If you are like most Americans, you alternate between trying to understand what is going on in financial markets and trying to ignore the fact that they exist. I feel your pain. I think most of us deal with financial market developments and political policy in much the same way. Deep in the recesses of our brains we suspect that the stuff matters. Between boredom, intimidation and life's other burdens we mostly just hope for the best. There seems to be a credit Wild West out there. This increases the number of people who prefer to not get involved. Avoidance is always a risky strategy. It was become a national disaster. While you were out, others were about. They have agenda's, needs and desires. Theirs were met -- sometimes at your expense. Our government and credit markets are changed places -- not least your place within them has changed. In the clichéd battle between the quick and the dead, the public has not been quick. Let's take a gander at some recent changes and why they matter.
As you know and we have discussed, there was a long, rock-star size credit extravaganza. You were invited. Some of you came for the "free" lunch. Some of you were the free lunch. Now the party is winding down and clean-up is looking daunting. There are hangovers, missing keys, broken furniture and sticky floors. Hopes are high -- and many of the attendees are too -- that there will be vital clean-up help. Hope now centers on the Fed to fix things and do much of the dirty work. The bored are suddenly interested -- at least in getting some help with immediate and pressing issues. A growing chorus is surveying the scene and declaring it ugly. Ours is a story of the Fed, the Bored and the Ugly.
Credit is a little like alcohol. It is great in moderation but, can become a problem. Early in the credit boom, debt was great opportunity lubricant and allowed all to more easily and profitably negotiate mismatches between incomes and needs/desires. So far, so good. The problem started when we got hooked and starting to turn to credit as crutch. We were not the only ones hooked. Our leading credit, goods and services suppliers developed a dependence on our debt fueled spending. This is how the bubble got so big, lasted so long and came to encompass so much. The bored waited for the Fed to call off the party, they didn't. More and more credit was consumed and folks got drunk and dependent. The party moved toward ugly. It was too big, the guest list went out the window, and the crowd got drunk and rowdy. No one wanted to call of the festivities and everyone hoped it would work itself out.
All this got us to now. Things look ugly. The bored and the eternally optimistic want the Fed to fix it. Some are suggesting we just throw another party. After all, the place is trashed. Maybe that will be the path we take. More and more, people are calling on the Fed. Some savagely critique the Fed as responsible for the entire mess. We will call them Fed-o-phobes. Some believe the Fed will wave its wands and make the mess all go away. We will call them Fed-o-philes. The size, complexity and nature of the mess seem lost on these folks. The bored condemn or look to the Fed as their situation gets ugly. What changed and what do you need to know to begin to make sense of all this?
Monetary authorities -- the Fed among others -- are wed to laissez faire understandings of their economic role. Central bank policy is vastly powerful. It is also vastly diminished in its reach. The Federal Reserve acts through bank regulation, market purchase and sale of Treasury Securities and influencing public opinion. They showed up late to the party's messy aftermath and have been trying to motivate a clean-up ever since. The focus has been on public opinion and some action at the discount window. This involved making more money available to banks at lower cost for longer periods. They have done some direct action, injecting tens of billions of extra cash into the US financial system. There is evidence that this and all their PR has helped to slow the declines and reassured some very bored and optimistic observers. The real problem is that they lost control of the party for a reason. This reason restricts their ability to do the kind of fast and full clean-up that many now expect or demand.
Decades of financial market deregulation and financial product innovation have radically altered our landscape. Monetary authorities have encouraged the development of concentric rings of ever more lightly regulated/supervised activity. A regulated financial core exists with significant Fed oversight. Core institutions have seen some de-regulation but, institutions and balance sheets remain subject to restriction and reporting. Radiating outward are rings upon rings of less and less monitored financial actors. These more nimble players are subject to greater boom and bust cycles, are less transparent and harder to reach with Fed action. Many leading lights, not least our present Fed Chairman Bernanke, heaped praise on this arrangement over past decades. It has worked "well". The layers of nimble players produced more credit, faster and for more profits than our previous more regulated and cautious system. We dismantled some of the standards and regulations on belief in the markets' ability to perform better than regulation.
A result of recent innovation there has been a 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. Rapid regulatory decline took place during the bull market, 1982-2000, and during the bubble re-inflation 2003-2007. History makes clear that lighter regulatory oversight commonly accompanies booms and heavier oversight is born of busts and the anger they generate. As innovation revolutions have transformed the banking landscape, they have changed the power of the Fed. The rise of securitization has changed the position of insured depository institutions. Securitization is the process of transforming loans into traded bonds. This involves transforming private loan contracts between creditors and borrowers into tradable securities. Financial globalization has grown and spread farther, wider, faster than regulatory influence.
The 25 year period from 1982-2007 hosted several financial revolutions. I would argue that financial product development has changed as rapidly and completely in the last 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. Fed regulated banks continue to grant loans -- alongside many competitors. These loans are increasingly and rapidly securitized. The pool of securities has grown exponentially. Between 1995 and 2005 the total value of US asset backed securities rose over 400% to above $2trillion. Assets in hedge funds, private equity funds, insurance companies and pensions have also grown. Un-supervised growth has run much faster than supervised growth. The Fed's orbit of authority has shrunk as a portion of financial markets. Less than 25% of financial asset in the US now reside in insured/ highly supervised depositories. Powerful indirect authority and influence mechanisms continue to connect Fed policy to the growing outer rings of the financial system. However, authority and influence are slower, less direct and more likely to go astray. After all, isn't that a part of the story of the credit bubble that is unwinding now? The Fed planned for this arena to be "market disciplined." Now that massive punishment looms, no one is interested in market discipline.
It's a great big world. US financial markets are a great big part of the world. They have steadily fallen as a percentage of global financial wealth, assets and activities. Bank for International Settlements (BIS) data reveals that total assets in the EU passed the US in 2005. Rapid internationalization and growth of non-US domiciled and non-U$D denominated assets have produced a pronounced falling of US weight in world assets. This too acts to dilute the power of the Fed. The Fed has less direct supervision, reduced authority through globalization and fewer policy options. Fed-o-phobes and Fed-o-philes can debate Fed policy all they want, basic structural changes are the new reality.
All of this is to say, the Fed is less able to rapidly and precisely influence the course of asset prices, credit access and interest rates in a growing majority of our financial markets. This becomes acute as we factor the internationalization of finance and the declining weight of US markets in total global activity. The world has grown away for the core control and direct regulatory authorities of the Federal Reserve. The extent to which this is true is likely to emerge amidst growing accusation and bail-out request. It is not just that the Fed may have acted late and slow. It is also that we followed our ideological commitments to deregulation until trouble started. Then many began to scream for government assistance. This is understandable but is now compromised by the changes made.
As recognition of the mess ebbs and flows you will hear people blame the Fed, praise the Fed and assure that the Fed will save the day. We have changed the rules. The sheriff is not all powerful in the Wild West town that finance built. The Fed, The Bored and the Ugly will all have to lend a hand in sorting out the mess and slogging through the clean-up.