countries continuing to improve on a monthly basis. Compliance among the quota busters ranged between 31% (Ecuador) and 69% (Venezuela) and among the quota compliers between 77% (Algeria) and 93% (UAE). Saudi Arabia was the sole member to fully comply with its quota in February." Vincent Lauerman, "Saudis Give Up Role As OPEC Swinger," The Ottawa Citizen (March 31, 2009) citing International Energy Agency data. See Also: International Energy Agency, "Oil Market Report" OECD/IEA (March 13, 2009).
10. 10. Office of Management and Budget, "A New Era of Responsibility, Renewing America's Promise," (Budget of the United States for the 2010 Fiscal Year) United States Government Printing Office (February 26, 2009).

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