Macro Financial Modeling
Bretton Woods, June 18-22, 2017
Leo Melamed

Allow me to begin by applauding the Becker Friedman Institute for initiating this Macro Financial Modeling Project and to congratulate its two Project Directors, Lars Peter Hansen, of the U of C and Andrew W. Lo of MIT.

While I congratulate them and agree that identifying the root causes of the 2008 crisis and similar calamities---in a quest to discover a canary for the financial mineshaft---is a noble mission, I feel compelled to tell them that their task is daunting. They are attempting to defy what Georg Wilhelm Hegel sadly told us two hundred year ago: "Experience and History," he stated, "teach us that people and governments never have learned anything from history, or acted on principles deduced from it."

Hegel's admonition stands nearly unblemished.

That said, I feel honored to support this innovative initiative by offering some brief thoughts. I assume that one reason for my invite here is that much of my life is intertwined with Bretton Woods. As everyone knows, it was here in Bretton Woods, at the Mount Washington Hotel, in 1944, that there was an assembly of 730 delegates from 44 Allied Nations in order to re-establish financial order in a war-torn world after the Second World War. No, I was not present. I was just a child at that time and had just arrived to this country.

The Conference lasted three weeks, from July 1 to July 22. The agreement established a system of fixed exchange rates in which world currencies became pegged to the dollar, with the dollar itself convertible into gold. Its two principal architects were John Maynard Keynes, representing the British Treasury, and Harry Dexter White, representing the U.S. Treasury. The Articles of Agreement were hailed as a seminal achievement and ratified on December 27, 1944. It ambitiously prescribed open markets but with fixed exchange rates.

There was but one squeaky wheel. A single voice defying the near-unanimous applause for this achievement. The voice belonged to Milton Friedman. He argued that Bretton Woods was doomed to failure. It tried to achieve incompatible objectives: freedom for countries to pursue an independent internal monetary policy; fixed exchange rates; and relatively free international movement of goods and capital.

Allow me to digress. The world eventually learned that Milton Friedman's opinions were not to be ignored. That truism was adroitly described by Milton's very good friend, Nobel Laureate, George Stigler, on the occasion of 1976 Nobel Prize celebration for Milton Friedman. Professor Stigler introduced Friedman in the following fashion:

Milton, he said, will begin a debate by asking you to grant him three simple assumptions. For instance: That $2 is better than $1; That the law of diminishing returns is valid; And, that individuals do not have complete knowledge of the future.

Simple, undeniable assumptions, right? My fundamental advice," said Professor Stigler, "Do not grant him these assumptions. For if you do, you will find yourself led, by inexorable logic, to conclusions such as these:" That the Federal Reserve System should be abolished; that the Board of Governors of the Federal Reserve should be put on Social security; and that Social Security should be abolished.

During the first decade of Bretton Woods, the system worked fine and it looked as if Friedman was wrong. Trouble was the 44 nations grew up. Some of them on a fast track who became competitive to each other and to the U.S. In practice, maintaining announced parities became a matter of prestige and political controversy. Foreign exchange became a competitive tool. Countries held on to parity as long as they could, in the process letting minor problems grow into major crises and then making large changes. Friedman's prediction was coming true.

Then, beginning in the late 1950s, the curtain opened on the "Information Era." Technology created the transistor---perhaps the greatest invention of the 20th Century. With the transistor communication was revolutionized and information began to flow globally in minutes rather than in days or weeks. The technological revolution which is still very much alive, enabled markets to learn facts before finance ministers could gather to react. It became impossible for a fixed exchange rate system to cope with continual changes in currency values resulting from the daily flows of political and economic information. By the late 1960s, the Bretton Woods fixed exchange rate system had become a joke.

As it happened, I was then the chairman of an insignificant, back-water, pork-belly futures market, the Chicago Mercantile Exchange. My good friend, Adlai Stevenson, the former US Illinois Senator, likes to tell the story this way. One day in August of 1971, as Chairman of the Senate Subcommittee on International Finance, he received a note that the President, Richard Nixon, had closed the gold window. Stevenson says he had no idea what this meant. In fact, in his view nobody in Congress knew what it meant. And maybe, he goes on to say, no one in the US--- except this one guy at the Chicago Mercantile Exchange.

That is a bit of an overstatement but several things are certain. It wasn't easy. What the modern world needed, I thought, was a system that would allow currency values to adjust in an ongoing fashion. In other words---at a futures market in financial instruments ---where prices reflected continuous changes as demanded by the constant flow of new information. Such a system would allow risks to be hedged and opportunities to be captured in real time.

In early 1971, my suggestion for a futures market in foreign exchange was met by derision and contempt, not only by my board of directors, but by practically the whole financial world. The idea prompted a prominent New York banker to laughingly say, that "foreign exchange couldn't be entrusted to a bunch of pork belly crapshooters in Chicago."

As some in Chicago were apt to say, "Futures in Finance, fuhgeddaboudit."

Besides, I was a lawyer, not an economist. To achieve a measure of credibility I went directly to Milton Friedman. Not only did he like the idea, at my request, he authored a feasibility paper embracing the concept. That paper proved magical. His fee was $5,000. The International Monetary Market, IMM, was launched by the CME on May 16, 1972 and merged with the CME in 1976. Some will tell you that today the CME has a street value of perhaps $100 billion. Now that's what I call a pretty good trade.

Actually Friedman also tried to defy Hegel's law by urging President Nixon to abandon fixed exchange rates directly after his election in 1968. Nice try! By the time Nixon acted on August 15, 1971, world currency values were so screwed up, they were nearly beyond repair, and the US was about to go broke selling gold to the whole world at $35 an ounce.

I must admit our timing was lucky. If one could ordain the perfect backdrop for the creation of a new futures exchange designed to manage the risk in instruments of finance, one could not have bettered what actually happened. The decade that followed can be described as a "Perfect Financial Storm," --- turmoil that tested the very foundations of western civilization.

The U.S. dollar plunged precipitously; U.S. unemployment reached in excess of 10%; oil prices skyrocketed from about $7 a barrel to $39; the Dow fell to 570; gold, from its $35 base, reached $800 an ounce; U.S. inflation climbed to an unprecedented peacetime rate of 20%; interest rates went even higher.

The IMM went from currency futures to interest rates to stock indexes and to derivatives across the entire financial spectrum. We were copied by every industrial nation in the world. Not to brag, but in 1986, Nobel Laureate, Merton Miller called financial futures the most important financial invention of the past twenty years.

So, what did history teach us over the past five or so decades? Well, yes, that necessity is the mother of invention. And yes, that timing is everything. But we also learned that when it comes to innovation, the US is the place to be. Could the Internet, Google, Apple, Microsoft, Facebook, or Amazon, to name but a few, have been created somewhere else? I have grave doubts. Could the IMM have been initiated in another country? Same answer.

Thomas Friedman said it best: America, he wrote, allows "extreme freedom of thought, an emphasis on independent thinking, a steady immigration of new minds, and a risk-taking culture with no stigma attached to failure." Yes, those are the precise attributes that make our nation exceptional. We are the world's crucible for innovation.

This Becker Friedman undertaking is another example. It is an initiative within the academic sciences which to my knowledge has not been undertaken anywhere else. An innovative effort to jointly advance our understanding of the links between financial markets and the macro-economy. To construct more comprehensive models for assessing systemic risk. To foster discussion and research. To collect resources for analysis and study. And, to the extent possible, to create and share a data-bank of economic information.

In short: To learn from history and act on principles deduced from it, and finally prove Georg Wilhelm Hegel wrong. I wish you luck.



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