It thus happened that Leo Melamed, a small-time pork-belly (i.e., bacon) trader who kept his modest office near the Chicago Mercantile Exchange trading floor stocked with generous supplies of Tums and Camels, found his opening and hired Professor Friedman. Even as several dozen traders at the Merc labored in obscurity to ping-pong a thousand or so futures contracts per day covering eggs, onions, shrimp, cattle and pork bellies, Melamed was busy plotting the launch of new futures contracts in the major currencies. In so doing, he inadvertently demonstrated how radically unprepared the financial world had been for the Friedmanite coup at Camp David.
THE PORK-BELLY PITS: WHERE THE AGE OF SPECULATIVE FINANCE STARTED
Leo Melamed was the genius founder of the financial futures market and presided over its explosive growth on the Chicago “Merc” during the last three decades of the twentieth century. He understandably ended up exceedingly wealthy for his troubles, but on Friday afternoon of August 13, 1971, it would not have been evident to most observers that either of these outcomes was in the cards.
At the time of the Camp David weekend that changed the world, the Chicago Merc was still a backwater outpost of the farm commodity futures business. It originated as the Butter and Egg Board a century earlier and had recently branched out into livestock. Leo Melamed was its rising star. He had been a sensation at an early age, trading egg, bacon, and onion contracts, and had emerged as a charismatic leader and innovator obsessed with growing the range and volume of contracts traded on the Merc.
The utter unlikelihood that only thirty years hence, tens of billions of trades per hour in worldwide currency, bond, and equity futures contracts would pass through the modern-day CME Group trading platforms (Merc’s successor) is underscored by Melamed’s singular achievement during the decade before Camp David: he persuaded the exchange’s old-timers to relinquish an ancient trading verity which held that futures contracts would only work for storable farm commodities like corn. With this breakthrough, Melamed got them to take a great leap forward; that is, into the trading of cattle on the hoof and uncured bacon on the slab.
The latter became the notable “pork belly” contract, and Melamed perfected the art of day-trading its considerable volume. By 1971, Melamed was managing to scalp several hundred thousand dollars annually from his high-velocity bacon trading and was the biggest hitter among a dozen or so pure speculators who made markets for “hedgers” such as food processors who held seats on the Merc. Still, Melamed’s prospects for hitting the big leagues of finance were not evident.
THE ASTONISHING 50,000X GROWTH OF MERC
The next chapters in the tale of Melamed and the Merc are downright astonishing. In 1970, Melamed made an intensive inquiry into currency and other financial markets about which he knew very little, in a desperate search for something to replace the Merc’s rapidly dwindling eggs contract. The latter was the core of its legacy business and was then perhaps $50 million per year in annual turnover.
Four decades later, Leo Melamed’s study program had mushroomed into a vast menu of futures and options contracts—covering currencies, commodities, fixed-income, and equities, which trade twenty-four hours per day on immense computerized platforms. The entire annual volume of the old eggs contract is now exceeded in literally the blink of an eye.
This stupefying explosion of volume has obviously been enabled by modern information technology. Yet the hundreds of exotic contracts which now continuously careen through CME’s cyberspace do not exist because Leo Melamed and his colleagues had a superior entrepreneurial facility for inventing new types of futures contracts.
In fact, prior to entry into what became the brave new world of financial futures, Melamed’s forays into new contracts on frozen shrimp, frozen broilers, scrap iron, apples, and onions all fell by the wayside. So the reason futures contracts on D-marks and T-bills took off like rocket ships is that the fundamental nature of money and finance was turned upside down at Camp David. In effect, Professor Friedman’s floating money contraption created a massive market for hedging that did not have any reason for existence in the gold standard world of Bretton Woods, and most especially under its more robust pre-1914 antecedents.
When currency exchange rates were firmly fixed and some or all of the main ones were redeemable in a defined weight of gold, exporters and importers had no need to hedge future purchases or deliveries denominated in foreign currencies. The spot and forward exchange rates, save for technical differentials, were always the same.
