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 (http://www.nytimes.com/2010/03/31/business/31regulate.html?ref=business) 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 (http://www.ft.com/cms/s/0/cef26d7c-3c41-11df-b316-00144feabdc0.html). 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.

The "Next Greece" Again

The New York Times business section carries the headline, “Traders Turn Attention to the Next Greece”: http://www.nytimes.com/2010/03/04/business/global/04bets.html?ref=business.

“Is Spain the next Greece? Or Italy? Or Portugal?”

Sounds vaguely similar to another article on the topic, my post of March 1, “Where is the Next Greece?”: http://seekingalpha.com/article/191242-where-is-the-next-greece. But, the subject is in the air these days.

The New York Times article wades into the issue of whether or not the “banks and hedge funds” should be doing what they are doing.

“Indeed, some banks and hedge funds have already begun to turn their attention to other indebted nations, particularly Portugal, Spain, Italy and, to a lesser degree, Ireland.” Aha, the PIIGS, of course without the G.

“The role of such traders has become increasingly controversial in Europe and the United States. The Justice Department’s antitrust division is now examining whether at least four hedge funds colluded on a bet against the euro last month.”

The same concern has been expressed over short sales.

Little concern was expressed about the debt policy of nations, states, municipalities, businesses and consumers when they were piling on massive amounts of debt to their balance sheets.

Of course, nations, and others, have good reasons for loading up with debt. It stimulates the economy and everyone wants prosperity and full employment. Well, don’t they?

Everyone wants businesses to prosper. Everyone wants everyone else to own their own home.

All good reasons for piling on debt.

But, when do “good intentions” spill over into “foolish behavior”?

And, in an environment where excessive amounts of credit are being pumped into the economy (thank you again Federal Reserve)n to spur on housing or some other “good”, shouldn’t it be expected that “extra-legal” means will be used to “get the credit out”.

But, when does serving “societal goals” become fraudulent and hurtful?

The problem in both cases is that there is a very blurry line between the “good” and the “bad”. On the upside, of course, emphasis is placed on the “good” being done, and the “bad” is alluded to but quickly dismissed. A common theme in such periods is that “Things are different now!”

On the other side, however, great pain takes place. One can certainly sympathize with those who live in Ireland, and Spain, and these other countries.

This, however, is just where “moral hazard” raises its ugly head. There is a downside to the excessive behavior of nations, states, and so on! There is pain on the other side of the pinnacle.
And, eventually the pain must be paid for. Bailing out those that used excessive amounts of debt just postpones the situation and usually leads people to behave just the way they did before the crisis. That is, the lesson learned is the one can behave badly and, if there is the threat of sufficient societal pain, little or no cost will be carried forward because of the previous un-disciplined behavior.

The problem is that those in power get mad at the bankers and the hedge funds and try to prohibit them in some way from moving against those private or public organizations that are financially weak. But, in doing so they are taking away a tool that can be used to enforce discipline on those who have lived excessively. The same applies to short selling.

We have seen behavior like that exhibited by the “banks and hedge funds” in the past. The last time these predators were called “shadowy international bankers”, many of whom were pictured as living in Switzerland. In that time the “ bankers” attacked the currencies of profligate nations. France, under the leadership of François Mitterrand, is perhaps the best known example of such a situation. Mitterrand, the socialist, had to pull back from his grand plans and became a believer in fiscal discipline and an independent central bank. Similar cases are on record.

It is disconcerting to see the increased efforts to reduce or eliminate financial tools that help to bring discipline to the market place. If these investment vehicles get punished or face harsh controls and regulations then the world is so much the worse for it.

Yes, I agree, at this stage it looks like the strong are kicking the weak member of the party. But, in these cases we forget that many benefitted greatly on the upside, particularly the politicians that promoted goals and objectives that were underwritten by the undisciplined use of debt. And, the central banks were prodigal in underwriting this credit inflation.

And, now the piper is calling in the debt.

It is a rule of life: those in power that create a given situation are often the most vocal opponents of those that respond to the consequences of what the powerful have created. If you create an inflationary environment fueled by excessive credit expansion then, sooner or later, the price must be paid.
Greece, Spain, Italy, Ireland, Portugal, England, and others are now facing the downside of so many years of “good intentions.” Let’s not just blame, or punish, the “bankers and hedge funds” for creating the situation we now face