Introduction:
* Chris Paxson, Dean of the Woodrow Wilson School, welcomed attendees to the sixth and final panel discussion on financial market regulation and reform.
* Paxson thanked John Corzine for organizing the lecture series and introduced Joshua Golden, a visiting professor and former director of the Office of Management and Budget.
* Paxson praised Golden’s contributions to the school and introduced the main speaker, Paul Volcker.

Volcker’s Opening Remarks:
* Volcker expressed surprise at being asked to give a speech and joked about signing away his rights.
* He contrasted the present day with his arrival at Princeton in 1945, highlighting the significant changes in the global landscape.
* Volcker emphasized that the United States is no longer the dominant global leader it once was, politically, economically, and militarily.

Global Economic Shifts:
* Volcker shared his recent experiences in meetings and visits to Asia, emphasizing the shifting global power dynamics.
* He noted that the United States is no longer in the same position it was in during his time as Chairman of the Federal Reserve in the 1980s.

Financial Market Regulation and Reform:
* Volcker stressed the importance of financial market regulation and reform in light of the changing global landscape.
* He called for a focus on promoting stability and resilience in the financial system.
* Volcker emphasized the need for global cooperation and coordination to address the challenges posed by interconnected financial markets.

Conclusion:
* Volcker concluded his remarks by emphasizing the need for thoughtful and comprehensive financial market regulation and reform.
* He urged attendees to consider the implications of the changing global landscape for the future of financial markets.

The Changing Global Economic Landscape:
Since 1990, the United States’ economic dominance has declined, while China’s has risen dramatically. Japan’s economic growth has slowed significantly since the 1990s. India’s economy is projected to grow significantly in the coming decades. Europe’s economic weight is expected to diminish relative to China’s.

The Financial Crisis and Its Impact:
The global financial system experienced a major collapse in 2008. The combination of recession and financial collapse has resulted in slow economic recovery. Unemployment rates remain high, and a return to pre-recession employment levels is not expected for several years.

Globalization and Its Effects:
Globalization has increased significantly in recent decades, particularly in financial markets. Globalization has had positive effects on emerging economies but has not led to widespread prosperity in developed countries. Typical household incomes in developed countries have not increased in real terms for over a decade. Income gains have been concentrated among the top 1% of the population, leading to concerns about stability and the payoff of globalization.

The Changing World Economy:
The world economy has seen a significant shift in recent decades, with emerging countries, particularly China, becoming economic powerhouses. The traditional dynamic where developed countries assist emerging countries during economic crises has reversed, with emerging countries now financing developed countries like the United States.

The United States’ Role in the World Economy:
The United States is no longer the dominant economic leader it once was, and its influence has declined in international forums like the G20. The US now finds itself in a position where it is being told what to do by other countries, particularly China. The US needs to take action to address its economic imbalances and regain its influence in the global economy.

Japan as a Harbinger for the United States:
Some economists see Japan’s economic struggles over the past few decades as a potential warning sign for the United States. Japan’s experience highlights the need for the US to address its economic imbalances and take steps to prevent a similar decline.

The United States’ Responsibility:
Despite the challenges, the United States has a responsibility to play a constructive and benign role in the global economy, as it has done for much of the past century. The US needs to take the lead in addressing global economic problems and fostering growth and stability.

Conclusion:
The world economy is facing significant challenges, and the United States needs to take action to address its economic imbalances and regain its influence in the global economy. The US has a responsibility to play a constructive role in the world economy and should work towards fostering growth and stability.

Misinterpretation of Japan’s Experience:
Japan’s economic stagnation in the last 15 years has been less severe than portrayed. Japan’s population decline of 1% annually has contributed to a per capita growth rate of 2% plus, which is comparable to the U.S. despite its lower overall growth rate of 1.5%. Japan’s unemployment rate, though higher than its historical average, remains relatively low at 4-5%.

Commonalities with the United States:
Both Japan and the U.S. experienced excessive bubbles in the stock market and housing market, leading to financial shocks. The severity of these bubbles and their impact on the financial system were more pronounced in Japan. The resulting financial crisis in both countries caused a lending freeze and economic sluggishness.

