Tale of Two Markets

The following is an excellent excerpt from the book “THE GREAT DEFORMATION: The Corruption of Capitalism in America” by David A. Stockman from Chapter 14 “Pork Bellies, Floating Money, and the Rise of Speculative Finance” on page 300 and I quote: “Tale of Two Markets – In September 1960 the Merc was down to a single commodity;: a dying contract egg 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 thoroughly 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 department 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 round 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.
So Sprinkel did not require a Washington sherpa to pave the way. He simply trotted Melamed into the boardroom of the Eccles Building. There he made his pitch directly to the chairman of the Fed. No other parties were needed.
The timing could not have been more fortuitous. As shown by Burns’ own diary published thirty years later, the nation’s top central banker by then had become thoroughly flummoxed. He had found he could not explain, predict, or control the sudden violent lurch of the business cycle from boom to bust, and the wild swings in interest rates, commodity prices, exchange rates, and inflation expectations that had accompanied it. Indeed, as a keen student of financial history and prior business cycles, Burns knew full well that the wild financial fluctuations of 1972-1975 had never before occurred in peacetime history.
So Melamed’s proposition was a perversely welcome alternative. If the central bank could not deliver stable money to the market, then why not enable the private market to shield itself from the disorders emanating from the Fed. “What a clever idea,” Burns is reported to have said, adding, “Such futures contracts would be used by government securities dealers, investment bankers, all sorts of commercial interests, as well as speculators.”
The Fed chairman had that partly right. Not only did the big Wall Street bond houses like Salomon Brothers and investment banks like Morgan Stanley and Goldman learn to use financial futures, but within the next decade and a half they had turned their traditional business models inside out.
Historically, they had plied their underwriting and advisory trades on the basis of much trust and sparse capital. Once they piled into the new financial futures markets and the related over-the-counter (OTC) trading venues, however, their balance sheets, leverage ratios, and use of short-term wholesale funding expanded like Topsy. As detailed in chapter 20, asset footing went from the millions to the trillions in less than two decades.
Ironically, the exceedingly lucrative core business of these new Wall Street trading machines involved selling over-the-counter options to their clients and then laying off the risk on the organized futures and options exchanges. Had the pork-belly traders (or other speculators) never been empowered by Friedman’s floating money contraption to create the financial futures and options exchanges, the “investment banks”–Bear Stearns, Lehman, Goldman, Merrill, and Morgan Stanley—which thrived on the OTC never would have grown to such massive size.
Yet the most important dimension of Melamed’s proposition burns got plainly wrong. According to Melamed’s account of the meeting, Burns had been quick to seize on the “free markets” aspect of the financial futures concept. Turning to Sprinkel he had queried, “This futures contract would become a predictor of the direction of interest rates, isn’t that right, Beryl?”
The implication was that the Fed would gain a valuable new tool in the form of free market signals about the price of money and capital that it could use in the conduct of monetary policy. When Sprinkel ventured that such market signals would perhaps be as good as the Fed’s own econometric forecasting model, Burns dispatched the economist’s musings with proof that he had learned something at Richard Nixon’s knee after all.
“That [model],” chuckled the chairman of the Fed, “Isn’t worth a shit.”
Here was the heart of the post-Camp David monetary problem. The Fed had been trying to “manage-to-model,” which by Burns’ own colorful admission didn’t work owing to the deficiencies of the Fed’s primitive, even if data and equation riddled, rendering of the massive US economy. Now the suggestion was that the Fed could “manage-to-signal.” Since such interest rate signals would putatively emanate from the pure free market—that is, the open outcry trading pits of the Merc—they would be more reliable and monetary policy would therefore be more successful.
That was a misplaced presumption. The new financial futures markets were soon giving out an abundance of signals, but they were not of the wholesome free market character expected. Instead, the futures pits plunged into the business of handicapping and guesstimating the Fed’s own futures moves. For instance, if traders believed there was an 80 percent chance that the federal funds rate would be increased by 50 basis points in four months, the futures contract for that month would exceed the spot rate by a corresponding amount.
More importantly, beyond handicapping what the Fed “might” do the futures pits also provided Wall street an avenue to convey what it “should” do. Not surprisingly, the consensus was invariably biased in favor of lower interest rates. Such action by the central bank would elevate the price of dealer-held inventories of stocks and bonds, thereby providing carry gains. It would also ginger the financial environment, enhancing their ability to peddle these securities and other investment products to their customers.
