But there was a big difference. Speculators in the corn and hog pits do not exactly perform God’s work, but they most surely price it. The primary economic function of traditional commodity futures is not to turn corn into casino chips, thereby permitting punters to bet on corn prices over arbitrary time periods.
Instead, these traditional futures markets were essentially seasonal smoothing mechanisms. They were a forum where farmer-sellers could lock in fall harvest prices before they planted in the spring, and buyers at flour mills could stabilize their harvest time grain purchase prices in the same manner.
Since seasonal weather fluctuations are, so far, an act of God, the futures market for farm crops is a marvelous price discovery mechanism. During the corn-growing season, for example, the futures market prices reflect the daily effects of weather—heat, rain, drought, hail, winds, and frost—based on crop condition reports issued continuously by the US Department of Agriculture and private crop services.
Early in the season during June, for example, the reporting services indicate the percentage of the crop which has been “planted” and “emerged” each week, and later in the season they report the percentage of the corn crop which has “silked,” “doughed,” and “dented,” respectively. Expert traders compare this information, and much more, to prior years’ data for the same week in the crop cycle and from there extrapolate implications for supply and price, ultimately placing their bets accordingly.
Seasonal weather variation, therefore, was at the heart of traditional farm commodity futures markets: it could cause unpredictable but violent swings in short-term crop prices due to its impact on harvested supply, thereby making the cost of the speculator’s capital an efficient investment for buyers and sellers alike.
The same is true of nonfarm commodities like natural gas where weather can radically impact demand, such as summer air-conditioning peaks in gas-fired electric utility use and winter variation in heating degree days. Even in the case of some metals like copper, where demand and inventory levels are highly sensitive to the business cycle, short-term price discovery through futures trading helps buyers and sellers navigate the extreme price fluctuations which can accompany cycles of inventory stocking and reduction.
In short, the speculator’s capital provides the liquidity needed to facilitate short-term price discovery in markets for weather-driven crops and inventory-intensive commodities. The resulting hedges consume modest real economic resources and allocate sufficient profits away from hedgers to the speculator community, so as to attract the trading capital needed to provide these markets with liquidity.
There was, therefore, a perfectly good reason why farm commodity futures markets existed for hundreds of years while there never emerged any crusading Leo Melamed crisscrossing the globe peddling currency futures. The truth is that honest money did not require the price discovery services of speculative capital.
The gold content of the pound sterling, for example, did not change other than in wartime for 215 years between 1717 and 1931, and the gold content of the US dollar was set in 1832 and did not change until FDR tinkered with it in January 1934.
Indeed, even in August 1971 the dollar did not need price discovery; it needed the honest defense of a White House that would fulfill its treaty obligations, and an economic policy based on the nation living within its means. What it got instead was the equivalent of monetary weather fluctuations and, frequently, monetary storms of violent and capricious aspect.
Moreover, in Professor Friedman’s brave new world of floating central bank money, there were no benchmarks—no Fourth of July corn tassel counts or January heating degree days to tabulate and compare to historic norms. In fact, the new currency storms were strictly sui generis: the random outcome of a continuously shifting batch of central bankers trying to manipulate interest rates, consumer prices, output, employment, trade, and eventually sovereign bond prices, and the stock market index, too.
RELAPSE TO THE MONETARY DARK AGES
So a half century after the war disruption of August 1914, the world ironically slipped back into a monetary dark age of economic nationalism and government-manipulated money. Ironic, because in the half century prior to 1914 there was nearly continuous monetary progress and enlightenment, toward common world money (gold-linked currencies) and uniform consumer prices and wages throughout the developed world.
The driver of this convergence had been the automatic movement of gold and other monetary reserves from countries with balance of payments deficits to those with surpluses. As the enforcer of financial discipline, these gold reserve movements caused domestic banking systems to expand and contract, thereby inducing the impacted national economy to heat up or cool down.
Accordingly, wholesale and consumer price levels and domestic wages and production costs among countries got constantly leveled and homogenized by this “rule of one price.” Countries experiencing a gold drain and monetary stringency tended toward wage and price deflation, while those experiencing a gold gain and easier money markets tended toward inflation.
After the world plunged into the inflationary abyss in the 1970s, however, any remaining knowledge of the pre-1914 world of common international money and price convergence was lost. For example, Keynesians and nationalistic monetarists alike would have been shocked to learn that after adjustment for tariff differences, late-nineteenth-century wage rates in Manchester, Dusseldorf, Lyon, Milan, Barcelona, Pittsburgh, and Chicago were quite closely aligned.
Indeed, when Senator William B. McKinley campaigned for president in 1896 on a “full lunch pail,” he recited from memory the wage rates in these cities. Not surprisingly, candidate McKinley was also not loath to explain to voters that it was only the “McKinley tariff” which gave American labor a competitive edge, owing to the margin of the tariff over the world price.
Stated differently, fixed exchange rates harmonized wages and prices among the major developed economies. Working silently through the free market, fixed exchange rates forced a continuous and decentralized process of adjustments in domestic demand, costs, and prices when balance of payments and trade accounts got out of alignment.