China’s Role in Global Economic Imbalances:
The global economy faces deep imbalances, primarily due to China’s low consumption and the developed world’s low savings. Addressing these imbalances is crucial for the health of the global economy.

Currency Manipulation and China’s Economic Growth:
Paul Volcker emphasizes that the term “currency manipulation” is politically charged and avoids using it. China actively maintains a stable exchange rate with the US dollar, resulting in an overvalued Chinese currency. China’s rapid economic growth and poverty reduction efforts necessitate maintaining this growth momentum.

China’s Export Dependency and Consumption Imbalance:
China’s economic growth is heavily dependent on exports, leading to global trade imbalances. Chinese consumption is significantly lower than in developed countries, creating an imbalance reflected in international trade. Volcker suggests that China needs to encourage greater consumption and reduce savings to rebalance its economy.

Global Economic Imbalances and Symmetry:
Other countries, including South Korea, criticize the United States for its high fiscal deficit and financial excesses. The United States and China share responsibility for addressing their respective economic imbalances. Volcker believes that China should accelerate its shift towards domestic consumption, but this alone will not resolve global imbalances.

Complementary Actions by the Rest of the World:
Volcker emphasizes the need for coordinated global efforts to address economic imbalances. The rest of the world must take complementary actions to support China’s rebalancing efforts. Global cooperation is crucial for achieving sustainable and balanced economic growth.

Causes of Financialization:
Innovation in the financial sector led to high profitability and incomes for some participants. Bright individuals with backgrounds in engineering, mathematics, and physics were attracted to the financial industry due to its perceived high earning potential.

Consequences of Financialization:
The financial sector’s contribution to GDP, measured by value-added, almost doubled in a 15-year period. However, when adjusted for inflation, the increase was less significant, raising questions about the actual contribution of financial markets to economic growth. The complexity and interconnectedness of financial markets led to systemic risk, which became evident during the financial crisis.

Innovations in Financial Markets:
New financial instruments and techniques, such as derivatives, were developed to manage risk more effectively. These innovations were initially perceived as a way to defuse risk and protect the economy. However, the complexity of these instruments and their interconnectedness contributed to the severity of the financial crisis.

Challenges and Reforms:
The financial crisis exposed the limitations of analytical approaches used to assess risk in financial markets. There is a need for reforms to address the systemic risks and ensure the stability of the financial system.

Human Institutions vs. Physical Phenomena:
Financial markets, unlike physical phenomena, are driven by human behavior and psychology.

Humans React to Past Events and Market Conditions:
Market participants base their decisions on historical data and current market conditions. Rapid trading and short-term reactions can lead to extreme fluctuations.

Overreliance on Models and Contagious Behavior:
Overreliance on mathematical models can overlook human behaviors, leading to dangerous market conditions. Contagious market behavior can exacerbate fluctuations and make markets more volatile.

The Need for Adjustment:
Financial markets require adjustments to address these inherent limitations. A focus on fundamental value rather than high returns can lead to more stable markets.

Balancing Sophistication and Simplicity:
Financial markets should not be overly complex and should focus on providing consistent returns. Aiming for unrealistic returns often leads to unsustainable practices and market breakdowns.

Financial Innovation Skepticism:
Paul Volcker expressed skepticism towards financial innovation, particularly credit default swaps (CDSs).

CDSs: Origins and Purpose:
CDSs were invented around 1995 to address the need for hedging against corporate loans and securities. The initial intention was to provide insurance protection against adverse credit movements.

CDSs: Rapid Growth and Excess:
By 2008, the nominal value of CDSs reached $60 trillion, significantly exceeding the $10 trillion value of the underlying debts. This excessive use of CDSs raised concerns about their true purpose and potential risks.

Milquetoast Reforms:
Volcker attended a meeting where financial market experts discussed the need for reforms. The proposed reforms, such as improved corporate governance, were considered insufficient to address the systemic problems.

Financial Markets’ Self-Importance:
Volcker criticized the financial markets’ self-importance and their claims of driving global productivity. He argued that the only recent financial innovation that genuinely contributed to economic productivity was the automatic television.

Quantitative Easing Reaction:
Volcker did not elaborate on his reaction to the Fed’s quantitative easing policy. He emphasized that he would provide his thoughts on the matter later in the discussion.

