The Great Deformation (58 page)

Melamed's experiment with financial rocket fuel should have been of abiding interest to the congressional banking committees, but he helped ensure that the new Commodities Futures Trading Commission, created in late 1974, was in the jurisdiction of the congressional “ag” committees. There it remained secure in the bosom of the wheat-cotton-corn and livestock coalition that ran the US farm cartels.

In enlisting the farm bloc, Melamed hired the chief aide to legendary House Agriculture Committee chairman W. R. Poage as his Washington lobbyist. Not coincidentally, the free market had no more demagogic detractor on Capitol Hill than Poage's fellow Texan Jim Wright, who was majority leader and then House Speaker throughout the 1980s.

Nevertheless, Wright was the first Washington fireman to be offered an “honorarium” to visit the floor of the Merc and had no trouble at all understanding the grand bargain. The free market futures industry would support the anti–free market farm programs and the farm belt Democrats who depended upon them. In turn, the Agriculture Committee kept the free market in the futures pits clear of regulatory interference.

Later, Melamed would note that Wright “understood the Merc and its potential and would become the champion of the industry.” Yet what Wright actually understood was that maintenance of the Democratic majority in the House required more and more campaign money, including a fair share of the take from business lobbies.

And in that department Melamed had equipped the futures industry to meet Wright's fondest expectations. In fact, within only a few months of the T-bill contract launch, Melamed had been advised to form a political action committee, which he went about with his usual gusto.

The surprising part, however, was that the prompt had come from “none other than the chairman of the CFTC.” Melamed thus invited Bagley to come to Chicago and talk political turkey to five hundred assembled Merc traders. In what was undoubtedly a new advance in the art of crony capitalism, the Washington regulator of Melamed's troops delivered a civics lesson on how they needed to pay to play: “You guys will never have a voice in the process until you have political muscle. For that, you need a political action committee.”

The distribution of the largesse from the Merc's PAC was one matter on which Melamed most definitely did not seek the advice of Milton Friedman. In the 1988 presidential campaign, for example, it supplied $20,000 each to the campaigns of Republicans George H. W. Bush and Bob Dole and Democrats Al Gore, Richard Gephardt, and Paul Simon.

Still, the PAC was only the tip of the influencing-peddling iceberg. As Melamed grandly explained, “In the agricultural heyday of the Merc, the visiting dignitary was often a grand champion steer or a prize hog, but after finance came to the Merc, so did politicians.”

Accordingly, no fewer than eighty-five senators and two hundred congressmen visited the Merc during the fifteen years after the mid-1970s, where they undoubtedly preened in the same circle on the trading floor where grand champion steers had once stood. The excitement of placing an order for $10 million T-bills or Malaysian ringgit kept the politicians streaming to Chicago, as did the handsome honorarium they were paid upon completion of the trade.

In fact, over the years nearly every politician of national importance was paid to pay a visit to the Merc, including Tip O'Neill, Hubert Humphrey, Ed
Muskie, Walter Mondale, and Ronald Reagan. But there was one habitual visitor who embodied the essence of the new-style crony capitalism which had taken instant root in Milton Friedman's free market in financial futures.

Dan Rostenkowski was the chairman of the House Ways and Means Committee and the leader of the machine Democrats who formed the core of the House majority. At an early 1980s dedication of a still newer and larger Merc facility, Rostenkowski simply noted that “the Merc is to Chicago what oil is to Texas or Oklahoma, what milk is to Wisconsin and what corn is to Iowa.”

THE ARRIVAL OF “CASH SETTLEMENT” AND THE EXPLOSION OF LIBOR DERIVATIVES

By 1980, the Merc's currency and T-bill contracts were thriving, and it was also drawing competition in New York, London, and especially from its crosstown rival where the Chicago Board of Trade's thirty-year Treasury bond contract had been a booming success. Yet there remained a more formidable barrier to truly explosive growth than the Merc's exchange rivals; namely, the age-old rejection by traditional agricultural futures exchanges of “cash settlement” upon contract expiration.

