Paul Volcker’s Previous Speech to the Economic Club of New York:
Paul Volcker’s first speech to the Economic Club of New York was over 30 years ago, when he was the newly minted president of the Federal Reserve Bank of New York. He addressed the concern that New York City was unable to finance itself, leading to fears of a financial crisis in the already weakened economy.

Calls for Federal Reserve Intervention and the Resulting Moratorium:
There were urgent calls for the Federal Reserve to intervene using emergency lending authority enacted during the Great Depression. The idea of enforcing discipline and avoiding bailouts led to the city declaring a moratorium on its short-term debt.

Eventual Government Support and New York City’s Recovery:
After a contentious political debate, the federal government provided limited liquidity support with strict conditions. With new management and strict oversight, New York City regained its financial footing and flourished as a world financial center.

Relevance to Today’s Financial Turmoil:
Volcker drew parallels between the New York City crisis and today’s financial turmoil. Prior to the New York City crisis, the country had been free from any clear sense of financial crisis for more than 40 years.

Background and Context:
In the past 25 years, there have been five severe financial breakdowns, indicating a fundamental issue.

Changes in the Financial System:
The financial system has shifted from a commercial bank-centered, regulated model to a complex, highly engineered system. Financial intermediation has moved beyond official oversight, involving trillions in derivative instruments.

Economic Impact and Profitability:
Finance has accounted for a substantial portion of corporate profits, but economic growth and productivity have not surpassed previous decades. Prosperity is less widely shared compared to earlier periods.

Current Crisis Characteristics:
Complexity, opaqueness, and systemic risks have complicated responses to the crisis. Normal trading relationships among established institutions are in question. Mutual trust among market participants, essential for a strong financial system, is at risk.

Federal Reserve Actions:
The Federal Reserve has taken actions beyond its traditional powers to address the crisis. Lending directly to non-banking financial institutions raises concerns about future implications. Mortgage and mortgage-backed securities transfers to the Federal Reserve test central banking principles.

Lessons and Implications:
The crisis highlights the need for full debate and legislative review of Federal Reserve actions. The complexity of derivatives and securitization contributes to the crisis’s challenges. There are concerns about the proper use of government power and lobbying interests.

Conclusion:
The financial crisis is not just about financial structure and regulation but requires a comprehensive response. Market exuberance and excessive risk-taking often precede financial crises.

Financial Excesses and Imbalances:
The recent financial crisis, like the New York City crisis, resulted from excessive spending and borrowing, leading to unsustainable financial structures. The United States became addicted to spending and consuming beyond its capacity, leading to a lack of personal savings, rising imports, and a trade deficit. Other countries and investors financed this spending by buying Treasury securities, financing home buyers and banks, and investing in businesses.

Breaking Points and Adjustments:
Financial crises are recurrent in free and open capital markets, and the 40 years of relative tranquility were an exception. The subprime mortgage crisis exposed the excesses of the housing market, leading to painful but necessary adjustments in the economy.

Risks in Financial Intermediation:
Financial intermediation involves inherent risks, such as credit and maturity risks, in reconciling the need for funds with the demand for safe and liquid assets. Traditionally, commercial banks, savings institutions, and insurance companies absorbed these risks under comprehensive regulation.

The New Paradigm of Open Markets:
In the new paradigm, financial intermediation has shifted to open markets, aiming to minimize risk by separating maturity and credit risks and slicing and dicing obligations. Trading is encouraged through sophisticated packaging and derivatives, but this has led to thin capital positions and high leverage.

Challenges in the Lending Process:
The intellectual rationale for this approach is to encourage arbitrage and enhance market efficiency. However, it lacks two practical imperatives: clear lender responsibility for judging creditworthiness and the secondary market’s ability to appraise the nature and value of acquired credits.

Current Market Vulnerabilities and Supervisory Issues:
Market vulnerabilities include the retention of significant parts of the loan or loan packages by the originator, the reliance on credit rating agencies, and the complexity of financial engineering. Supervisory lapses include the inability of established agencies to keep up with complexities, fragmented responsibilities, and resistance to change.

Compensation Practices and Incentive Misalignment:
Pervasive compensation practices reward successful trades and loan originations but often fail to impose symmetrical losses for failures. Compensation committees and consultants struggle to break the pattern of misaligned incentives.

Reform Challenges:
Intelligent reform will be lengthy and arduous, requiring time for debate and maturation. Immediate ad hoc approaches need to be taken while considering long-term solutions.

