“We have got someone that is morbidly overweight,” a hedge-fund manager named Michael Masters told the US House Committee on Energy and Commerce on 23 June 2008. “He probably needs to diet. He probably needs to exercise. There’s a lot of things that he needs to do. But right now he’s having a heart attack.” Commodity prices were skyrocketing as the escalating Financial Crisis was plunging the global economy into recession. Oil was an eye-watering $130 a barrel and wheat prices had reached historic highs. The UN had declared a “Global Food Crisis” as 100 million starved and riots broke out in Egypt, Haiti and the Côte d’Ivoire. These spikes hadn’t been seen since the oil shocks of the 1970s. But there was no oil embargo. No revolution in Iran.
Some blamed growing demand from China’s industrial revolution, others believed oil supplies had “peaked.” But food and oil production was up from the previous years, and the recession was depressing demand. And it wasn’t just food and oil: the prices of all commodities were moving upwards together for the first time. There was no reason why the supply of American wheat, Indian cotton, Guatemalan coffee, Russian oil, Chilean nickel or Qatari natural gas should be connected. It was unprecedented.
Michael Masters had a theory. “Index speculators have bought more commodities futures contracts in the last five years than any other group,” he told the committee. These “index speculators” were investors who had purchased a complex derivative product called a “commodity index fund.” Sold by Goldman Sachs, AIG and other financial institutions, they allowed investors to park their money in a mixture of around two dozen commodities. Masters put up a graph to show the committee how investments into commodity index funds had grown from $13 billion in 2003 to $260 billion in the middle of March 2006. “If they had been the largest buyer of futures contracts,” he asked, “is it not reasonable that they would have had one of the largest impacts on futures prices?”
To understand this hidden transformation, I had to start at the beginning: what is a “price” supposed to be?
Masters quoted Goldman Sachs’ answer. “Without question increased fund flow into commodities has boosted prices,” the bank’s own analysts had concluded just a month earlier. Indeed, Masters had found that China was spending less money buying commodities than Wall Street was spending through commodity index funds. And it was because commodity index funds purchased commodities as a bundle that all commodity prices were moving upwards together. This onslaught of financial capital was pushing prices away from their “fundamental” real-world values. It was a classic speculative bubble. All bubbles eventually pop, and by the end of 2008 commodity prices had crashed. But for the hundreds of millions caught up in the Global Food Crisis the market “correction” had come too late. “Keynes had a great expression,” Masters had warned the committee at the peak of the bubble: “In the long run we’re all dead.”
“After my testimony it was sort of like kicking over an anthill,” Masters tells me at his home in the Atlanta suburbs. “There was a visceral reaction from the financial industry. They were very upset that someone from the financial industry would actually come out and say, ‘Hey, this is a problem.’ And there were a lot of attacks on me, ad hominem attacks. There was disbelief that I was doing this.” The Wall Street “Masters of the Universe” treated him as a traitor and a heretic. He’d be out at dinners with hedge-fund managers and bankers, and they all wanted to know the same thing: why was he doing this? He was a fellow Master of the Universe, how could he betray the financial world so publicly, and in Congress of all places? There were rumors that it was a calculated move, that it would somehow help his own speculative bets. After all, what other motivation could he possibly have? The idea that one of their own would call out the irrationality of commodity prices was beyond reason.
The more I learnt about this episode, the more disturbed I became. I thought I knew what prices were. Ever since I can remember, I’ve counted pounds and pennies—and later dollars and cents—to pay for things. Prices are simply how much things cost. But as I looked closer, I found that prices were so much more than that. And, like peering down a microscope, a hidden alien world revealed itself. I saw new features of prices, new structures and powers I didn’t know existed. There was a secret world made of ones and zeros, a world that lives in a state of constant revolution—a revolution that dramatically affects the global distribution of the essential goods we all need to survive. To understand this hidden transformation, I had to start at the beginning: what is a “price” supposed to be?
Thousands and thousands of suppliers across a global supply chain can coordinate their production just by looking at a single number: the price.
