No fat tail. Nor black swan. Nor once every 100 year occurrence.
Paul Volcker: It’s clear to everyone that we are in the midst of a massive economic and financial crisis. It’s big in the United States, but it is characterized by being very international, and we’re going to hear the reverberations about this for a long time. I do not agree with those–this is part of the 20% I don’t agree with–that somehow [believe] we may get through this crisis, it will be forgotten about and revert to the same financial system we had before the crisis. I don’t think that’s going to happen–too many weaknesses and flaws have been exposed.
I do think it’s appropriate, I’ve never quite known what the center of capitalism and society was about, but I now realize there are challenges to capitalism and society, and I want it known that I think capitalism will survive this crisis, in most respects.
This isn’t any ordinary crisis. One of the things that kind of shocked me–“shocked” me is the right word–is the extent to which it’s become international. We could sit here, we sat here a year ago, I would have made a few comments that this is a pretty bad crisis, maybe the mother of all financial crises in the U.S., but the rest of the world is doing pretty well, and so long as the rest of the world holds up, for various reasons, including great growth of American exports, maybe we’ll get through this without too much damage.
Well that may have been correct if the rest of the world held up. The rest of the world has not held up, as you well know.
Amazing to look at some of the figures. Industrial production in most countries is going down faster than in the United States–and it’s been going down very fast in the United States in recent months, down 10% or more. The world in the last six months–I don’t remember any time, maybe even the Great Depression, when things went down quite so fast, quite so uniformly around the world. Obviously [we’re at] a level way above where we were in the 1930s.
We’ve reached the point where one aspect of capitalism, which I will call relatively unbridled financial markets operating on a global basis, has broken down. And it has broken down in [such a] way that I don’t think it can be replicated in the form that it took earlier. It’s broken down right in the face of almost all policy and intellectual analysis.
Now I hear and you hear that this is, well, kind of dismissed: This is a terrible thing that happens every once, every hundred years–or it’s a Black Swan or Fat Tail. For reasons maybe I don’t want to go into, the description of fat tail reflects the kind of analysis that isn’t appropriate. They think that financial markets follow natural distributions, and, I won’t go into this forever, but one remark I will leave with you is the financial world follows a normal distribution pattern. If you think that you’re a financial engineer, you’re not a very good financial analyst.
It’s not like earlier crises. Earlier crises were all invented by the Federal Reserve. The Federal Reserve tightened money, the economy went down, and they ease money [and] the economy goes up. I don’t know– the implication is the Federal Reserve is some kind of serial killer. I mean it’s a psychopath. You would have thought business cycles never existed before there was a Federal Reserve or a central bank.
Let me just say, for the record: Business cycles reflect imbalances in the economy, and as time passes it takes different forms. It used to be inventory excesses, equipment excesses, sometimes housing excesses, sometimes all of them. Money got tight because of the imbalances of the economy and implications of that for the future, and if you didn’t do something to deal with it, you’d have a worse recession.
That brings me back to the present. Nobody did anything about imbalances. The U.S. spent too much–5% or more than we were producing. China exported too much; they sent the money back here. It was all kind of nice–we got cheap goods, kept the inflation rate down, production up–but it was [an] unsustainable phenomenon [and] nobody wanted to do anything about it.
You could even rationalize it. You could talk about monetary policy, or, likely, you talk about fiscal policy. We were over-spending all this time, what about exchange-rate policy, what about Chinese policy? They’re all kinds of contributors to the problem.
We poured out so many financial engineers that succeeded in obscuring the weakness in the credits that the crisis went on for some years longer than it had to go on. You know the circumstances.
This is one recession that cannot–a very serious one that cannot–be traced to tight money. The ready availability of money, low interest rates, the imbalance, confidence in price stability, confidence in a strong dollar–all that contributed to the excesses and the imbalances to set the stage for these unfortunate events.
Now what are we going to do about it in terms of financial reform? As I suggested, I think the very rapid and sweeping changes we’ve had in financial markets in recent decades helped prolong the imbalances in the real economy but in a very overall way. In the past 20 to 30 years, banks have gone from the major suppliers of credit at the heart of the financial system to just another supplier of credit, maybe accounting for a quarter to 20% instead of 60% or 70%.
The open market, however you define that, with a lot of securitization, supplied the rest, and this really went forward with enormous rapidity. The whole of subprime mortgages–what do I know, I’m just sitting there reading the newspaper–but subprime mortgages went from virtually nothing to close to a trillion and a half dollars in the space of maybe two and a half years. What an enormously rapid change–just reflecting the change in general developments in the market toward reliance on open market securitization and all the rest.
Statistically you can measure that. I think there’s also a behavioral personality kind of aspect which should not be overlooked. We went from banks to the open market, and in the process we went from a financial system that was largely, not entirely, devoted to what might be called relationships.
It was important to a bank to make a loan to a customer, and he had other interests in that customer, other than lending money typically. He may lend money because he had other interests. You went to a very impersonal kind of market where there was no real customer relationship–everything was a deal. It was a deal maybe several times a day in a foreign-exchange market, or a deal in [mergers and acquisitions] or some other bigger-sized transaction, but they were arms-length transactions without any continuing customer interest. Maybe a bit, but not too much. I think that has added to the problems in the market that we have.
In this environment, regulation and supervision didn’t quite wither away, but it’s fair to say they lost support and lost potency, partly as a matter of ideology but partly because the banks that were the most heavily regulated lost relative importance in the market so there was overall less regulation. Now we have the crisis, we have the breakdown; a lot of rethinking is in order.
The first priority is to restore some semblance of stability and order in the market and restore the flow of credit. I’m not going to talk about that. I haven’t got–if I had the answer I might talk about it, but I’m not sure I have it, so I think we’ll neglect that for the moment.
