TCS Daily

Futures Shock

By John E. Tamny - May 11, 2007 12:00 AM

Under the Bretton Woods system of fixed exchange rates from 1947 to 1971, the free world was on a dollar standard where central banks were obligated to buy and sell dollars in the foreign exchange market to maintain the international value of their currencies. At the center of the post-World War II currency regime, the United States was required to create and extinguish dollars to maintain a dollar value of $35 per gold ounce.

A stable currency was essential in the post-war world, and it led to enormous growth - particularly for the countries devastated by World War II. From 1947 to 1967, real gross domestic product averaged 6.4 percent in Britain, France, England, and Germany, and with currency stability enabled by the constant that is gold, wholesale inflation in the U.S., Japan and Europe averaged 1 percent.

In a recent op-ed for the Wall Street Journal, Leo Melamed (chairman emeritus of the Chicago Mercantile Exchange) lauded Richard Nixon's decision in 1971 to end the aforementioned dollar/gold convertibility. His argument was that the "irreversible breakdown of fixed exchange rates initiated the modern era of globalization," and it "provided the rationale for the launch of financial futures by the Chicago Mercantile Exchange (CME)." While the floating dollar doubtless did spur the rise of various trading exchanges stateside, Melamed ignored the historical negatives of floating world currencies; some that made the CME and other derivatives markets more essential to begin with.

With the dollar no longer convertible into gold, it lost a great deal of credibility as a store of value. Rampant inflation in the U.S. was the quick result. Worse, with the dollar in freefall, countries that were formerly part of the Bretton Woods compact sold their currencies with abandon to prop up the falling greenback. Dollar inflation soon became world inflation. While the Dow Jones Industrial Average rose 245 percent in the '50s and 45 percent in the '60s, it rose a mere 3.5 percent in the '70s, and in real terms, plummeted.

Oil is priced in dollars, so with the dollar rapidly depreciating, oil rallied handsomely. The blowback of the devaluation of course haunts us to this day, in that while oil's flat price of roughly $2.50/barrell in the '60s made OPEC and its member countries largely irrelevant on the world stage, the rising oil price in devalued dollars created a very belligerent Middle East in the '70s and beyond. We didn't experience oil shocks in the '70s, but instead dollar shocks that made oil a weapon.

When it comes to trade, contrary to Melamed's assertion that floating exchange rates ushered in greater globalization, floating currencies allowed countries to gain short-term trade advantages that foretold an era of rising protectionism. While the trade gains that result from currency machinations are largely illusory, the money illusion led to a great deal more in the way of trade disputes.

Indeed, from 1951 to 1971 the yen/dollar rate was fixed at 360/1, and during that time protectionist barriers between the U.S. and Japan fell, while trade grew rapidly. After 1971, the formerly harmonious trade relationship between the two countries deteriorated into acrimony. When the U.S. wasn't forcing currency revaluations on Japan, it was enforcing "voluntary" export limits on Japanese products, all the while demanding that Japan accept voluntary import minimums of U.S. products.

As mentioned before, Melamed cheered Nixon's decision to leave Bretton Woods for the financial innovations that resulted, and which led to the creation of world-leading commodities and derivatives markets stateside. What he says is certainly true about the new exchanges and financial innovations, but it merely speaks to the massive uncertainty generated by floating currencies such that those innovations were necessary.

Simply put, untethered exchange rates did then and do now introduce a great deal of volatility into all business transactions. On the micro level, investment and trade is retarded because currencies with ever-changing values make it difficult for long-term contracts to be signed. Think of it this way: if I agree to buy with my dollars 100 barrels of oil at a fixed price a year from now under a stable currency regime, there's no risk for me as the buyer that my dollars will appreciate such that I'll overpay. Conversely, for the seller, there's no risk that I'll be buying those barrels with dollars that are greatly reduced in value.

On the other hand, the post-Bretton Woods world of floating currencies meant that long-term transactions were at best risky, and at worst impossible for the uncertainty of the future value of deals. The markets Melamed describes were the predictable result of unstable money, in that experts in derivative and other financial innovations rose in prominence given that deals were only feasible if the buyer and seller could hedge first-order currency risk, and second order commodity volatility that resulted from gyrating currencies.

Melamed says the uncertainty driven by floating exchange rates was worth it for U.S.-based financiers gaining a "first mover advantage" in derivatives and other capital markets. Sure, but by that logic we should impose an even more draconian version of Sarbanes-Oxley so that U.S. lawyers and accountants can innovate ahead of their overseas brethren.

What he ignores is that economies have producers and facilitators; the latter a necessary but dead-weight economic cost for the former. Today, thanks to a floating dollar and myriad other rules and regulations, we have lots of experts financial and otherwise who help producers dodge the various roadblocks created by government meddling. While we should be thankful for their existence, we shouldn't mistake what they do for real economic growth. To the extent that currency instability increases the need to hedge all transactions in the marketplace, financial innovators merely facilitate economic growth.

Importantly, the brilliant innovations wrought by financiers in our capital markets can't just be measured in terms of the lucrative nature of what they do. While it would be foolish to criticize their essential role in our economy today, we have to ask about the unseen here; as in what kind of productivity-enhancing innovations would these great minds have created had the floating dollar and other regulations not driven them into facilitator roles? Melamed seemingly ignores this, and while we've somewhat recovered from the inflationary chaos that resulted from our leaving gold, it seems worthwhile to ask what the American Century would be had we not gone down that path to begin with.

John Tamny is the editor of RealClearMarkets. He can be reached at


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