"Technological progress has merely provided us with more efficient means for going backwards." —Aldous Huxley

Thomas L. Friedman’s 2005 book, The World is Flat, describes the convergence of forces, technologies, and ideas (Friedman calls these “flatteners”) that helped level the global economic playing field between the developed and developing worlds at the dawn of the 21st century. As we try to demystify the housing/credit/liquidity crisis and likely economic recession of 2007 – 2008, applying some of the conceptual theory behind Friedman’s “flatteners” leads to the probable conclusion that technological innovation and faster information speeds have been both a blessing and curse and are partly to blame for the current debacle.

Long dominated by traditional brokers and large money-center banks, and propelled by quantum leaps forward in information technology, productivity gains, globalization, and a post-Cold War peace dividend, a roughly 20-year stock market rally ended with the dot-com bubble burst of early 2000, and stocks have more or less treaded water since.

Figure1. 28-Year S&P 500 Index

As Wall Street’s deep equity profit-center began to dry up, many investment banks, under increasing shareholder pressure for profits, expanded into into new, more complex markets such as securitization, prime brokerage services, buyout financing, derivatives, and commodities.

Just as the productivity gains from technology innovation drove the record corporate profits that fueled the IPOs and bull stock markets (and lined Wall Street’s pockets) in the 1980s and 1990s, technology also leveled the financial playing field by lowering Wall Street’s self-erected and long-standing barriers around information and capital. By providing greater access to information, technology served to dis-intermediate industry middlemen, hastened the commoditization of financial products and services, reversed the flow of capital, and led to increased overall margin compression within many formerly profitable and protected business lines that were dependent on fee income.

In other words, just as technology was helping to tip the global balance of power from the industrialized to the developing world, it was also forcing Wall Street into riskier and more complex businesses, while the levers of financial power were falling under the control of alternative investors with large pools of private capital (e.g., private equity buyout shops, hedge funds, foreign central banks, and sovereign wealth funds). The hedge fund industry, which probably peaked somewhere between 2005 – 2006, ballooned to as much as $1 trillion assets under management, and sovereign wealth funds, which grew rapidly from globalization and the commodities boom, are estimated to hold anywhere from $2 and $7 trillion in assets. Meanwhile, the number of primary dealers—those firms that underwrite U.S. Treasury securities and trade directly with the Fed in open market operations—shrank from 44 in the late 1980s to 21 firms today.

As the transformation of power was underway from Wall Street to large pools of private money, unusual market conditions (e.g., the inverted yield curve and ultra-low implied volatility) exacerbated the situation by encouraging excessive risk-taking by both banks and investors. This diluted banks’ power even further, and generally led to more intertwined, co-dependent trading and lending counterparties and correlated markets.

Technology is here to stay, and this crisis will ultimately lead to less cavalier views of risk, leaner workforces, and consolidation of banks. But just as the rust-belt of the U.S. reels from the loss of manufacturing jobs overseas, Wall Street will continue to not only lose more power to alternative investors, but also will be held under much greater regulatory scrutiny going forward.

By Jonathan Hartley, Institutional Sales and Trading Manager at the Federal Home Loan Bank of Seattle.

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