Paul Volcker (USA Former Chairman of the Federal Reserve) – On the current financial crisis (May 2012)
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Abstract
Paul Volcker, a prominent figure in economic policy, recently addressed critical issues in the financial world, drawing parallels between the current financial turmoil and past crises, notably the New York City fiscal crisis of the 1970s. In his comprehensive speech, Volcker criticized the evolution of the financial system, pointing out its complexities and systemic risks that have led to repeated crises. He highlighted the urgent need for comprehensive reform in financial regulation and oversight, emphasizing the Federal Reserve’s controversial role during these crises. His insights extended to broader economic impacts, including the looming inflation and potential dollar crisis, while expressing support for political change, symbolized by his backing of Barack Obama.
Article Body
Financial Crises and Systemic Breakdowns
Volcker’s insights began with a historical perspective, noting the regular occurrence of severe financial crises over the past 25 years. He drew attention to the fundamental issues within the financial system that have contributed to these crises, signaling the need for a significant overhaul.
Evolution of the Financial System
He critically examined the shift from a regulated, commercial bank-centered system to a complex, engineered one with significant intermediation beyond effective oversight. This transformation has introduced greater systemic risks and complexity, making it more challenging to manage financial crises effectively.
Complexity and Systemic Risks
The new financial system’s complexity and opaqueness have not only made it difficult to respond effectively to crises but also eroded trust among market participants, a cornerstone of a robust financial system.
Failure of the New Financial System
Despite the presence of talented individuals and substantial rewards, Volcker argued that the new financial system has failed to withstand the marketplace’s tests, necessitating a rethink of its structure and functioning.
Federal Reserve Actions
The Federal Reserve’s extraordinary measures, including lending to non-banking institutions and questionable asset transfers, have pushed the boundaries of its legal powers, raising critical questions about central banking principles.
Complexity and Legislative Review
The intricate nature of modern financial instruments like derivatives and securitization demands a comprehensive legislative review and debate regarding the Federal Reserve’s actions.
Systemic Response Needed
Volcker emphasized the need for a comprehensive response that extends beyond structural and regulatory issues to address the fundamental flaws in the system.
Financial Crises and Market Exuberance
He pointed out that financial crises often stem from self-reinforcing market exuberance, underscoring the importance of understanding deeper market dynamics to prevent future crises.
Paul Volcker’s Previous Speech to the Economic Club of New York
Volcker’s first speech to the Economic Club of New York, more than 30 years ago, addressed concerns about New York City’s impending financial crisis and the potential implications for the national economy. The crisis was averted through limited liquidity support from the federal government, coupled with strict conditions. Volcker drew parallels between that crisis and the current financial turmoil, highlighting the lack of major financial crises in the preceding 40 years.
Paul Volcker’s Perspective on the Financial Crisis of 2008
In the past 25 years, severe financial breakdowns have occurred, indicating fundamental issues in the financial system. The shift from a commercial bank-centered model to a complex, highly engineered system has introduced systemic risks and challenges. Finance has accounted for a substantial portion of corporate profits, but overall economic growth and productivity have not surpassed previous decades. The current crisis involves complexity, opaqueness, and systemic risks, affecting normal trading relationships and trust among market participants. The Federal Reserve’s actions, including lending to non-banking institutions, raise concerns about future implications and test central banking principles. The complexity of derivatives and securitization and the debate over the proper use of government power and lobbying interests add to the crisis’s challenges. The financial crisis requires a comprehensive response beyond structural and regulatory issues, addressing the fundamental flaws in the system.
Financial Intermediation and Its Evolving Role
The recent crisis, triggered by the subprime mortgage market, showcased the risks associated with financial intermediation. The shift from traditional, regulated intermediation to a new paradigm characterized by open markets and sophisticated techniques has resulted in a fragile financial system, highlighting the need for reform.
Rethinking Financial Intermediation
Volcker argued for reconciling long-term funding needs with the demand for safe, liquid assets. He noted the traditional model’s ability to cushion market volatility and criticized the new paradigm for encouraging risky practices like high leverage.
Market Vulnerabilities and Supervisory Lapses
The reliance on credit rating agencies and mathematical modeling, along with practices like mark-to-market accounting and off-balance-sheet operations, were identified as significant vulnerabilities that contributed to the crisis.
Systemic Failures and Regulatory Challenges
Volcker pointed out the fragmented responsibilities and competing objectives in regulatory bodies, alongside pervasive compensation practices that incentivized risky behaviors, as key factors in the crisis.
The Federal Reserve’s Role in the Crisis
The Fed’s resort to emergency powers and its role in managing GSEs like Fannie Mae and Freddie Mac raised concerns about its independence and effectiveness, highlighting the need for a reassessment of its structure and role.
The Future of Financial Regulation
The debate about the Federal Reserve’s future role as a regulator and lender of last resort is crucial. Proposals range from extending its oversight to investment banks to creating a new consolidated regulatory authority.
Clarifying the Fed’s Role
Clarifying the Fed’s dual role as lender of last resort and regulator is essential, especially in defining which institutions are eligible for borrowing privileges.
Oversight and Regulation
Expanding the Fed’s oversight or consolidating supervisory responsibilities into a single agency represents different approaches to achieving consistent regulatory coverage.
Collaboration with the Central Bank
Effective regulation requires close collaboration between the central bank and any new regulatory agency.
Regulation and Supervision
Volcker argued for regulating excessive leverage in hedge funds and ensuring the independence of governance structures in equity and hedge funds from bank sponsorship.
Globalized Regulation
In a globalized financial world, common standards for capital requirements, accounting, auditing, and derivative settlements are necessary.
Financial Crises and Central Bank’s Role
The central bank, especially the Federal Reserve, has a responsibility to moderate economic forces and maintain a reliable currency, which is crucial given the dollar’s global role.
Positive Outcomes from Market Turbulence
Volcker sees the market’s penalization of excesses and the realignment of national spending as opportunities for regulatory reform and sustained economic stability.
Paul Volcker’s Support for Barack Obama
Volcker’s support for Obama was based on his dissatisfaction with the country’s direction and the need for political change, rather than a thorough examination of Obama’s economic program.
Inflation Outlook
Volcker expressed concern about potential inflation, drawing parallels to the early 1970s with factors like a weak dollar and rising oil prices.
Dollar Crisis
He predicted a high likelihood of a “crisis time” for the dollar, underscoring the need for preventive measures without delving into specifics.
Conclusion
In sum, Paul Volcker’s comprehensive analysis of the financial system highlights the need for substantial reform in financial intermediation, regulation, and oversight. His insights into the Federal Reserve’s role, the evolving nature of financial crises, and the broader economic implications offer a roadmap for navigating current and future financial challenges. His support for political change, exemplified by his backing of Barack Obama, and his concerns about inflation and the dollar crisis, reflect his deep understanding of the interconnectedness of political, economic, and financial fields.
Notes by: Hephaestus