Volcker’s Connection to LSE:
Paul Volcker studied at the London School of Economics (LSE) in 1951 and 1952 as a Rotary Foundation ambassadorial fellow. During his time at LSE, he lived on a $2,100 stipend for 15 months, a modest sum even for LSE students at the time.

Volcker’s Career Highlights:
After graduating from LSE, Volcker rejoined the Federal Reserve in 1952 and eventually became its chairman. He has served as an advisor and mentor to many individuals throughout his career.

Volcker’s Advice to Howard Davies:
In 1997, when Howard Davies was Deputy Governor of the Bank of England, he met with Volcker to discuss the creation of the Financial Services Authority (FSA). Volcker cautioned Davies about the challenges he would face in leading the FSA and advised him to retain his sense of humor.

Volcker’s Current Role:
Volcker currently serves as the chairman of the Economic Recovery Board.

Question to Volcker:
Davies asks Volcker if he believes the economic recovery is well underway, using Larry Summers’ phrase “escape velocity.”

The Economic Situation:
The economy has slightly improved, but not as expected. The recovery from the deep recession is slow due to high unemployment, lack of exports, and sluggishness in Europe and Japan. Manufacturing has increased, but housing and business investment remain stagnant despite companies’ healthy financial positions.

Recovery Challenges:
There are no external shocks hindering recovery, but it is unlikely to reduce unemployment quickly. Consumption-led recovery is undesirable as it was the cause of the initial economic issues. Reliance on investment, better competitiveness, and exports is necessary, but it takes time to materialize.

Fiscal Position:
The U.S. deficit is excessively large and cannot be drastically reduced immediately. Drastic spending cuts or tax increases are inappropriate given the current economic situation, particularly the unemployment rate and excess capacity. A commission on financial reform is appointed to educate the public about the problem’s nature.

Historical Revenue and Spending Patterns:
Prior to the recession, revenue consistently generated around 18.5% of GDP, while spending hovered around 20%. The deficit was modest by today’s standards. Currently, the deficit has reached 10% of GDP due to stimulus programs and tax reductions.

Current Spending and Tax Trends:
Government spending has reached a high level, currently around 25% of GDP. Spending momentum is strong due to factors such as Social Security, healthcare, and defense. Despite the likelihood of some spending restraint, it’s unlikely to return to 20% of GDP.

Taxation Challenges:
Personal income taxes have shown volatility without significant impact on revenue. Corporate taxes are already among the highest in the world. Payroll taxes have become the most important source of revenue despite theoretical objections.

Potential New Taxes:
The need for a new tax is recognized due to the limitations of current tax sources. A carbon tax or a stiff energy tax are potential options, given environmental concerns and the desire for energy independence. Value-added tax (VAT) is another possibility, despite its historical unpopularity in the United States.

The Debate Ahead:
The commission will engage in a debate about the need for a new tax. The public’s willingness to accept a new tax remains uncertain.

The Eurozone’s Challenges and Structural Weaknesses:
Paul Volcker, a former Chairman of the Federal Reserve, expressed his concerns about the eurozone’s ongoing crisis and its potential implications for Europe’s integration. Volcker highlighted the structural weaknesses within the eurozone, particularly the lack of a common fiscal policy to complement the common monetary policy. He emphasized that the Stability Pact, which aimed to maintain fiscal discipline among member states, was not effectively enforced, leading to unsustainable fiscal imbalances. The failure to implement necessary economic adjustments in countries like Greece contributed to the crisis and exposed the fundamental challenges facing the eurozone.

Europe’s Reaction to the Crisis:
Volcker acknowledged the European authorities’ immediate response to the crisis, providing massive support programs to buy time and stabilize the situation. However, he stressed that this approach is only a temporary solution and does not address the underlying structural issues. Europe needs to decide whether to pursue further integration or consider the possibility of a less integrated eurozone, which could raise questions about the future of the euro.

Central Bank Independence and the Crisis Response:
Volcker discussed the impact of the crisis on central bank independence, particularly in the context of the European Central Bank (ECB) engaging in government bond purchases. He emphasized that these actions were necessary given the extraordinary circumstances and did not indicate a compromise of central bank independence. Volcker argued that during a crisis, central banks must respond to the broader financial stability concerns rather than solely focusing on inflation control.

Regulatory Reform in the United States:
Volcker provided an update on the progress of regulatory reform in the United States, specifically the Dodd-Frank Wall Street Reform and Consumer Protection Act. He expressed optimism about the bill’s chances of passage, noting a growing momentum and support for certain key proposals he has advocated for. Volcker acknowledged that the bill contains elements he is not entirely in favor of but believes it includes necessary reforms and deserves support. He credited the recent Goldman Sachs controversy with helping to dispel doubts and facilitate progress on the legislation.