Quantitative Easing (QE2):
QE2 involves the Federal Reserve purchasing long-term Treasury bonds to lower interest rates and stimulate the economy. Volcker does not object to the policy but questions its effectiveness given the low interest rates. He views it as a reasonable approach and compares it to the Federal Reserve’s actions during the financial crisis, which were more unprecedented.

China’s Currency Appreciation:
China maintains an undervalued currency, benefiting its exports and hurting American consumers. Volcker argues that China’s professed objective of increasing consumption and helping consumers would be aided by an appreciation of the Renminbi (RMB). However, China has other priorities and is hesitant to revalue the RMB significantly. A gradual revaluation could worsen the situation as speculators anticipate further appreciation.

Federal Reserve’s Role:
Volcker discusses the Federal Reserve’s historical involvement in buying Treasury bonds as a normal policy to influence interest rates. He emphasizes that the recent actions under QE2 are not as significant as the unprecedented measures taken during the crisis. The Federal Reserve’s focus is not on manipulating the dollar but on stimulating the economy.

Currency Exchange Control:
China maintains controls on investing in China, specifically investing in currency. The US has been urging China to remove these controls, but China is hesitant due to concerns about the potential impact on its economy. China’s concern is that removing the controls suddenly could lead to a rapid appreciation of the RMB, which could hurt export industries and slow economic growth.

Volcker’s View on the Role of Finance in the Economy:
Volcker has been critical of the value-added role of finance in the economy. He believes that the financial sector has become too large and complex and that it has contributed to economic instability.

Potential Conflict of Interest:
There is concern about potential conflicts of interest when academics who research and advise policymakers on financial regulation also have financial ties to the regulated institutions. Critics point out that some professors have received funding from the very banks they are researching or regulating. While not all such relationships are necessarily problematic, there is a concern that they could lead to biased research and policy advice.

Business Schools’ Contribution to the Financial Crisis:
Paul Volcker criticizes business schools for promoting an economic theory that viewed financial markets as efficient, self-regulating, and possessed of rational foresight. This theory, promulgated by academic institutions, served as a convenient rationale for financial institutions and regulators, leading to the belief that the market could take care of itself and prevent crises. Business schools, motivated by profit and the desire to attract students, perpetuated this doctrine, training individuals who went on to work in the financial markets.

Personal Anecdote:
Volcker shares an email exchange with a friend who teaches at Harvard Business School, expressing concerns about the ethical sense and conflict of interest issues in financial markets. He points out the responsibility of business schools in propagating an economic doctrine that did not hold up well.

The Role of Economists:
Volcker acknowledges that economists often criticize the theories of the previous generation. He sees a positive trend in the emergence of a new crop of economists who are challenging the theories that prevailed 20 years ago.

Personal Experience During the Inflation Crisis:
Volcker was convinced that the United States was headed for economic trouble when he became Chairman of the Federal Reserve in 1979. He believed that the country had been living beyond its means and that inflation needed to be brought under control.

Former Federal Reserve Chairman’s Perspective on Inflation and Recession:
Paul Volcker emphasizes that by the late 1970s, inflation had reached alarming levels, causing economic distress and prompting the need to address the underlying issues. He refutes the notion that the Federal Reserve’s policies solely caused the recession, asserting that economic problems would have arisen regardless of interest rates.

Volcker’s Determination and Public Support:
Volcker expresses unwavering conviction in his approach, despite facing significant pressure and criticism. He highlights the public’s general recognition that something was amiss and their willingness to grant him a degree of support, acknowledging that addressing the problem would likely involve painful measures.

President Reagan’s Understanding and Support:
Volcker commends President Reagan’s intuitive grasp of the gravity of the inflation crisis. He acknowledges Reagan’s trust in the Federal Reserve’s efforts to combat inflation, even in the absence of a close personal relationship.

Importance of Public Understanding and Support:
Volcker stresses the necessity of public understanding and support for implementing challenging monetary policies. He emphasizes the need for the public to grasp the rationale behind policy decisions, as a lack of understanding can lead to severe difficulties.

Volcker’s Candor and Honesty:
The speaker expresses appreciation for Volcker’s candid and honest approach, recalling a similar demeanor during their previous encounter two decades earlier.