By contrast, floating currencies and fiat money caused economic adjustments to shift to external exchange rates rather than internal demand and prices. This led to government manipulation of the adjustment process, and therefore to divergence rather than convergence of industrial world economies, that is, to protectionism, economic inefficiency, and lower real incomes.
In this setting, central banks became a fount of capriciously valued national monies, the very opposite of the pre-1914 régime of a single gold money expressed in numerous paper currencies of constant value. Indeed, Friedman’s folly made Melamed and his trader army fabulously rich because it transformed the nation’s currency into the residual swing factor in the chain of economic causation.
In effect, the dollar became the Mexican jumping bean of finance. This previously unknown exchange rate volatility sucked speculator capital into the new currency futures markets in a great deluge, where it scalped massive profits from inefficient trading markets still in their pioneering stage.
More importantly, by fueling short-run herd behavior in the trading pits, this restless deluge of speculator capital aggravated the price swings even further among newly unhinged national currencies. In the face of gyrating exchange rates, national economic policy managers attempted to counteract these market forces by implementing polices aimed to push domestic interest rates, prices, demand, and employment in a more congenial direction.
The result was that even greater turbulence was passed down the line in hot-potato fashion to the currency exchanges. Needless to say, this feedback loop was manna from heaven for the newly emboldened currency futures speculators. In the iconic Wall Street vernacular, Leo Melamed and friends were indeed backing up their trucks to the Merc’s Jackson Boulevard loading docks.
The truth is, these financial derivative markets do not rationally and
efficiently price weather-type forces, nor do today’s interest rate and exchange rate fluctuations have an exogenous cause. Most assuredly they are not the work of the financial gods pursuing their own insouciant whims. Rather, they reflect the actions of central bankers engaged in a tug-of-war with the markets themselves: policy action begets market reaction in a continuous loop of adjustment.
For this reason, currency futures markets do not really engage in efficient and useful price discovery. They generate no “public good” because the currency season never ends; it just iterates through an endless loop. Indeed, the modus operandi of central bankers soon became fixed on incessant manipulation of the macroeconomic drivers of the exchange markets, including interest rates, inflation, output, and external trade and capital flows.
Consequently, the currency futures and options markets rapidly became an arena for purely private rent-seeking. Invariably, fleet-footed traders figured out how to exploit and arbitrage the clumsy maneuvers of central bankers.
THE LESSONS OF THE LIRA
During the decade and a half after the Merc began trading currency futures, for example, the Italian lira circumnavigated an even more extreme path than the D-mark, and mostly in the opposite direction. This was due to the fact that Italian fiscal and monetary profligacy far surpassed even that of the United States.
Consequently, the dollar stood at 582 lira in May 1972, but in sharp contrast to its hard fall against the D-mark, the dollar had actually gained nearly 40 percent through early 1980. Then, when Paul Volcker slammed on the monetary brakes, the dollar soared even higher, reaching an exchange rate of 2,040 lira per dollar by the February 1985 peak.
Needless to say, a speculator who had been continuously short the lira on Melamed’s futures exchange would have generated a 12,000 percent return over the thirteen-year period. Even had this trader overstayed his hand and been bruised by Baker’s dollar defenestration at the Plaza Hotel, he still would have collected 1,300 lira per dollar by the end of 1987, meaning a total return of 6,000 percent.
Yet that was just for starters. Denizens of the Merc currency pits who had been bold enough to skip past the dollar entirely and put on a pair trade of long D-mark and short lira over the initial fifteen years of this new futures market would have reaped a 17,000 percent return. Likewise, any trader who noticed that Japanese statesmen became extremely timid, even sweaty, in the presence of Texas politicians wearing the big hat in Washington would have bet that 360 yen would soon buy a lot more than one dollar.
In fact, after Japanese statesmen had received the Connally “treatment,” and professed to enjoy it, they were rewarded thirteen years later by the drastically more bracing Baker “treatment.” In the aftermath of the latter, the exchange rate rocketed all the way up to 128 yen to the dollar by December 1987, meaning a 12,000 percent gain on the trade over the fifteen-year period.
In short, the Merc traders had every reason to sing the praises of Professor Friedman, even as they peddled their commercial wares to the hapless exporters and importers caught up in these exchange rate maelstroms. Never before in financial history had such a lucrative casino been established as the one Leo Melamed opened on Jackson Boulevard in the shadows of Milton Friedman’s University of Chicago classroom.
“WHOREHOUSE OF THE LOOP” NO MORE
To be sure, few traders were adroit enough to carry these trades to full term and there were maintenance margins to post and big risks of being wrong when trading direction reversed. Yet even after these allowances, the returns on speculator capital were so enormous and so unattainable elsewhere that currency trading became a powerful magnet for financial capital. Indeed, only two decades earlier the Merc had been derisively known as the “Whorehouse of the Loop,” owing to the corrupt antics which surrounding its trading in onions and eggs. Now, thanks to currency futures, the inflow of capital to the Merc exceeded during a few brief years the combined capital of all the commodity futures exchanges in the world as of May 1972. Even in purely physical terms, the growth of the Merc was stunning. By 1987, daily contract volume had risen by a factor of thousands and the Merc’s trading floor had grown from the size of a modest Chicago neighborhood saloon to encompass a space equal to three football fields.
