The following is an excellent excerpt from the book “THE GREAT DEFORMAITON: The Corruption of Capitalism in America” by David A. Stockman from Chapter 14 “Pork Bellies, Floating Money, and the Rise of Speculative Finance” from page 294 and I quote: “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.
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 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 market 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 regime 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 feed-back 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 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.
The 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 indicted, 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.
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.”
(THE PROBLEM WITH MILTON FRIEDMAN, THE MAN WHO DIDN’T BELIEVE IN GOVERNMENT, WAS HAVING THE FED BUY GOVERNMENT DEBT. THE ONLY PROBLEM WITH THAT, COMING FROM A REPUBLICAN, SUCH AS MILTON FRIEDMAN WAS, IS THAT AT SOME POINT, YOU’RE GOING TO HAVE TO RAISE THE INCOME TAXES ON THE WEALTHY BECAUSE THAT’S THE ONLY PEOPLE THAT HAD ANY MONEY LEFT, IF YOU FIGURE ON RUNNING A GOVERNMENT THAT COULD SUPPORT A MILITARY, AS WELL AS A CIVILIAN STRUCTURE, WITH ROADS AND OTHER STRUCTURES, WHERE THEY COULD KEEP THE MORALE HIGH ENOUGH ON YOUR SIDE, SO YOU DIDN’T GET INTO A CIVIL WAR.
I QUOTE FROM CHAPTER 13 “Milton Friedman Folly: Rise of the T-Bill Standard” from page 267: “When Professor Friedman Opened Pandora’s Box: Open Market Operations – At the end of the day, Friedman jettisoned the gold standard for a remarkable statist reason. Just as Keynes had been, he was afflicted with the economists’ ambition to prescribe the route to higher national income and prosperity and the intervention tools and recipes that would deliver it. The only difference was that Keynes was originally and primarily a fiscalist, whereas Friedman had seized upon open market operations by the central bank as the route to optimum aggregate demand and national income.
There were massive and multiple ironies in that stance. It put the central bank in the proactive and morally sanctioned business of buying the government’s debt in the conduct of its open market operations. Friedman said, of course, that the FOMC should buy bonds and bills at a rate no greater than 3 percent per annum, but that limit was a thin reed.
Indeed, it cannot be gainsaid that it was Professor Friedman, the scourge of Big Government, who showed the way for Republican central bankers to foster that very thing. Under their auspices, the Fed was soon gorging on the Treasury’s debt emissions, thereby alleviating the inconvenience of funding more government with more taxes.
Friedman also said democracy would thrive better under a regime of free markets, and he was entirely correct. Yet his preferred tool of prosperity promotion, Fed management of the money supply, was far more anti-democratic than Keynes’ methods. Fiscal policy activism was at least subject to the deliberations of the legislature and, in some vague sense, electoral review by the citizenry.
By contrast, the twelve-member FOMC is about as close to an unelected politburo as is obtainable under American governance. When in the fullness of time, the FOMC lined up squarely on the side of debtors, real estate owners, and leveraged financial speculators—and against savers, wage earners, and equity financed businessmen—the latter had no recourse from its policy actions.
The greatest untoward consequence of the closet statism implicit in Friedman’s monetary theories, however, is that it put him squarely in opposition to the vision of the Fed’s founders. As has been seen, Carter Glass and Professor [Parker] Willis assigned to the Federal Reserve System the humble mission of passively liquefying the good collateral of commercial banks when they presented it.”
LaVern Isely, Overtaxed Independent Middle Class Taxpayers and Public Citizen and AARP Members