Paul Volcker’s Introduction:
Kishore Mabubani introduces Paul Volcker, lauding his accomplishments as Chairman of the Fed and his profound impact on the economy.

Volcker’s Reflections on the Crisis:
Volcker acknowledges the magnitude of the financial crisis, describing it as unprecedented and beyond the influence of individual leaders. He highlights the rapid decline of prominent investment banking houses and government interventions to stabilize the financial system.

Global Cooperation and Government Intervention:
Volcker emphasizes the need for coordinated action among developed countries to address the crisis. He discusses government measures such as deposit guarantees, liquidity injections, and interventions in the mortgage market.

Necessity of Government Intervention:
Volcker expresses discomfort with government intervention and guarantees, as they deviate from free-market principles. However, he acknowledges their necessity in restoring stability and confidence in financial markets.

Analogy of the Financial System:
Volcker compares the financial system to a patient in the emergency ward, requiring intensive care for a considerable period.

Managing the Crisis and Avoiding Recession:
Volcker stresses the importance of understanding the causes of the crisis and preventing severe damage to the real economy. He anticipates a recession but believes it can be managed with determined government commitment.

Causes of the Crisis:
Volcker acknowledges that free financial markets have inherent volatility and recurrent crises. He suggests that this crisis is exceptional, likely causing damage to the real economy and leading to a recession.

Trends and Imbalances:
The United States spent more than it produced, resulting in a significant current account deficit, leading to reliance on foreign borrowing. Consumption in the US rose exceptionally high, exceeding its normal level by 5%.

Financial Developments:
Extraordinary gains in the stock market in the 1990s gave a false sense of wealth, reducing the need for savings. Low interest rates and easy credit creation further fueled the consumption binge. Rising house prices and housing construction provided a new source of comfort and perceived stability.

Subprime Mortgages and CDSs:
Subprime mortgages emerged, providing loans to homeowners who couldn’t afford them, leading to a trillion-dollar market. Credit default swaps (CDSs) became popular, acting as insurance policies for bonds in default, reaching $60 trillion outstanding in 2007.

Potemkin Village:
The financial markets resembled a fragile Potemkin village, disguising a weak foundation of credit, particularly subprime mortgages. The decline in housing prices and rise in foreclosures weakened the foundation, triggering the crisis.

Regulatory Failures:
Banking regulators and supervisors failed to adequately oversee the market, particularly in areas outside the closely supervised banking sector. Credit rating agencies also failed to accurately assess the risks associated with subprime mortgages and CDSs.

Underlying Enabling Conditions for the Crisis:
Financial Engineering and Complexity: A new profession of financial engineers emerged, specializing in complex credit market instruments. The intent was to eliminate excessive risk and sell them to sophisticated investors. However, the complexities made markets opaque and difficult to analyze, leading to unnoticed weaknesses. Excessive Compensation: High compensation for financial leaders, traders, and others created incentives for risk-taking. There were few penalties for losses, resulting in a machine that exaggerated market movements.

Current Situation and Priorities:
Stabilizing the System: The primary focus is on stabilizing the financial system through heavy governmental intervention. This is necessary despite concerns about government intrusion in private markets. Global Reach of Large Banks: A dozen or so large banks operate in many countries, making them interconnected and vulnerable to global financial crises.

The Nationalization of Banks:
Large banks have been nationalized due to their guaranteed liabilities and government capital support. This step toward nationalizing private financial markets is unprecedented in developed countries.

Economic Recession and Stimulus Measures:
The decline in house prices has not yet ended, indicating more losses to come. The economy is in recession, requiring stimulus measures despite the budget’s current condition. More bad loans are expected as the recession persists, making a quick and strong recovery unlikely.

Rebuilding the Financial System:
The financial system needs to be rebuilt from the ground up. The large independent investment banks no longer exist. The big international commercial banks are growing larger by absorbing vulnerable firms. Smaller, purely private institutions have emerged from the crisis in better shape and are playing a larger role in the economy.