Likewise, interest rates tended to change at a glacial pace, if at all, under the gold standard, especially the pre-1914 variant. During the Bretton Woods quietude of years like 1955 and 1964, for example, the notion of a T-bill hedging contract would have been laughable. There wasn’t enough volatility in rates to make it profitable or plausible; in fact, most of the time during those halcyon years, rates did not move at all.
Even more importantly, the newly emergent need of corporations and investors to hedge against currency and interest rate risk caused other fateful developments in financial markets; namely, the accumulation of capital and trading resources by firms which became specialized in the intermediation of financial hedges. Purely an artifact of an unstable monetary régime, this new industry resulted in prodigious and wasteful consumption of capital, technology, and labor resources.
The four decades since Camp David also show that the Friedmanite régime of floating money is dynamically unstable. Each business cycle recovery since 1971 has amplified the ratio of credit to income in the system, causing the daisy chains of debt upon debt to become ever more distended and fragile.
At the same time, the Fed’s maneuvers in the financial markets have become increasingly more blatant, massive, incessant, and desperate. The build-up of financial system leverage coupled with intensifying central bank activism, in turn, fueled the headlong growth of pure speculative arbitrage. In fact, the great pools of capital which gravitated to the hedging markets quickly found a more compelling objective than hedging currency risk on container loads of Toyotas.
The infinitely more productive arena for deployment of speculative capital was the Wall Street–centered money and capital markets themselves: economic districts which were once the meeting place of savers and investors. After August 1971, however, they steadily morphed into casinos focused on speculation in the vast array of hedging instruments and markets, not capital raising for the main street economy.
That became evident when in the fullness of time the overwhelming share of activity on the CME and its counterparts around the world boiled down to front-running and arbing the financial currents emanating from the untethered central banks. The provision of hedging services to Main Street businesses and investors impacted by these financial currents, by contrast, amounted to small beer.
Currently, the daily volume of foreign exchange hedging activity in global futures and options markets, for example, is estimated at $4 trillion, compared to daily merchandise trade of only $40 billion. This 100:1 ratio of hedging volume to the underlying activity rate does not exist because the currency managers at exporters like Toyota re-trade their hedges over and over all day; that is, every fourteen minutes.
Due to the dead-weight losses to society from this massive churning, the hedging casinos are a profound deformation of capitalism, not its crowning innovation. They consume vast resources without adding to society’s output or wealth, and flush income and net worth to the very top rungs of the economic ladder—rarefied redoubts of opulence which are currently occupied by the most aggressive and adept speculators. The talented Leo Melamed thus did not spend forty years doing God’s work, as he believed. He was just an adroit gambler in the devil’s financial workshop—the great hedging venues—necessitated by Professor Friedman’s contraption of floating, untethered money.
THE LUNCH AT THE WALDORF-ASTORIA THAT OPENED THE FUTURES
According to Melamed’s later telling, by 1970 he had “become a committed and ardent disciple in the army
that was forming around Milton Friedman’s ideas. He had become our hero, our teacher, our mentor.”
On slow days in the pork-belly pits Melamed had snuck into Friedman’s classroom lectures: “What I heard made my spirits soar. Here was the voice of supreme economic authority saying that the system of fixed exchange rates was wrong. That it was time for its demise.”
Thus inspired, Melamed sought to establish a short position against the pound, but after visiting all of the great Loop banks in Chicago he soon discovered they weren’t much interested in pure speculators: “if you didn’t have any commercial reasons, the banks weren’t likely to be very helpful.”
The banking system was not in the business of financing currency speculators, and for good reason. In a fixed exchange rate régime the currency departments of the great international banks were purely service operations which deployed no capital and conducted their operations out of hushed dealing rooms, not noisy cavernous trading floors. The foreign currency business was no different than trusts and estates. Even Melamed had wondered at the time whether “foreign currency instruments could succeed” within the strictures designed for soybeans and eggs, and pretended to answer his own question: “Perhaps there was some fundamental economic reason why no one had before successfully applied financial instruments to futures.”
