John Lothian July 2008 Open Letter to Congress
From MarketsWiki
An Open Letter to Congress
From John J. Lothian
When futures prices go up, they are advertising for selling. When prices go down, they are advertising for buying. With futures prices going up for crude oil and many other commodities, a truth has emerged in the cash markets that we have not grown our farming, drilling, mining or processing capacity to meet the increasing demand of a developing global economy. High commodity prices are sending an important message. We need to listen to that message and respond.
We need to respond to higher prices with more selling. We need to find a way to meet the growing global demand with real production of oil, metals, grains, fibers and many other commodities. We need the higher prices to spur the investment in that production. This is a demand-pull rally in prices, not a supply shock. We should not be shocked that millions of Chinese who work in factories in cities (rather than in agriculture in the country) need to buy food, transportation and clothing. This change in lifestyle has created a change in demand with higher wages and a rising living standards. Look at the label on the goods you buy and the clothes you wear and you can find similar economic/human migration stories in other countries around the world.
Laws artificially muting market prices will only make the problem worse. And messing around with a global problem in a narrow nationalistic way, especially in a way that exacerbates the problem, is the kind of thing that can lead to wars. People need to be fed, clothed and kept warm. They need transportation to get to work and move their goods and services around the world. History has shown free markets are the best mechanism by which this can be accomplished.
One of the tragic economic errors after World War I and causes of World War II was the rent control laws in Germany in the 1920s. With an upper bar on rent prices due to a well-intentioned but tragically flawed law, it was difficult to find housing. People would not move because they were locked in to a rent-controlled apartment. Landlords were forced to accept less than the open market would yield, and as a result they would let the apartments fall into disrepair because they could not afford to pay for the upkeep. New housing was not built, because the return on the controlled rents was less than the cost of capital to build it.
Listen to what the higher prices are telling us. We need more selling. More selling can come from new supplies, or from consumers switching from one choice to another. Higher prices spur changes in consumption. They create the economic conditions for new technologies, systems and ventures to emerge and compete. These are the ingredients of economic growth. Government should not pick the winners, the market should.
Some investors figured all this out before others. This spurred the development of an investment class in commodities, using futures contracts as proxies for the underlying physical products. Long-only commodity index funds have emerged as a major fundamental factor in the futures markets. Billions of dollars are linked to indices of commodities.
While traditionally these participants would be classified as “speculators,” they are in fact investors. Many of these funds fully fund each and every contract they buy. Margins on a $16 contract of soybeans might be $3,000, but these investors are putting aside the full $80,000 to invest in these commodities on an un-leveraged basis.
These investors are putting their capital on the line, daring the market to find the selling to match their buying. There is nothing wrong or illegal in the way these market participants are using the futures markets. In fact, there is a lot that is right about it. Millions of investors use similar investing strategies to invest in other asset classes, including equities, fixed-income and real estate funds. The free flow of capital into this area is delivering an important message we need to heed. We need more selling. We need more production, processing and refining capabilities. We need to spur the market to allow alternatives to develop. We listen and respond to the market every day. This is no time to stop listening.
Proposals in Congress to raise the margins on futures contracts would have no impact on many of the long-only index funds as they have 100 percent in cash or equivalents of the contracts’ value. On the other hand, increased margins would reduce the number of traditional speculators; that would lead to less efficient markets, higher execution costs and generally higher prices.
When Treasury Bonds were introduced in the 1970s, the bid-offer in the cash market for Treasuries was regularly a full basis point wide, or $1000 between the bid and offer. The successful introduction of Treasury bond futures allowed that bid-offer to narrow to 1/32 or $31.25. Investors offered transparent, liquid markets can do more with their money.
Speculators come in different shapes and sizes, the same is true with hedgers. Commercial concerns are impacted by these higher prices and the accompanying volatility. Some hedges are held for months on end, and spiraling capital costs can kill a company. Some grain elevators have stopped taking forward-priced contracts because they can’t afford to finance the hedges for the farmers. This is a concern. Increased margins on market participants would only make this situation worse. We need more sellers, not less.
Speculators have often been vilified through the ages. In the current real estate crisis, many of the worst impacted areas for foreclosures were where the highest level of speculative activity occurred. Politicians publicly stated about how they wanted to help fix the problems in real estate but did not want to reward the speculators.
The first Treasury Secretary of the United States, Alexander Hamilton, was faced with a similar speculative situation in the early days of the republic. It seemed that many debts had been issued by the 13 colonies during the Revolutionary War to fund it. Original owners of the debt were often soldiers themselves, merchants or others. After the war, convinced these bonds would never be repaid by the colonies; many holders sold their holdings to speculators who paid pennies on the dollar.
Hamilton’s great plan was to nationalize all that debt of the new states and to issue new USA debt to replace it, thereby establishing a national debt market. By repaying the state debt, some owed to foreign holders too, he also raised the credit rating of the country in the world’s markets. However, in order to execute his plan, he had to handsomely reward the speculators who had accumulated the debt from the original buyers. Lucky for us that Hamilton did the right thing for the country and the hard thing to do politically.
As Congress contemplates how to respond to the political and economic risks we are faced with globally because of the jump in commodity prices, let’s remember the tragedy that sprung from German rent controls, the value of transparent, efficient and fair markets and the wisdom and political courage of Alexander Hamilton. Let’s remember higher prices mean we need more selling, not more regulation. Let us remember to listen to the market.