Political Polarization and the Prospects for Reform:
Volcker discussed the initial political polarization surrounding the Dodd-Frank bill, with Republicans debating whether to oppose all of President Obama’s proposals. However, he observed that the ongoing financial repercussions have contributed to a shift in attitudes, leading to a less polarized stance on the issue. Volcker expressed confidence that the similarities between the Senate and House bills would facilitate a smooth conference process to reconcile the two versions. He predicted that the bill would likely be passed before the summer recess in August.

Paul Volcker’s General Concerns:
He feels the bill is too focused on the electoral cycle and may not provide lasting solutions. He would have preferred the Federal Reserve to have a more prominent role in oversight, similar to the Bank of England. He believes the bill does not adequately address issues with credit rating agencies or other regulatory lapses.

Paul Volcker’s Specific Concerns:
He objects to changes in the Federal Reserve Act, particularly regarding the election or appointment of Federal Reserve presidents. He finds it odd that the president will appoint the president of the Federal Reserve Bank of New York.

Section 619: Prohibition of Proprietary Trading:
This section instructs the Financial Stability Oversight Council to prohibit proprietary trading by insured depository institutions. Volcker explains that the rationale behind this rule is often misunderstood, as it is not solely about risk but also about conflicts of interest and the appearance of impropriety.

Volcker’s Concluding Remarks:
He emphasizes the importance of avoiding conflicts of interest and maintaining the integrity of the financial system. He stresses that these reforms should not be viewed as a solution to all financial problems but rather as a step in the right direction.

The Role of Banks in Financial Crises:
Paul Volcker highlights that the biggest risk banks face is making loans, not their other activities. He emphasizes the need for reasonable control over banks’ lending practices.

The Moral Hazard Problem:
Volcker expresses concern over the moral hazard created by the government’s response to financial crises. He points out that protecting banks and other institutions from failure encourages excessive risk-taking.

The Need for a Resolution Authority:
Volcker proposes the establishment of a resolution authority to deal with failing financial institutions. This authority would have the power to promptly intervene, liquidate the institution, and protect workers and obligations.

The Importance of Liquidation:
The goal of the resolution authority would be to liquidate failing institutions, eliminating the expectation of bailouts. This approach would aim to change the behavior of creditors, management, and stockholders, reducing moral hazard.

The Role of Central Banks and Deposit Insurance:
Volcker acknowledges the role of central banks as lenders of last resort and the importance of deposit insurance during crises. He emphasizes that these mechanisms are not meant to encourage excessive risk-taking.

Banks’ Essential Functions:
Running the payment system, ensuring secure and efficient transactions. Providing credit to small and medium-sized businesses. Underwriting and providing protection for large credits. Serving as a safe place for people to deposit money.

Systemic Risks:
Disruption of these essential functions can have severe consequences for the economy. Speculative trading activities by banks can lead to instability and crises. Conflicts of interest arise when trading and speculative cultures mix with traditional banking.

Volcker’s Argument:
Taxpayers should not be responsible for protecting banks’ speculative trading activities. Only a handful of large US banks have significant trading operations. European banks may have a larger mix of trading activities, but it’s still a relative handful. Adjusting to reduced trading activities would not significantly weaken banks.

Alternative Approach:
Treating all financial institutions as hedge funds and regulating them all strictly. This would limit the intensity of regulation to those providing essential services. However, it raises concerns about regulating entities that do not pose systemic risks.

Volcker’s Argument against Kroszner’s Claim:
Paul Volcker challenges Randy Kroszner’s argument that pushing risk-taking out of commercial banks would make the entire financial system more fragile. Volcker believes that separating risky activities from commercial banking and moving them to the open market would limit risk-taking and prevent systemic crises.

Volcker’s Concerns about the Implicit Protection of Investment Banks:
Volcker criticizes the current system that provides implicit protection to investment banks with commercial banking licenses. He argues that this protection encourages excessive risk-taking and undermines the stability of the financial system.

Volcker’s Vision for Financial System Reform:
Volcker proposes separating risky activities from commercial banking and subjecting them to market discipline. He believes that this approach would limit risk-taking and promote a more stable financial system.

Question on Central Bank’s Role in Setting Interest Rates:
A student named Philip raises a question about the central bank’s role in setting interest rates in the money market. He compares this to a planned economy where prices are set centrally, leading to inefficiencies and misallocations of resources. Philip expresses concern about the lack of independence of central banks from the government and its potential impact on interest rate decisions.

Free Banking vs. Central Banking:
Free banking advocates argue that the central bank’s control over short-term interest rates creates moral hazard problems. Historical examples show that free banking systems can be unstable, leading to frequent bankruptcies.

Stability in Industrial Societies:
In an industrial society, large institutions with international scope and technical capacity are necessary. A purely free banking system may not be able to produce these institutions.

Global Macroeconomic Imbalances:
Global imbalances exist, such as between the U.S. and China and between Germany and Greece. These imbalances can lead to systemic problems.

IMF’s Role:
Proposals were made in 1944 to require both creditors and debtor countries to adjust their economies to address imbalances. These proposals were not adopted due to U.S. opposition.

