The Great Deformation (56 page)

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 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 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.

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 terrific 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 future 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.