Dr. Irvine is Associate Professor of Philosophy at Wright State University in Dayton, Ohio.
American futures markets have long played the role of villain in popular economic thinking. In his 1903 novel The Pit, for example, Frank Norris offers his readers the following description of the Chicago Board of Trade:
Within there, a great whirlpool, a pit of roaring waters spun and thundered, sucking in the life tides of the city, sucking them in as into the mouth of some tremendous cloaca, the maw of some colossal sewer; then vomiting them forth again, spewing them up and out, only to catch them in the return eddy and suck them in afresh.
Elsewhere in The Pit, Norris drops the sewer metaphor and instead describes in realistic fashion the action on the trading floor. Here, for example, is his description of the opening of trading on the Chicago Board of Trade:
Instantly a tumult was unchained. Arms were flung upward in strenuous gestures, and from above the crowding heads in the Wheat Pit a multitude of hands, eager, the fingers extended, leaped into the air. All articulate expression was lost in the single explosion of sound as the traders surged downwards to the center of the Pit, grabbing each other, struggling towards each other, tramping, stomping, charging through with might and main.
It was probably Norris, as much as any author, who was responsible for creating the image of futures-market-as-madhouse.
This novelistic image of futures trading has not only survived the passage of time, but has been enhanced by the advent of television. Broadcasts from commodities exchanges demonstrate that Norris did not exaggerate: Futures exchanges are wild—some would say surrealistic—places.
All these images have had an impact. Ask most Americans what futures traders do, and they’ll tell you that futures traders are adult men and women who make vast fortunes by standing in a circle, gesticulating wildly, and shouting at each other. In the minds of many Americans, futures traders resemble frenzied gamblers on a casino •floor or participants in a contact sport whose rules are particularly demented. Should such people, many Americans wonder, be allowed to play a role in the shaping of the American economy? Indeed, should such people be allowed to roam the streets freely?
Even among those who are not swayed by this image of futures traders, there has been considerable antipathy towards futures markets. This antipathy is founded on the belief, common among many intellectuals, that futures markets play no significant economic role and have no socially redeeming value; instead, they exist simply so that greedy people can make fortunes at the expense of farmers, small investors, consumers, and other “little people.”
A Growing Distrust
In the last few years, the traditional distrust of futures markets has grown apace as the result of two events. The first was the 1987 stock market crash. Many investors, regulators, and theoreticians pointed an accusing finger at stock index futures as being partially responsible for the crash. The second event was the criminal investigation (still under way) into trading abuses on the floors of various futures exchanges, abuses that allegedly included cheating customers, market manipulation, fraud, and tax evasion.
As the result of this double blow, the future of American futures is in doubt. There are a number of people calling for regulation. “Shouldn’t the government do something about futures exchanges,” they ask, “particularly if the members of these exchanges are corrupt or if their trading activities can cause stock market crashes?”
Should we, then, “do something” about American futures markets? Would greater government regulation be advisable? Indeed, should futures trading be banned altogether? In what follows, I would like to defend futures markets as an economic institution and inquire into the proper role that the government should play with respect to these markets. There is, I think, a role for the government in futures markets, but I think this role stops far short of the kind of heavy-handed regulation that many have called for.
Before I begin my defense of futures markets, a few words of explanation are in order.
To begin with, a futures contract, as its name implies, is a contract between individuals. Whereas many contracts (e.g., a bill of sale for a car) specify an immediate exchange of goods, a futures contract specifies an exchange of goods at some future date.
Although individuals can draw up “custom made” futures contracts between themselves, there are advantages to using the standardized contracts traded on futures exchanges like the Chicago Board of Trade or the Comex in New York. For one thing, at organized exchanges it is much easier to find someone with whom to enter into a contract; and if one later decides to “back out of’ the contract, it is much easier to find someone willing to assume the contract in question.
By buying a futures contract, one becomes obligated to take delivery of a certain amount of a certain commodity for a certain price on a certain date. The commodity in question can be something mundane like orange juice or pork bellies (from which bacon is made), or it can be something exotic like palladium, or something intangible like a “basket” of common stocks. In parallel fashion, by selling a futures contract, one becomes obligated to deliver a certain amount of a Certain commodity for a certain price on a certain date.
Who Buys Futures Contracts?
Who would buy and sell such contracts? And what would motivate them to do so? Many Americans think that the only people who would buy or sell futures contracts are speculators, and that the motive of these speculators is greed. In fact, speculators are only one of the groups who participate in futures transactions. The other major group consists of the producers and consumers of various commodities—i.e., businessmen, farmers, and other sober-minded types.
A farmer might, for example, want in July to lock in the price of the wheat he will harvest in September. Selling a futures contract enables him to do so. Conversely, a baker might want in July to lock in the price of the wheat he will need in September. Buying a futures contract—say, from the farmer just mentioned—can give him the price guarantee he seeks. Thus, when the farmer sells a futures contract to the baker, the transaction serves the interests of both; and both would be worse off if they were prohibited from entering into the contract in question.