In point of fact, yes, there was a huge reason and it suggests that while Melamed might have audited Milton Friedman’s course, he had evidently not actually passed it. There were no currency futures contracts because there was no opportunity for speculative profit in forward exchange transactions as long as the fixed-rate monetary régime remained reasonably stable.
Indeed, this reality was evident in a rebuke from an unnamed New York banker which Melamed recalled having received in response to his entreaties shortly before the Smithsonian Agreement was announced. “It is ludicrous to think that foreign exchange can be entrusted to a bunch of pork belly crapshooters,” the banker had allegedly sniffed.
Whether apocryphal or not, this anecdote captures the essence of what happened at Camp David in August 1971. There a motley crew of economic nationalists, Friedman acolytes, and political cynics supinely embraced Richard Nixon’s monetary madness. In so doing, they opened the financial system to a forty-year swarm of “crapshooters” who eventually engulfed capitalism itself in endless waves of speculation and fevered gambling, activities which redistributed the income upward but did not expand the economic pie.
So even as a GOP-inspired wage and price freeze descended over the nation in the fall of 1971, Leo Melamed pursued his lonely quest to financialize the impending currency turmoil with no help at all from the established banking system. As he told a reporter a decade later, “Wall Street jeered and Washington yawned. Morgan Guaranty laughed at me and treated me like I had snake bite.”
As it happened, Melamed did not waste any time getting an audience with the wizard behind the White House screen. At a luncheon meeting with Professor Friedman at the New York Waldorf-Astoria on November 13, 1971, which Melamed later described as his “moment of truth,” he laid out his case.
After asking Friedman “not to laugh,” Melamed described his scheme: “I held my breath as I put forth the idea of a futures market in foreign currency. The great man did not hesitate.”
“It’s a wonderful idea,” Friedman told him. “You must do it!”
Melamed then suggested that his colleagues in the pork-belly pits might be more reassured about the venture if Friedman would put his endorsement in writing. At that, Friedman famously replied, “You know I am a capitalist?”
He was apparently a pretty timid capitalist, however. In consideration of the aforementioned $7,500, Melamed got an eleven-page paper that launched the greatest trading casino in world history. It made Melamed extremely wealthy and also millionaires out of countless other recycled eggs and bacon traders that Friedman never even met.
Modestly entitled “The Need for a Futures Market in Currencies,” the paper today reads like so much free market eyewash. But back then it played a decisive role in conveying Friedman’s imprimatur.
In describing the paper’s impact, Melamed did not spare the superlatives: “I held in my hand the Holy Grail for the Chicago Mercantile Exchange. The most influential economic mind of the twentieth century provided the CME with the intellectual foundation upon which to build its financial superstructure.”
THE MORNING AFTER THE SMITHSONIAN AGREEMENT: LEO MELAMED’S TIMELY LAUNCH
Friedman’s paper arrived just in the nick of time. With his weighty endorsement in hand, Melamed hurriedly announced his new currency futures market the very next business day after the Smithsonian Agreement was announced on December 21, 1971. To be sure, had Melamed and his Merc not invented financial futures, another punter would have come along, because soon thereafter prices of virtually every financial instrument—currencies, commodities, and interest rates—were gyrating wildly as the brave new world of floating exchange rates and printing-press money fully emerged.
Yet the fact that the explosion of hedging products did emerge in the shadows of the University of Chicago is not entirely a historical factoid. As is evident in Melamed’s self-described relentless campaign to promote his new products, his born-again pork belly traders also incorporated a significant element of free market evangelism in their pitch.
Referring to Friedman’s paper as an “unvanquishable secret weapon,” Melamed recounted how his small team of traders had “crisscrossed the nation … visited every nation on the planet … [and] when we were told that we were crazy, we responded Friedman is one of us! And each and every time, his name made the difference…. Presidents, finance ministers, central bankers, businessmen who would not otherwise have given us the time of day … allowed us near their door because of his name.”
