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.
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