How Governments Play the Market

We recently came across someone who was looking at the prospects for growth in "the water market." Why, the enquirer asked, has water been overlooked as an investment instead of being traded as a commodity like energy and metals? What are the prospects for growth in the market? At the end of a list of series of questions was, "What is the best way for an investor to play the water market right now?" "Play the market" is "Wall Street Speak" for speculation and manipulation.

Back in 1907, the president of the Knickerbocker Bank and Trust got the third largest bank in New York City into very big trouble by speculating in copper. He and a small consortium used the resources of the bank to try and "corner" copper. A "corner" is a market manipulation, a speculative monopoly of a stock or commodity created by purchasing or having an option to purchase all or most of the available supply.

If successful, a corner allows speculators to set the price of the commodity and make enormous profits. If unsuccessful, the speculators stand to lose everything and more. The president of the Knickerbocker and his friends were unsuccessful, went bankrupt, and the "Panic of 1907" resulted.

Lacking enough cash (accumulated savings) to make a purchase outright, speculators usually take out options or futures contracts. An option — a form of contract — is the right to buy something on certain terms. If the option is not exercised, the holder loses the "consideration," the thing of value that he put up to induce the other party to offer the option. A futures contract is a commitment to purchase a commodity at a specific price on a certain date. Options and futures are often negotiable instruments, and serve as part of the money supply.

Both options and futures were "invented" as an aid to commerce. In the ordinary course of events, there isn't any more opportunity for the speculators to make money off of them than there would be if they dealt in the actual commodities instead of contracts involving the commodities. Commodities brokers serve a useful purpose by intermediating between producers and their customers, buying contracts at "wholesale" and selling them at "retail," making life easier for parties on both sides of the transaction.

Farmers often need futures contracts — "pre-sales" — to get financing for the year's crop. They protect themselves against crop failure or wide swings in prices by taking out insurance that allows them to meet the terms of the contract if something happens. Processors and manufacturers use options and futures to lock in future resources at a current fixed price.

By offering and accepting options or futures contracts, parties to the agreements create money without the necessity of first having to come up with the marketable good or service they are buying or selling, that is, without first having to "save" — defining "save" as Keynes does: past reductions of consumption. It is thus possible for both producers and their customers to create money based on the present value of a future transaction by offering and accepting contracts, sell, discount, or use the contracts directly as money, and use the proceeds to form capital, e.g., buy land and equipment or build a factory.

Parties to the contracts can then start producing the goods and services needed to redeem the contracts when they fall due — all without first having to come up with the cash to start the process. This defines "save" more correctly as either "past reductions in consumption" or "future increases in production" (the latter being something Keynes claimed is impossible, yet which happens every day in commerce).

The proper use of options and futures contracts (like all forms of money) is thus to facilitate transactions and store value using a common and stable standard of value. Used as intended, such instruments allow the economy to grow at a rate determined by the current and future productive capacity of the economy, not what has been withheld from consumption in the past. This shifts the orientation of the economy from insufficiency to abundance.

The goal of the speculator is different. He tries to move the market for a commodity from abundance to scarcity.  In a market economy, the price of anything tends to fluctuate naturally, based on the "laws" of supply and demand. Broadly speaking, if something is in short supply but nobody wants it, the price will be low. If something is so abundant that everyone can have what he or she wants without effort, the price will be extremely low, sometimes non-existent: an "economically free" good. On the other hand, if something is in short supply and everyone wants it, the price will be high, especially if the thing is essential to survival.  The goal of a producer in a market economy is to move from an insufficiency of a marketable good or service, to an abundance of that marketable good or service, and to make a profit by supplying that abundance.

Shortages tend to occur more or less naturally. Crops fail, veins of ore run out, production costs rise, and so on. These things happen, and are the reason farmers take out crop insurance and processors and manufacturers buy options and futures contracts. An honest speculator, like any other good gambler, makes a more or less educated guess as to whether a shortage will occur, and buys accordingly, hoping for a change in the price favorable to him, depending on whether he bought long or short.

A dishonest speculator, like a crooked gambler, tries to stack the deck by creating an artificial shortage in order to take advantage of it. He is not, in fact, a true gambler, but a cheat, a card shark, nicking aces, marking cards, slipping holdouts up his sleeve, dealing from the bottom of the deck, and so on. He commits himself to purchase massive quantities of something at or above market in order to lure owners to sell to him at an inflated price . . . so that the speculator can sell it back at an even more inflated price.