Challenges of the Future:
The reliance on a small number of huge institutions supported by the government is not a stable or desirable long-term solution. These institutions are prone to conflicts of interest due to their multiple roles as lenders, traders, and investors. Weaning these institutions from government support and ensuring financial stability is a significant challenge.

Extension of Government Supervision:
Stronger regulation and supervision are needed, including for hedge funds and equity funds. Capital limits for leverage funds and liquidity requirements should be implemented. Balancing government oversight with the strength of the private sector is essential.

Perverse Incentives of Compensation:
The perverse incentives of compensation that have exalted risk over prudence need to be addressed. Financial ups and downs and crises are inevitable, but the recent structure has been excessively fragile and overextended.

Conclusion:
The financial structure must be rebuilt to prevent future economic damage from fragile and opaque financial systems. The rebuilding process will require international cooperation, innovative thinking, and a clearer understanding of the risks involved.

Overview:
This chapter offers insights into the causes of the 2008 financial crisis, its potential impact on globalization, and how it relates to the Austrian School of Economics.

Key Points:

Warning Signs and Missed Opportunities:
Paul Volcker had warned of an impending crisis in 2005 due to excessive risk-taking in the financial sector. Despite these warnings, many financial institutions continued to engage in risky practices due to the allure of short-term profits.

Globalization and the Crisis:
The financial crisis highlighted the interconnectedness of global financial markets. The crisis had significant impacts beyond the United States, affecting Europe and other countries. While this crisis reinforced the need for caution, it is unlikely that globalization will be reversed due to technological advancements and market integration.

Trade Liberalization and the Crisis:
The crisis may lead to pressures against trade liberalization if the recession persists. However, it is unlikely that there will be a reversal of trade liberalization, as markets are highly integrated and shutting them off is no longer feasible.

Views on Alan Greenspan:
Paul Volcker declined to comment on his successor, Alan Greenspan’s, performance as Chairman of the Federal Reserve. He acknowledged that during Greenspan’s tenure, there were both positive and negative developments in the economy.

Austrian School of Economics:
The crisis brought renewed attention to the Austrian School of Economics, which emphasizes the role of individual incentives and market forces. Some argue that the crisis is a vindication of the Austrian School’s critique of central bank intervention and monetary manipulation. Volcker, who had studied under an Austrian economist early in his career, acknowledged that the Austrian School may offer valuable insights into the crisis.

Conclusion:
This chapter highlights the complexities and far-reaching effects of the 2008 financial crisis. Experts continue to debate its causes and implications, with discussions ranging from globalization to economic theories. Understanding these perspectives is crucial for shaping policies and preventing future crises.

Credit Creation and Economic Imbalance:
Paul Volcker highlights the significant increase in credit creation in the United States, resulting in a threefold rise in credit outstanding relative to the Gross Domestic Product (GDP).

Financial Leverage and Asset Risk:
This excessive credit creation led to financial firms, investment banks, and commercial banks leveraging their balance sheets on both the liability and asset sides.

Economic Consequences of Excessive Credit:
Volcker emphasizes that the easy credit environment and lack of perceived risks led to a situation where financial institutions lacked sufficient capital to support their credit obligations.

Inflation Concerns in Light of Monetary Policy:
Despite the massive money infusion into the economy, Volcker does not foresee a near-term inflation problem due to the prevailing recessionary conditions.

Importance of Inflation Control:
He stresses the need to be vigilant against inflation once the economy recovers from the recession, drawing from his experience as the “great inflation slayer” in the early 1980s.

Recession vs. Stagflation:
Volcker predicts a period of recession rather than stagflation, emphasizing the potential severity of the economic downturn.

Nationalization and Privatization of Banks:
Volcker comments on the irony of Western governments partially nationalizing commercial banks while China and Vietnam were previously engaged in privatizing state-owned banks.

Need for Balanced Financial System:
He questions whether the “middle ground” between nationalization and privatization is a stable solution, suggesting that lessons can be learned from the Chinese and Vietnamese experiences in denationalizing their financial systems.