Reevaluating IMF’s Role:
The need to reevaluate the IMF’s role in addressing global macroeconomic imbalances is raised. This includes imbalances between China and the U.S. and between Germany and Greece.

Former System:
The Bretton Woods system, which linked currencies to gold and required symmetrical adjustment by surplus and deficit countries, ended in the 1970s. The subsequent system allowed countries to choose between fixed and floating exchange rates, but it lacked effective adjustment mechanisms.

Current Imbalances:
Large and persistent imbalances have emerged, such as the U.S.-China trade imbalance and imbalances within Europe. These imbalances have not been effectively addressed, leading to concerns about the stability of the international monetary system.

Volcker’s Proposal in the 1970s:
Paul Volcker, a former U.S. Treasury Secretary, proposed using reserve indicators as a signal and discipline for adjustment in both surplus and deficit countries. This proposal aimed to address the problem of asymmetrical adjustment, where only deficit countries were forced to adjust.

Application to Today’s Imbalances:
China’s excessive accumulation of reserves and the United States’ large liabilities could have triggered adjustments under Volcker’s proposal. The gross imbalances between these countries indicate that reserve indicators would have provided a useful signal for corrective action.

Conclusion:
Volcker believes that it is time to consider a more fundamental reform of the international monetary system, given the challenges posed by persistent imbalances and the lack of effective adjustment mechanisms.

Volcker’s Observation on the Financial System:
Paul Volcker expressed concern about the immense wealth generated in the financial system in the United States before the crisis, which reached 35-40% of all profits for several years. He questioned how the financial world, relatively small in employment, could account for such a significant portion of profits while average American incomes remained stagnant during the same period.

Assignment for PhD Students:
Volcker proposed a PhD research topic for budding economists to examine whether there is any real value added in the financial activities conducted in the last 10 years. He encouraged students to use mathematical models or other methods to assess the contribution of financial engineering to the economy.

Questioning the Necessity of Complex Financial Instruments:
Volcker expressed skepticism about the necessity of complex financial instruments like credit default swaps and CDOs for the economy’s functioning. He highlighted that the economy survived and even thrived in the past without these instruments.

Impact of Financial Engineering on Economic Growth:
Volcker observed that there seems to be no significant difference in economic growth or productivity during the years of financial engineering compared to the years before. He suggested that the slower growth in recent times may be attributed to other factors.

Volcker’s Suggestion for the Eurozone:
Volcker suggested that the Eurozone should either become more integrated or less integrated, as the current situation is unsustainable. He did not provide specific recommendations on which direction the Eurozone should take.

Advice for the UK Government on Bank Splitting:
Volcker did not provide any specific advice for the UK government’s committee looking into the possibility of splitting up banks.

Europe’s Monetary Integration:
Volcker believes Europe needs to decide whether to pursue more integration or less. He acknowledges that the euro was initially driven by political motives, specifically the desire to strengthen ties between Germany and France. He questions whether a common currency and monetary policy can coexist without a common government. Volcker respects Europe’s sovereignty and does not want to influence their decisions.

Splitting Up Banks in the UK:
Volcker suggests that the UK government could consider reforms similar to those being discussed in the United States. He emphasizes that he has not been asked to chair the commission exploring this issue in the UK.

US Financial Reform Efforts:
Volcker expresses frustration that the US government has not been at the forefront of international reform efforts. He cites the lengthy vacancies in key Treasury positions, which have hampered the US’s ability to address financial issues effectively. Volcker hopes that the recent appointment of undersecretaries will improve the US’s role in promoting international consistency in financial regulation.

Prop Trading and Market-Making:
Volcker acknowledges the difficulty in clearly distinguishing between proprietary trading and market-making activities, especially in complex financial institutions. He suggests that simple cases may be easier to identify, but it becomes challenging in more intricate situations.

Defining Proprietary Trading:
Proprietary trading involves a bank speculating for its own benefit, distinct from customer-related trades. Historically, some banks had separate proprietary trading desks, but this practice has declined due to regulatory scrutiny. Hedge funds and equity funds have a defined organizational structure and are not considered proprietary trading under the proposed rule.

Identifying Proprietary Trading Disguised as Customer Trading:
Excessive trading activity relative to the bank’s size and customer base may indicate proprietary trading. Volatility in daily results suggests unhedged position-taking, a characteristic of proprietary trading. Experienced traders can often recognize proprietary trading by observing a trader’s behavior and market activity.

Regulatory Response to Suspected Proprietary Trading:
Regulators can impose special reserve and capital requirements on banks suspected of engaging in proprietary trading. This approach is consistent with ongoing discussions in Basel regarding higher capital requirements for trading activities. The capital requirement may become punitive if the bank is found to be engaging in significant proprietary trading under the guise of customer trading.

Discussion on Inflation:
Volcker expressed his personal belief that inflation in the United States is unlikely to return during his lifetime. This opinion was prompted by a question during a fundraising event for salmon conservation, where the conversation shifted to the financial system. The discussion was cut short due to time constraints, and the audience was advised to leave promptly.