Former Federal Reserve (Fed) Chief Paul Volcker’s so called Financial Reform Plan, released after President Obama’s speech decrying ‘fat cats’ on Wall Street, could be one of the most important prescriptions for the post-financial crisis. We interview two of today’s most important economics bloggers, University of Oregon Economics Professor Mark Thoma, editor of Economist’s View, and Dr. David Caploe, Chief Political Economist of the Singapore-based EconomyWatch.com, who holds a Ph.D. in International Political Economy from Princeton.
Before getting to their intriguing thoughts, I would emphasize three contextual aspects of the environment in which any financial reform must operate.
“Systemic” concerns clearly go beyond such proposals as Consumer Financial Protection Agency to regulate financial products, or the so-called “populist” move to “downsize” megabanks, disallowing a market share beyond a certain size, say, 10 percent of deposits held nationally. One of the intentions of the Volcker Plan is to have the right to dissolve financial companies before they pose systemic risk. In addition, banking proprietary trade – trading on their own account – will be banned, and commercial banks will also be forbidden from owning hedge funds and private equity firms.
A new complex financial ecosystem
Following Giovanni Arrighi, we think a prime focus should be on so-called “financialization”: “systemic cycles of accumulation” of increasing scale and decreasing duration, each consisting of a phase of material expansion and a phase of financial expansion.
In this general context, the financialization wave from the 1970s changed completely the banking and financial ecosystems. While it was enough in the 1930s, for example, to separate commercial and investment banking, today, maintaining a wall between traditional banking and the leverage mania of new financial investment trusts and funds is no longer sufficient. The system is much more complex, as Gary Dymski has already explained in his research and the interview we published. Given this, a proposed modern form of the New Deal-era Glass-Steagall Act may not be adequate.
As David Caploe, in the interview below, emphasizes: “As you note, [the Plan] does nothing to deal with the serious issues that were raised by the ‘under cover of night’ revocation of any sort of regulation of derivatives in the waning days of the Clinton administration, which are the real problem today, and which Volcker simply doesn’t deal with in any way.”
This is what leads us to wonder whether the Volcker Plan misses the target.
The question therefore is whether the Obama administration has enough focus on Wall Street’s current business model. As Chris Wallen, from Cumberland Advisors, recently posted: “Volcker has become an advocate of reform, but only focused on those areas that do not threaten Wall Street’s core business, namely creating toxic waste in the form of OTC derivatives such as credit default swaps, and unregistered, complex assets such as collateralized debt obligations, and stuffing same down the throats of institutional investors, smaller banks and insurance companies.”
TBTF hold Washington hostage
It seems also the Plan does not deal with the lending freeze and the rent-seeking lobbying. Caploe argues: “The ‘lending freeze’ is a conscious effort of the Too Big To Fail (TBTF) banks and insurance companies to hold the political system hostage.”
This dovetails with another aspect: the liaison of lobbying with financial rent-seeking and “exuberant” financial leverage.
A study by Deniz Igan, Prachi Mishra, and Thierry Tressel, published in the Working Papers of the International Monetary Fund, found that lenders lobbying more on issues related to mortgage lending a) had higher loan-to-income ratios, b) securitized more intensively, and c) had faster growing portfolios than other lenders. Since the crisis, delinquency rates are higher in areas where lobbyist’ lending grew faster, and which experienced abnormally negative stock returns during key crisis events.
In their paper, “A Fistful of Dollars: Lobbying and the Financial Crisis”, the three IMF researchers studied empirically the hot “link”: “Lobbying is associated ex-ante with more risk, and ex-post with worse performance.”
One point is particularly relevant: in the current crisis, sixteen of the twenty lenders that spent the most on lobbying between 2000 and 2006 received funds provided by the government under the Emergency Economic Stabilization Act. In total, lenders that lobbied on specific issues received almost 60 percent of the funds allocated.
This “linkage” reveals one of today’s huge structural problems: political influence in the financial ecosystem, which has serious impact on overall financial stability.
The study concludes: “Our analysis suggests that the political influence of the financial industry can be a source of systemic risk. Therefore, it provides some support to the view that the prevention of future crises might require weakening political influence of the financial industry, or closer monitoring of lobbying activities to understand the incentives behind them better.”
As analyst Mark J. Lundeen recently put it, “politicians and lobbyists have become bigger players in the ‘free markets’ than the actual buyers and sellers.”
In countries like the US and the UK, the financialization wave went farther with politically dominant financial sectors. As Lord Robert Skidelsky posted recently: “At root, the battle between the two approaches is a question of power, not of technical financial economics”. Says the English biographer of Keynes, “Much more powerful financial lobbies now stand between pen and policy. If reformers are to win, they must be prepared to fight the world’s most powerful vested interest”.
As Mark Thoma says in the interview below: “One of those [things] is to make sure that bank executives have an interest in the long-run outcome of the transactions they engage in – the maximization of short-run profits through excessive risk-taking has to be stopped.”
Professor Thoma highlights one of the management barriers of today: optimal executive compensation induces managers to favor speculative components and a rent-seeking dynamic. Short-termism is thus linked with risk-taking. Any reform that is to be taken seriously will need to change these incentive dynamics.
INTERVIEWS by Jorge Nascimento Rodrigues, 2010 © I thank David Caploe for his helpful comments and careful revision.
David Caploe: “From a political point of view, it’s, as we say, DOA — dead on arrival. No one in [the US] Congress is taking it very seriously.”