“Look at this lead pencil,” Milton Friedman says as he holds up an unassuming black and yellow striped pencil. I’m watching him talk in his PBS documentary Free to Choose on YouTube. “There’s not a single person in the world who could make this pencil.” The “eraser” probably “comes from Malaysia.” The “wood,” he supposes, was “cut down in the state of Washington.” The “graphite,” he believes, comes from “some mines in South America.” And as for the yellow and black paint or the brass ferrule, he admits with a chuckle that he has “no idea” where it came from. “Literally thousands of people cooperated to make this pencil. People who don’t speak the same language, who practice different religions, who might hate one another if they ever met! . . . What brought them together and induced them to cooperate to make this pencil? There was no commissar sending out orders from some central office. It was the magic of the price system: the impersonal operation of prices that brought them together and got them to cooperate, to make this pencil, so you could have it for a trifling sum.”
But how do prices perform this “magic”?
Friedman argued that every time something is bought the buyer is “voting” for its worthiness. These “votes” tell us what is valued and what we need to make more of. Take his pencil. Imagine that, for whatever reason, the world’s supply of rubber is diminishing. Perhaps there’s a freak weather event or a revolution in the country exporting most of the world’s rubber. Whatever the reason—you don’t even need to know why—the price of rubber will start to rise. There are too many buyers chasing too little rubber. The information—“there’s not enough rubber”—is incorporated into the price, or rather, the rising price communicates the information “there is not enough rubber.”
Suppose you own land in Malaysia. Now that the price of rubber is rising, you can make a profit by planting rubber trees and take advantage of the higher prices. It’s not just you either, it’s all these other people with land for rubber trees. Without anybody being given an order, the resources—land, seeds, fertilizer—are brought together to fix the problem of too little rubber. Thousands and thousands of suppliers across a global supply chain can coordinate their production just by looking at a single number: the price.
Friedman was illustrating an idea articulated by his friend and colleague Friedrich Hayek. He viewed prices as information-gathering machines. It is this information that gives prices their magical power. Prices coordinate. “The function of prices,” Hayek said, “is to tell people what they ought to do.” This function made state planning unnecessary: no “commissar” was needed to tell people how much to produce of what. Instead, prices could coordinate through a decentralized network that Hayek called a “spontaneous order.” Economists soon pushed this idea a step further: prices are better at gathering and synthesizing information than anything else. No technocrat, government regulator, hedge-fund manager or super-computer has better information than what is already contained in the price.
This is because, they believed, prices derive from the collective wisdom of the crowd. They are the result of votes cast by people with their own money. This crowd can draw on local knowledge and instantly incorporate it into the price. So-called experts—often hundreds or thousands of miles away—would always be a step behind. Economists would come to call this information-gathering function of prices “efficiency.” And the idea that prices would always be more efficient than anything else human beings could come up with was formulated in 1970 as the Efficient Market Hypothesis. Only it didn’t remain a mere “hypothesis” for long: it soon became the taken-for-granted orthodoxy of the economics profession.
Something had gone deeply wrong with the “magic” of the price system.
For Friedman, the consequences of this idea were not just economic but political. “A political system, in which you decide by a vote,” Friedman said of democracy, “is a system of highly weighted voting in which special interests have far greater roles to play than does the general interest.” This is because, according to Friedman, special-interest groups will always fight harder for what’s important to them; they’ll also know more about it and have the upper hand in getting what they want from feckless politicians. So, although a democracy allegedly works by one man, one vote, in practice it is governed not by the majority but by a highly motivated minority. “Consider, by contrast with this, the characteristic of the economic market, where voting is by dollars.
It also is a system of unequal voting with one dollar worth one vote, because some people have more dollars than other people; but it is no more unequal than one man one vote, in the political system, where, as I have shown, you also have unequal voting; and the great virtue of the economic method of voting is that each person gets what he votes for.” Think about the pencils—you get the pencils you vote for with your purchasing power as a consumer. If I only want pink pencils, pink pencils are all I will get. This market democracy where people vote with dollars is, according to Friedman, a far more effective democracy than the actual democracy of voting with ballots. “The existence of a free market does not of course eliminate the need for government,” Friedman clarified. “[G]overnment is essential both as a forum for determining the ‘rules of the game’ and as an umpire to interpret and enforce the rules decided on.”
