When Paul Volcker speaks, Republicans and Democrats, labor and business, listen. The former Federal Reserve chair consented to a rare and exclusive interview with Leslie H. Gelb, a frequent columnist for Newsweek and The Daily Beast. The 6-foot-7, 85-year-old, gruff, plain-spoken yet very careful Volcker had some blunt and important messages for government and banking leaders—and for all Americans.
Gelb: Are the troubles in banking and finance—the illegal trading, the possibly illegal LIBOR-rate setting, the sky-high risk taking, the supposed difficulties bank heads have being able to control their subordinates—really something new?
Volcker: I believe it is something new in degree. I say that with some reluctance, thinking maybe it’s just that I’m an old man and didn’t know what was going on before. But I am struck by the number of not just friends but other observers who share the belief that there has been a real change in the mental approach of people in markets. They used to be more customer-oriented, with some sense of fiduciary responsibility that’s been very much reduced into an impersonal, “you’re a counterparty, you’re not a customer” caveat emptor.
That attitude lies behind a lot of these difficulties and has been spurred by enormous changes in compensation practices that have tempted people to cut corners. I’m afraid that the temptation now becomes greater—that if I can, as they say, cut some corners, maybe I’ll get some of this magic dust myself in proportions that seemed unimaginable a few years ago.
When they cut corners, is the head of the bank in a position to know and stop it, or have operations become so big and complex that bank heads can’t know what’s going on?
They can’t know what’s going on in detail, but the important thing is setting the tone and standards at the top to which people are expected to adhere—and if they don’t, then action will be taken. All these banking institutions have fine statements of their ethical practices on paper, but how much it’s really enforced, how much is in the instincts of staff, and particularly the traders, up and down the ranks, is difficult to say.
And you think it’s worse today because the opportunity to make fortunes is now so great?
Yes, that’s the point I’m trying to make. That contributes to it. What I detect is—and I hope I’m not just imagining things in old age— but when I was a young man in banking, you didn’t have these huge compensation practices; bonuses were not considered appropriate, people didn’t raid each other for talent, and so forth. There was a certain pride in professionalism. If you had stature as an important international banker or as an important person known in the trading field, etc., it was a matter of professional pride. And there was much more emphasis on that than on making extraordinary amounts of money.
Is there any way to deal with runaway compensation, or is this a problem that can’t be fixed?
In the end, it only really can be fixed by behavior in the marketplace, by which these rewards wouldn’t be justified. I think part of the problem, to be a little bit personal, is this proprietary trading instinct, which gives rise to a very aggressive kind of behavior in an effort to make a killing for yourself as well as the company. It spreads through the institution, and people say, “Well, why don’t I have that same kind of opportunity?”
Are the regulations now too vague, or are the regulators not capable enough?
Regulators obviously have an enormous challenge. These complexities were always a challenge; now they’re more so. But I think the regulators and markets and government have been imbued with the idea that markets left alone will discipline themselves. In a way, the regulators are outgunned. They do need the support of the senior executives of the institutions. If the talent at the top is forgiving of bad practices, or even encourages these practices, it’s going to be very hard for the regulators to do anything. It comes back to this: what is the punishment when wrongdoing is found?
Let’s take the LIBOR escapade [the London Interbank Offered Rate, an average interest rate calculated from data submitted by major London banks, some of which were found to be manipulating their rates for their own benefit]. Here you get a bunch of bankers responsible for setting the LIBOR interest rate, setting it lower, maybe even significantly lower, than it should have been set. Is there any way to deal with that? Or can you really catch it only after the fact?
It’s a good example. This was an arrangement that arose among the banks themselves. The British Bankers’ Association was supposed to exercise surveillance and be reliable. Yet even there, the temptation apparently couldn’t be resisted. It is a reflection of the fact that there has been a loss of discipline about what is right and natural and ethical. How can you rely on the banks to set rates when the banks themselves are the measuring stick?
Are you saying that the bulk of the solution has got to come from the industry more than from government?
I would like to think that’s true, but I don’t have the sense that the leadership is there yet. And that is a sorry statement. It’s a discouraging thing that here we are, faced with the worst economic crisis certainly since the Great Depression, and whether there really is a sense in the marketplace that something is going seriously wrong—that it needs a serious revamping—I’m not sure that that attitude is even there. A different side of it is the amount of money spent on lobbying, the amount of money spent on elections, all of which affects the political process. It is a little discouraging. I put that very mildly.
