in recent years. For example, Japanese monetary authorities, after
having accumulated nearly $40 billion a month of foreign exchange, pre
*Such swaps are quite different from the liquidation of equities whose values are falling because
the discounted expectations of future earnings are falling. In that case, the overall value
of equities declines. There is no offset. It is not a swap.
t Aggregate holdings of foreign exchange by central banks and world private-sector portfolios
of foreign cross-border liquid assets approached $50 trillion in early 2007, according to the BIS
and IMF. Domestic nonfinancial corporate liabilities are also available as substitutes for U.S.
treasuries, probably at modest price concessions. Such liabilities net of foreign holdings of the
United States and Japan alone amounted to $33 trillion at the end of 2006.
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dominantly in U.S. treasuries, between the summer of 2003 and early 2004,
abruptly ended that practice in March 2004. Yet it is difficult to find significant
traces of that abrupt change in either the prices of the U.S. Treasury
ten-year note or the dollar-yen exchange rate. Earlier, Japanese authorities
purchased $20 billion of U.S. treasuries in one day, with little result.
While it is conceivable that as part of a financial crisis brewing for
other reasons, major liquidations in holdings of U.S. treasuries by foreign
central banks could cause havoc, I see even that as a stretch.
But that is not the end of financial fears. Along with the dramatic rise
in liquidity since the early 1980s has come the development of technologies
that have enabled financial markets to revolutionize the spreading
of risk, as we have seen. Three or four decades ago, markets could deal only
with plain vanilla stocks and bonds. Financial derivatives were simple and
few. But with the advent of the ability to do around-the-clock business
real-time in today's linked worldwide markets, derivatives, collateralized
debt obligations, and other complex products have arisen that can distribute
risk across financial products, geography, and time. Although the New
York Stock Exchange has become a lesser presence in world finance, its
trading volume has risen from several million shares a day in the 1950s to
nearly two billion shares a day in recent years. Yet, with the exceptions of
financial spasms such as the stock market crash in October 1987 and the
crippling crises of 1997-98, markets seem to adjust smoothly from one
hour to the next, one day to the next, as if guided by an "international invisible
hand," if I may paraphrase Adam Smith. What is happening is that millions
of traders worldwide are seeking to buy undervalued assets and sell
those that appear overpriced. It is a process that continually improves the
efficiency of directing scarce savings to their most productive investment.
This process, far from its characterization by populist critics as blind speculation,
is a major contributor to a nation's growth in productivity and its
standard of living. Nonetheless, the never-ending jockeying for advantage
among traders is continuously rebalancing supply and demand at a pace
that is too fast for human comprehension. The trades, of necessity, are thus
becoming increasingly computerized, and traditional "outcry" trading on
the floors of stock and commodity exchanges is rapidly being replaced by
computer algorithms. As information costs drop, the nature of the U.S.
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economy will change. With investment banks, hedge funds, and private equity
funds all seeking niche or above risk-adjusted rates of return, the distinctions
between these institutions will gradually blur. So will the defining
line between nonfinancial businesses and commercial banks, as the distinction
between what constitutes finance and commerce largely disappears.
Markets have become too huge, complex, and fast-moving to be subject
to twentieth-century supervision and regulation. No wonder this globalized
financial behemoth stretches beyond the full comprehension of even the
most sophisticated market participants. Financial regulators are required to
oversee a system far more complex than what existed when the regulations
still governing financial markets were originally written. Today, oversight of
these transactions is essentially by means of individual-market-participant
counterparty surveillance. Each lender, to protect its shareholders, keeps a
tab on its customers' investment positions. Regulators can still pretend to
provide oversight, but their capabilities are much diminished and declining.
For over eighteen years, my Board colleagues and I presided over much
of this process at the Fed. Only belatedly did I, and I suspect many of my colleagues,
come to realize that the power to regulate administratively was fading.
We increasingly judged that we would have to rely on counterparty
surveillance to do the heavy lifting. Since markets have become too complex
for effective human intervention, the most promising anticrisis policies are
those that maintain maximum market flexibility—freedom of action for key
market participants such as hedge funds, private equity funds, and investment
banks. The elimination of financial market inefficiencies enables liquid
free markets to address imbalances. The purpose of hedge funds and others
is to make money, but their actions extirpate inefficiencies and imbalances,
and thereby reduce the waste of scarce savings. These institutions thereby
contribute to higher levels of productivity and overall standards of living.
Many critics find this reliance on the invisible hand to be unsettling. As
a precaution and backup, they wonder, should not the world's senior financial
officers, such as the finance ministers and central bankers of major nations,
seek to regulate this huge new global presence? Even if global
regulation can't do much good, at least, it is argued, it cannot do any harm.
But in fact it can. Regulation, by its nature, inhibits freedom of market action,
and that freedom to act expeditiously is what rebalances markets.
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Undermine this freedom and the whole market-balancing process is put at
risk. We never, of course, know all the many millions of transactions that
occur every day. Neither does a U.S. Air Force B-2 pilot know, or need to
know, the millions of automatic split-second computer-based adjustments
that keep his aircraft in the air.
In today's world, I fail to see how adding more government regulation
can help. Collecting data on hedge fund balance sheets, for example, would
be futile, since the data would probably be obsolete before the ink dried.
