While reading Trade Wars are Class Wars (a book I highly recommend for those interested in the inter-country trade relations) I came across one of the best explanations I've seen on the history of central banks and their role in society. This week's issue opens with us looking at excerpts from the book before diving into the story behind congress's decision to make it illegal to bet on future prices/performance of onions.
History of Central Banks (3 min)
Banning Onion Futures (2 min)
Why were central banks originally formed?
Trust is essential in any monetary system. For centuries, gold has been one of the most trusted assets in existence. A combination of government authority and public consensus has conferred upon it a value that people trust as a store of wealth. After all, "Gold is difficult to destroy, its supply changes little from year to year, and its value does not depend on anyone's creditworthiness." Many paper currencies (including the U.S. dollar until 1971) were backed by a guarantee that a certain quantity of notes could be turned in for a specified amount of gold (from 1944 until 1971 that number was $35/ounce of gold).
Banks were one of the original creators of paper currency as they "used to issue notes to the public that could be redeemed for fixed amounts of the precious metal. At first, banks made money by actually charging depositors a fee for storing gold. Later, as it became clear that redemption notes could act as money, banks profited by issuing more notes than the value of the gold they held in reserve and using the additional notes to make interest-bearing loans." The key element in this transformation was that people trusted that the bank's paper notes were 'as good as gold'.
Prior to the appearance of central banks any individual private bank was always at risk from too many people trying to redeem their notes for gold at any given time. Because they were re-lending deposits as long term loans banks could never meet all of the obligations that they had created in the form of paper money (or IOUs if you will). "Once word got out that a bank wasn't able to meet its obligations, note-holders suddenly realized that their money was not quite as good as they had thought. If enough banks were hit at the same time, the result was a financial crisis. Central banks emerged in response to these crises. They could lend gold to private banks in exchange for claims on the bank's assets and calm panics before they turned into a crisis. Eventually, banks started to deposit their gold with the central bank directly and gave out central bank printed notes as the main currency. Thus, the credibility of the gold peg to paper currency was transferred from private lenders to national governments [and the central bank became an essential institution]."
Another way to think about this is to imagine if everyone tried to get all of their cash out of a single ATM on the same day. Even if there was enough money in the banking ecosystem to satisfy people's withdrawal needs, that single ATM would eventually run out of money. The central bank acts to make sure the ATM (in this case a bank) doesn't ever "run out" if a situation like the one in the picture below occurs.
Today the mandate of a central bank has extended far beyond simply ensuring that citizens continue to have faith in the money supply. Interest rates, inflation targets, unemployment numbers, foreign currency reserve levels, and debt issuance are now the purview of central banks around the world. Even so, trusts role in the system has become more important now than ever before since currencies are no longer backed by anything except faith that the issuing government will honor its commitment written on the notes it prints.
Source: Trade Wars are Class Wars by Matthew Klein and Michael Pettis
In Other Words
Central banks were created to confer legitimacy onto the financial system and ensure that people trust that the currency in circulation is worth using. They act as a backstop against runs on any private bank and until recently were also responsible for handling the convertibility of paper currency into precious metals (usually gold or sometimes silver). Their original goal was to protect banks that were technically solvent but for whom the maturity mismatch between assets and liabilities made it impossible for them to redeem liabilities on demand (avoiding a run on the bank and subsequent financial crisis as people rushed to get rid of their paper currency all at once).
Why did the Federal Government ban the trading of onion and movie futures in 1956?
In 1955 onions were one of the more popular commodities traded on the Chicago Mercantile Exchange (accounting for 20% of the trading volume at the time). An onion farmer (Vincent Kosuga) and a commodities trader (Sam Siegel) decided to team up and see if they could influence price movements by buying every available onion they could find. By the fall of 1955 they had 30 million pounds of onions in Chicago, which was 98% of the market. With this many onions, they were free to charge higher prices and began making significant sums of money both by selling onions directly and betting that onion prices would continue to increase in the futures market.
Realizing that they could drive the price of onions both up and down they ended up taking a large short position in the onion futures market and buying hundreds of put options on the future price of onions (betting that there would be a significant downturn in prices) right before flooding the market with the stockpile of onions that they had previously been slowly releasing at high prices. The sudden influx of onions crashed the price of a bag of onions from 2.95 a bag to just .10 (which was the same price as the mesh bag the onions came in).
In total the two men made over $8.5 million that year. In the process, they bankrupted many onion farmers and angered others who thought that what they had done was reckless and irresponsible. Congress agreed, and in 1958 passed the Onion Futures Act which banned the trading of onion futures (and curiously enough also banned futures markets for movie results at the box office as well after pressure from the MPAA).
In Other Words
Two men were able to corner the onion market by buying up 30 million pounds of onions. They used this control to set prices for the onion market and made money betting on the price movements of the commodity in the futures market. They started by betting that the price of onions would rise (buying call options) before switching to betting that the price would go down (buying put options) and flooding the market with onions to force the price movement they had bet on. They ended up with $8.5 million for their efforts and Congress passed a law outlawing futures markets for onions as a result.
That’s all for this week. Thanks for making it this far and I hope you found these answers as interesting to read as I found them interesting to write. If you liked what you read, feel free to share it with someone who you think will enjoy it.
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