Restoring Private Finance:
Volcker expresses doubts about learning from the Chinese model and hopes they continue to enhance the flexibility and privatization of their financial system.

Liquidity Trap and Recovery Duration:
Volcker does not believe the US economy is currently in a liquidity trap and refrains from making a specific forecast on the duration of the recovery.

Volcker’s Perspective on the Liquidity Trap:
Volcker argues that the current economic situation is not a liquidity trap in the traditional sense, where low interest rates fail to stimulate borrowing due to economic depression. Instead, he emphasizes that the problem lies in the lack of willingness to lend, rather than a lack of demand for borrowing. Volcker suggests that this “trust gap” or “confidence gap” hinders lending, despite efforts by central banks to provide liquidity.

Addressing the Trust Gap and Confidence:
Volcker stresses the importance of restoring confidence in the financial system, particularly among large banks, to encourage lending and restore economic activity. He highlights the role of governmental capital and deposit protection in facilitating this process and restoring trust in the banking sector.

Longevity of the Current Economic Situation:
Volcker acknowledges that the current economic situation is not a short-term issue and will require sustained efforts to address. He emphasizes the need to focus on restoring confidence and trust among financial institutions as a crucial step toward economic recovery.

Volcker’s Concerns about Inflation and the US Dollar:
Volcker expresses his concerns about the potential for inflation and the stability of the US dollar, given the significant monetary and fiscal interventions. He acknowledges that his past experiences with inflation and the dollar’s fluctuations influence his perspective on these matters. Despite his concerns, Volcker finds reassurance in the global recognition of the US dollar as a reserve currency and its role in facilitating international trade.

Weakened Financial System:
The American financial system has been under significant attack and is in a weakened position. The prospect of a recession and uncertainties have led to a strengthened dollar as people seek safety and confidence. There is a feeling that the United States’ weight as an economy and its record in rule of law and government stability are still strong.

Bank Exposure and Size:
There is growing scrutiny of the exposure of various countries and their banks relative to the size of their economies. The United States has a big financial problem with very large institutions and significant money involved. Despite this, the size of the financial problem in the United States is smaller compared to many other countries, including European countries.

Bank Failures and Government Intervention:
There is a debate on whether unfit banks should be allowed to fail due to their unfitness. Governments have decided to prop up unfit banks to avoid the significant short-term pain of a large bank failure, which could undermine long-term gain. This decision is considered reasonable, given the potential consequences of a bank failure.

Moral Hazard and Creditor Comfort:
Allowing big banks to fail, as seen with Lehman Brothers, reinforces the idea that these institutions will be protected during crises. This creates moral hazard, where lenders may engage in less prudent practices, expecting government intervention. Creditors may become more comfortable with lending to these banks, potentially leading to less vigilance in assessing credit risks.

Long-Term Consequences:
The long-term problem of moral hazard and its impact on lending practices may not be a determining factor in today’s decision-making. Short-term concerns and immediate economic issues take precedence over long-term consequences.

Gold Standard Currency:
The question of reinstating the gold standard currency is raised. Various currencies, including the US dollar, renminbi, euro dollar, Japanese yen, and Singapore dollars, are mentioned as potential candidates for a gold standard.

Fairness and Appropriateness:
The fairness, appropriateness, and timing of reinstating a gold standard currency are brought into question.

Strategic Maneuverability and Free Trade:
Strategic maneuvering by Wall Street financial dealers, taking advantage of free trade mechanisms, is mentioned as a factor in economic issues between China and the West. The speaker implies that China’s awareness of these practices may be a reason for maintaining the inconvertibility of the renminbi.

In Summary:
The discussion focuses on the implications of moral hazard resulting from protecting big banks during crises. The long-term effects of such actions are acknowledged but not seen as immediately relevant. The question of reinstating a gold standard currency is raised, with implications for fairness, appropriateness, and timing. Strategic maneuvering and free trade mechanisms are mentioned in the context of economic issues between China and the West.