Friedman was optimistic that once the rules of the game were established, once people across the world were free to “vote” for things that they wanted, then conflicts of all kinds would disappear. “That is why the operation of the free market is so essential,” Friedman said as he concluded his discussion of the pencil and the magical price system. “Not only to promote productive efficiency, but even more to foster harmony and peace among the peoples of the world.”
In 2008, this uplifting story of magical prices was exposed as a fairy tale. Prices were not synthesizing information across the global supply chains as they were supposed to. Instead, prices reached record highs right as supply was peaking—more food had been produced in 2008 than at any point in human history—and demand was falling as the global economy cratered. Nor were prices bringing in an era of “harmony” and “peace”: riots had broken out in forty-eight countries, 100 million were starving and two governments had been deposed. Something had gone deeply wrong with the “magic” of the price system.
“There were many things that led this to happen,” Masters tells me. “First of all, you had the Commodities Futures Modernization Act.”
This Act began life at a hearing held by the US House Committee on Banking and Financial Services on July 17, 1998. The committee rooms were usually drab places where jowly and bespectacled faces droned into microphones. This day was different. The committee room was packed. It was billed as the battle of the bureaucrats, the regulator-on-regulator bust-up of the decade. It was Brooksley Born, the chairwoman of the Commodities Futures Trading Commission, versus Alan Greenspan, the chairman of the Federal Reserve. The question: should “derivatives” be regulated?
“If somebody says to me, I’m contemplating punching you in the nose,” Greenspan said into the microphone, “I don’t presume that that is a wholly neutral statement. My inclination is to pack up and move to another neighborhood.”
“I may just add,” Born interjected, “I think what we are saying is, in—”
“You don’t intend to punch Dr. Greenspan in the nose, do you, Ms. Born?” Congressman LaFalce interrupted.
“It is more correctly stated, do you think you need a punch in the nose? That is the question that is being asked,” Born shot back.
“I will yield to your interpretation,” Greenspan responded dryly.
“I would say that the implication is that if the answer to that question is yes, then the commission has said it has the full authority to administer that punch,” said Treasury Undersecretary Hawke.
One price was rooted in the real world, the other in finance. This is the heart of financial alchemy.
At the time, few outside Wall Street had even heard of “derivatives,” let alone knew what they were or understood why they made Born feel compelled to punch Greenspan on the nose. Yet they were one of the fastest-growing parts of the American economy. The notional value of these new financial products had tripled from 1994 to 1997 to over $28.7 trillion. Born proposed releasing a white paper to see if these new products required oversight. The pushback was swift. “I have thirteen bankers in my office,” Lawrence Summers—then Bill Clinton’s Deputy Secretary of the Treasury—warned her over the phone, “and they say if you go forward with this, you will cause the worst financial crisis since World War II.” Born released her report. No crisis ensued.
Clinton’s team feared the report was just an opening shot. Greenspan organized a Congressional hearing to launch the administration’s counter-offensive. Greenspan’s testimony hinged on what a “derivative” actually was and why they were so deeply connected to commodities. Their invention and regulation, Greenspan testified, “were a response to the perceived problems of manipulation of grain markets that were particularly evident in the latter part of the 19th and early part of the 20th centuries.”
When Chicago became the grain capital of North America in the mid-19th century, the market was chaotic. Farmers would arrive in Chicago at the same time with their freshly harvested wheat. Supply soared, prices plummeted, and farmers ended up dumping their worthless grain into Lake Michigan. A contract was invented that would let farmers store their grain at home and then have a guaranteed delivery date at some point in the year. They called them “futures contracts.” Farmers could pre-sell their crop in advance to real buyers, such as hotels or bakeries.
Since there may not always be enough buyers throughout the year, private investors—later called “speculators”—were invited into the market to make sure that somebody would always be available to buy the farmer’s contracts. The speculators guaranteed to pay an agreed-upon price for the wheat in the future, and the farmers could then use this guarantee to get a bank loan to fund the harvest. The speculators were given a small discount to compensate them for the risk they were taking, called the “risk premium.” Since the value of these contracts was “derived” from something real—bushels of wheat—they were among the first so-called derivatives.
