In November 1967, University of Chicago economist Milton Friedman was turned down for a loan, a rejection that ended up changing the course of financial history.
The problem was that he wanted to borrow in British pounds. He expected the pound to be devalued as a consequence of Britain’s big-spending government policies, and then he could repay the loan at a low cost in dollars.
Chicago bankers, to Friedman’s surprise, declined to perform the transaction, stating that the economics professor did not have a proper commercial interest in exchanging currency. Foreign-exchange speculation, it turned out, was discouraged by the Federal Reserve and the Bank of England.
However, Friedman, though not yet the Nobel Prize winner he’d become less than a decade later, was an economist already known for his free-market views and one with the prominent public platform of a regular column in Newsweek. He subsequently used that column to complain that currency trading was hampered by unjustified restrictions.
Those writings got the attention of Leo Melamed, a Chicago Mercantile Exchange board member who became its chairman in 1969. Drawing on Friedman’s ideas and support, Melamed in the coming years would pioneer the expansion of futures trading from its traditional bailiwick of agricultural products into the realm of exchange rates, interest rates and other financial variables. The 1970s would see the birth of financial futures, a vast new frontier for the financial services industry.
Ending Bretton Woods
Currency futures, the first type of financial futures to be introduced, emerged against the backdrop of the unraveling of the Bretton Woods system of fixed exchange rates, named for the New Hampshire town where it was set up at an international conference in July 1945. The system was under growing strain by the late 1960s, with major currencies pushing against the narrow bands in which they were supposed to fluctuate.
The dollar, the system’s linchpin, was increasingly overvalued, as U.S. inflation edged up as a result of heightened federal spending on the Vietnam War and Great Society. Policymakers first tried to tinker with Bretton Woods to make the fixed rates more flexible. Then, on Aug. 15, 1971, the Nixon administration closed the “gold window” at which foreign central banks had been allowed to exchange greenbacks for gold at $35 an ounce. This step opened the way for floating exchange rates.
Floating exchange rates were a policy regime that Friedman had long favored, as they could adjust to changing trade and capital flows without requiring government intervention. However, other free-market economists took a different view, believing fixed rates, especially with a link to gold, were preferable because they limited government printing and spending of money. That debate echoes on today.
But in the early 1970s, the world was moving, however uncertainly, to floating exchange rates. And that meant that companies and investors had a greater interest than ever in guarding against — or profiting from — currency fluctuations, which would now be constant as opposed to the occasional adjustments that had characterized Bretton Woods. Currency exchange, once a quiet service provided by banks through over-the-counter forward contracts, was about to become something much more open and noisy.
Trading in the Pits
Back in Chicago, Melamed was contemplating whether the commodity exchange he headed could play a role in the prospective currency market. This would be a radical departure. The Chicago Merc had gotten its start trading contracts on butter and eggs, before branching out into live cattle, frozen pork bellies and other agricultural futures. The idea of trading purely financial items in the pits was unfamiliar, to say the least.
Melamed had been inspired by Friedman’s calls for free-market reforms — even sneaking into a University of Chicago classroom to hear the economist lecture at one point. The two had breakfast at New York’s Waldorf Astoria on Nov. 13, 1971. “Is there any reason foreign currency might not work in futures markets?” Melamed asked.
“None I can think of,” Friedman replied.
To the contrary, the professor said it was a “wonderful idea” and encouraged Melamed to implement it. But the Merc executive, worried about the skepticism likely to greet such an unusual innovation, asked Friedman to put something in writing on the subject.
“You know I am a capitalist?” Friedman inquired. The two agreed on $7,500 for a feasibility study, which was titled “The Need for Futures Markets in Currencies.”
Melamed was right to think he could use some help in overcoming doubts about the initiative. Futures trading had been used for agricultural goods since the 19th century, and some in the business were wary of trying to transplant it elsewhere. Meanwhile, there were some financial types who regarded the Chicago trading pits as d?class?.
“It’s ludicrous to think that foreign exchange can be entrusted to a bunch of pork belly crapshooters,” said one New York banker just before the opening of the Merc’s International Monetary Market in May 1972. Business Week ran an article titled “The New Currency Market: Strictly for Crapshooters,” saying the market would have great appeal “if you fancy yourself an international money speculator but lack the resources.”
With Friedman’s paper in hand, Melamed was able to convince bankers, brokers and government officials that currency futures had merit. Shortly after the IMM began trading, Melamed visited Treasury Secretary George P. Shultz, to whom he had sent the economist’s study. Shultz, after listening to Melamed’s pitch for the new market, said: “Listen, Mr. Melamed. If it’s good enough for Milton, it is good enough for me.”