What does the Dodd-Frank law [a 2010 measure boosting regulation of banks in hopes of preventing another 2008-style collapse] really buy us?
Dodd-Frank takes the position that individual financial institutions will not be rescued. There are profound suspicions and skepticisms that this law won’t work very effectively, so that in itself isn’t adequate. I take a more hopeful view. But it’s certainly true that success in that area, as in other areas, will depend upon a high degree of international cooperation, because these big banks and big financial institutions are the epitome of being international.
If, heaven forbid, the banks, which are even bigger today than they were before the crisis, started to fail again, Dodd-Frank notwithstanding, should we bail them out again?
According to Dodd-Frank, you would not bail them out. You would effectively take them over, with the implication that they would be liquidated over time—or more realistically, they would be broken up and sold off in pieces, which would end up, hopefully, with a net reduction in the size of these average institutions. Stockholders and management would be out. Some creditors are at risk. That’s the theory of it.
How would the Volcker rule [a section of Dodd-Frank that seeks to restrict banks’ ability to engage in some kinds of speculative investing] affect these problems?
It’s a step in a number of directions. To some extent, it reduces risk directly. There are many risks in banking, but we’ve seen cases where even individual traders can get a bank into trouble. That’s unacceptable. But as important, maybe more important, is what it means for the culture of the institution, about compensation practices.
But can you go back to Glass-Steagall [the 1933 banking law erecting a wall between commercial and investment banks]?
Glass-Steagall said banks can do no trading, period. I’m a very moderate person. I’m not saying ban all trading, just speculative trading. Banks should be able to do normal market making and underwriting. Glass-Steagall would have prohibited that. The Volcker rule is not unimportant, but there’s no magical elixir for the whole system. The derivatives area is extremely important.The big thrust of regulation has been to standardize derivatives and force them into some kind of a clearinghouse to better assure, at least in times of crisis, that the situation is being resolved more readily. There’s great resistance to that because the profitability has been in so-called custom-made derivatives, where by some complicated alchemy, banks say they will protect you against risks.
This situation is reinforced by a lack of discipline in the international monetary system. I’m thinking about the big, persistent deficits of the United States matched by big, persistent surpluses in China, at least until recently—the enormous flow of funds out of the United States, as a result of our balance payment deficits, the enormous buildup in assets in China and elsewhere, lent back to the United States at very cheap interest rates, which helped to promote undisciplined lending, as with housing mortgages.
With all the changes in the world economy, is it possible that the U.S. or Western Europe, for example, can really fix their economies and get back to the growth economies of the 1990s?
I can’t bring myself to believe that the structural problems can’t be overcome in the time frame that you’re talking about. We’ve had a lot of dissonance. We’ve had this explosion in the emerging economies, epitomized particularly by China, with hundreds of millions of people being taken out of poverty, and so much manufacturing has moved out of the United States and some other advanced countries, inevitably, but so rapidly as to leave us with a significant adjustment problem.
Can we expect any time in the next 3-5 years or beyond to get our unemployment rate down by very much, if at all?
Yes! I can get pretty pessimistic about things, but I’m not pessimistic that we can get the unemployment rate down in the time frame you state—even though the present recession contains deeper structural changes than past recessions. Still, we see glimmerings even in the United States of some leveling off of the manufacturing decline. Whether in a recovery today we can solve unemployment with a distribution of income of the kind we were accustomed to 20–30 years ago is another question.
Meaning what? That the income gap between rich and middle class is unfixable?
We have a situation in the United States that seems almost unbelievable. It’s going to take some time to fix this. The most recent unemployment figures are consistent with the recent pattern. We’re continuing slow job creation without substantial possibilities of reducing unemployment for a while. That is the situation of the constraints on growth in the deleveraging period.
Which vision on how to fix the U.S. economy makes more sense to you: the Paul Ryan plan of tax cuts for the wealthy and deep bites into federal spending, or Simpson-Bowles [the presidential commission that offered a major deficit-reduction plan by increasing some taxes and cutting spending], which increases taxes for the wealthy with far less dramatic reductions in federal expenditures?
