A Conversation With Paul Volcker
On the evening of December 7th I was very fortunate to attend, with just a couple of hundred others, “A Conversation With Paul Volcker” at the Museum of American Finance in New York. Paul Volcker is most notably known for being Chairman of the Board of Governors for the Federal Reserve System in the late ‘70’s and early ‘80s and for having the courage to dramatically raise interest rates to break inflation in the face of extraordinary popular and political opposition. I was also very fortunate to meet and speak with Mr. Volcker at the President’s speech on financial services reform in 2010 (see hasty photo below). He is an all too rare and true hero in finance, economics and public life in addition to being a really nice guy. Below are my notes and thoughts on the presentation.
The event was moderated by Dr. Richard Sylla, Professor at the New York University Stern School of Business. He began by covering some of the highlights of Volcker’s educational background (Princeton, Harvard and the London School of Economics) and government service (Treasury and the Federal Reserve, being appointed to Chairman by President Carter and reappointed by President Reagan). As noted above, Volcker is credited with breaking inflation by raising interest rates to 20% in June of 1981. Subsequent to his retirement from the Fed, he was called into service by the UN to chair a commission to investigate dormant accounts of holocaust victims and later to investigate the Iraqi oil for food program. More recently he chaired the President’s Economic Recovery Board and has championed the “Volcker Rule” prohibiting banks from engaging in proprietary trading. Dr. Sylla compared Volcker to Cincinnatus, the Roman leader who would be called into service during moments of crisis and then humbly return to his farm after the crisis had been resolved.
The first question, as you might expect, was about Europe. Volcker’s immediate response was “You want me to tell you what’s going to happen in Europe when they’re over there meeting over and this is going to play out in the next few days, so we find out it less than a week whether I was right or wrong? That doesn’t sound like a very smart thing to do.” Smart or not, he spent the better part of the next half an hour talking about the history, the situation in general, the challenges and some possible solutions.
His first observation was that the Europeans are in the very unique position of having a central currency without a central government. This leads to an inability to coordinate fiscal and monetary policy as monetary policy is managed by the European Central Bank (ECB) while fiscal policy is carried out by the individual member countries. The problem comes when some countries are more fiscally responsible than others yet they share a single credit rating. In other words the more fiscally responsible (e.g. Germany) are viewed as being the same credit risk as less fiscally responsible countries (e.g. Greece). This goes directly to the cost of capital or interest rate that a country (or any borrower) has to pay. Traditionally Greece would have had a difficult time borrowing so much because their interest rate would have been much higher, but since they were able to essentially borrow at Germany’s rate that left them able to take on far more debt than they would have otherwise. Suddenly lenders don’t want to lend to anyone in the European Union.1
Traditionally countries (Russia, Argentina and Mexico to name a few relatively recent examples) who borrowed too much and were unable to repay the debts in full would devalue their currency. This had the effect of reducing the value of the country’s outstanding bonds (debt) and handing a loss to those who lent to (bought the bonds of) these countries. These bondholders were functionally punished for making a bad lending decision.
The problem that Mr. Volcker pointed out is that Greece (or Ireland or Portugal or Spain or Italy….) can’t devalue because they don’t have their own currency and there is no provision in the treaty for a country to leave the currency. To make matters worse the lenders of last resort are demanding austerity measures as a condition of lending which exacerbates already struggling economies.
There has been a recent recognition among policy makers that if the Euro is to survive there needs to be more central authority. But will European countries, who are historically very nationalistic, allow a central authority to have control over their budgets, borrowing, taxes rates etc.? In Volcker words, “this goes to the heart of sovereignty.” He further put forth that the financing of these countries would not continue without lenders having some control over fiscal policy.
He then addressed specific measures and said that a $2 trillion pool was probably needed to convince lenders that the crisis was contained. There would also have to be some assurance that European banks are sufficiently capitalized. He noted that the $2 trillion probably wouldn’t actually be needed, but just having it there would provide sufficient reassurance. This is somewhat analogous to then Treasury Secretary Henry Paulson’s comment during the 2008 credit crisis that “if you walk around with a bazooka, you’re probably not going to have to use it.”
Volcker then talked about where this money might come from. He pointed out that by the treaty that created the Euro the European Central Bank is specifically prohibited from lending to member countries. The rationale being that the central banking function would become politicized. He then pointed out the parallels to the US credit crisis and said “The Fed and the Treasury didn’t exactly follow the letter of the law during the financial crisis.” He prefaced his comments that followed with “I’m no expert (on the Fed) I just read the newspapers and such….,” proving that there is such a thing as central banker humor. He pointed out that the Fed and Treasury were very creative in lending to non-bank institutions such as GE, GM and money markets funds among others. The underlying concept was that the Europeans had probably learned some things from the US crisis and probably aren’t going to let the finer points of history or a treaty stop them from putting a decisive end to the crisis. My summation is that politics rather than law is probably a bigger hurdle.