In fact, it was the requirement for physical delivery of the product that kept speculation in check. An overly exuberant bidder on the last day of a contract could find himself flooded with carloads of corn or bacon on which he would have to pay storage and ultimately liquidate in the cash market at a loss. Indeed, Melamed himself had once observed that “without delivery, we were not much different than a gambling den.”

The Carter-era CFTC chairman, former state insurance commissioner James Stone, thought the same thing, arriving at that conclusion out of an abundance of experience with moral hazard in the insurance business. Accordingly, he would not even entertain the notion of new financial contracts based on cash settlement rather than traditional physical delivery.

As a practical matter, therefore, Stone's stubborn opposition closed the door to what Melamed and his R&D shop could see as the almost limitless next frontier for futures: contracts based on an index or other derivative as opposed to the actual physical unit, such as a carload of bacon or stack of Treasury bill certificates.

And this had become far more than an academic matter. By then the race was on to launch a Eurodollar future in order to tap the market for hedgers and speculators in the vast offshore dollar markets.

That these markets even existed, of course, was a tribute to the post–Camp David breakdown of the international monetary order. Printing dollars
with reckless abandon, the Fed had fueled the petroleum and related commodity booms of the 1970s, and these soaring commodity prices, in turn, had generated massive windfall rents which OPEC producers deposited in London-centered dollar deposits.

In the face of the wildly gyrating interest rates that the Fed's maneuvers and manipulations had bestowed on these rapidly expanding offshore dollar markets, the opportunity for profitable speculation was simply mouth-watering. Yet the interest rate in question—the London Interbank Offered Rate, or Libor—was a composite index of short-term deposit rates offered by nearly a dozen leading London banks.

Consequently, the proposed Eurodollar futures could not be settled with physical delivery because there were no actual Eurodollar contracts to dump on some errant trader's lawn. The “commodity” in question was only the paper index published by a banking consortium, an operation which in the fullness of time would be revealed to be crooked to the core.

In the context of this dilemma, the election of Ronald Reagan in 1980 brought an ironic resolution. At the time that Melamed had supported the creation of the CFTC back in 1974, one of his objectives had been most un-Friedman-like. “The thought hit me,” Melamed recalled, “that only a federal agency could ordain the legitimacy of cash settlement. If it did, then the Merc could have stock indexes and lord only knows what else.”

The crony capitalist cat at the heart of the financial derivatives market was thus let out of the bag. The Merc had been free all along to offer cash settlement contracts because there was no federal law against them. As Herb Stein had put it, they were “voluntary agreements between consenting adults.”

What Melamed actually wanted, therefore, was not regulatory permission but federal sanction. The regulatory approval would amount to a good-housekeeping seal for cash settlement contracts. In short, if the Merc was to sally forth from the prosaic world of agricultural market price discovery to an arena of out-and-out gambling, Melamed wanted Uncle Sam's blessing.

He also wanted federal preemption of any exposure to anti-wagering statutes which still cluttered the books of more than a few states, including Illinois. Accordingly, the free market–oriented CFTC commissioners appointed by the Reagan administration soon found themselves immersed in an awkward project.

In the midst of quoting Milton Friedman on the virtues of free market trading pits and the right of traders to agree to settle their contracts with cash, a right they already had, the CFTC ratified the futures industry plan. So doing, they accomplished nothing less than an abridgement of the
Tenth Amendment of the Constitution and the long settled right of states to regulate gambling.

ULTIMATE REGULATORY CAPTURE: WHEN THE CFTC WENT INTO THE FRANCHISED GAMBLING BUSINESS

In the final analysis, of course, state laws against gambling are no more compatible with the requisites of a free society and individual liberty than any other “nanny state” intrusion, whether arising out of mischief on the Potomac River or legislative finagling in the environs of Springfield, Illinois. Yet in gaveling through the 1981 approval of the Merc's Eurodollar contract, the Reagan commissioners did not really strike a blow at the nanny state, as their rhetoric implied.