This tidal wave of resources, transactions, and speculative capital, in fact, was so massive that speculators soon became their own counterparty; that is, bona fide commercial hedgers accounted for a rapidly diminishing share of transactions. By the end of its first decade of currency trading, about 90 percent of transactions on the CME consisted of pure gambling. The exchange’s spin doctors, of course, were pleased to describe these gamblers as “liquidity providers,” but that claim doesn’t even remotely hold up under serious examination.
Melamed himself made no bones about the fact that the Merc aimed to facilitate equal opportunity wagering: “Why shouldn’t the individual have the same right as the corporation to trade currency … doesn’t the individual have a right to protect or enhance his personal estate?”
The answer might have been that the individual home gamer usually didn’t have income in D-marks or lira to cover. What was happening, of course, was that the right of consenting adults to gamble on the free market was being confused with the monetary reason why the currency futures market existed in the first place.
The incoming flood of speculative capital also gave rise to a profusion of new financial futures and options products which soon surpassed even the exploding currency markets. Not surprisingly, these new contracts were initially focused in the interest rate arena, and were driven by the same monetary policy activism as the currency futures.
In fact, interest rate movements stemming from the machinations of central banks during the first fifteen years were every bit as volatile as exchange rates. As indicated, this too represented a radical departure from historical experience.
The decade from 1955 through the end of 1964 arguably represents the golden era of Martin-Eisenhower financial discipline. While the Martin Fed had not been loath to nudge money market interest rates at cyclical turning points, its overarching objective had been to keep inflation near zero, the dollar strong, and the financial markets stable on a long-term basis, and to exercise a light touch in its open market operations.
Accordingly, short-term interest rates had moved at only a glacial pace during this golden era. During the 1955–1964 period the interest rate on Treasury bills, for example, remained in a tight range of 1.5–3.5 percent. In fact, yields traded inside those bounds in 80 percent of monthly observations over the entire decade and rarely moved more than 100 basis points within any twelve-month period.
Needless to say, under these conditions there was no market whatsoever for interest rate futures because businesses using short-term revolving credits or medium-term capital loans were exposed to virtually zero risk of significant interest rate fluctuation. The prime rate for business loans remained at 4.5 percent for a remarkable seventy-five consecutive months between 1960 and late 1965, a span that exceeded the term of 95 percent of bank commercial and industrial loans outstanding at the time. No businessman, rational or otherwise, could have been persuaded to spend good money on hedging interest rates that would not change over the term of his loan.
TALE OF TWO MARKETS
In September 1960 the Merc was down to a single commodity: a dying contract in eggs futures which traded languidly in a small pit surrounded by Ping-Pong tables and card games. Ironically, the egg contract was on death’s door because modern poultry farming had brought the hens out of the weather-exposed farmyard and into industrialized egg factories where stable conditions resulted in a constant output of eggs. There was no trading vigorish in eggs which got laid on a regular basis.
Exactly sixteen years later in February 1976, Milton Friedman himself stood on the floor of what were vastly expanded and opulent new digs at the Merc to commence trading in the world’s first T-bill futures contract. In contrast to the tranquil performance of the nation’s now thor
oughly industrialized laying hens, the market for its short-term debt had become tumultuous.
Between January 1972 and mid-1974, for example, the T-bill yield rocketed from 3.2 percent to 9.2 percent. Needless to say, short-term floating rate borrowers had not been prepared for an unprecedented 600 basis points surge in their debt service costs.
Nor were they any more prepared for the sharp slump in rates which followed the initial violent increase. Interest rates plummeted when the Fed brought the US economy to its knees as it attempted to contain the virulent inflation it unleashed. While the experience of a cyclical downturn was not new, the 400 basis point plunge of short-term interest rates during less than fifteen months in 1974–1975 was another unprecedented shock to the commercial loan market.
Overall, the Camp David event spawned interest rate volatility and swings of previously unimaginable magnitude. In a radical departure from its flatlining trend of the early 1960s, the prime rate, which then was still the major benchmark for business loans, became financially hyperkinetic. During the first four years after the Smithsonian meeting, the prime rate changed forty-four times, moving from 5 percent to 12 percent and then back down to 7 percent, thereby traversing 1,200 basis points of change within the lifetime of a typical five-year term loan.
THE BIRTH OF T-BILL FUTURES:
MELAMED TO SPRINKEL TO BURNS
Not surprisingly, when in late 1975 Melamed made the rounds in Washington with his proposed T-bill product, he encountered an amenable audience among the very policy officials who were responsible for the money market turbulence which made interest rate futures plausible. By then he had recruited to the board of the Merc affiliate that conducted currency trading one of Friedman’s leading monetarist disciples, Beryl Sprinkel, the chief economist of a major Chicago bank. More crucially, Sprinkel had done his graduate studies under Arthur Burns and would keep Friedman’s monetarist candle burning brightly during the Reagan administration as undersecretary of the treasury for monetary affairs.
The Great Deformation Page 41