Should we set up a global reporting system of the positions of hedge and
private equity funds to see if there are any dangerous concentrations that
could indicate potential financial implosions? I have been dealing with financial
market reports for almost six decades. I would not be able to judge
from such reports whether concentrations of positions reflected markets
in the process of doing what they are supposed to do—remove imbalances
from the system—or whether some dangerous trading was emerging. I
would truly be surprised if anyone could.
To be sure, the "invisible hand" presupposes that market participants
act in their self-interest, and there are occasions when they do take demonstrably
stupid risks. For example, I was shaken by the recent revelation that
dealers in credit default swaps were being dangerously lax in keeping detailed
records of the legal commitments that stemmed from their over-thecounter
transactions. In the event of a significant price change, disputes
over contract language could produce a real but unnecessary crisis.* This
episode was a problem not of market price risk but of operational risk—
that is, the risks associated with a breakdown in the infrastructure that enables
markets to function.
Superimposed on the longer-term forces I've discussed, it is important
to remember, is the business cycle. It is not dead, even though it has been
muted for the past two decades. There is little doubt that the emergence of
just-in-time inventory programs and increasing service output has markedly
diminished the amplitude of fluctuations in GDP. But human nature
does not change. History is replete with waves of self-reinforcing enthusi
*Fortunately, with the assistance of the Federal Reserve Bank of New York, this particular
problem is on its way to being solved.
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asm and despair, innate human characteristics not subject to a learning
curve. Those waves are mirrored in the business cycle.
Taken together, the financial problems confronting the next quarter
century do not make a pretty picture. Yet we have lived through far worse.
None of them will permanently undermine our institutions, or even likely
topple the U.S. economy from its place of world leadership. Indeed there
are currently a number of feared financial imbalances that are likely to be
resolved with far less impact on U.S. economic activity than is generally
supposed. I indicated in chapter 18 that the unwinding of our current account
deficit is not likely to have a major impact on economic activity or
employment. The fear that a liquidation of much of China's and Japan's
huge foreign-exchange reserves will drive U.S. interest rates sharply higher
and dollar exchange rates lower is also exaggerated.
There is little we can do to avoid the easing of global disinflationary
forces. I view that as a return to fiat-money normalcy not a new aberration.
What is more, we have it within our power to sharply mitigate some of the
more dire features of the scenario I have outlined above. First, the president
and Congress must not interfere with the Federal Open Market Committee's
efforts to contain the inevitable inflationary pressures that will eventually
emerge (the members will need no encouragement). Monetary policy
can simulate the gold standard's stable prices. Episodes of higher interest
rates will be required. But the Volcker Fed demonstrated that it can be done.
Second, the president and Congress must make certain that the economic
and financial flexibility that enabled the U.S. economy to absorb the
shock of 9/11 is not impaired. Markets should remain free to function
without the administrative constraints—particularly those on wages, prices,
and interest rates—that have disabled them in the past. This is especially
important in a world of massive movements of funds, huge trading volumes,
and markets rendered inevitably opaque by their increasing complexity.
Economic and financial shocks will occur: human nature, with its
fears and its foibles, remains a wild card. The resulting shocks will, as always,
be difficult to anticipate, so the ability to absorb them is a paramount
requirement for stability of output and employment.
Hands-on supervision and regulation—the twentieth-century financial
model—is being swamped by the volume and complexity of twenty-first
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century finance. Only in areas of operational risk and business and consumer
fraud do the principles of twentieth-century regulation remain intact. Much
regulation will continue to be aimed at ensuring that rapid-fire; risk-laden
dealings are financed by wealthy professional investors, not by the general
public. Efforts to monitor and influence market behavior that is proceeding
at Mach speeds will fail. Public-sector surveillance is no longer up to the
task. The armies of examiners that would be needed to maintain surveillance
on today's global transactions would by their actions undermine the
financial flexibility so essential to our future. We have no sensible choice
other than to let markets work. Market failure is the rare exception, and its
consequences can be assuaged by a flexible economic and financial system.
H
H
owever we get to 2030, the U.S. economy should end up much larger,
absent unexpectedly long crises—three-fourths larger in real terms
than that in which we operate today. What's more, its output will be far
more conceptual in nature. The long-standing trend away from value produced
by manual labor and natural resources and toward the intangible
value-added we associate with the digital economy can be expected to continue.
Today it takes a lot less physical material to produce a unit of output
than it did in generations past. Indeed, the physical amount of materials
and fuels either consumed in the production of output or embodied in the
output has increased very modestly over the past half century. The output
of our economy is not quite literally lighter, but it is close.
Thin fiber-optic cable, for instance, has replaced huge tonnages of copper
wire. New architectural, engineering, and materials technologies have
enabled the construction of buildings enclosing the same space with far less
physical material than was required fifty or one hundred years ago. Mobile
phones have not only downsized but also morphed into multipurpose communication
devices. The movement over the decades toward production of
services that require little physical input has also been a major contributor
to the marked rise in the ratio of constant dollars of GDP to tons of input.
If you compare the dollar value of the gross domestic product—that is,
the market value of all goods and services produced—of 2006 with the
GDP of 1946, after adjusting for inflation, the GDP of the country over
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TH E DE LPH IC FUTU RE
which George W. Bush presides is seven times larger than Harry Truman's.
The weight of the inputs of materials required to produce the 2006 output,
however, is only modestly greater than was required to produce the 1946
output. This means that almost all of the real-value-added increases in our
output reflect the embodiment of ideas.
