Paul Volcker (USA Former Chairman of the Federal Reserve) – Discussion at Vassar (Oct 2010)

Chapters

Abstract

The Legacy and Insights of Paul Volcker: A Comprehensive Overview

Paul Volcker, a towering figure in economics and public service, left an indelible imprint on the financial and political landscape of the US and beyond. In pivotal roles as Chairman of the Federal Reserve, Undersecretary of the Treasury, and leader of numerous critical committees, Volcker’s contributions extended beyond his high-profile positions. His profound understanding of economic complexities and unwavering commitment to public service set him apart. This article explores his significant achievements, unwavering principles, and lasting impact, notably the Volcker Rule and his insights into the financial crisis, systemic risk, and regulatory reforms.

Paul Volcker’s Career and Principles

Paul Volcker’s career was marked by significant positions, including his tenure as Chairman of the Federal Reserve and President of the Federal Reserve Bank of New York. Associates like Jeffrey Goldstein expressed gratitude for Volcker’s generosity in sharing knowledge and time, emphasizing the importance of doing the right thing, even when unpopular. During his time as Fed Chair, Volcker exemplified this principle by leading the fight against rampant inflation. His integrity and focus on achieving the right outcome made him a role model for generations of policymakers.

Volcker’s 30 years of public service extended beyond government positions, as he led two private nonpartisan commissions aimed at reforming and improving the civil service. Through his leadership of high-level entities, he tackled complex public policy issues with national and international impact.

Addressing Moral Hazard in Large Financial Institutions

The issue of bailing out large financial institutions creates moral hazard problems and disparities between large and small institutions. The belief that large institutions will be saved encourages risky behavior, leading to potential bailouts. The size and scale of institutions make bailouts disruptive to the marketplace.

To address moral hazard, the government aims to credibly commit to not bailing out large institutions. The Resolution Authority is established with the authority to take over failing financial institutions. The Resolution Authority has the power to settle immediate obligations and liquidate the institution.

Non-banks are less likely to be bailed out due to their less critical role in the financial system. Banks are subject to stricter regulation and capitalization to prevent the need for bailouts. Small banks may still face bailouts, similar to their current treatment.

The challenge of international banks with operations in multiple countries is acknowledged. There is a need to address the issue of prearranged division of responsibility and liability among countries. The case of Iceland highlights the complexity of bailing out international banks with depositors in different countries. Resolving such situations can be challenging, as seen in the negotiations between Iceland and the UK.

The Financial Crisis: Causes and Perspectives

Volcker saw the financial crisis as part of a larger crisis of globalism, exacerbated by unsustainable US consumption patterns and a housing boom. He identified the economic imbalance between China and the US, as well as the failure of regulators to oversee complex financial markets, as key contributing factors.

The Economic Imbalance Between China and the United States

China’s Production and Consumption:

China produced more than it consumed, while the United States consumed more than it produced. This difference resulted in massive imports from China, paid for by the United States with dollars.

Low Interest Rates and Dollar Holdings:

The Chinese held the dollars, which helped keep interest rates low in the United States. This allowed the United States to consume cheaply while China accumulated dollar holdings.

Unsustainable Borrowing:

The United States could not continue to borrow hundreds of billions annually from abroad.

Foreign Ownership of Treasury Securities:

Foreigners, including the Chinese, own more than half of the United States’ treasury securities.

Housing Boom and Financial Engineering

The economic imbalance contributed to a housing boom facilitated by modern financial engineering and complex financial markets. Financial regulators were not adequately overseeing these developments.

Financial Crisis Triggered by Housing Market

The housing boom ended when house prices stopped rising, leading to the financial crisis.

Understanding the 2008 Financial Crisis: Systemic Issues and Regulatory Oversight

The 2008 financial crisis exposed the need to address systemic risks in the financial system, not just idiosyncratic risks at individual banks. There is a need for macroprudential oversight to monitor the system as a whole and ensure its integrity.

Regulation of Non-Bank Institutions:

The investment banks, hedge funds, and other institutions that contributed to the crisis were largely unregulated. Traditional regulation by the SEC focused on protecting investors’ interests rather than ensuring safe banking practices.

Expansion of Regulation:

The Dodd-Frank Wall Street Reform and Consumer Protection Act extends regulation to non-bank institutions, including systemically important institutions. The Federal Reserve is given the responsibility for regulating these institutions.

New Oversight Body:

The law establishes a new oversight body composed of all U.S. regulators to oversee the entire financial market. This body is intended to address the fragmented regulatory landscape and ensure that no systemic risks are overlooked.

Lack of Attention to Subprime Mortgages:

The subprime mortgage market grew rapidly in a short period, reaching $1.5 trillion in three years. Despite its size, there was little oversight or understanding of the risks involved in this market.

Role of Credit Default Swaps:

Credit default swaps, which contributed to the collapse of AIG, were invented in the mid-1990s and were not subject to regulation. The lack of oversight and understanding of these complex financial instruments contributed to the crisis.

Systemic Failure:

The combination of factors, including the rapid growth of subprime mortgages and the lack of regulation of credit default swaps, led to a systemic failure in the financial system. This failure had far-reaching consequences, including the collapse of major financial institutions and a global economic crisis.

The Volcker Rule and Regulatory Reforms

The Volcker Rule, aimed at preventing banks from engaging in proprietary trading and investing in hedge funds and private equity funds, was a significant response to the financial crisis. This rule intended to reduce systemic risk and conflicts of interest. Volcker also proposed separating commercial banks from other financial institutions, a move intended to reduce the risk to the economy and the taxpayer.

