The Great Deformation

by David Stockman

  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.

  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 Green-span 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 House 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 fina
ncial 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 rewarded 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 though 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.

  THE OTHER CHICAGO SCHOOL—OF REGULATORY POLITICS

  Leo Melamed had also audited another course in Chicago: the one conducted by Richard M. Daley at city hall. By October 1987, the futures industry had bought and paid for influence in the corridors of Washington in a manner that mirrored the techniques hizzoner had perfected among the aldermen of Chicago. The first was making sure the building inspector knew who he was working for.

  At the time Melamed was making his rounds on the T-bill contract, his third stop was with his building inspector, William Bagley, chairman of the newly created Commodity Futures Trading Commission (CFTC). Bagley was a California lawyer and state legislator who knew little about commodities or futures. But he did know Ford’s chief of staff, Don Rumsfeld, and the latter had rushed him to Washington in order to open the new CFTC for business by the statutory deadline in April 1975.

  Only a few months later Melamed was pressing him to approve the proposed T-bill contract, but Bagley quickly made clear that he knew exactly who he was working for. Although approval of the T-bill contract was technically within the purview of the CFTC, Bagley insisted that a matter of that moment was well above his pay grade. “I love you like a brother and want to do it,” he told Melamed, “but I need someone higher up to give me an okay.”

  That someone was Bill Simon, newly installed secretary of the treasury, but Melamed had not yet made the acquaintance of the legendary bond trader turned policy maker. He was therefore reluctant about making a cold call, reasoning, Chicago style, that “to go without proper protection seemed wrong.” To remedy this he began to “call around” and, according to Melamed’s account, “Sure enough, I hit pay dirt.”

  The pay dirt in question was Sanford Weill, the chief of an aggressive trading house known as Shearson and Co. Melamed described Weill as a “shrewd market analyst” who “sensed the great potential of our T-bill contract.”

  Rarely did Leo Melamed indulge in understatement, but in this instance he surely did. Sandy Weill not only got in on the ground floor, but over the next thirty years proceeded to build a financial trading colossus out of Salomon, Citibank, and dozens of others. In no small measure due to the financial futures markets pioneered by Melamed, Citigroup sported a balance sheet by 2006 which was larger than the entire US banking system had been the day Sandy Weill escorted Melamed into the office of his Wall Street chum.

  At least according to Melamed’s telling, however, even the formidable Sandy Weill had not actually carried the day alone. As an “additional precaution” he had asked Milton Friedman to call Bill Simon and “again weave his magic.” Undoubtedly, it did not require much of Friedman’s ample talent for persuasion to convince the free market–loving Simon.

  Nor was that outcome either surprising or inappropriate. The problem with Melamed’s financial futures was not the free market, but the freely printed money which corrupted it.

  When Melamed finally had his audience with Simon “it was a done deal.” Yet as in so many other inflection points along the way to September 2008, there was no hearing or issue analysis behind the momentous step of opening up the US Treasury market to the futures pits. According to Melamed’s account, Secretary Simon “quickly agreed and signed the prepared approval letter to Bagley.”

  A TALE OF TWO TRADING HOUSES: SALOMON BROTHERS VS. COUNCIL GROVE NATIONAL BANK

  Soon thereafter on January 6, 1976, Milton Friedman rang the opening bell on the Merc’s T-bill contract, thereby ushering in the age of interest rate futures. During his usual frenetic campaign to promote interest in the new contract, Melamed had two contrasting encounters which dramatize the true extent of the financial revolution he was triggering.

  Salomon Brothers was then the dominant cash market trader of government bonds and accordingly was at the top of Melamed’s sales call list. But after giving a polite hearing to Melamed’s pitch, the trading house’s venerable senior partner, William Salomon, curtly announced that “this is not for Salomon” and thereupon showed the Chicago eggs and bacon trader the door.

  Thus, it is perhaps a measure of the radical change in the financial system then in the offing that four and a half years after the events of Camp David, the smartest bond traders in the world had not yet imagined the possibilities of the financial derivatives game. They failed to see that rather than trading cash bonds for thin spreads, they could position themselves on 20 to 1 leverage in T-bill futures, positions that would be driven by and anticipate each and every move of the nation’s newly unshackled central bank.

  It is perhaps not surprising that even as the House of Salomon took a pass, a Kansas grain farmer with a PhD in financial economics did not have the same reluctance. Wayne Angell operated a 3,300-acre wheat farm and was also a Kansas state legislator, a professor of economics at a local college, and an energetic bank officer at the Council Grove National Bank.

  The Kansas bank was a midget and most definitely not on Melamed’s call list. So Angell made the call instead, tracking down the Merc’s high-profile mover and shaker after reading about the new T-bill futures in the Wall Street Journal.

  As a veteran user of wheat futures, Angell was fully familiar with calendar “spread trading,” which involved a simultaneous short position in one month and long position in another, and also “basis arbitrage” stemming from the difference between the futures price at the exchange and the cash market at any given local delivery point.

  Reasoning from these familiar features of wheat futures, Angell told Melamed that he planned to short the T-bill in the cash market and buy the exchange’s T-bill futures of the same duration. He would thereby execute an arbitrage that had little risk and would fatten yields on his bank’s investment portfolio by a lot more than chump change.

  In short order, the Council Grove National Bank was minting money where Salomon Brothers had not yet dared to tread. More importantly, an economically savv
y wheat farmer had quickly grasped that financial futures had opened up a vast new arena for leveraged speculation—margin requirements on the new T-bill contract were only 5 percent—and that the “arb” could never really be traded away. Instead, the continuous forays into the Treasury market by the Fed’s open market desk would perpetually roil calendar and basis spreads, thereby creating a renewable feast of trading profits.

  In any event, there was no special rocket science to Angell’s trading math. Within a year Salomon Brothers had been aroused from its slumber, joined the IMM (the Merc financial division), and according to Melamed became “the number one user of our T-bill market and a friend of the IMM for all time.”

  Indeed, Salomon Brothers soon became the first Wall Street House to go public. It thereby positioned itself to raise the massive amounts of capital that could now be profitably deployed in trades that straddled the cash and futures markets for government debt and a growing range of other securities.

  As it turned out, however, Wayne Angell became an even better friend to the Merc than Salomon, and not on account of his small-time trading orders. In 1985, Senator Bob Dole was struck by the idea that the Federal Reserve Board needed nothing so much as the fresh perspective of a small-town banker and farmer who happened to be his constituent. Needless to say, the chairman of the Senate Finance Committee did not need to ask twice the White House chief of staff to approve Angell’s appointment, even if Don Regan was a former Wall Street titan not much impressed by country bankers from Kansas.

  As vice chairman of the Fed, Wayne Angell saw eye to eye with Greenspan on the merits of financial futures and derivatives. Consequently, when the stock market crash came in October 1987, the message from the leadership suite of the Eccles Building was stereophonic: the S&P futures pit at the Chicago Merc had only been the messenger; unspecified “animal spirits” had been the cause of the crash. In short, in linking up with Greenspan and Angell back in 1976, the clever Leo Melamed had succeeded in erecting some potent defensive perimeters more than a decade before he even knew they would be needed.