Instead, they facilitated an act of regulatory capture that literally changed the future course of financial history. Perhaps this outcome was unwitting on the part of some commissioners, but the key CFTC policy maker in this episode, Gary Seevers, fully understood the import. Not long after the ruling he became a Goldman Sachs partner specializing, not surprisingly, in cash-settled financial futures!

So at the end of the day there arose a great irony. According to pure free market theory, the CFTC had no real reason for existence. Yet by virtue of an action which was deceptively portrayed as “deregulation,” it had now actually given gratuitous legal and moral sanction to a form of futures contract that would be hazardous even in a stable system of honest money. Under a régime of central bank printing-press money, it was a ticket to catastrophe.

It did not take long for this to become fully evident. The Merc's Eurodollar contract was a smashing success in its own right, but its real “contribution” as viewed by the futures industry was that it validated the concept of cash-settled contracts. This breakthrough then and there opened the door to trading in trillions of new index-based futures and other “derivative” contracts, both on organized exchanges and in over-the-counter trading.

This assessment could not have been more cogently expressed than in Melamed's own words, written in 1993 when the derivatives explosion was just gaining its initial head of steam. “If ever the CFTC needs to prove its value to the marketplace,” he opined, “it can, above all else, point with pride at the innovation of cash settlement.”

In the event that there was any confusion that Melamed and the incipient financial futures industry viewed the CFTC as their captive enabler rather than independent regulator, Melamed went on to remove all doubt: “I seriously doubt that our industry could have achieved even a fraction of the transaction volume we have already achieved or plan for …
without
removal of the requirement for physical delivery from futures trade
. That could never have happened
without the CFTC.”
[emphasis mine]

THE PERVERSE SEQUENCE:

INFLATION ENDS, GAMBLING STARTS

As it happened, breaking the cash settlement barrier with the Eurodollar contract could not have occurred on a timelier basis. Soon thereafter in April 1982, the Merc launched a truly transformative trading vehicle: the cash settled S&P 500 futures contract.

In less than six months, the wrenching recession which Volcker had triggered to quash the prior decade's virulent inflation reached bottom. Thereupon, a fifty-month run of booming output growth and declining inflation followed, with real GDP growth averaging more than 5 percent annually.

Needless to say, the stock market, which had languished for sixteen years beneath its 1966 peak of 1,000 points on the Dow, now sprung to life and for good reason: corporate earnings began to rebound while the sharp decline in the inflation rate permitted the PE multiple to climb out of the single-digit sub-basement were it had been consigned by the Great Inflation. By early 1983 the Dow zoomed past 1,000 and then reached 2,000 a few years later, finally scaling to 2,700 by August 1987, or more than three times the level it stood at when the S&P futures contract was launched.

While some substantial part of this munificent stock market gain was due to earnings and disinflation, there can be little doubt that the market was now being driven by an artificial turbocharger. Not only did the cash settlement contracts in the S&P futures pits add directly to the speculative froth, but they also facilitated a massive embrace by stock portfolio managers of one of those crackpot trading schemes that invariably bring bull market euphoria to tears.

Mutual fund and other stock portfolio managers had been persuaded that they could ride the bull without trepidation due to a mechanism enabled by the new S&P futures contract called “portfolio insurance.” The latter would make them whole for any drop in the S&P index below the set points for which they were insured.

Nor were the mechanics of this swell new financial invention all that mysterious. Whenever the S&P futures price dropped below the trigger points, the portfolio insurer would automatically sell S&P futures, and keep selling until the futures market stopped falling. Thus, if an investor's portfolio declined by 10 percent in the cash market where he was long, this loss would be offset by a 10 percent gain from his position in the S&P futures where he was short.