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Sunday, October 23, 2011

Volcker on the Market and Regulation

Paul Volcker, former Chairman of the Federal Reserve, may strike the conventional "wisdom" as an oxymoron regarding the market mechanism and government regulation. I contend that he could teach that "wisdom" a lesson or two.

Regarding systemic risk, Volcker has called the perils of institutions that are too large or interconnected to be allowed to fail the greatest structural challenge facing the financial system. He said we must shrink the risks these companies pose, “whether by reducing their size, curtailing their interconnections or limiting their activities.” This goes beyond what The New York Times refers to as his “addressing capital requirements (make them tough and enforceable), derivatives (make them more standardized and transparent) and auditors (ensure that they are truly independent by rotating them periodically).” To reduce a large corporation’s size, interconnections, or business activities is essentially to say that a company that is too big to fail should not be permitted to continue to exist unless it is downsized. So it is not enough to increase the capital requirements of a large, $1 trillion plus bank that is too big to fail; the bank itself must shrink. Even though market pressure could lead a bank such as Bank of America to downsize, that mechanism is not enough; government should step in to make sure the downsizing is adequate even if the market is ok with the status quo. Essentially, the message is that the market mechanism itself is insufficient to obviate systemic risk. At the same time, Volcker wants to bolster that mechanism by riding of it of the effects of large players that are guaranteed by government even as they are not controlled by it. 

Regarding Fannie and Freddie, Volcker, who was once a presidential appointee to Fannie’s board said, “A public agency intervening in the mortgage market in a limited way doesn’t bother me. But if you want to subsidize the mortgage market, do it more directly than hiding it in a quasi-private institution.” The very nature of a “quasi-private institution” is abhorrent to him because the profit motive does not go well with being protected on the downside by a government. “You ought to be either public or private; don’t mix up private profit-making opportunities with an institution that is going to be protected by the government but not controlled by it.” Such a mix can be expected to result in distorted incentives, such as unduly risky behavior. Furthermore, the mix enables government officials to hide the government’s potential liability from the guarantee. Referring presumably to Treasury officials, Volcker said, “They didn’t want the mortgage to be a government expenditure. It was a volatile thing to put on the budget. They made the wrong choice.” The choice can be explained by the fact that it followed the path of most convenience from the standpoint of democratic accountability. Therefore, from both the standpoint of economics and political theory, private should be clearly distinguished from public as regards institutions. Volcker was not saying, however, that government ought to stay out of the housing market—only that such involvement should not be mixed with the profit motive.

To be sure, Fannie and Freddie have powerful defenders on Capitol Hill and at the White House. Extracting the two mortgage guarantors from the housing market would be an up-hill battle. Vested power in the U.S. can make use of the government’s many access-points, moreover, to stave off change. This is also true regarding proposals to regulate mutual funds. “Because they are not subject to reserve requirements and capital requirements,” Volcker observed, “they are a point of vulnerability in the system.” Yet in a letter to the Financial Stability Board, an international organization charged with developing strong regulatory and supervisory policies for financial institutions, the Investment Company Institute said: “We do not believe banklike regulation is appropriate, necessary or workable for funds registered under the Investment Company Act of 1940.” Strangely, Americans tend to take the rather-obvious positions of such vested interests at face value and accord them validity. Well ok, the conventional wisdom might conclude, then I guess we shouldn’t regulate mutual funds then. The conflict of interest in the mutual fund industry’s own position regarding regulation ought to have the immediate effect of relegating that position in the public debate and in Congressional offices.

Interestingly, Paul Volcker simultaneously disavows relying exclusively on the market mechanism (e.g., regulating to minimize systemic risk) and advocates keeping any government involvement in the market from mixing with the profit motive. In other words, he opposes distortions on that motive even as he is not laissez-faire. Because he is fine with a role for the government in the housing market as long as the public sector involvement does not work through an institution’s profit motive, I view him as being closer to the "government regulation" position than the "free market" position. Even so, he should not be pigeon-holed as “free market” or as “big government” because he does not line up with the "purists" on either "side." Even as he is for financial regulation such as the Volcker Rule, he wants to stress the importance of an "arm’s length distance" between business and government in a market. Government can act in its unique way to protect the market itself (i.e., minimize systemic risk by breaking up firms too big to fail and regulating shadow banking) even as the profit motive is protected from government-backed distortion. The rest of us can take a lesson from Volcker’s wisdom. Accordingly, we might want to avoid easy slogans being bandied about on either “side” of the ideological aisle.

Source:

Gretchen Morgenson, “How Mr. Volcker Would Fix It,” The New York Times, October 22, 2011. http://www.nytimes.com/2011/10/23/business/volckers-advice-for-more-financial-reform.html