The market-pricing signals that Burns mused about thus eventually became something very different than honest assessment of financial market conditions. In effect, they became Wall Street’s marching orders to the Fed. The message was that if Wall Street “expectations” of continuous accommodation by means of low and even lower interest rates were “disappointed,” then an economically threatening market sell-off or even panic was likely to ensue.
That is why the Greenspan Fed unilaterally disarmed after the cataclysmic but short-lived stock market meltdown of October 1987. As detailed in chapter 15, the Fed developed a deathly fear of confounding market expectations embedded in the futures markets—so it sheathed the very instruments which could have checked endemic market speculation against its own future policy actions.
All it needed to do in order to curb this bare-faced front-running was to surprise Wall Street with higher margin requirements on stock trading accounts or an unexpected 150 basis point increase in the federal funds rate—or even dust off some bracing rhetoric such as William McChesney Martin’s famous admonition that the Fed’s job is to “take the punch bowl away just when the party is getting started.”
In short, what the Fed needed to do was to openly defy what the market had priced in, thereby pitching the “smart money” surf riders into the drink. Yet, other than its short-lived tightening moves in 1994, the Greenspan Fed allowed the market to dictate monetary policy. In so doing, it transformed the financial futures market into an instrument by which Wall Street captured effective control of the nation’s central bank.
The new financial futures trading pits thus were not at all what they seemed. Evangelists like Melamed promoted them as an expression of pure free market innovation. Yet they were actually a free market deformation arising from an anchorless central bank money system that was itself driven by speculators in the pits.
Crony Capitalism, Even in the Free Market Futures Pits – Since this kind of central bank-enabled financial speculation became fabulously profitable, the participants in these newly opened casinos sought to protect them at all hazards. Ironically, then, financial futures markets soon became a hotbed of crony capitalism as their Friedman-quoting leaders mounted a legislative and regulatory influence-peddling apparatus of immense scale and potency.
As it happened, Melamed’s next stop after Burns had been a meeting with the chairman of President Ford’s Council of Economic Advisors. And there the improbable transformation of Melamed’s eggs and bacon exchange had another serendipitous encounter. Describing this meeting as ‘a shot in the arm,” Melamed recalled that he had been interrupted even before he could explain his proposed T-bill contract. “What a great idea,” he reported Alan Greenspan as exclaiming, who then proceeded to “rattle off a dozen uses for such a market.”
To be sure, on that particular afternoon in late 1975 Greenspan was merely the Council of Economic Advisors chairman, with not much to do. The Ford White Hours was still inclined to keep its hands off the US economy. So the future maestro couldn’t offer much help except to marvel over the theoretical free market efficiencies which the T-bill contract might bring to finance.
Yet Greenspan’s hearty embrace of Melamed’s financial futures market that day eventually turned out to be the kind of “shot in the arm” which was literally heard around the world. During his nineteen years’ tenure at the Fed, of course, Greenspan tenaciously defended the financial futures market from scrutiny and the occasional challenges of regulators.
There was nothing wrong with that per se, since the free market always needs a defense in the nation’s political capital. Yet what Greenspan utterly failed to see was the stunning disconnect between the paean to hard money and the gold standard that he had written as recently as 1966 and the free market romanticism about financial futures which he now so enthusiastically embraced.
Better than anyone else, a lapsed goldbug like Greenspan should have understood that Melamed’s currency and interest rate futures market had no rationale for profitability, and therefore existence, unless money was unstable, unreliable, and unanchored in anything more enduring than the ever-changing whims of a board of twelve monetary commissars. Unlike the case of weather-driven corn or natural gas futures, therefore, there was no economic basis for “price discovery” in the Merc financial pits.
The truth was that the market for money futures was being constantly maneuvered, manipulated, and massaged by the central bank. Indeed, had Greenspan given serious reflection to these inescapable truths, he might have realized that fiat money-based futures markets are inherently rent-seeking endeavors; that is, they scalp profits from trading in financial instruments which have no useful or productive economic purpose.
More importantly, he might have also realized that such rent-seeking enterprises could metastasize by leaps and bounds if they were enabled and encouraged by policy actions, such as backstopping speculative asset prices with a central bank put.
In October 1987, in fact, Greenspan regarded the Merc speculators involved in Melamed’s most lethal invention, the S&P futures contract, with just that kind of put, flooding the market with liquidity to rescue speculators even thought the main street economy was hale and hearty. From that inflection point forward, Wall Street was off to the races that ended in the meltdown of September 2008.”