Well if you’re just aiming for a balanced budget—it would be extremely difficult to achieve without some significant reform in the entitlement area. We’ve also got to take some look at the defense area, where expenditures are so large relative to the rest of the world that there might be some room for savings. But on top of that, you’re going to need some additional revenues. It’s not possible right now, but we need a real structural reform in our tax system if we’re going to approach equilibrium between spending and taxation. In addition, we’ve got great budget pressure on state and local governments.
So what would you do on taxes?
To put it bluntly, we have to move more toward a consumption tax. There are different ways you could do that, but that’s what we ought to be doing.
Would you get rid of the Bush tax cuts?
In the short run, you’ve got to deal with your income taxes. You can do that either by repealing the Bush tax cuts, at least for some people, or by rearranging the exemptions and loopholes, all those things people talk about adopting, something along the lines of Simpson-Bowles.
How has Obama done in handling the economic recovery?
Everybody thinks it would be nice if the administration were more effective in promoting a balanced package on taxes and spending. The problem is that the political system has been so ideologically divided, and the congressional situation is such that it’s been hard to get any degree of consensus on any sensible program.
Did Obama do enough to promote a bigger stimulus package?
He took about as much stimulus package as he thought he could get away with at the time, and it was very substantial. And when Congress got on it, they did a lot of things to meet political desires rather than economic efficiency and speed of disbursement. I don’t have any big criticism of the administration not pushing hard enough on the overall volume. They did what they could.
Has Treasury Secretary Tim Geithner done enough to deal with the housing mess?
Housing was less susceptible to a quick emergency fix than the banking area. You have too many mortgages out there at values not supported by the value of the house itself. Ultimately you can say forgive a lot of the mortgages, but to write off and make a choice on which mortgages are bad is extremely difficult. I haven’t seen any convincing answer for how to clear it up more rapidly.
What do you think of the Ryan plan?
I am no budget expert, but what I sense is that it’s left a lot of things open and kind of a wing and a prayer. I don’t think it answers all the questions; let me put it that way. If it’s not going to raise taxes anyplace, it doesn’t seem to me it can be adequate.
Does either political party make a powerful case for its economic policy, or are we in a “he says, she says” argument?
Well, I don’t think it’s quite that bad. You are stating an enormous indictment of the economics profession (laughs). I think the economic debate is not as wide as the ideological debate. But it is true that economists have a lot to answer for.
To oversimplify, Democrats say expand demand and supply will follow, while Republicans say put more money in the hands of suppliers and demand will increase. What do you think?
In the end, you need the increase in demand. But it’s hard to see how changing marginal tax rates, which is all Republicans are talking about, will stimulate suddenly all entrepreneurial juices, and cause people to spend more or investors to invest more. Of note, we’ve had a lot of investment in the past with a lot higher tax rates than anybody is proposing now. We have to look at the total economic environment, including whether you have a market to buy.
Do you think that some version of Simpson-Bowles or Rivlin-Domenici [another bipartisan panel putting forth a deficit-reduction plan] is the best we can do?
Yes, absolutely. I wish Mr. Obama would do it today. Those two approaches have the essentials. Neither has the kind of tax restructuring that I envision, though Rivlin-Domenici had a little bit of it. Ironically, the easiest thing to do, politically and otherwise, is Social Security reform. Such reform would be important as an example of what we can do in the medium and longer run.
Do you think the Fed has gone into wholly new terrain, whether it’s helping or hurting with all these quantitative easings [the Fed buying up bonds to keep interest rates low], as with the new QE3 announced Thursday?
It’s certainly new terrain, and that was obvious in the midst of the crisis. They went into new terrain because the economy was in new terrain. The Federal Reserve has limited tools. They’ve run out of really strong action and are approaching the limits of their ability to deal with the situation. There aren’t any magic bullets there.
I think people think the quantitative easing helps pep up the stock market and may reduce long-term interest rates a little bit. But I don’t think it does enough to make a really significant difference in the basic outlook, which remains one of limited job creation in the private sector, but not really enough to reduce the unemployment rate at all rapidly. There is slow progress toward deleveraging—and that’s the outlook. And the Fed action doesn’t remove the need for tough fiscal policy in a medium-term horizon.
Is the Federal Reserve Bank living up to its charter of maintaining price stability and promoting full employment?
I’ll be radical and say this dual mandate confuses the issue. The most important thing the Federal Reserve can do over time is maintain price stability. Obviously when you’re in the midst of a recession to start they can maintain price stability and provide a lot of stimulus at the same time.