The Federal Reserve’s Role in the Mortgage Market:
The Federal Reserve has been burdened with restoring liquidity to the mortgage market despite the existence of large, long-standing institutions like Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. The role and structure of these government-sponsored agencies need to be reconsidered during financial reform.

The Future Role of the Federal Reserve:
The Federal Reserve’s role as lender of last resort, regulator, and supervisor is being examined. Extending the Fed’s regulatory responsibilities to investment banks and beyond requires careful consideration.

Urgency for Reform:
Recent developments justify a sense of urgency in addressing the challenges in financial reform.

Clarifying the Federal Reserve’s Role:
The Federal Reserve’s role as lender of last resort and regulator requires clarification, especially in light of recent actions that suggest investment banks of systemic importance should be privileged during times of stress.

Defining the Universe of Systemic Institutions:
It is crucial to define the universe of institutions considered systemically important to determine which ones should be eligible for borrowing privileges during times of stress.

Oversight and Regulation Responsibilities:
If the Federal Reserve is to have clear authority to oversee the financial system, it needs to take direct responsibility for oversight and regulation of institutions deemed systemically important.

Internal Reorganization of the Federal Reserve:
To effectively carry out its oversight and regulation responsibilities, the Federal Reserve needs to undergo internal reorganization to provide clear lines of accountability and a stronger, larger, and more experienced professional staff.

Alternative Approach: Consolidating Supervisory Responsibilities:
Alternatively, all supervisory and regulatory responsibilities for safety and soundness could be consolidated into a single super agency, similar to approaches taken in the UK and other countries.

Importance of Liaison and Cooperation:
If a super agency approach is adopted, close liaison and cooperation with the central bank would be essential, as highlighted by recent UK experiences.

Volcker’s View on Regulatory Reform:
Volcker emphasizes the need for comprehensive regulatory reforms to address the shortcomings exposed during the recent financial crisis. He highlights the importance of ensuring that regulation is not overly intrusive or arbitrary, balancing the need for stability with the creativity and value that venture capital and equity funds bring to the market. Volcker cautions against excessive leveraging by hedge funds and stresses the need to mitigate systemic risks posed by their potential failure.

Importance of International Collaboration:
Volcker recognizes the significance of international cooperation in regulatory efforts, particularly in areas such as capital requirements for banks, accounting standards, auditing practices, and settlement arrangements for derivatives. He commends the progress made in these areas under the auspices of the G7 and other international forums.

Critique of Regulatory Laxity:
Volcker criticizes the toleration of lax regulation and competition in financial markets, emphasizing that it is not a sustainable approach. He dismisses the notion that European regulators might be more lenient than their American counterparts, expressing confidence in their commitment to effective regulation.

Emphasis on Central Bank’s Role in Economic Stability:
Volcker reiterates the critical responsibility of central banks, especially the Federal Reserve, in maintaining economic balance and moderating self-reinforcing enthusiasm or fears that can lead to financial crises. He emphasizes the importance of prioritizing price stability and maintaining a reliable currency worthy of trust and confidence, both domestically and internationally.

Caution against Inflationary Pressures:
Volcker expresses concern about the potential for inflationary pressures amidst the current economic turmoil and the weakened dollar. He stresses the need to decisively address emerging inflationary risks by demonstrating a commitment to maintaining price stability.

Recognizing the Positive Outcomes of Turmoil:
Volcker acknowledges the positive aspects of the market turbulence, including the penalization of market excesses, the exposure of excessive leveraging, and the alignment of spending and consumption with production capacity. He sees an opportunity to lay the foundation for sustained growth and stability by implementing necessary regulatory reforms.

Volcker’s Endorsement of Barack Obama:
Volcker admits to initially endorsing Barack Obama’s presidential candidacy without thoroughly examining his economic program or voting record. He explains his support based on his dissatisfaction with the country’s direction, the decline in public trust in government, and the need for a change in the political climate. Volcker observes a generational divide in the early election returns, with younger voters favoring Obama, and expresses hope for the future.

Volcker’s Concerns about Inflation:
Volcker expresses concern about the potential for inflation, drawing parallels between the current situation and the early 1970s. He emphasizes the need to prevent the buildup of inflationary expectations and the importance of considering inflationary risks in policy deliberations.

Volcker’s Views on the Dollar Crisis:
Volcker clarifies that he had predicted a “crisis time,” not specifically a dollar crisis, four years ago, and considers the current situation to be a crisis.