Volcker’s Proposal: Separating Commercial Banks from Other Financial Institutions

Volcker’s Proposed Separation:

Volcker proposes separating commercial banks from other financial institutions due to their essential role in the economy.

Importance of Commercial Banks:

Commercial banks handle payments, deposits, and global monetary transfers, which are critical for the functioning of the global financial system. Deposits in commercial banks are protected through deposit insurance and access to borrowing from the Federal Reserve.

Distinction Between Protected and Unprotected Financial Institutions:

Banks should focus on essential economic functions, while other financial institutions may engage in speculative trading. Speculative trading should not be protected or bailed out by taxpayers.

Proprietary Trading Concerns:

Banks should not engage in proprietary trading, which is trading for their own profit, as it creates a moral hazard due to government protection. Proprietary trading can lead to excessive risk-taking and potential bailouts.

Separation Principle:

To prevent taxpayer-funded bailouts, a clear distinction should be made between protected commercial banks and unprotected financial institutions.

Volcker’s Rule:

Volcker’s proposed rule would prohibit banks with deposit insurance from engaging in proprietary trading. This separation aims to protect the stability of the financial system and prevent future crises.

Addressing Systemic Risk and Structural Faults

Volcker argued for reforms to mitigate moral hazard and reduce the likelihood of future bailouts. This included advocating for the establishment of a Resolution Authority to handle failing institutions and a new oversight structure, as established by the Dodd-Frank Act. The Financial Stability Oversight Council (FSOC) was created to prevent systemic risks by monitoring the entire financial market.

Economic Imbalance and the Housing Crisis

The economic imbalance between production and consumption in China and the US, coupled with low interest rates and the influx of dollars, were highlighted as contributing factors to the financial crisis. The housing crisis, fueled by rising house prices and weak credit, was a trigger that revealed the underlying weaknesses in the financial system.

The Challenges of International Complexity and Regulation

Volcker pointed out the complexity of dealing with international banks and the challenges in resolving their failures. The need for cooperation and negotiation among countries was emphasized, particularly in the context of systemic risk and regulation of financial institutions.

The Subprime Mortgage Crisis and Its Aftermath

The subprime mortgage crisis, which grew rapidly to a $1.5 trillion market, was a key aspect of the financial crisis. The crisis’s trigger was the failure of these mortgages, compounded by the creation of complex financial instruments like credit default swaps, whose risks were poorly understood. Volcker highlighted the need for better regulatory oversight to prevent such crises in the future.

Paul Volcker Discusses Federal Reserve Policy and the Need for Regulatory Oversight

Zero Interest Rates and Their Impact on Bank Lending:

Keeping interest rates near zero can discourage banks from serving the real economy as they have no incentive to invest due to the lack of pressure to lend.

Challenges of Zero Interest Rates:

Zero interest rates may lead to speculative activities, such as subprime mortgages and housing, due to the easy availability of money. Low interest rates may disincentivize consumer and business lending, affecting commercial lending.

Federal Reserve’s Dilemma:

Balancing economic stimulus through low interest rates with the potential risks of speculative activities is a challenge for the Federal Reserve.

Need for Regulatory Oversight:

Traditional interest rate monetary policy may not be sufficient to address issues like subprime mortgages. Regulatory authorities should have the power to prevent risky lending practices, such as 3% down mortgages without credit checks. Fannie Mae and Freddie Mac should have been subjected to stricter regulations to prevent the subprime mortgage crisis.

Concerns Regarding Large Budget Deficits and the Importance of Addressing the Issue

Federal Reserve’s Concerns:

– Concerns about the long-term effects of large budget deficits leading to higher interest rates and inflationary pressures.

– Fears of significant inflation beyond the current low levels.

– Unusual situation where fully unified, underdeveloped countries are booming economically while developed economies struggle.

– Challenges in controlling budget deficits without reducing expenditures or increasing taxes.

– Vulnerability to foreign markets and dependence on borrowing from countries like China and Thailand.

– Potential loss of confidence in the U.S. dollar.

– Emphasizing the need for budget planning and public discussion.

– Addressing Social Security reform, considering long-term implications.

Reflections on Government Trust and the Economy

Government Trust and Public Opinion:

– Public trust in the government has significantly declined, impacting problem-solving.

– Lack of trust complicates addressing issues and implementing solutions.

– Recent confidence jumps after events like 9/11 dissipate quickly.

– The economy lost 7 million jobs during the recession, affecting job availability for graduates.

– Freshmen may have better job prospects due to the changing economy and job market.

Economic Recovery Challenges and Outlook

Current Economic Situation:

– The economy is experiencing slow growth and high unemployment.

– Obstacles to recovery include housing, exports, consumption, and business investment.

– Pockets of strength, such as Silicon Valley and Apple, indicate economic resilience.

– Slow recovery timeline with several years needed to reduce unemployment.

– Discussions on additional stimulus measures, including fiscal stimulus, are ongoing.

Volcker’s Enduring Legacy

Paul Volcker’s life and work represent a profound commitment to public service and a deep understanding of economic systems. His insights into the causes of the financial crisis, his advocacy for regulatory reforms, and his emphasis on fiscal responsibility and public trust remain relevant and influential. Volcker’s legacy is not just in the policies he helped shape but in the example he set for future generations of policymakers and public servants.

Notes by: Flaneur