Market Institutions Can Protect Against Fed’s Manipulations

Market Institutions Can Protect Against Fed’s Manipulations
January 17, 2010

The nation is in the midst of a financial crisis, according to most analysts, but arguments rage among them over what to do about it.

At the heart of government policy is the Federal Reserve, which some people blame for many of the economic woes. The Fed manipulates the nation’s money supply and interest rates and has expanded its purview to cover investment banks and federal regulation of credit default swaps that were created to insure against the collapse of housing securities.

These securities were the product of a widespread program urged by the government to extend home ownership to those who did not qualify under normal credit criteria.

Many Fed critics, including Rep. Ron Paul (R-TX), say the Fed should be abolished. Paul makes a strong case for this in his new book, End the Fed. Paul also has introduced a bill to audit the Fed's actions.

However, Paul and other critics could strengthen their case by emphasizing there are already viable and functioning alternative market institutions that offer better hedging opportunities than are provided by the Fed and other government agencies.

Merc Transparency, Fed Murkiness
One such institution is the Chicago Mercantile Group, called the Merc. The Merc trades liquid contracts in foreign exchange, gold, interest rate derivatives, energy derivatives, and Standard & Poor’s indexes (which correlate with the general level of economic activity). Many of these contracts extend to a decade or more.

Businesses, individual investors, and hedge funds use these contracts and those on other exchanges to hedge their risk exposure from the changing value of the dollar and other currencies, interest rate movements, expected changes in overall economic activity, and fluctuations in energy prices.

There are some important fundamental differences between the Fed and the Merc.

The minutes of the Fed’s Open Market Committee, which sets Fed policies, are not made public until six months after the Committee meets. Fed policies also are not guaranteed. They can change on a whim.

The contract prices at the Merc and other exchanges, by contrast, are instantaneously known and guaranteed. Moreover, there are clearing institutions that protect the honoring of trades.

Outstanding open interest is settled twice a day at the Merc, to reduce the temptation of traders to default. When traders try to default, their positions are covered by the Merc, which acts as counterparty and guarantees the success of the trades. No trade has failed in the Merc’s 110- year history, former Merc Chairman Leo Melamed reports in his 2009 book on the Merc, For Crying Out Loud.

Protecting Traders vs. Trades
The Fed and other government agencies behave far differently from the Merc and other exchanges. The government protects the traders, especially the big ones. The Merc, on the other hand, protects the trades.

The government creates a moral hazard and promotes bad behavior by bailing out large institutions, whereas the Merc and other exchanges promote good behavior and the flawless honoring of contractual obligations.

In August of 1971 the Nixon administration, at the suggestion of the late Nobel Prize-winning economist Milton Friedman and colleague George Shultz, eliminated the fixed exchange rates and convertibility of the dollar into gold. Melamed recognized an opportunity to fill the gap by trading foreign exchange futures and options. Friedman endorsed the idea, and trading began May of 1972.

Since then the hedging of foreign exchange risk has been a combination of exchange-traded and over-the-counter contracts such as those at the Merc.

Worries Over Regulation
Of course, overregulation or the institution of a proposed tax on financial transactions could spoil the hedging. Too few people appreciate that traders provide crucial liquidity, and, more importantly, do targeted arbitrage. Without these actors the markets would be substantially less efficient.

Markets are available at the Merc and other exchanges to substitute for a flawed Federal Reserve, as long as the government does not destroy their effectiveness by overregulation.

Cathy Fasano (cfasano@maplecity.com) is a longtime consultant to trading institutions. Jim Johnston (jamesljohnston@cs.com) is an economic advisor to The Heartland Institute.