I QUOTE FROM CHAPTER 13 Milton Friedman’s Folly: Rise of the T-Bill Standard” on page 272: “Milton Friedman: Freshwater Keynesian and the Libertarian Professor Who Fathered Big Government – The great irony, then, is that the nation’s most famous modern conservative economist became the father of Big Government, chronic deficits, and national fiscal bankruptcy. It was Friedman who first urged the removal of the Bretton Woods gold standard restraints on central bank money printing, and then added insult to injury by giving conservative sanction to perpetual open market purchases of government debt by the Fed. Friedman’s monetarism thereby institutionalized a regime which allowed politicians to chronically spend without taxing.
Likewise, it was the free market professor of the Chicago school who also blessed the fundamental Keynesian proposition that Washington must continuously manage and stimulate the national economy. To be sure, Friedman’s “freshwater” proposition, in Paul Krugman’s famous paradigm, was far more modest than the vast “fine-tuning” pretensions of his “salt-water” rivals. The saltwater Keynesians of the 1960 proposed to stimulate the economy until the last billion dollars of potential GDP was realized; that is, they would achieve prosperity by causing the state to do anything that was needed through a multiplicity of fiscal interventions.
By contrast, the freshwater Keynesian, Milton Friedman, thought that capitalism could take care of itself as long as it had precisely the right quantity of money at all times: that is, Friedman would attain prosperity by causing the state to do the one thing that was needed through the single spigot of M1 growth.
But the common predicate is undeniable. As has been seen, Friedman thought that member banks of the Federal Reserve System could not be trusted to keep the economy adequately stocked with money by voluntarily coming to the discount window when they needed reserves to accommodate business activity. Instead, the central bank had to target and deliver a precise quantity of M1 so that the GDP would reflect what economic wise men thought possible, not merely the natural level resulting from the interaction of consumers, producers, and investors on the free market.
For all practical purposes, then, it was Friedman who shifted the foundation of the nation’s money from gold to T-bills. Indeed, in Friedman’s scheme of things central bank purchase of Treasury bonds and bills was the monetary manufacturing process by which prosperity could be managed and delivered.”

LaVern Isely, Overtaxed Independent Middle Class Taxpayer and Public Citizen and AAPR Members


About tim074

I'm a retired dairy farmer that was a member of the National Farmer's Organization (NFO). Before going farming, I spent 4 years in the United States Air Force where I saved up enough money to get my down payment to go farming. I also enjoy writing and reading biographies and I write about myself as well as articles and excerpts I find interesting. I'm specifically interested in finances, particularly in the banking industry because if it wasn't for help from my local Community Bank, I never could have started farming which I was successful at. So, I'm real interested in the Small Business Administration and I know they are the ones creating jobs. I have been a member of Common Cause and am now a member of Public Citizen as well as AARP. I have, in the past, written over 150 articles on the Obama Blog (my.barackobama.com) and I'd like to tie these two sites together. I'm also on Twitter, MySpace and Facebook and find these outlets terrifically interesting particularly what many of these people did concerning the uprising in the Arab world. I believe this is a smaller world than we think it is and my goal is to try to bring people together to live in peace because management needs labor like labor needs management. Up to now, that hasn't been so easy to find.
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