Federal Reserve & Interest Rates

While in some ways the current global recession began with the collapse of the U.S. housing market and the subprime mortgage meltdown, much of the ensuing damage was amplified because of the explosive growth of the over-the-counter(OTC) derivatives market.  It will also be exceedingly difficult for the Federal Reserve to develop a regulatory structure for this complex and unwieldy market that many observers have called a ticking time bomb for the financial system.

The government has been holding hearings recently on revamping the entire regulatory structure of the entire financial system in order to prevent the kind of shocks that nearly brought it to it’s knees over the past year.  A major concern for the Fed is the currently unregulated OTC derivatives market and some of it’s members gave their views before Capitol Hill today, on ways to finally regulate a market that is pretty much a festering wound waiting to happen.

The events of the last two years have demonstrated the potential for difficulties in one part of the financial system to create problems in other sectors and in the macroeconomy more broadly. OTC derivatives appear to have amplified or transmitted shocks. An important objective of regulatory initiatives related to OTC derivatives is to ensure that improvements to the infrastructure supporting these products reduce the likelihood of such transmissions and make the financial system as a whole more resilient to future shocks.

The key goal of any of the changes to the financial regulatory structure will be to dampen systemic risk and the derivatives market as it currently stands poses a grave threat to future global financial stability.  Unfortunately the task ahead at this point may be akin to closing the barn door after all the animals have already left.

Because the market has grown so large in such a short time, it will take a global effort from central banks around the world to realize any significant changes in the short term for it to be effective.  At this point acting on it’s own, the Fed’s can only realistically try to mitigate any possible shocks to the financial system as opposed to attempting to prevent them entirely.

Later this week, Treasury Secretary Timothy Geithner will unveil his regulatory reform plan before Congress.  How much it will resemble his predecessor, Henry Paulson’s so called “blueprint for regulatory reform” remains to be seen.

Regulatory reform of the financial services industry could take quite some time, with the current emphasis by the administration on healthcare reform.  However long it takes, the outcome will likely see the Federal Reserve exert a firmer control on the economy.

We may see some of the broad powers that the Fed has already used during the financial crisis become more institutionalized.  Also, some of the powers that are currently under the control of the Security and Exchange Commission(SEC) may also pass into their control.

The Fed is expected to gain regulatory power over institutions that are deemed systemic risks to the rest of the economy.  The SEC received a black eye when it failed to spot serious flaws in a number of financial institutions, most notably Bear Stearns and Lehman Brothers.

Other agencies likely to gain increased regulatory powers are the Federal Deposit Insurance Corporation and the Office of Thrift Supervision.  While much of the focus lately have been on the nation’s largest banks, hundreds of smaller regional banks face difficulties and a number of them are expected to fail in the next few years.

Ultimately we could see a considerable rollback of much of the deregulation that has occurred in the previous two decades and it will likely shape the financial landscape for years to come.

The current financial crisis has changed the role for many governments in capitalistic economies around the world.  In socialist economies, the government normally takes a more active role but in democratic societies the standard is usually a more hands off approach.

The intervention comes at what may prove to be a steep price. Future investment may be allocated less efficiently as risk-averse politicians make business decisions. Whenever banks decide to lend again, they are likely to find new capital requirements that will curb how freely they can do it. Interest rates may be pushed up by government borrowing to finance trillions of dollars of bailouts.

“We’re seeing a more statist world economy,” says Ken Rogoff, former chief economist at the International Monetary Fund and now a professor at Harvard University in Cambridge, Massachusetts. “That’s not good for growth in the longer run.”

The government has had to spend an unprecedented amount of money to rescue the financial system and try to maintain economic growth in the face of falling demand.  However, the more money being spent, the more control the government is exerting on the economy.

The surprising aspect is the ownership stakes the government is taking in banking institutions, something that would be more commonplace in a state run economy.  Also, the repercussions could be fairly long term as we are likely to see the start of a new era of increased regulatory oversight.

The government is receiving a lot of criticism for bailing out failing companies.  At first the government seemed to hold to a certain financial standard when it declined to help Lehman Brothers because the company’s asset were insufficient as collateral.

That standard went out of the window with the auto industry bailout.  In this case there are serious doubts on whether the government will ever get paid back or not.  Yes, many jobs were saved but it’s been obvious for years that this has been a failing industry and it’s not like this is the first time the government has had to bail them out.

There are obviously companies that are” too big” to fail but some are apparently more important than others.  We all saw the havoc that ensued in financial markets when Lehman failed and if the government were to do it again they would probably intervene.

But where does it end?  There are going to be more companies in danger of failing before a recovery happens but the government will have to weigh the cost to taxpayers versus the cost to the economy.