August 15, 2003

An important issue that should be addressed is need for market participants to hedge their energy price risk.  That is, the energy derivative markets need more liquidity.  It seems that recently the only time policymakers were willing to discuss derivatives and energy prices was when they were pointing fingers at Enron as examples of “corporate greed.”  This fascination with the Enron collapse missed an important point:  energy price risks need to be hedged.  Enron was an important player in that market.  Now with no Enron to make the markets the overall level of risk has increased, many have argued.

So let’s see if the policymakers get the economics right or not.  Hopefully they will move beyond finger pointing and assessing of blame, and have an honest discussion on energy policies.

Congressional Misunderstanding.  Speaking of policymakers and not understanding derivative markets, did you see the brouhaha over the Defense Department’s suggestion of creating a futures market to hedge terrorist attack risk?  When Congress found out about the plan many Senators were outraged.  They claimed that some would “profit from a terrorist attack” and this they found unacceptable.

I think the Senators over-reacted.  To me the idea looks sound.  What we need is a way to hedge this “terrorist risk” since insurance companies seem reluctant to issue “conventional” insurance policies to cover such event.  In addition, the DoD thought that a futures market may be a good way to extract information on potential terrorist attacks.  Markets do a very good job of uncovering information that others might miss.

So on a number of levels the plan seemed reasonable.  As far as the idea that such a market might encourage terrorists attacks, I would argue just the opposite.  If this market is closely watched by the Homeland Security office, and let’s say, some Neo-Nazi group in Wyoming takes a position in the market…might that not tip off officials to watch those people more closely?  Think of it more as a dynamic game theory problem than a simple static pay-off game.

But I guess our elected officials are not capable of such a thought process…instead they were aghast that the DoD would consider such a plan and thus forced the Pentagon to end the program.  A shame really when you think about it.

The Fed and the Yield Curve.  Over the past 20 months or so I have been suspicious of the Fed’s public statements.  After September 11^th, the Fed claimed that it was lowering its target for short term interest rates in order to stimulate the economy in the short run.  I had my doubts about this…over the past few decades it has been generally accepted that the Fed really should not try to stimulate the economy in the short run.  So…what were they up to?

I suggested to a few people that maybe what Greenspan and Fed were really up to was trying to recreate the 1950’s.  During the 1950’s the yield curve was very flat and hugged the horizontal axis.  Think of the 1950’s:  solid economic growth, low inflation, technological progress, etc.  All of this was killed off, it is argued, by the inflation that started in the 1960’s.  If (and this is a big if) the Greenspan Fed could lower short term rates without triggering inflationary expectations, they might be able to recreate the 1950’s era yield curve.  So…they went expansionary, to push rates down, but had to convince the markets that it would not trigger inflation…and it has worked…most people talked more about deflation than inflation over the last year and a half.

But…those long term rates have remained stubbornly high, despite the Fed lowering the short term rates.  So NOW what is the Fed saying:  it might start to target medium and long term interest rates.  Hmmm.  They might get that 1950’s era yield curve yet.

Think of what kind of legacy this would leave Greenspan.  He was finally able to “slay the inflation dragon”…he was able to finish the job Volcker started in 1979.  An amazing accomplishment, if he can pull it off.

But there are risks!  What if all of this expansionary monetary policy (not to mention expansionary fiscal policies) results in rekindling inflation?  Opps…

Keep on eye on the Fed’s future public statements.  Watch to see if they continue to talk about going after medium and longer term interest rates.  I hope they can pull it off.

All the best,