WHEN NIXON’S MONETARY ARSONISTS YAWNED AND THE D-MARK GYRATED
Much to Melamed’s surprise, however, his hurried May 1972 launch of the first currency futures contracts in dollars, lira, pounds, marks, francs, and guilders did not stir much interest or enthusiasm among the very monetary arsonists in Washington who should have understood its significance. “No one really cared,” he later recalled. Shultz waved him off and observed that “if it’s good enough for Milton, it’s good enough for me.”
In short, a somewhat rickety but salvageable international monetary system had been rashly and casually jettisoned in a matter of weeks, even though it had embodied the wisdom and best practices of the ages. Yet the White House arsonists didn’t care about the currency mayhem just around the corner. So the financial deformation to which the demise of Bretton Woods gave rise—massive, wasteful speculation in financial futures and options—was born largely unnoticed in the humble bacon-trading pits of Chicago, wrapped in the swaddling garb of free market ideology borrowed from the university across town.
In due course, all monetary hell broke loose. Radical fluctuations in exchange rates and interest rates became routine occurrences, charting swings with amplitudes never experienced in peacetime history. The rambunctious journey of the D-mark provides a case in point.
When Melamed opened up his currency futures market in May 1972, West Germany was the largest trading partner of the United States, and its exchange rate was 3.2 D-marks per dollar. The dollar then fluctuated violently downward in response to the Fed’s profligate money printing during the tenure of Arthur Burns and William Miller, respectively. When it reached an interim low of 1.72 D-marks in early 1980, the dollar had lost 45 percent of its buying power.
Under Volcker’s relentless campaign to quash domestic inflation and restore the integrity of the US dollar, however, the mark-to-dollar exchange rate abruptly and massively reversed direction in favor of the dollar. By February 1985, the exchange rate was all the way back to 3.05 D-marks per dollar, meaning the greenback had gained 90 percent since early 1980.
Then Jim Baker moved from Reagan’s chief of staff job in the White House to the Treasury Building, wh
ere he dusted off John Connally’s monetary chainsaw and launched another Texas dollar massacre, this one known as the Plaza Accord of September 1985. Bullied into selling dollars with nearly reckless abandon, Japan and Germany joined the United States in flooding the currency exchange markets with an unrelenting “offer” on the dollar.
Consequently, during the next twenty-four months the exchange rate was hammered back down to about 1.6 D-marks per dollar, meaning that by year-end 1987 the greenback had drastically reversed direction yet again, this time losing 50 percent of its value against the D-mark in less than thirty months.
In all, the dollar lost 50 percent of its exchange value against the D-mark during the first fifteen years after the Merc contracts opened, but the violent round trips and fluctuations during the interim amounted to the equivalent of 400 percentage points of gross change. Needless to say, corporations doing business in German marks had no choice except to purchase costly hedging protection against this unprecedented, radical exchange rate volatility.
At the same time, in order to accommodate the massive new demands for currency-hedging protection, Melamed needed gobs of speculative capital to take the other side of his rapidly expanding volume of futures contracts. This turned out to be no problem whatsoever.
The Merc required traders to post an initial margin of only 2 percent on currency contracts. This meant that if the dollar moved by 10 percent, say from 3 marks per dollar to 2.7 marks per dollar, a punter could collect a 500 percent profit. And if this 10 percent move in the underlying currency pair occurred within the span of three months, as happened not infrequently, the annualized rate of return on capital at risk would be 2,000 percent.
WHY CURRENCY FUTURES WERE NOT EXACTLY GOD’S WORK
In the tradition of the farm commodity exchanges, Melamed considered such outsized returns as evidence that speculators were doing God’s work. After all, someone had to take the other side of the trade in order to accommodate the hedging needs of pig farmers and machine tool exporters alike.
The Great Deformation Page 40