Financial innovations and their effects on macroeconomic time series have fueled a substantial literature in both economics and finance over the last two decades. Two examples of these literatures are the Federal Reserve and the cessation of transitory (seasonal) fluctuations (Barsky et al., 1988; Clark, 1986; Fishe, 1991; Fishe and Wohar, 1990; Friedman and Schwartz, 1963; Holland and Toma, 1991; Kool, 1995; Mankiw and Miron, 1986; Mankiw et al., 1987; Miron, 1986 and Miron, 1996), and commodity futures contracts and the stabilization of commodity spot prices (Chari et al., 1990; Kawai, 1983, Morgan, 1999; Morgan et al., 1994; Turnovsky, 1983; Turnovsky and Campbell, 1985; Santos, 2002).
Both of these literatures are deeply woven into the fabric of macroeconomics. In the late nineteenth and early twentieth centuries, students of seasonal fluctuations explored whether these fluctuations were relevant to the study of other, ostensibly more important, business cycles (Jevons, 1884; Kemmerer, 1910; Kuznets, 1933; Mitchell, 1927; Pigou, 1929; Burns and Mitchell, 1947; and more recently, Miron, 1996), whereas early twentieth century grain trade historians conjectured that commodity futures markets diminished spot price volatility and perhaps even stabilized aggregate fluctuations propagated by agricultural production processes (Clark, 1966; Chandler, 1977; Irwin, 1954; Rothstein, 1966). In this paper, I unite these literatures; I identify changes in the behavior of nineteenth century US money markets and demonstrate that the evolution of commodity futures trading can explain these changes.
Essentially, economists believe interest rate fluctuations, prior to 1914, were mean reverting and fueled primarily by the (seasonal) interregional cash transfers that financed the planting, harvesting and moving of the nation’s crops (Davis, 1965; Friedman and Schwartz, 1963; Kemmerer, 1910). Then, in 1914, all transitory fluctuations in interest rates, including seasonality, virtually disappeared; here the literature essentially sides with Miron (1986), who argues that the Federal Reserve began to deliberately smooth interest rates, or provide an elastic currency, at that time (Barsky et al., 1988; Friedman and Schwartz, 1963; Holland and Toma, 1991; Mankiw and Miron, 1986; Mankiw et al., 1987; Miron, 1986 and Miron, 1996).1
However, whereas I do not address the change in interest rates around 1914, my tests on extant ante- and postbellum US interest rates suggest the standard interpretation of pre-1914 interest rates pertains only to the period from 1874 onward, and that rates exhibited a different behavior prior to 1874. That is, before 1874, movements in interest rates are relatively volatile and driven primarily by real autumnal shocks; meanwhile, monthly seasonal movements are statistically insignificant. Only after 1874 do the stylized facts regarding US money markets apply. After consideration of putative alternative hypotheses for the cause of this change in behavior, I propose, and demonstrate how, commodity futures trading is the likely principal proximate explanation.
Historians of the grain trade tell us futures contracts were immensely popular by the mid-1870s thanks to a combination of storage and shipment technologies available by the 1850s and a nationally recognized system of staple grading established by 1874 (Chandler, 1977; Rothstein, 1966). Moreover, equally popular by the 1870s was the notion that futures markets stabilized commodity spot prices (Chicago Board of Trade, 1936; Clark, 1966; Chandler, 1977; Irwin, 1954; Rothstein, 1966). Indeed, contemporary research demonstrates that efficient futures markets can quell commodity spot price volatility (Bond, 1984; Chari et al., 1990; Kawai, 1983; Morgan et al., 1994; Turnovsky, 1983; Turnovsky and Campbell, 1985), and recent empirical research demonstrates the following: that corn and wheat prices were relatively less volatile after the late 1870s; and that nineteenth century US corn and wheat futures markets were efficient and hence capable of stabilizing commodity prices (Santos, 2002).
I use a standard mean–variance framework to demonstrate how futures markets could quell interest rate volatility. Borrowing from Turnovsky (1983), I model the optimizing behaviors of risk averse producers and risk neutral speculators in the absence and presence of futures contracts. I show that, so long as one party (speculator or producer) to a futures contract was risk averse, futures markets would have insulated traders from the annual fluctuations in interest rates (and commodity spot prices) caused by variations in planting and harvesting conditions. Technically, the ability to hedge in the futures market increased the price sensitivities of aggregate supply and aggregate demand, thereby diminishing the variability of both the price level and the interest rate in the presence of supply and/or demand shocks. So, despite real agricultural shocks, which persisted before and after 1874, the real money supply was relatively less affected after 1874, thanks, at least in part, to futures contracts.
In general, economists believe interest rate fluctuations, prior to 1914, were mean
reverting and fueled primarily by the (seasonal) interregional cash transfers that
J. Santos / Journal of Macroeconomics 25 (2003) 561–578 573
financed the planting, harvesting and moving of the nation’s crops, whereas after
1914and the establishment of the Fed, all transitory fluctuations in interest rates, including
seasonality, virtually disappeared. However, whereas I do not address the
change in interest rates around 1914, my tests on extant ante- and postbellum US
interest rates suggest the standard interpretation of pre-1914interest rates pertains
only to the period from 1874onwar d, and that rates exhibited a different behavior
prior to 1874. Namely, before 1874, movements in interest rates are relatively volatile
and driven primarily by real autumnal shocks; meanwhile, monthly seasonal movements
are statistically insignificant. Only after 1874do the stylized facts regarding
US money markets apply.
In this paper I proposed, and demonstrated how, commodity futures trading is
the likely principal proximate explanation for this change in behavior of interest
rates. According to grain trade historians, futures contracts were immensely popular
by the mid-1870s thanks to a combination of storage, shipment and communication
technologies available by the 1850s and a nationally recognized system of staple
grading established by 1874. Moreover, contemporary research demonstrates theoretically
that futures markets can indeed quell commodity spot price volatility; meanwhile,
recent empirical research demonstrates the following: that corn and wheat
prices were relatively less volatile after the late 1870s; and that nineteenth century
US corn and wheat futures markets were efficient and hence capable of stabilizing
commodity prices.
Using the standard mean–variance framework of the spot price volatility literature,
I showed how futures trading might have quelled money market volatility.
My results indicated that, when producers are risk averse and speculators are risk
neutral (both of which were likely in the nineteenth century), the ability to hedge
in the futures markets increases the price sensitivities of aggregate supply and aggregate
demand, thereby diminishing the variability of both the price level and the
interest rate in the presence of supply and/or demand shocks.
