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     Sep 14, 2007
Fedophiles and Fedophobes
By Max Fraad Wolff

As the credit crunch worsens, volatility and re-pricing create swings of fortune. In times of uncertainty, markets look to monetary authorities. The US Federal Reserve receives massive attention.

Experts and opinion leaders attribute calm or turbulence to every Fed policy and statement as though this institution could or does control investment and monetary outcome. Some specialize in blaming all trouble on Fed interest-rate decisions, interventions

and pronouncements. Others see the Fed as a guardian angel always available to right the natural inflationary course of asset prices.

Fedophiles and Fedophobes alike are increasingly incorrect in their assessments and suggestions. Monetary authorities are wedded to laissez-faire understandings of shrinking regulator authority. Central-bank policy is vastly powerful. It is also vastly diminished in its reach and influence since the early 1990s. As the debate about volatility and loss management intensifies, it is vital to situate the size and role of regulators properly. Absent adjusting your understanding, you will be tempted to blame the wrong party or wait for a rescue that cannot be made.

Decades of financial-market deregulation, capital-movement de-control and financial-product innovation have radically altered the asset topography. Monetary authorities have encouraged the development of concentric rings of ever more lightly regulated/supervised activity. A regulated financial core exists with significant central-bank oversight. Core institutions have seen some deregulation, but institutions and balance sheets remain subject to myriad restrictions and significant reporting.

Radiating outward are ring upon ring of less and less monitored and reported non-bank financial actors and intermediaries. These more nimble players are subject to greater boom-and-bust cycles, and are less transparent and harder to reach with Fed action. Many leading lights, not least the present Fed chairman, Ben Bernanke, heaped praise on this arrangement over past decades. It has worked "well". The layers of nimble players have provided greater liquidity, speed, speculative opportunity and yield to daring and well-funded investors.

A result of recent innovation and growth has been the steady and rapid decline in the supervised portion of financial activity. The fraction of transactions, measured in numbers, size or value, directly overseen by the Fed has fallen appreciably. Rapid regulatory decline took place during the bull run of 1982-2000 and during the bubble reinflation of 2003-07. History makes clear that lighter regulatory oversight commonly accompanies booms and heavier oversight is born of busts and the anger they generate. The US Sarbanes-Oxley Act provides just one recent example.

As innovation revolutions have transformed the banking landscape, they have changed the role and scope of regulatory power. The rise of securitization has changed the position of insured depository institutions. Financial globalization has grown and spread further, wider, and faster than regulatory influence.

The 25-year period from 1982-2007 has seen change in financial technology, product mix and risk treatment. I would argue that financial products have developed as rapidly and completely in the past 25 years as computer technology. The main difference is that one series of revolutions is known and acknowledged and the other is not. This is evident in a 50% reduction in the percentage of financial assets under depository supervision.

Depository institutions continue to grant loans - alongside many competitors. These loans are increasingly and rapidly securitized. The pool of asset-backed securities has grown exponentially. Between 1995 and 2005 the total value of US asset-backed securities rose by more than 400% to above US$2 trillion. Assets in hedge funds, private-equity funds, insurance companies and pensions have also grown. Unsupervised growth has run much faster than supervised growth.

The Fed's orbit of authority has shrunk as a portion of financial markets. Less than 25% of financial assets in the US now reside in insured/highly supervised depositories. Powerful indirect authority and transmission mechanisms continue to connect Fed policy to the growing outer rings of the financial system. However, authority and influence are slower, less direct and more likely to go astray. After all, isn't that a part of the story of the credit bubble that is unwinding now? We have planned for this arena to be "market disciplined".

Now that massive punishment looms, no one is interested in market discipline.

It's a great big world. US financial markets are a great big part of the world. They have steadily fallen as a percentage of global financial wealth, assets and activities. Bank for International Settlements data reveal that total assets in the European Union passed the US in 2005. Rapid internationalization and growth of non-US domiciled and non-dollar denominated assets have produced a pronounced trend of falling US weight.

This too acts to dilute the power of the Fed. This is before we stop to consider the US dollar hitting lows before the Fed attempts to stave off housing pain and recession with rate cuts. The Fed has less direct supervision, reduced authority through globalization, and fewer policy options. Fedophobes and Fedophiles can debate Fed policy all they want, but basic structural changes are the new reality.

All of this is to say that the Fed is less able rapidly and precisely to influence the course of asset prices and risk supervision in a growing majority of US financial markets. This becomes significantly acute as we factor the internationalization of finance and the declining weight of US markets in total global activity. The world has grown away from the core control and direct regulatory authorities of the Federal Reserve. The extent to which this is true is likely to emerge amid growing acquisition and bailout requests.

Max Fraad Wolff is a doctoral candidate in economics at the University of Massachusetts, Amherst, and editor of the website GlobalMacroScope.

(Copyright 2007 Max Fraad Wolff.)

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