Paul Volcker (USA Former Chairman of the Federal Reserve) – LSE Director’s Dialogue with Paul Volcker (Dec 2010)


Chapters

00:00:00 Economic Recovery Board: A Dialogue with Paul Volcker
00:02:44 Economic Recovery and Financial Reform
00:08:12 Taxation Debates and Potential Solutions
00:10:57 European Economic and Financial Crisis
00:18:29 Financial Reform Bill: Key Points and Controversies
00:22:14 Government Intervention and Risk in Financial Institutions
00:26:21 Volcker Rule Discussion: Regulatory Considerations
00:33:14 Central Banking's Role in Preventing Financial Crises
00:37:12 Addressing Global Macroeconomic Issues: Imbalances, Exchange Rates, and Adjustment
00:40:09 Reforming the International Monetary System: Challenges and Opportunities
00:43:47 Financial Value of Recent Innovations in Finance
00:47:23 Challenges and Solutions to Eurozone Integration
00:52:53 Defining and Distinguishing Proprietary Trading from Legitimate Market Making

Abstract

The Dynamics of Economic Recovery and Financial Reform: Insights from Paul Volcker – Updated Article

Introduction:

Amidst global economic uncertainty, this article explores crucial aspects of economic recovery and financial reform. It draws insights from a dialogue between former Federal Reserve Chairman Paul Volcker and Howard Davies, shedding light on economic recovery, the Eurozone crisis, regulatory reform, and the future of the financial sector. Volcker’s extensive experience and expertise provide a comprehensive perspective on the current economic landscape and potential paths forward.

Volcker’s Connection to LSE and Career Highlights:

Paul Volcker’s journey at the London School of Economics (LSE) in 1951 and 1952 as a Rotary Foundation ambassadorial fellow played a pivotal role in shaping his career trajectory. His time at LSE, though marked by limited financial resources, was highly influential in his subsequent achievements. Volcker rejoined the Federal Reserve in 1952 and rose to become its chairman. His expertise and experience have made him a sought-after advisor and mentor throughout his career.

Volcker’s Advice to Howard Davies:

When Howard Davies served as Deputy Governor of the Bank of England, he sought advice from Volcker regarding the formation of the Financial Services Authority (FSA). Volcker cautioned Davies about the challenges he would face in leading the FSA, emphasizing the need for resilience and a sense of humor to navigate the complexities of financial regulation.

Economic Recovery: A Slow and Complex Process

The US economy’s recovery from a severe recession has been sluggish, characterized by high unemployment and sluggish growth across various sectors. Volcker identified excessive consumption, low investment, and limited exports as major impediments to recovery. He stressed the need to shift focus towards increasing investment, improving competitiveness, and enhancing exports. Regarding fiscal deficits, Volcker pointed out the unsustainable nature of the current 10% GDP deficit, advocating for a comprehensive approach to address it.

Taxation and Spending: Seeking Balance in a Challenging Economy

The imbalance between tax revenues and government spending poses a significant challenge. With current spending at 25% of GDP, traditional sources of tax revenue fall short in addressing the budget deficit. Volcker suggested exploring new tax avenues like a value-added tax (VAT), carbon tax, or energy tax. These options, while potentially unpopular, may be necessary to bridge the fiscal gap.

The Eurozone Crisis: A Test of Unity and Financial Stability

Volcker’s analysis extends to the Eurozone crisis, emphasizing the lack of a unified government to enforce economic adjustments and fiscal discipline among member states. The existential crisis facing Europe, with the potential disintegration threatening the euro’s existence, underscores the need for deeper integration. The US, initially supportive of the euro, has grown more critical, with some economists adopting a “told you so” attitude towards the ongoing crisis.

Volcker expressed concerns about the Eurozone’s structural weaknesses, such as the lack of a common fiscal policy to complement its monetary policy and the failure to effectively enforce the Stability Pact, leading to unsustainable fiscal imbalances. He emphasized the need for Europe to make a critical decision on whether to pursue further integration or a less integrated eurozone, raising questions about the euro’s future. Volcker acknowledged the European authorities’ immediate response to the crisis, offering massive support programs to buy time and stabilize the situation. However, he stressed that this approach is temporary and does not address the underlying structural issues.

Central Bank Independence and Regulatory Reforms

The independence of central banks like the ECB and the Bank of England has been questioned due to their involvement in buying government bonds. Volcker argues that such actions are justifiable during extraordinary crises. In the US, the Dodd bill, including proposals supported by Volcker, signals a move towards significant regulatory reform. This bill, gaining momentum partly due to the Goldman Sachs incident, addresses critical issues like the regulation of credit rating agencies and the structure of the Federal Reserve.

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. During a crisis, central banks must respond to broader financial stability concerns rather than solely focusing on inflation control.

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. He 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.

Volcker discussed the initial political polarization surrounding the Dodd-Frank bill, with Republicans debating whether to oppose all of President Obama’s proposals. However, 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.

Addressing the “Too Big to Fail” Dilemma

A central problem identified by Volcker is the moral hazard created by the government’s response to the financial crisis, protecting institutions deemed “too big to fail.” He advocates for a resolution authority to intervene and liquidate failing financial institutions, eliminating protections for stockholders and management. This approach aims to mitigate the risk-taking behavior encouraged by implicit government protection.

Banks perform essential functions like running the payment system, providing credit, underwriting, and serving as a safe place for deposits. Disrupting these 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 cultures mix with traditional banking.

Volcker’s Argument:

Taxpayers should not protect banks’ speculative trading activities. Only a few large US banks have significant trading operations. European banks may have more 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 strictly. This would limit regulation intensity to those providing essential services. However, it raises concerns about regulating entities that do not pose systemic risks.

Volcker’s Perspective on Banking and Financial Stability

Volcker argues for separating commercial banks from riskier activities to enhance financial system stability. By limiting risk-taking and potential failures within commercial banks, the financial sector can be made more resilient. This separation would ensure that banks focus on their essential functions while restricting their involvement in speculative activities.

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

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 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.

Revisiting the International Monetary System

The international monetary system’s deficiencies, particularly evident in the context of US-China trade dynamics and the European debt crisis, call for fundamental reform.

Volcker highlighted the historical efforts to address asymmetrical adjustments between creditor and debtor countries. The recent surge in reserve accumulation and U.S. liabilities underscores the need for more profound changes in the system.

Global imbalances exist, such as between the U.S. and China and between Germany and Greece. These imbalances can lead to systemic problems. 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. The need to reevaluate the IMF’s role in addressing global macroeconomic imbalances is raised.

Paul Volcker’s Testimony on Proprietary Trading and Inflation

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.

A Call for Reform of the International Monetary System

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.

The Path Ahead for Economic Recovery and Financial Reform

In conclusion, Paul Volcker’s insights provide a roadmap for navigating the complexities of economic recovery and financial reform. From addressing the Eurozone crisis to rethinking the international monetary system and refining financial regulations, the challenges are manifold. As the world economy continues to evolve, the wisdom and experience of experts like Volcker will be invaluable in charting a course towards stability and prosperity.


Notes by: MythicNeutron