The Dismal Science
Illustrations by Robert Neubecker How Copper Came a Cropper
Sumitomo's robber-baron tactics make the case for regulation.

By Paul Krugman
(1,171 words; posted Friday, July 19; to be composted Friday, July 26)

       Last year, the world was astonished to hear that a young employee of the ancient British firm Barings had lost more than a billion dollars in speculative trading, quite literally breaking the bank. But when an even bigger financial disaster was revealed last month--the loss of at least $1.8 billion (the true number is rumored to be $4 billion or more) in the copper market by an employee of Sumitomo Corp.--the story quickly faded from the front pages. "Oh well, just another rogue trader," was the general reaction.
       Thanks largely to investigative reporting by the Financial Times, however, it has become clear that Yasuo Hamanaka, unlike Nick Leeson of Barings, was not a poorly supervised employee using his company's money to gamble on unpredictable markets. On the contrary, there is little question that he was, in fact, implementing a deliberate corporate strategy of "cornering" the world copper market--a strategy that worked, yielding huge profits, for a number of years. Hubris brought him down in the end; but it is his initial success, not his eventual failure, that is the really disturbing part of the tale.
       To understand what Sumitomo was up to, you don't need to know many details about the copper market. The essential facts about copper (and many other commodities) are 1) It is subject to wide fluctuations in the balance between supply and demand, and 2) It can be stored, so that production need not be consumed at once. These two facts mean that a certain amount of speculation is a normal and necessary part of the way the market works: It is inevitable and desirable that people should try to buy low and sell high, building up inventories when the price is perceived to be unusually low and running those inventories down when the price seems to be especially high.

So far so good. But a long time ago somebody--I wouldn't be surprised if it were a Phoenician tin merchant in the first millennium B.C.--realized that a clever man with sufficiently deep pockets could basically hold such a market up for ransom. The details are often mind-numbingly complex, but the principle is simple. Buy up a large part of the supply of whatever commodity you are trying to corner--it doesn't really matter whether you actually take claim to the stuff itself or buy up "futures," which are nothing but promises to deliver the stuff on a specified date--then deliberately keep some--not all--of what you have bought off the market, to sell later. What you have now done, if you have pulled it off, is created an artificial shortage that sends prices soaring, allowing you to make big profits on the stuff you do sell. You may be obliged to take some loss on the supplies you have withheld from the market, selling them later at lower prices, but if you do it right, this loss will be far smaller than your gain from higher current prices.
       It's nice work if you can get it; there are only three important hitches. First, you must be able to operate on a sufficiently large scale. Second, the strategy only works if not too many people realize what is going on--otherwise nobody will sell to you in the first place unless you offer a price so high that the game no longer pays. Third, this kind of thing is, for obvious reasons, quite illegal. (The first Phoenician who tried it probably got very rich; the second got sacrificed to Moloch.)

Illustrations by Robert Neubecker The amazing thing is that Sumitomo managed to overcome all these hitches. The world copper market is immense; nonetheless, a single trader, apparently, was able and willing to dominate that market. You might have thought that the kind of secrecy required for such a massive market manipulation was impossible in the modern information age--but Hamanaka pulled it off, partly by working through British intermediaries, but mainly through a covert alliance with Chinese firms (some of them state-owned). And as for the regulators ... well, what about the regulators?
       For that is the disturbing part of the Sumitomo story. If Hamanaka had really been nothing more than an employee run wild, one could not really fault regulators for failing to rein him in; that would have been his employer's job. But he wasn't; he was, in effect, engaged in a price-fixing conspiracy on his employer's behalf. And while it may not have been obvious what Sumitomo was up to early in the game, the role of "Mr. Copper" and his company in manipulating prices has apparently been common knowledge for years among everyone familiar with the copper market. Indeed, copper futures have been the object of massive speculative selling by the likes of George Soros, precisely because informed players believed that Hamanaka was keeping the price at artificially high levels, and that it would eventually plunge. (Soros, however, gave up a few months too soon, apparently intimidated by Sumitomo's seemingly limitless resources.) So why was Hamanaka allowed to continue?

The answer may in part be that the global nature of his activities made it unclear who had responsibility. Should it have been Japan, because Sumitomo is based there? Should it have been Britain, home of the London Metal Exchange? Should it have been the United States, where much of the copper Sumitomo ended up owning is warehoused? Beyond this confusion over responsibility, however, one suspects that regulators were inhibited by the uncritically pro-market ideology of our times. Many people nowadays take it as an article of faith that free markets always take care of themselves--that there is no need to police people like Hamanaka, because the market will automatically punish their presumption.
       And Sumitomo's strategy did indeed eventually come to grief--but only because Hamanaka apparently could not bring himself to face the fact that even the most successful market manipulator must accept an occasional down along with the ups. Rather than sell some of his copper at a loss, he chose to play double or nothing, trying to repeat his initial success by driving prices ever higher; since a market corner is necessarily a sometime thing, his unwillingness to let go led to disaster. But had Hamanaka been a bit more flexible and realistic, Sumitomo could have walked away from the copper market with modest losses offset by enormous, ill-gotten gains.
       The funny thing about the Sumitomo affair is that if you ignore the exotic trimmings--the Japanese names, the Chinese connection--it's a story right out of the robber-baron era, the days of Jay Gould and Jim Fisk. There has been a worldwide rush to deregulate financial markets, to bring back the good old days of the 19th century when investors were free to make money however they saw fit. Maybe the Sumitomo affair will remind us that not all the profitable things unfettered investors can do with their money are socially productive; maybe it will even remind us why we regulated financial markets in the first place.

Paul Krugman is a professor of economics at Stanford whose books include The Age of Diminished Expectations and Peddling Prosperity.

Illustrations by Robert Neubecker