In its ongoing quest to make capitalism safe for human consumption, the Obama Administration has resurrected on the an economic policy concept discredited under President Nixon, whose 90-day wage and price freeze of 1971 morphed into a series of government programs lasting into 1974. Programs being put forward by Team Obama offer price controls in sheep's clothing.
Conservative Republicans – whose concept of Free Markets includes drafting legislation to crush free competition – may have met their match in a liberal Democrat, who appears to favor every aspect of the free market, as long as the market itself is kept under lock and key. The operative factor underlying the recent White Paper’s regulatory initiatives is the notion that Someone is doing something they shouldn’t, and it is the job of government to put a stop to it. Having a traffic cop on duty reduces traffic accidents and pedestrian fatalities.
And, while the traffic cop who does not permit anyone to move at all will have the highest safety ranking, we demand that the traffic flow nonetheless, because the concept of acceptable risk is fundamental to notions of societal balance, progress, and human happiness.
In the earlier stages of the financial meltdown pundits debated about whether “this” would spill over into “the real economy.” But it is devilishly difficult to separate “real” from “not real” in the marketplace, and the attempt to define one group of market participants out of existence – or to sequester their activities – is the cusp of an extremely slippery slope. The policy and social implications of clamping down on broad areas of market activity are broad ranging, and frankly unpredictable.
Trying to define where the market ends, and the “real economy” begins is like trying to find the line separating the air from the sky. Further, since everything meaningful – and market events that cause social shocks are certainly meaningful – occurs at the margins, the activity at the market / real economy interface is sufficient to drive political concerns on a global scale.
As reported in the NY Times (7 July, “US Considers Curbs on Speculative Trading of Oil”), CFTC Chairman Gary Gensler is gearing up for a showdown over speculative trading in natural resources. This was highlighted recently by widely reported “speculative” swings in the price of oil – as exemplified by the story of the world’s largest OTC oil broker, PVM Oil Associates, which disclosed unauthorized orders entered by a “rogue broker” that generated $10 million in losses for the firm, after causing an inexplicable run-up in the price of oil (Financial Times, 3 July, “Rogue Oil Broker Triggered Price Spike”).
These price swings, by the way, occurred almost exactly one year after the last “unreasonable” spike in the price of oil, likewise attributed to “speculative excess”. We recall discussions over the years with energy market participants, many of whom referred to some kind of pricing cycle that peaks in the summer, before prices retreat into the fall.
We would welcome a study on this – any one will do, it should not be difficult to determine price moves over time – but the conspiracy theorist in us salivates in Pavlovian glee at the suggestion that there might be a “cycle” that “everyone knows about” in a market that is prone to “speculative excess” and “manipulation.”
Indeed, some folks we know have observed this pattern based on insights gained from Goldman Sachs (GS), the firm where CFTC Chairman Gensler was once a partner. This was before he served as deputy Treasury secretary under President Clinton – at whose behest he drafted the language used to defeat the urgent proposals from then CFTC Chair Brooksley Born who pushed, to no avail, for oversight of the derivatives markets.
Has this leopard changed its spots? We are willing to believe that people can learn from their mistakes. Chairman Gensler would no doubt say he was learning from other people’s mistakes – specifically, from the mistake publicly admitted by Chairman Greenspan. Whatever the cause, we wish Chairman Gensler well in his quest to force transparency in the derivatives markets. This idea has tremendous merit – it’s what market regulation is supposed to do.
Perhaps dancing to the tune of his new political masters, Gensler is doing some muscle-flexing in other areas, and catching some flak for it. We think contract limits for speculative traders is a relatively benign outcome for most participants, though perhaps not for the ETF / ETN business, of which we shall have more to say in our forthcoming screed.
On the other side is the argument that the job of regulation is to keep enough of the playing field open so that “legitimate” market participants can have reasonable access. The issue is: who decides where the borders of legitimacy lie. Many industrial companies have come out against Chairman Gensler’s proposals to limit speculative trading. Why, as these are the very markets on which they rely for the key inputs to their livelihood, would they not want speculation curbed?
We believe there are several forces at work. One is simply that capitalists see government interference in markets as bad. Governments are notoriously inept at helping markets to improve, and efforts to “fix” markets invariably end in what the Germans call Schlimmverbesserung – an improvement that makes things worse. Call it what you will, the attempt to tamp down speculative trading through legislation is price fixing.
If you want proof of just how rotten an idea it is, you have but to look at the Op Ed piece in the Wall Street Journal (8 July, “Oil Prices Need Government Supervision”) co-authored by Nicolas Sarkozy and Gordon Brown, and calling for a controlled pricing mechanism to keep the price of oil within a stable band.
Even as these champions of government control of industry mount their soapboxes, Europeans are playing the regulatory equivalent of "Beggar Thy Neighbor" by considering looser rules on derivatives than those proposed for the US (Financial Times, 12 July, “Geithner Warns of European Threat to Derivatives”).
Industrial companies see both edges of the blade: today, the government will be setting the price at which producers can sell key inputs. Tomorrow, the government will be dictating the prices at which manufacturers can sell output. Along the way, the increased costs associated with implementing the new regulations will drive a number of smaller operators out of business. This is regulatory Lysenkoism at its finest.
Secretary Geithner’s testimony on Friday contained soothing words, assuring industrial companies that the legitimate use of futures for hedging purposes is not the target of these reforms.
But it seems no one is buying it. The financial companies that take the other side of these bets are the target, and any restriction on their activities will dramatically increase the costs of doing business. Which will be passed directly to You Know Who. The majority of derivative contracts for the world’s largest corporations are issued by two firms – JP Morgan Chase (JPM), and BofA/Merrill (BAC). These are big-ticket operators, and the companies that rely on them for their hedge contracts must permit them to overcharge them for services. In the case of Morgan, they are paying for one of the only really competent risk managements in the world. In the case of BofA, they are paying for the implicit ongoing government guarantee and the fact that the firm continues to wield incredible market clout.
This is all based on degrees of trust. Trust in the soundness of the bank, in the judgment of the bankers, and in the soundness of the financial system and those who oversee its smooth functioning.
This reminds us of Paul, one of our favorite brokerage customers – a long-suffering gent with a seemingly endless ability to absorb market abuse. Paul had the same plangent refrain every time a new stock idea was presented. He would listen to the sales pitch, old his breath for a few silent seconds, then invest ten thousand dollars into the idea. Each time, before hanging up the phone, he would sigh, “this better be good…”
But of course, it almost never was.