Wednesday, March 31, 2010

Mr. Volcker Speaks

Former Fed Chairman, Paul Volcker spoke yesterday at the Peterson Institute for International Economics. All week I had been hearing comments about this speech and how people seemed to be waiting for Volker’s remarks. Yet, this morning, there was only one report on the speech which appeared in the New York Times ( and then it was buried at the bottom of page B6 of the business section.

It seems as if Volcker didn’t really say very much. In fact, the discussion of his remarks was combined with a discussion of the words of Robert Gibbs, the White House Press Secretary. The bottom line: it is highly likely that the United States will get a re-regulation package for its financial system this year. Gibbs even said that “the Senate might move on the legislation by the end of May”.

Just a couple of comments on the issues that were mentioned in this article.

First, the article states that the legislation to “overhaul the nation’s financial system…is intended to prevent a recurrence of the conditions that led to the 2008 financial crisis and the government bailouts that followed.”

If this is what the legislation is intended to do, we have already lost the battle. As I have stated over and over again, the problem with regulatory legislation is that it is always fighting the last war.

Let me state this as bluntly as possible: We will never have “a recurrence of the conditions that led to the 2008 financial crisis!”

Financial crises do not repeat themselves.

I do agree with Carmen Reinhart and Ken Rogoff in their book “This Time is Different” that the buildup to a financial crisis is always accompanied by the cry of those riding the crest of the economic expansion that “This time is different!” This claim, however, refers to the belief of the perpetrators of the claim that no collapse will follow the buildup that they are going through.

When I say that financial crises do not repeat themselves I mean that the specific conditions preceding a financial collapse, the specific behavior of the financial institutions and the financial leaders, are always different from past collapses. There is new technology, new instruments, new institutional arrangements, and so forth. Things change significantly enough so that the new regulations put into effect at the end of the last financial collapse don’t quite apply to the conditions that exist before the next financial collapse.

This gets into my second point which addresses Volcker’s concern about the growth of the financial services industry relative to the growth in other sectors in the rest of the economy.

We are told that “Mr. Volcker was critical of the broad growth in the financial services industry in recent decades. Finance came to represent an ever-greater share of corporate profits, even as average earnings for most American workers did not rise.”

Volker is quoted as saying “The question that really jumps out for me is, given all that data, whether the enormous gains in the financial sector—in compensation and profits—reflect the relative contributions that sector has made to the growth of human welfare.”

The article continues, “He also asked whether the financial sector contributed to underlying imbalances in the economy, as Americans raided their savings and relied on a housing bubble to maintain excessively high consumptions levels.”

My response to this is that from 1961 through 2008, the purchasing power of the dollar declined by almost 85%. In this inflationary environment, many American families came to believe that the best way to “save” was to buy a house and watch the value of the house rise. In addition, they could further leverage the constantly rising value of their house to “maintain excessively high consumptions levels.”

Mr. Volcker, more than anyone else in the United States, recognized the problem created by the inflationary environment of the late 1970s and early 1980s and, during his tenure as the Chairman of the Board of Governors of the Federal Reserve System, fought inflation with all that the Fed could bring against this destructive dragon. He deserves major praise for what he accomplished at this time.

Still, over this 1961-2008 period, inflation was the major economic incentive in existence in the economy. By the end of the 1960s, commercial banks had innovated to the point that they became “liability managers” and created the ability to expand to any size that they wanted. This happened because the start of this inflationary period made it necessary for banks to have the flexibility to expand beyond the geographic and asset constraints that restricted their ability to compete.

In the early 1970s the mortgage-backed security was invented (by the government by-the-way) and in the middle 1980s the mortgage market became the largest component of the capital markets. As inflationary expectations rose and resulted in higher interest rates during this time, interest rate risk became more of an issue and the interest rate futures market was created.

Need I say more? Financial innovation thrived in the inflationary environment and, as a consequence, the financial industry grew! And, grew! And grew!

Did the “enormous gains in the financial sector reflect the relative contributions that sector has made to the growth in human welfare”? Did “the financial sector contribute to underlying imbalances in the economy”?

I think you know how I would answer both of these questions.

Another piece of the news this morning struck me. Citigroup is spinning off Primerica ( Primerica was one of the first companies purchased by Sandy Weill in the late 1980s that became part of the financial conglomerate Citigroup. Everything about financial innovation and the relative growth of the financial services sector of the economy during this inflationary period is captured in Weill’s wild ride to the top as he constructed Citigroup piece by piece.

And, now we have the dismantling of Citigroup. Is this picture the icon of the new age of finance?

Higher capital requirements can contribute to sounder financial behavior. More disclosure and increased audit standards can also contribute to sounder financial behavior. Still, we cannot build a regulatory structure that will prevent a recurrence of financial crises whether based on the 2008 experience or the experience of some other time period. Furthermore, we cannot prevent greedy politicians from supporting policies that create an inflationary bias to the economy in order to get re-elected.

Regulation of the “bad guys” on Wall Street is popular now. However, it won’t prevent a volatile future.