And then we’ll be faced–if we get through this crisis–with how we undo the type of emergency actions that have been taken in a way that doesn’t leave us with another problem. In particular one that people worry about is the resurgence of inflation, but there are other aftermaths that we have to worry about. What I want to talk about is the kind of financial system that we want to have in the future when we get through this.
I guess I’m in the “George Soros School” of saying I’m not so sure how fast we want to go in instituting actual changes until we have a better sense of where we want to go and how this crisis is going to work its way out. But I don’t think that’s inconsistent with saying [that] the more international agreement we have on where we want to get to, the better off we’ll be.
Now let me just lay out one possible vision for the future, which by some odd coincidence will be what was incorporated in the G30 report recently that I had something to do with. I will just describe what I take as the philosophy behind that report, because I certainly share it. I’ll talk about the vision rather than the detail.
The basic point of departure, the foundation of the approach taken in that report, is that inevitably the banking system in general is going to be protected. That is nothing new, but there will be some very sizable, systemically important banking institutions that will certainly be protected by all governments in all circumstances, and with that must go a certain extra attention to the supervision of those institutions.
All banks must be supervised and regulated, but those of systemic significance around the world, which, almost inevitably, not every case but most, those institutions are international, they’re not just national, will be subject to a particular layer of supervision.
In this vision, those banks will be the heart of the system. I think they become more important in the provision of credit rather than less in the future. It’s the reverse of what’s happened recently. I think of those as relationship-oriented, service-oriented institutions. Their function is to deal with individuals, businesses, nonprofits, universities, whatever provides certain necessary services. They provide a depository on the one side for savings, on the one side, of course, they provide stability for your funds, and they provide credit on the other side, and they provide a lot of ancillary services. That can be done without enormous risk, but there are risks.
I at least would prohibit those institutions from sponsoring hedge funds and equity funds and from engaging in a great volume of proprietary trading–those things that their management has loved to do in recent years. And it got them in trouble.
Because they involve great risk, those managements got enormous reward for these innovative activities. All those innovative activities over time produce losses rather than gains, but the incentives were not well-designed, so let’s have some stable, strong banking institutions responsible for the backbone of the infrastructure, the payment system, clearing arrangements, [those kinds] of things. Let’s prohibit them from really high-risk activity.
The old investment banks, when they existed as free-standing institutions, could engage in no activity that didn’t present a conflict with other customer interests. That is a very difficult thing to manage.
Now we do worry about innovation and flexibility. Maybe innovation is a little overrated. I find little correlation between the sophistication of the banking system and the rate of the productivity growth. I think the whole [gross national product] was inflated because bankers got paid so much: You measured GNP and value added by their incomes, and while their incomes went up the more the GNP went up. But it was not exactly something that penetrated down to the ordinary person.
When it comes to innovation I’ll raise a question with you: What is the most important financial innovation in the past 20 or 30 years for the average person? I think it’s the automatic teller machine. It’s not any high-class financial operation, it’s a technical improvement, which sure has changed banking. I have more connection with my automatic teller machine that any other part of the financial market.
So you have a two-tier financial system, and then you have a series of issues that I would put in a general label of market infrastructure–and this includes some really difficult issues: Accounting is a matter of great controversy. The credit rating agencies–how you deal with those, and is there any substitute? Clearing and settlement arrangements. A particularly important one now is credit-default swaps. And there are other elements of infrastructure that need attention.
If there is ever an opportunity to get a more uniform approach internationally on some critical issues or regulation and supervision, it is now, in the aftermath of this crisis. And I don’t think the crisis will be forgotten quickly. It is just so overwhelmingly apparent, in a world [where] the large international financial systems are themselves international–and that the scope of international regulation and national assistance–when they go bad just demands closer international coordination. And I think we’ll get it.
There is a lot of progress towards international consistency. It’s now, in fact, under a degree of attack because of the complaints about mark-to-market accounting. I think we have to get through that, and there’s legitimate questions there, but the overwhelming need is not to have different accounting systems in Europe and the U.S. and Japan and wherever. And I think we can see our way through that.
It’s only touched upon lightly in the G30 report, but it is evident that in the U.S. the central bank is taking on a role that is way beyond any traditional conception of what a central bank should be doing.
We have to stop quoting Walter Badget on what a central bank does–so far from the reality of what the central bank is doing today that it raises a question about the very name central bank. I was visiting with a Chinese friend at breakfast this morning–I said in a way you know the Chinese have moved from state-control to credit to private banks. We’re moving from private banks to state control of credit, where we meet in the middle someplace.
The explanation for this expansion of the central bank is obvious: Faced with crisis in concerns in the market and the economy, they felt they had to do what they could do (not just central bank but the Treasury as well, to take action to stop deterioration and promote stability). But … is that a permanent change in the role of the central banks in the future? And if not, how do we roll back the calendar and deal with the expectation that whatever we say, if we did it once and it was successful, that we’ll do it again?
I don’t know fully the answer to that question, but I think it’s something we ought to worry about. Which in turn raises the question that many of us think is rather basic in terms of future economic instability, and that is about the independence of the central bank. Because it’s a little hard to make the usual grounds for central bank independence when they are actively intervening so heavily in particular sectors.
As for the outcome of this crisis, we will come out with a feeling that maybe a little inflation isn’t so bad, I think a little inflation is bad, because I think a little inflation leads to more inflation, and I don’t think there is any argument for a little inflation solving our problems in any realistic sense, so I don’t want to lose what I think has been an accomplishment of the last 30 years of the central importance of price stability and the central bank role–the role of an independent central bank in maintaining their price stability. So I just would leave you with that thought and the hope and expectation that that kind of question will be front and center in thinking as we do redesign the financial system as we should.