Nothing like watching a captured regulator like the Fed use a public hue and cry to execute a big bait and switch. Here the ploy is to change rules to further disadvantage the parties making complaints. But it takes finesse to make the finger in the eye look plausible and reasonable, so that when the well-understood bad effects show up later, the perp can pretend to be mystified.
The issue at hand is commodities speculation and price manipulation by major financial firms. In 2003, the Fed relaxed the rules that had formerly prohibited depositing-taking banks from trading commodities. In the early summer of this year, four members of Congress wrote to Bernanke asking whether the Fed had given adequate consideration of the systemic risk of letting major banks participate in the physical commodities. What, for instance, if a systemically important bank had its commodities trading operation fail? And these questions were raised in the backdrop of more general concerns about bank participation in the commodities business leading to other troubling outcomes, such as increased financialization and price volatility, which works to the detriment of real economy users.
A timely bit of reporting by David Kocieniewski of the New York Times in July showed that these reservations were valid and used Goldman to provide a concrete example of demonstrable, measurable harm. And that harm was the direct result of rule changes that allowed financial firms to operate in physical commodities, not just as traders in financial contracts (update: these were not the 2003 rule changes that applied to banks, but earlier liberalization of the investment banking rules, which were grandfathered for 5 years when Goldman became a bank in 2008 to give it access to the Fed window). They started backward integrating into owning major components of the delivery and inventorying systems. They gained not only a big information advantage by having better access to underlying buying and selling activity. but also the ability to manipulate inventories, and thus, prices. This piece created a firestorm at the time of its release and increased pressure on the Fed to take the Congressional inquires seriously. And Congress kept the heat on: the Senate Banking Committee held a hearing in late July.
The Goldman Example of How Letting Financial Firms Operate in Physical Commodities Activities Hurts Real Economy Users
Kocieniewski showed how Goldman had identified and exploited a critical choke point in the aluminum market. The new rules allowed Goldman to buy Metro International Trade Services, a business in Detroit with 27 warehouses that handles a bit over 25% of the aluminum available for delivery. Metro proceeded to lengthen delivery to end customers from six weeks to 16 months. And despite the firm’s pious claims that, really, it was doing the best it could, many warehouse employees reported that Goldman was using its trucks and staff not to deliver to customers, but to run ore around among the warehouses:
Industry analysts and company insiders say that the vast majority of the aluminum being moved around Metro’s warehouses is owned not by manufacturers or wholesalers, but by banks, hedge funds and traders. They buy caches of aluminum in financing deals. Once those deals end and their metal makes it through the queue, the owners can choose to renew them, a process known as rewarranting.
To encourage aluminum speculators to renew their leases, Metro offers some clients incentives of up to $230 a ton, and usually moves their metal from one warehouse to another, according to industry analysts and current and former company employees.
To metal owners, the incentives mean cash upfront and the chance to make more profit if the premiums increase…metal analysts, like Mr. Vazquez at Harbor Aluminum Intelligence, estimate that 90 percent or more of the metal moved at Metro each day goes to another warehouse to play the same game. That figure was confirmed by current and former employees familiar with Metro’s books, who spoke on condition of anonymity because of company policy…
Despite the persistent backlogs, many Metro warehouses operate only one shift and usually sit idle 12 or more hours a day. In a town like Detroit, where factories routinely operate round the clock when necessary, warehouse workers say that low-key pace is uncommon.
When they do work, forklift drivers say, there is much more urgency moving aluminum into, and among, the warehouses than shipping it out. Mr. Clay, the forklift driver, who worked at the Mount Clemens warehouse until February, said that while aluminum was delivered in huge loads by rail car, it left in a relative trickle by truck.
Now here is the nasty bit:
Longer waits might be written off as an aggravation, but they also make aluminum more expensive nearly everywhere in the country because of the arcane formula used to determine the cost of the metal on the spot market. The delays are so acute that Coca-Cola and many other manufacturers avoid buying aluminum stored here. Nonetheless, they still pay the higher price.
So here is the beauty of this scheme: Goldman is able to increase prices as if it were cornering the market without taking the risk of a corner (buying the all the extra aluminum and warehousing it). And as the party controlling the squeeze, it can profit both from the price increases on the inventory accumulation (which every good neoclassical economist agrees will increase prices over the normal market clearing level) and the downdraft if it decided to let up and reduce the excess inventories. And there is ample evidence this is happening. As we wrote:
The Times’s sources estimate the price impact across the market at 6 cents per pound, which adds $12 to the price of a typical car. Goldman piously claims it obey all the rules, but obeying the rules is far from operating in a fair or pro-customer manner. Metro’s inventories ballooned from 50,000 tons in 2008 to 850,000 tons in 2010. By 2011, Coca Cola complained to the London Metals Exchange, which attempted to address the situation by increasing the amount that warehouses must ship daily from 1,500 tons to 3,000 tons. But all that appears to have taken place is that Goldman simply shuffles more inventory among the 27 Metro warehouses while thumbing its nose at the LME (its inventories have almost doubled again from the 2010 levels, standing at 1.5 million tons).
How Does the Fed React? Of Course, It Sides With the Banks
An excellent report at Quartz explains how an anodyne-seeming response from the Fed is actually another huge gimmie to the banks:
Last week, Federal Reserve officials leaked to the Wall Street Journal their tentative plan to limit the ability of Goldman Sachs and big banks to own metals warehouses, power plants, and other physical commodity assets.
But experts say that, if implemented, the policy the Fed is floating would actually expand the rights of all banks to enter these physical markets, by creating an official entrance instead of locking the door shut. Presented like a deterrent, it would also be a novel enabler.