Bubbles:
It is challenging to recognize a bubble during its formation. Retrospectively identifying bubbles is easier than recognizing them in real-time. Policymakers face pressure to avoid bursting bubbles due to the perceived benefits associated with them, such as homeownership expansion. Bubbles often come with persuasive explanations justifying their existence.

Tax Cuts:
Extending President Bush’s tax cuts may not be the most effective approach to job creation during a recession. Profound tax reform is needed, prioritizing middle-income and lower-income individuals. Instead of extending tax cuts for the wealthy, the funds could be allocated towards infrastructure development.

Synthetic Investment Vehicles:
Synthetic investment vehicles, extreme derivatives, and credit default swaps contributed to the economic downturn and problems experienced in recent years. The complexity and interconnectedness of these instruments amplified the impact of the housing bubble’s collapse.

Financial Complexity and Interconnections:
The complexity and interconnections in the financial market, along with the obscurity inherent in these instruments, contributed to the severity of the financial crash.

Overuse of Financial Instruments:
Paul Volcker argues against the notion that financial instruments were overused, emphasizing that the principal agency problem played a significant role in the crash.

Principal Agency Problem:
The principal agency problem arises when the people making investment decisions (pension funds, mutual funds, etc.) do so through financial intermediaries who have their own interests and incentives, leading to excessive manipulation and fees.

Fees and Profit-Seeking:
The accumulation of fees charged by financial intermediaries, even small percentages, can amount to billions of dollars, contributing to the financial industry’s wealth.

G20 Concerns and Fed’s Lending:
China and Germany expressed concerns about the $600 billion printed by the Federal Reserve for the U.S. economy. The Fed also lent significant amounts of money to European banks, which Volcker does not consider a negative action.

Changing Role of the Fed:
A question is raised about whether the Fed, like Princeton University, has expanded its scope and influence beyond its original purpose.

Challenges of International Banking:
The current financial system lacks clear guidelines and established rules for handling situations where large international banks face financial distress. There is uncertainty regarding which country’s responsibility it is to bail out a failing bank with international operations. This issue became evident during the financial crisis when the Bank of England was unwilling to rescue the Royal Bank of Scotland, leaving the United States to intervene.

Moral Hazard and Taxpayer Burden:
A significant challenge in financial reform is addressing the issue of moral hazard and taxpayer bailouts of large financial institutions. The design of financial reform aims to develop a mechanism that allows failing banks to be resolved without taxpayer involvement.

Unresolved Issues:
The financial reform process faces unresolved issues, including determining who is responsible for bailing out international banks and how to effectively address the moral hazard and taxpayer burden associated with bailouts.

Volcker’s View on Bankruptcy of Financial Institutions:
Paul Volcker proposes a system where financial institutions can fail without causing market disruptions, involving a government-controlled process to handle liquidations and protect creditors. In the absence of such a system, institutions had to be rescued to prevent widespread panic, leading to the inclusion of non-traditional entities like General Electric’s finance company in government bailouts.

Future Expectations and the Role of the Government:
Volcker emphasizes the need to avoid creating a culture where financial institutions expect government bailouts. Better regulations should ensure that institutions can fail without jeopardizing the stability of the financial system.

Protecting Essential Financial Institutions:
The basic banking system, especially traditional banks, should be protected due to their vital role in the economy. Volcker supports measures to strengthen banks through capital requirements and regulations.

The Problem of Non-Bank Financial Activities:
Volcker criticizes banks engaging in activities that non-protected entities can perform, relying on taxpayer support. He advocates for separating protected banking activities from riskier non-bank activities.

Icelandic and Irish Bank Failures as Examples:
Iceland’s overly large banks led to international bailouts, with the UK and the Netherlands covering deposit liabilities. Iceland struggled to repay the debt. Ireland faced a similar situation with aggressive banks that made extensive investments abroad. The Irish government’s decision to protect depositors resulted in a significant increase in government debt, requiring assistance from Europe, particularly Germany.

Conclusion:
The discussion highlights the complexities of financial institution failures, the need for effective regulations, and the importance of protecting essential banking functions while addressing the issue of non-bank activities by banks.