Futures contracts, then, can be seen as a form of insurance, but instead of insuring people against loss of or damage to a physical asset like a house or a car or a crop of wheat, futures contracts “insure” producers and consumers of a certain commodity against price changes in the commodity in question. In other words, futures contracts function to shift the risk of price changes from the producers and consumers of a commodity to spec ulators, who are willing to assume the risk in question in return for the chance to profit from doing SO.
It should thus be clear that by buying and selling futures contracts, people are engaging in one of their most basic economic rights, the right to enter into contracts with other individuals. This in turn means that when the government curbs the activities of futures exchanges, the government is to some extent infringing on the right of Americans to enter into contracts with others.
Furthermore, the right in question is not an abstract right, but a right, the violation of which can do real harm to real people. For notice that in a free society, people enter into a contract only if they judge that it is in their best interests to do so. When the government steps in and prevents people from entering into contracts or places restrictions on the contracts they can enter into, it is blocking them from doing what they take to be in their own best interests.
It is true that the parties to a contract may be mistaken about what is in their best interests. However, a case can be made that people generally have a far better idea of what is in their own interests than politicians do. Indeed, someone sophisticated and affluent enough to trade futures is generally someone who has demonstrated his competence in handling practical affairs; not every politician or government regulator can say as much. This suggests that we should leave it:to people to decide what contracts they should enter into—and this in turn means leaving it to the futures exchanges to set the rules for trading contracts and to determine the standardized form contracts should take.
What if people don’t like the contracts or trading rules offered by a futures exchange? What if they think the rules or contracts are unfair? Then they won’t trade on the exchange in question; they will instead trade on other exchanges (whose rules or contracts they like better) or they won’t trade at all. Notice, however, that it is in the interests of futures exchanges to offer the public the contracts and trading rules that they desire; for the only way that members of an exchange can make a living is if people are willing to do business at their exchange. When thinking about this issue, we should also keep in mind that in America there exist several different futures exchanges competing for the business of futures traders.
The Proper Role of Government
Does this mean that the government should have no role at all in the operation of futures markets? By no means. Most people agree that one proper role of government is to act as the enforcer of contracts into which individuals have entered. If you make a contract with someone and he fails to live up to his end of the deal, you can seek compensation in a court of law. Thus, if a futures exchange does not live up to its own rules—and fails to compensate those who are thereby harmed—the courts should enter the picture.
In summary, leave it to the futures exchanges to design standardized contracts and to set trading rules; leave it to the government to take action when futures exchanges fail to enforce the rules they have set.
Some will complain that in making the above remarks I ignore the fact that events on futures exchanges can harm the economy in general (say, by causing stock-market crashes) and thus can affect Americans everywhere. Since the events that take place on exchanges can harm “innocent bystanders,” they will maintain that the government is playing an appropriate role when it tells exchanges how to conduct their business.
In reply to this criticism, two comments are in order. First, it is far from clear that events on futures exchanges can cause stock market crashes. This, at any rate, is an issue on which economists are divided. Second, even if events on futures exchanges could cause stock market crashes, it is far from obvious that stock market crashes harm the economy in general.
Along these lines, Nobel laureate Milton Friedman has argued that stock market crashes need not destabilize the economy. Those who are skeptical of this claim should recall the events of 1987: America witnessed a particularly severe stock market crash, but it had little effect on the economy. Not only didn’t we have a depression, we didn’t even have a recession.
Other economists have argued that financial crashes, although painful in the short term, can be beneficial to an economy in the long term. After all, these crashes, by wiping out marginal (and presumably inefficient) enterprises, keep the economy in fighting trim. By way of analogy, a herd of reindeer will, in the long run, be far healthier if there exist packs of wolves who pick off diseased and deformed reindeer, whose presence would otherwise jeopardize the overall health of the herd. It is true that stock market crashes have their victims, but a case can be made that society as a whole (and in the long run) is better off with these victims than it would be if it tried to create an economy in which marginal businesses were protected from destructive economic forces.
This brings us back to Frank Norris’s image of the Chicago Board of Trade as a great whirlpool, as the maw of a colossal sewer. I think that the whirlpool image is correct. What one sees at a futures exchange are the surface effects of much deeper currents. The currents in question are the economic forces of supply and demand. And if futures exchanges are whirlpools, then traders on those exchanges are like swimmers caught in a whirlpool: Some swimmers will benefit from the currents of the whirlpool, and others will surely drown. (This explains the panicky atmosphere in the trading pits of exchanges.) And although there may be traders who momentarily control the course of the whirlpool, no one is strong enough to control it for long; and those who try to are often destroyed in the attempt.
Norris was wrong, however, in presenting us with the image of futures exchanges as sewers; for these exchanges, rather than sucking in and then vomiting forth the life tides of a city, replenish the tides in question: Futures exchanges help far more people than they harm; and those they harm, more often than not, are speculators who knowingly and willingly exposed themselves to the risk of harm in return for a chance at profit.
Futures exchanges present a tempting target for government regulators. Even in the best of times, the public distrusts futures exchanges, and recent controversies surrounding these exchanges have made their political position weaker than ever. One can only hope that futures exchanges will retain their independence in coming years. We will all be poorer should regulators succeed in taming these last wild children of capitalism.