According to the Wall Street Journal, the Fed’s plan would call for balancing out the new right to hold assets with a requirement that banks hold more capital to cover the potential risks posed by these activities…
Some experts believe that this additional cost will lead most banks to abandon these lines of business. But it’s an unsafe bet. Not only is it not clear how the Fed would structure these surcharges, there is no guarantee that a steep fee would push banks out. “When you have regulatory costs associated with highly lucrative businesses, the banks just typically pass them through to customers and end users,” said Josh Rosner, managing director of Graham Fisher & Co, who testified in July on a Senate hearing about whether banks should be doubling as oil refiners and coal miners.
The Fed’s given the public no insight into its thinking on this crucial decision, but a surcharge generally works like a tax, meaning it makes sense for banks to continue these businesses if they bring in significant revenue. In other words, a surcharge could actually encourage banks to scoop up warehouses and refineries any time profits from trading metals and oil soar. As Marcus Stanley, policy director at Americans for Financial Reform, explained, “Next time there is a commodity boom, you could get very nice returns even with capital surcharges.”
Rosner’s and Stanley’s concerns are spot on. The Fed officials, if they are at all competent, should recognize that a tax is the wrong remedy for this sort of situation. First, we’ve already seen that Goldman was able to act as an oligopolist through its control of warehouses. Taxes don’t undermine the ability of oligopolists to push prices higher than where they would be otherwise. Second, in general, the alternatives for dealing with a situation like this is to consider prohibition versus taxation. Which you favor depends on which party bears the greater costs. In this case, the answer is clearly prohibition. Andrew Haldane of the Bank of England explained:
The taxation versus prohibition question crops up repeatedly in public choice economics. For centuries it has been central to the international trade debate on the use of quotas versus subsidies. During this century, it has become central to the debate on appropriate policies to curtail carbon emissions.
In making these choices, economists have often drawn on Martin Weitzman’s classic public goods framework from the early 1970s. Under this framework, the optimal amount of pollution control is found by equating the marginal social benefits of pollution-control and the marginal private costs of this control. With no uncertainty about either costs or benefits, a policymaker would be indifferent between taxation and restri
ctions when striking this cost/benefit balance.
In the real world, there is considerable uncertainty about both costs and benefits. Weitzman’s framework tells us how to choose between pollution- control instruments in this setting. If the marginal social benefits foregone of the wrong choice are large, relative to the private costs incurred, then quantitative restrictions are optimal. Why? Because fixing quantities to achieve pollution control, while letting prices vary, does not have large private costs. When the marginal social benefit curve is steeper than the marginal private cost curve, restrictions dominate.
The results flip when the marginal cost/benefit trade-offs are reversed. If the private costs of the wrong choice are high, relative to the social benefits foregone, fi xing these costs through taxation is likely to deliver the better welfare outcome. When the marginal social benefit curve is flatter than the marginal private cost curve, taxation dominates. So the choice of taxation versus prohibition in controlling pollution is ultimately an empirical issue.
Sports fans, the “should we give too-big-to-fail banks more running room in commodities land?” is as clear cut a case as you will ever find in the Weitzman framework. There is NO policy reason for letting the banks in save their own profits. We have efficient and well functioning physical commodities markets without their participation. So when we are considering “private benefit”, it is the additional profit to a handful of firms that are already too powerful, too sprawling, and have repeatedly demonstrated their tendency towards predatory behavior, rule-breaking, and regulatory arbitrage. There isn’t an obvious reason why they should get any breaks at all, save the Fed is working on their behalf, not the public at large.
On the “social benefit” which might also be framed as “public costs avoided” we have systemic risk and higher commodities prices. The stunning part of the New York Times article is that that market participants had firm estimates of the price impact, and across the market it was $5 billion. Aluminum is not an essential commodity, but even so, the harm in dollar terms was considerable. Banks can seek to find similar ways to either gain price advantage or use key choke points to manipulate prices.
And many commodities have an important, direct impact on consumer prices, particularly grains and energy commodities. Even small increases can have devastating impact on the hundreds of millions of people who are on the edge of survival. For instance, the Arab Spring outbreak was a direct result of increase in food and cooking fuel costs pushing more people into desperation and starvation. Analysts at Nomura even looked at the percentage of people in various countries who would be pushed into distress at an assumed further increase in fuel and food prices to determine which were at the greatest risk of similar revolts. So the potential public costs are large, and the private gains comparatively small (you could even omit them completely, since these are already highly subsidized companies with lavishly paid employees; what is the possible justification for giving them new looting opportunities?)
Finally, this is not the first time the Fed has tried to operate in bad faith, in terms of being asked to act on behalf of the greater public and using underhanded means to do the reverse. During the Audit the Fed discussions, the Fed lobbied Congress intensely, and said it had bill language that would do much of what Ron Paul and Alan Grayson had asked. Most Congressmen felt they could hardly deny the Fed its request if it was largely conceding what Paul and Grayson had asked for.
The Fed submitted its proposal the day before the vote. But rather than present a stand-alone bill, it instead presented a raft of amendments and definition changes to scattered pieces of existing legislation. Alan Grayson worked straight through to analyze it, and ascertained that the Fed had lied, and its language actually set out to weaken transparency and Congress’ oversight powers. The Fed’s clever ploy backfired. When Grayson presented how the proposed changes actually worked, it hardened sentiment against the Fed and helped secure the bill’s passage.
So the central bank looks to be up to its old tricks again, again hoping that the public doesn’t understand the ramifications of its commodities proposal. While we haven’t seen the exact language yet, even at this remove, it’s a big step in the wrong direction. I hope the Congressmen who are pushing the Fed on this issue are as appalled by this ploy as the House was during Audit the Fed and use their bully pulpits to beat back this shameless scheme.