Gold Standard:
Paul Volcker does not support the return of the gold standard due to the lack of confidence in gold and the unwillingness of countries to undertake such an obligation.

US and China’s Economic Imbalance:
The United States spends 70% of its GDP on consumption, while China spends only 35%. This imbalance contributes to the trade deficit between the two countries and the global economic crisis.

Global Recession:
Volcker believes that the United States and Europe are entering a recession of unknown duration.

IMF’s Economic Outlook:
The IMF’s prediction that the global economy will grow at 3% and that developing countries will not be significantly affected is questionable. Volcker emphasizes that emerging economies have been performing better than developed economies.

Subprime Mortgage Crisis:
The IMF estimates that there are $1.4 trillion in delinquent subprime mortgages, while the BIS and OECD estimate it to be around $400 billion. Volcker acknowledges that there is a growing number of delinquent mortgages but cannot provide a specific figure. He emphasizes that the $60 trillion in credit default swaps is a different type of instrument and that a large portion of it is hedged and could be netted.

CDSs and CDOs:
Volcker suggests that it may be possible to treat CDSs and CDOs as a type of asset that can be “sheared off” to address the global economic crisis.

Paul Volcker’s Views on Credit Default Swaps:
Credit default swaps caused more trouble than they were worth. The financial system could function without a market for credit default swaps. Warren Buffett’s famous remark: “They’re weapons of mass financial destruction.”

Arun Desai’s Question about Saving Lehman:
What would have happened if the Fed had saved Lehman instead of letting it fail? Paul Volcker’s response: It’s a question he doesn’t know the answer to. Saving Lehman might have helped restore confidence, but it’s uncertain.

Ramya from DBS Bank’s Question about Global Savings Glut and Bubbles:
Are property markets around the world in a bubble due to global savings glut? Paul Volcker’s response: He doesn’t know the answer. He emphasizes that the financial engineering and compensation practices were key factors in the crisis, not just American overconsumption.

Paul Volcker’s Clarification on American Overconsumption:
The underlying imbalance between American overconsumption and underconsumption was important. Financial engineering and compensation practices enabled this disequilibrium to continue, leading to the crisis.

Volcker’s Views on Causes of Financial Crisis:
The financial crisis was triggered by weaknesses within the financial system, particularly the subprime market in the United States. Other countries, like the UK and Spain, also experienced real estate problems, but to a lesser extent.

UN’s Role in Financial Crisis:
Volcker believes the UN should not be involved in resolving the financial crisis. He argues that the UN is not equipped to handle such complex economic issues and has enough problems resolving issues within its own field.

Response to Jim Rogers’ Argument:
Volcker disagrees with Jim Rogers’ argument that governments should let the free market resolve the crisis. He believes the risks of leaving the crisis to the free market were too great and that government intervention was necessary.

Central Bank Monetary Easing:
Volcker acknowledges the existence of a liquidity problem, where central banks are pushing money into the market but people are not lending it. However, he cautions against labeling the situation as a “liquidity trap” in the classic sense.

Greed as a Root Cause:
Volcker agrees that greed played a significant role in the financial crisis. He believes excessive greed and risk-taking were encouraged by a system that made it too easy to profit from risky financial instruments.

Asian Bankers and Financial Derivatives:
Volcker is not convinced that bankers in China and Singapore are immune to the risks of financial derivatives. He acknowledges their potential knowledge and skills but highlights the complexity and opaque nature of these instruments, suggesting that even experts can struggle to fully understand them.

Compensation Policies and Reforms:
Concerns about the current compensation structures in financial institutions and their contribution to the financial crisis are prevalent. Paul Volcker acknowledges the need for restructuring compensation practices to discourage excessive short-term rewards without consideration for long-term consequences. The issue of appropriate compensation levels remains a challenge without clear answers. Government involvement in banks, whether through ownership or protection, necessitates consideration of compensation practices. The recently passed American law requires a review of compensation practices in government-supported banks, but its implementation details are unclear.