Mark Thoma: “I don’t think the Volcker proposal by itself is nearly enough.”
Q: Do you think the Volcker Plan is appropriate to reform the financial system, and sufficient to limit the risks of the financialization trend?
David Caploe (DC): While I don’t think the Volcker Plan is particularly bad from an economic point of view — all it does is re-instate the division between commercial banking, which is relatively safe and boring and can legitimately receive deposit banking insurance from the Federal government and investment banking, which is much more speculative, and should NOT receive insurance from the government — it’s yet another example of, as we say in the US, “closing the barn door after the horse has already run out”: that is, it is simply not adequate to the issues the US and global financial systems currently confront. And from a political point of view, it’s, as we also say, DOA — dead on arrival. No one in [the US] Congress is taking it very seriously.
Mark Thoma (MT): I think that the Volcker plan does some good things, and it prevents some behaviors that could cause problems – big ones – in the future. And if a crisis does occur, as it will again someday, a rule like this will help to attenuate the effects. But I don’t see this particular problem as the key element of this crisis, so no, this alone is not enough. Much, much more is needed.
Q: Isn’t it too late? Or is now the right time to enforce limitations on what Obama called “the fat cats”?
DC: As my previous answer indicated, it’s WAY too late. There certainly needs to be both regulatory reform and — just as importantly — actual enforcement of regulations that already, and may soon, exist. But the Volcker Plan is just not relevant to either the immediate problems — above all, absolute transparency for ALL derivatives transactions, although, again, it’s also way too late for that as well — or the overarching ideological and ethical breakdown that began in the Reagan era and reached its unfortunate apotheosis during the nightmare years of Cheney / Bush.
MT: Well, it’s surely too late for the present crisis, but it’s not too late to do something to make things safer in the future. One of those is to make sure that bank executives have an interest in the long-run outcome of the transactions they engage in, the maximization of short-run profits through excessive risk-taking has to be stopped.
Q: It seems Volcker wants to return to some of the discipline rules of the Glass-Steagall Act of the FDR era, which were revised in the 1990s and gave “full speed ahead” to financial innovations in leverage, high speed trading, derivatives, etc. If passed in the Senate and House, will this shift in legislation return a sound financial system to the US?
DC: It’s precisely the return of Glass-Steagall, which the Democrats stupidly revoked when Clinton was in charge, under the direction of the “destructor-in-chief” Treasury Secretary Robert Rubin — former head of Goldman Sachs, then afterwards head of Citigroup, where he did such an excellent job of helping run it into the ground — and his loyal henchman, Larry Summers — now head of the National Economic Council — and HIS henchman, now Treasury Secretary, Tim Geithner. But as you note, it does nothing to deal with the serious issues that were raised by the “under cover of night” revocation of any sort of regulation of derivatives in the waning days of the Clinton administration, which are the real problems today, and which Volcker simply doesn’t deal with in any way.
MT: I don’t think the Volcker proposal by itself is nearly enough. I would like to see limits on leverage/higher capital ratios, much more transparency including using organized exchanges whenever possible (or at least reporting transactions to regulators), and more attention to the incentives the system creates for ratings agencies, mortgage brokers, real estate appraisers, etc.
Q: Financial people say this movement from the Administration will provoke a double dip in both the stock markets and the real economy. Does this seem possible? Or is it a purely political emanation from the financialization ecosystem?
DC: Not to speak too broadly, but financial people almost always argue that ANY kind of regulation is going to “shake investor confidence” and create problems in the markets, and, hence the real economy. How they have the nerve to say things like this after the absolute mess they created in the US and – because the US is the center of the world political economy – global economies is absolutely beyond me. The “lending freeze” is a conscious effort of the Too Big To Fail banks and insurance companies to hold the political system hostage via blackmail and extortion: until you assure us that you, the government / taxpayers, are going to cover ALL our losses — and remember, those from both derivatives AND unsecured credit cards have yet to explode, although the Greek crisis is giving us a small taste of the former — while we retain the profits, we’re not going to lend anybody anything, no matter how low the interest rate may be.
MT: They always make that argument, and always will. I am not worried about this.
Q: Is there a risk of an overlap of these and other financial reform plans with a fiscal or sovereign debt crisis in the US, as the deficit hawks argue?
DC: As Paul Krugman has correctly argued, there MAY be a problem in the distant future with inflation. At the moment, however, by far the most significant macro-level economic problem is unemployment in all sectors but finance, and the failure to do something serious about that is not just criminal from a human point of view, but is also totally destructive economically, since it continues the vicious cycle characterized by little or no growth due to the lack of effective overall demand — which remains the case, whatever the cooked numbers of the Bureau of Labor Statistics may pretend.
MT: I don’t think so. And there are some reforms, e.g. a transactions tax that could help with the long-run budget picture.
David is President & CEO of the Singapore-based American Center for Applied Liberal Arts & Humanities in Asia – ACALAHA, and before that was Founder and Director of the MA program in Media Studies at New College of California in San Francisco. He moved to the island city-state in mid-2007 and recently became Chief Political Economist of EconomyWatch.com, while continuing efforts to develop innovative graduate education in Singapore, the education hub of East Asia.
Mark A. Thoma
Associate professor of the Department of Economics of the University of Oregon, he teaches monetary theory, macroeconomics, Econometrics, International Finance, History of Economic Thought, International Economics, Money and Banking, Microeconomics and Managerial economics. He also edits the blog Economist’s View.