Like a bacterium multiplying under a microscope, the price of a bushel of wheat had split into two. One price was rooted in the real world, the other in finance. This is the heart of financial alchemy. Derivatives are a magic economy—only existing on bits of paper—but their existence is supposed to make the real economy—physical wheat—far more orderly. This was the promise of finance: a way to reorganize and smooth out the real world and make it more productive. Farmers got security, speculators were rewarded for risk and Lake Michigan was no longer full of perfectly edible grain.
Soon this magic economy became much bigger than the physical economy: there were far more wheat contracts than bushels of wheat. In 1875, the Chicago Tribune estimated that the physical market was $200 million, but the paper market was ten times greater at $2 billion. Rather than just taking the risk premium, speculators were making large bets on their future prices. Before these magic pieces of paper, speculating on the price of wheat or pork bellies was prohibitively cumbersome for most. Warehouses would have to be rented, the physical commodity delivered and stored.
Now all somebody needed to do was purchase a futures contract. And the wall between these two worlds—physical and magical—didn’t last long. Speculators tried to rig the futures prices by trying to corner the physical market by monopolizing the supply of wheat or oats or pork. Speculation in the derivative markets was changing the physical market. The tail wagged the dog. Prices swung wildly. Chaos had returned. President Franklin Roosevelt finally regulated the markets and curtailed speculation in 1934. Order had reigned ever since.
Prices, not the government, would truly be telling people what to do. Prices would reign.
Greenspan argued that this historical episode of speculative chaos said little about the brave new world of financial derivatives. For one, he remarked, speculation was largely overstated in Roosevelt’s era. The attempts to “corner” the market mostly failed. But there was a deeper issue at work here. Unlike traditional derivatives based on physical commodities like wheat and pork bellies, the new financial derivatives had no corresponding real-world object. Instead, they were magic pieces of paper that bet on the future prices of other pieces of paper, such as interest rates or currencies. This paper could not be “cornered” like wheat. “Because quantities of grain following the harvest are generally known and limited, it is possible, at least in principle, to corner a market,” Greenspan said. “Supplies of foreign exchange, Government securities, and certain other financial instruments are being continuously replenished… and, as a consequence, are extremely difficult to manipulate.” Governments, banks and insurance giants could always just print more of them in a way that farmers couldn’t simply grow new crops. They were, after all, just pieces of paper. Magic defied speculation.
When questioned about losses in the derivatives market in the next downturn, Greenspan replied confidently: “All markets will respond.” But, he explained, such a downturn would have “nothing to do with derivatives markets. I am talking about the underlying markets.” Dogs wag their tails. The magic prices follow the real prices. To Greenspan, the idea that speculators could manipulate the “underlying” physical markets on such a scale as to move prices was fanciful.
Instead, the prices of financial derivatives would stabilize markets and reduce risk. Prices, according to the Efficient Market Hypothesis, are the best possible tools ever invented for synthesizing information. So the prices of derivatives are the world’s best guesses about what will happen in the future. And institutions can protect themselves from future risks by purchasing derivatives as insurance products. If you’re a bank and you’re worried about homeowners defaulting on mortgages, you can protect yourself by purchasing a credit default swap that will cover your losses. The proliferation of these derivatives, Greenspan believed, made the financial system fundamentally safer. He told the committee that the Glass-Steagall Act—regulatory legislation passed during the Great Depression to stop speculation-prone investment banks from merging with commercial banks—was an “anachronism” thanks to the incredible “risk dispersion” derivatives allowed for. “[W]e very much would like to have this all reviewed, because there is a new world out there.”
Greenspan’s gambit won. Born resigned. Glass-Steagall was repealed. Greenspan co-authored a report with Larry Summers that would form the foundation of the Commodities Futures Modernization Act. The legislation was far more ambitious than Greenspan’s testimony suggested: commodity-trading would be deregulated alongside financial derivatives. Greenspan had changed the “rules of the game.” Now an unlimited number of Friedman’s speculative “voters” would be deciding the prices not just of financial products like currencies and insurance on mortgage-backed securities, but also the prices of products in the physical world. It would be a grand experiment in the “spontaneous order” of the market. Prices, not the government, would truly be telling people what to do. Prices would reign.
Excerpted from Price Wars: How the Commodities Markets Made Our Chaotic World by Rupert Russell. Copyright © 2022. Available from Doubleday, an imprint of the Knopf Doubleday Publishing Group, a division of Penguin Random House LLC.