A recent New York Times article suggesting that Goldman Sachs’ ownership of a significant fraction of aluminum warehousing capacity hurts consumers caused quite a stir in the financial press and in the economics blogosphere.
It also led key members of Congress and a Senate panel to immediately call hearings on the question.
It turns out that the story was not completely correct in its description of how this ownership of part of a commodity’s distribution infrastructure actually benefits Goldman or hurts other businesses and consumers.
However, the article did a broader service to society in raising larger policy questions about the role of large financial institutions in our economy. What are the advantages and disadvantages of letting an investment bank own and operate nonfinancial businesses such as aluminum warehouses or oil tankers, particularly when these businesses overlap with commodities in which the same investment bank takes its own large speculative positions? And do the advantages for society as a whole outweigh the disadvantages or not?
Start with the allegations of the Times article (which ran on Page 2A of Sunday’s Pioneer Press). It charged that Goldman Sachs is able to raise aluminum prices over sustained periods of time to businesses that use aluminum, especially beverage producers. Hence costs also were raised for consumers.
Goldman allegedly can do this because three years ago it bought Metro International Trade Services, “one of the nation’s biggest storers” of aluminum. It has 27 warehouses in the Detroit area. Metro operates in a contractual relationship with the London Metals Exchange, which sets certain rules including a requirement that minimum levels of metal be shipped each day.
The Times says Goldman meets this requirement by moving metal from one of its warehouses to another, while dragging its feet on responding to customers who request that the warehouses deliver product, ultimately for use by consumers. Such delays supposedly increase the spot or cash price of the metal on an ongoing basis, costs consumers end up paying — the price increases actually come to fractions of a cent per can of beer or pop, but amount to billions of dollars for Goldman.
Economists who read the story immediately raised questions. If it really takes 16 months to get your aluminum from these warehouses, as the story says, why don’t customers shop for other ones? There are no significant physical or financial barriers to entry to opening an aluminum warehousing business, so why don’t entrepreneurs jump into the activity and take customers away from Metro? And if this particular warehouse concern really is taking significant quantities of metal off the market at any particular time, why doesn’t general knowledge of that overhang press down on prices the way large stocks of corn or wheat in government storage did in the 1950s and 1960s?
Some experts in metals argued the Times had gotten it wrong, but weighed in with alternative explanations as to how Goldman could use this subsidiary to benefit its general commodity trading arm. The best of these was by Izabella Kaminska, writing for the Financial Times’ Alphaville blog on Monday. She explained how running a warehousing operation could be profitable in any time when the relationship between futures contract prices and the expected spot or cash price when these contracts mature.
The normal relationship, in which futures prices converge with this expected spot price from below is termed “backwardation.” But because of ongoing economic turmoil, we have been in a relatively rare situation of “cotango” in which futures contract prices converge with the expected cash price from above. Explaining this further would take an entire column, though Kaminska’s article explains it well and can be read on the FT’s Alphaville site, which requires a user registration.
Kaminska’s argument, which I think most economists would find coherent and convincing, does not see Goldman’s profits as stemming from some sort of underhanded “restraint of trade.”
But the aluminum users testifying before Congress as I write this do charge that market manipulation by Goldman and other financial firms is increasing prices, eventually passed on to consumers, by as much as $3 billion per year. Economists and sundry pundits will hash this out for years.
Congress operates in a shorter term than academics. It must decide if the general public or overall U.S. economy are being harmed by investment bank ownership of other businesses and, if so, what should be done about it.
This is not a long-standing problem. U.S. banking regulation generally has prohibited such activities for commercial banks, ones that accept deposits from the public, make loans and that are insured by the government.
Regulation of investment banks, the primary business of which historically was to underwrite the issuance of new stocks and bonds, is sketchier. But while such banks historically may have held large blocks of stock in corporations, especially back in the days of J.P. Morgan Jr. and E.H. Harriman, they did not directly operate entire businesses in areas like warehousing or transport. And they did not derive large portions of their profits from speculative trading of derivative securities such as commodities futures and options for their own account, as is true now.
Moreover, in the midst of the financial meltdown of late 2008, the Federal Reserve extended the umbrella of financial protection to these investment banks by pressing them to accept charters as bank holding companies. The institutions now want the best of both worlds — freedom to engage in any business activity while maintaining access to direct emergency lending from the Fed and coverage by the FDIC if they accept deposits, as JP Morgan does, for example.
Not all the evidence is in and not all the arguments have been made. But we clearly have erred on the side of tearing down prudent, time-tested restrictions on the activities of large financial firms. Allowing them to control big chunks of the logistics systems for commodities in which they themselves speculate is rife with moral hazard. The Fed does not need congressional action to put a halt to this and it should. But if it doesn’t, Congress should step in and firmly close the door.