The president of the Knickerbocker tried to do this, buying up options and contracts on shares in copper companies at a furious rate. He used depositors' money, the bank's capitalization and, worst of all, issued promissory notes drawn on the bank's creditworthiness — created money — in the hope that he would be able to buy enough future copper production at a high price to be able to set an even higher price and make a few hundred million dollars in speculative profit. The promissory notes of the Knickerbocker, like the bulk of today's "M2" money supply, were backed by the present value of a bet, that is, the hope that a gamble would pay off, not by the properly vetted present value of existing and future marketable goods and services.

The president of the Knickerbocker bet that he would be able to contract to purchase enough copper to control the market and set the price. He accepted "fictitious bills" drawn on the speculative future increase in the price of copper, and issued promissory notes based on the assumption of an even greater speculative rise in price to pay for the bills. He was, in effect, promising to make good on a possible loss out of resources he would have only if the bet paid off. He broke the first rule of gambling: don't play if you can't pay.

Similarly, the vast amount of government debt on the books (the national debt) as well as off (projected "off budget" future Social Security and Medicare benefits) is not backed by the present value of existing or future marketable goods and services. Government does not produce marketable goods and services. The government cannot, therefore, back its promises with what it does not own or to which it does not have an identifiable and enforceable claim.

What backs M2 and stands behind the trillions of dollars of government debt and off-budget Social Security and Medicare projections is not the present value of existing marketable goods and services that the government owns, or the present value of future marketable goods and services that the government reasonably expects to produce. Again, the government does not own or produce these things, and so cannot promise to redeem its promises with wealth it does not have and will not produce.

Ultimately what stands behind today's M2 is the government's ability to collect taxes in the future, thereby covering yesterday's spending with tomorrow's revenues. That is, the government is betting that citizens will be sufficiently productive to:

• Provide for current needs of themselves and their dependents,

• Make voluntary (charitable) contributions to cover others' needs,

• Set aside a reserve for emergencies,

• Save for anticipated future needs (e.g., education, retirement), and

• Have a surplus out of which to pay the cost of government,

to name a few of the more important. At the same time, the government — the servant of the people, not its master — is betting that citizens will:

• Be willing to grant taxes at a level sufficient to pay for government,

• Actually grant the taxes necessary to pay for government,

• Have a surplus large enough to be able to pay taxes at a level sufficient to pay for government, and

• Actually pay the taxes.

This last is simply an aspect of human nature. It is far easier to get people to agree to a tax if they believe that they won't be taxed. Thus, "the rich" are a favorite target, because few people really believe themselves to be "rich." The ideal people to tax, of course, are future generations. They don't yet exist, so they can't vote or complain.

There are thus at least nine things that have to happen before a government can win its bet — and the very fact that the government is gambling to try and cover its costs means that, in effect, it is betting on itself, which is much more risky than betting on something else that you can be more objective about. This becomes evident when we realize that the huge increase in national debts and ballooning budgets are the result of governments attempting to provide for the needs of citizens, supply what private charities formerly covered, meet emergencies, and guarantee education and retirement.

In consequence, governments throughout the world are, at one and the same time,

• Spending to make up for what the citizens aren't producing, and

• Hoping that the citizens produce enough to

- Meet their own needs,

- Pay current costs of government, and

- Pay past costs of government.

No matter which way you add up the numbers, or even what numbers you plug in, you cannot make such a system work. It is impossible to spend more than you produce and at the same time generate a surplus to cover the deficit.  That is why moral philosophers condemn things like speculation (gambling on price changes of something instead of investing in the present value of the stream of income it produces) and usury (taking a profit when no profit has been produced).

Some forms of speculation and usury are tolerable, even morally indifferent, e.g., a broker or dealer who inadvertently realizes a profit from an increase in the value of his inventory held for resale in the ordinary course of events, or a government that must pay interest in order to induce people to lend their existing savings so that can continue operating. This does not, however, include a dealer who deliberately holds goods off the market to drive up the price, or a government that emits bills of credit — pledges future tax collections — to meet current expenditures.

Is there a way out of this mess? As regular readers of this blog are aware — yes. It's called "Capital Homesteading." If you want to support the push for a Capital Homestead Act, you might want to attend the annual Rally at the Federal Reserve in Washington, DC on Friday, April 20, 2012 from 11:30 am to 1:30 pm.

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