The next question was his thoughts about some economists saying that the Fed should target a 4-5% inflation rate which would get housing going again, and functionally have the effect of reducing outstanding indebtedness. His initial response was “Those are mostly very young economists.” He elaborated and said that we’d be very foolish of we went out and deliberately created inflation because once people get used to inflation, it doesn’t work. Once it gets built into the psychology it’s very difficult to get rid of. He pointed out that “a little inflation leads to more inflation.” He concluded his remarks on inflation by saying there was no danger of it in this environment.
The conversation then turned to the Volcker Rule. He began with “There are several Volcker Rules, like don’t spend too much money….” More seriously, and somewhat surprisingly, he went on to say that it was an illusion that the Volcker Rule changed much in the legislative process from his initial proposal. The core of the Volcker rule is that banks cannot engage in trading of risk instruments for themselves. He said “I’m in favor of banks being banks, not speculative enterprises supported by the government.” He went on to say that with the current structure bank employees speculate in order to receive larger bonuses and expose the institution to greater risk, undercutting “the natural conservatism of banks.”
This led to a follow up question of whether he thought that Glass Steagall should not have been repealed. He responded with “In retrospect, you’d have to say yes” and observed that the repeal was an intriguing commentary on our political and banking systems. He then talked about the history of Glass Steagall and said the act (passed in 1933) had two key parts. First, a bank can sell a financial instrument, but it can never have an ownership interest in the security. The second was that banks and their subsidiaries can’t be “principally engaged in underwriting of securities.” He pointed out that for roughly 50 years the law was seen as clear enough that regulatory rules weren’t required. By the 1980’s however the bank lobby began asking what exactly was the definition of “principally?” An initial determination of 10% was made. Soon the lobbying began along the lines of “if 10% is ok, why not 15%? And if 15% is ok why not 20%? or 25%?” By the 1990’s the percentage was high enough that the view became “since banks are already in this business let’s just get rid of this antiquated law” and in 1999 that’s exactly what happened.
He compared Glass Steagall to the recent Dodd Frank bill by saying “it took 50 years for banks to start questioning Glass Steagall and about 10 minutes to question Dodd Frank.” In Volcker’s view banks shouldn’t be allowed to hold securities but only be able to affect transactions in them between third parties. He pointed out that if you were to make such a rule, that banks would come back and say “we need to hold some of these temporarily just in case a customer comes in” and then they begin to lobby for a longer definition of “temporarily” and the original intent begins to become undone.
Next was a question of whether we have addressed the too big to fail problem. He said that, while it hasn’t gotten much press, much has been done between governments around the world to address the potential problem of one or more large financial institutions failing.
Someone asked his thoughts on high frequency trading to which he responded “I have my doubts that high frequency trading contributes to the welfare of the world.” He said he has thought that there should be a small transaction charge or tax that would discourage much of this sort of trading. While on the topic of financial practices and products that don’t make sense to him, he also said “I don’t know why money market funds exist.”
He then began to talk about the political state in Washington which he characterized as a sad commentary. His biggest point was the influence of lobbyists which he described as being at an unprecedented scale which is very unhealthy. He also pointed out his work with Obama administration which included some discussion of putting together an “infrastructure bank” to address what he sees as a very real infrastructure problem here in the US. He used this as a launching point to describe the deterioration of the trust of the public in the government. He talked about his experience of being in government during the Eisenhower/Kennedy era when people trusted government to undertake lake projects such as the building of the interstate system and the space program. The trust numbers for government have steadily declined and people no longer have the faith that government can execute large scale projects honestly and efficiently.
The final question was what president or world leader what his hero. His response was “Presidents are less heroic the more you see of them…”
1To think of this another way, imagine a family decides they’re going to get together and pool their credit ratings, but not their money. Further imagine that the siblings in this family cover the spectrum from one who is very fiscally responsible and uses debt sparingly and wisely to one who is a profligate spendthrift who overspends and fails to pay his debts. The ones who are irresponsible will instinctively take advantage of new and seemingly boundless credit at cheap rates. They will of course predictably overuse it and default, leaving their more responsible siblings to cover for them. Congratulations, you now understand the European debt crisis.
The author and Mr. Volcker at the President’s Speech on Financial Services Reform, April 21, 2010 at Cooper Union in New York.
