The Great Deformation (55 page)

In due course, all monetary hell broke loose. Radical fluctuations in exchange rates and interest rates became routine occurrences, charting swings with amplitudes never experienced in peacetime history. The rambunctious journey of the D-mark provides a case in point.

When Melamed opened up his currency futures market in May 1972,
West Germany was the largest trading partner of the United States, and its exchange rate was 3.2 D-marks per dollar. The dollar then fluctuated violently downward in response to the Fed's profligate money printing during the tenure of Arthur Burns and William Miller, respectively. When it reached an interim low of 1.72 D-marks in early 1980, the dollar had lost 45 percent of its buying power.

Under Volcker's relentless campaign to quash domestic inflation and restore the integrity of the US dollar, however, the mark-to-dollar exchange rate abruptly and massively reversed direction in favor of the dollar. By February 1985, the exchange rate was all the way back to 3.05 D-marks per dollar, meaning the greenback had gained 90 percent since early 1980.

Then Jim Baker moved from Reagan's chief of staff job in the White House to the Treasury Building, where he dusted off John Connally's monetary chainsaw and launched another Texas dollar massacre, this one known as the Plaza Accord of September 1985. Bullied into selling dollars with nearly reckless abandon, Japan and Germany joined the United States in flooding the currency exchange markets with an unrelenting “offer” on the dollar.

Consequently, during the next twenty-four months the exchange rate was hammered back down to about 1.6 D-marks per dollar, meaning that by year-end 1987 the greenback had drastically reversed direction yet again, this time losing 50 percent of its value against the D-mark in less than thirty months.

In all, the dollar lost 50 percent of its exchange value against the D-mark during the first fifteen years after the Merc contracts opened, but the violent round trips and fluctuations during the interim amounted to the equivalent of 400 percentage points of gross change. Needless to say, corporations doing business in German marks had no choice except to purchase costly hedging protection against this unprecedented, radical exchange rate volatility.

At the same time, in order to accommodate the massive new demands for currency-hedging protection, Melamed needed gobs of speculative capital to take the other side of his rapidly expanding volume of futures contracts. This turned out to be no problem whatsoever.

The Merc required traders to post an initial margin of only 2 percent on currency contracts. This meant that if the dollar moved by 10 percent, say from 3 marks per dollar to 2.7 marks per dollar, a punter could collect a 500 percent profit. And if this 10 percent move in the underlying currency pair occurred within the span of three months, as happened not infrequently, the annualized rate of return on capital at risk would be 2,000 percent.

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 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.