"The Unfinished Business of Financial Reform" by Paul Volcker

Three years after the financial collapse of the US economy, what has been done by the federal government to ensure the crisis is not repeated? What progress has been made for financial regulatory reform, and what still needs to be done? According to Paul Volcker, a former Chairman of the Federal Reserve and Chairman of the President’s Economic Recovery Advisory Board, there has not been enough to address the unsustainable, imbalances between and within national economies. Additionally, there are a number of failures in national economic policy and an absence of a disciplined international monetary system.

NYRB: It should be clear that among the causes of the recent financial crisis was an unjustified faith in rational expectations, market efficiencies, and the techniques of modern finance. That faith was stoked in part by the huge financial rewards that enabled the extremes of borrowing, the economic imbalances, and the pretenses and assurances of the credit-rating agencies to persist so long. A relaxed approach by regulators and legislators reflected the new financial zeitgeist.

All the seeming mathematical precision that was brought to investment, all the complicated new products, including the explosion of derivatives, that were intended to diffuse and minimize risk, did not work as had been claimed. Instead, the vaunted efficiency helped justify an explosion of weak credit and an emphasis on trading along with exceedingly large compensation for traders.

If those remarks sound critical—and they are meant to inspire caution—let me also emphasize that the breakdown in financial markets and the “Great Recession” since 2007 are also the culmination of years of growing, and ultimately unsustainable, imbalances between and within national economies. These are matters of failures of national economic policy and the absence of a disciplined international monetary system.

Take the most familiar and egregious case. The huge surpluses China has accumulated from its external trade reflect the view of the Chinese government that it is desirable to have rapidly growing export industries that support employment growth. China was willing to build up trillions of short-term dollar assets, mainly US securities paying low interest rates—and thus kept the process going. Conversely, the United States happily utilized that inflow of low-interest dollars from China to sustain heavy consumer spending—much of it on Chinese products—a growing budget deficit, and eventually an enormous housing bubble.

Or consider the current European crisis. At its roots are years of growing imbalances within the countries of the eurozone. As in other parts of the world, the ability to borrow at low rates bridged for a while the proclivities of some countries to spend and import beyond their means, while other countries saved and invested, tending to reinforce an underlying gap in productivity between national economies.

Those were fundamentally matters of public policy—the result of decisions on taxing, spending, and exchange rates; they were not a reflection of the characteristics of the financial market. But neither can we ignore the fact that financial practices helped sustain such imbalances. In the end, the build-up in leverage, the failure of credit discipline, and the opaqueness of new kinds of securities and derivatives such as credit default swaps helped facilitate, to a truly dangerous extent, accommodation to the underlying imbalances and to the eventual bubbles.

All these developments derive in some part from the complexity implicit in the growth of the so-called shadow banking system—the nondepository banks, hedge funds, insurers, money market funds, and other largely unregulated entities that grew enormously in size after 2000—a system that by June 2008 was roughly the size of the traditional banking system. In the end, the consequence was to intensify the financial crisis and to severely wound the real-world economy. Even today, four years after the first intimations of the subprime mortgage debacle, high indebtedness and leverage, impaired banking capital, and a pervasive loss of confidence in a number of major financial institutions constrict an easy flow of credit to smaller businesses, potential home buyers, and consumers alike. (read more)