Social Cohesion and Inequality:
The impact of the financial crisis on social cohesion is a relevant concern. In the United States, the crisis has exacerbated income inequality and increased disparities between the wealthy and the working class. Some argue that the crisis has also led to a sense of solidarity and unity among certain segments of society, particularly those affected by the economic downturn. Kishore Mabubani highlights the importance of addressing income inequality and promoting social mobility to mitigate the negative consequences of the crisis on social cohesion.

Stagnant Real Income and Increased Wealth Inequality:
Paul Volcker highlighted the lack of real income growth for most people in the past 10-15 years, contrasting it with the substantial income increase experienced by the top 1%.

Political Reaction to Income Disparity:
Volcker observed that there was limited political or public response to this income disparity, with a perception that the wealth at the top was justified and the economy was performing well.

Economic Downturn and Public Debate:
The recent economic downturn has led to increased noise and debate about income inequality, with political discussions on how to address it gaining traction.

Compensation and Public Policy:
The issue of compensation in the financial industry was raised, specifically regarding the lack of sufficient compensation for UK FSA employees supervising complex financial products.

Public Policy Dilemma:
The dilemma lies in balancing the need for skilled professionals in the public sector with the government’s inability to match the compensation offered by the private sector, potentially leading to a talent drain.

Moral Hazard and Policymaking:
The question of moral hazard was brought up, particularly in the context of the US government’s decision to intervene and help Merrill Lynch and AIG while letting Lehman Brothers fall.

Policymakers’ Challenge:
The challenge for policymakers is to determine when to intervene and how to avoid creating moral hazard, especially when financial institutions face difficulties.

Paul Volcker’s Response to Questions:
Paul Volcker acknowledged the issue of moral hazard and the challenge of overcoming it during the financial crisis. He mentioned the ongoing debate about executive compensation in banks receiving government assistance, with some governments implementing policies to restrict bonuses and separation pay. Volcker highlighted the unresolved issue of executive compensation at Fannie Mae and Freddie Mac, emphasizing the complexity of the matter.

Questions from the Audience:
1. Rick Ram: Inquiry about Paul Volcker’s recommendations for tackling a potential recession in Singapore, to which Volcker responded that he had none.
2. Timothy: Questioned whether governments should intervene to identify and deflate real estate bubbles to prevent their growth and subsequent collapse.
3. Dr. Lim from FX1 Academy: Sought insights into the future of the currency market, considering liquidity and currency trading in the current scenario.
4. Anonymous Speaker: Asked about the role of the Federal Reserve (Fed) in the financial crisis, specifically regarding its policies during the housing bubble and the subsequent crisis.

Additional Questions:
An anonymous speaker inquired about the role of monetary accommodation in the housing bubble and subsequent crisis, citing Milton Friedman’s perspective.

Volcker’s Approach to Economic Issues:
Volcker emphasizes the difficulty in addressing economic issues like recessions and property bubbles. He acknowledges that straightforward answers may not always be available.

Property Bubbles:
Volcker views property bubbles as challenging for monetary policy and central banks to address, as they frequently occur on a small scale. He suggests that if a bubble becomes large enough to potentially destabilize the economy, it cannot be ignored and should be modified using available policy tools.

Currency Market:
Volcker expresses concern about the instability and passivity in the currency market, calling for reforms to address excessive volatility. He believes governments should take a more active role in managing currency markets rather than leaving it entirely to central banks.

Central Bank Intervention:
Volcker highlights the involvement of finance ministries and treasuries in market interventions, emphasizing that such actions should be undertaken by governments rather than central banks. He stresses the importance of preserving the independence of central banks and maintaining a clear distinction between governmental and central bank responsibilities.

Volcker’s Public Service Beliefs:
Volcker is a strong advocate for public service and emphasizes the need for effective regulatory agencies and government institutions to complement well-functioning markets. He expresses concern about the erosion of credibility in public institutions and supports initiatives like the Lee Kuan Yew School of Public Policy to strengthen public service and governance.