The man with 60 years of banking, financial markets and monetary policy experience under his belt, Paul Volcker, the Chairman of the President’s Economic Recovery Board (or PERAB), is making a public case in the New York Times for reforming financial markets regulations and institutions. He wants structural reforms if the system is to survive. That sentiment is completely valid.
Volcker is not a man known to mince his words and he had been correct about many things, including his early warning about the nature of the current crisis for the U.S economy: he had seen the decade following 2007 as a possible repeat of the 1970s (that said, a U.S steady state growth rate of 1.5 to 2 per cent at a CPI inflation of 5 per cent may not after all be stagflationary after the ending of the Great Moderation if the current economic structure is assumed for the foreseeable future provided the social choice the country is willing to make without social disruption, similar to the Europeans, is to tolerate 7 to 8 per cent persistent unemployment). He is perhaps the last man standing both in government and on Wall Street with a reputation for integrity on matters of money. He has duly earned it and fully deserves that reputation. His urging to reform regulations is but an indication of that integrity. However, the debate is about the how. What is the best way to reform the system?
The invisible hand argument of Adam Smith to make the case for a market place with little or no government intervention (Adam Smith had not written the Wealth of Nations in a democracy) also known as the laissez-faire or the classical case for economic management is predicated entirely on reputation risk. That honest dealing will raise social welfare in a perfect market of many competing buyers and sellers. The converse also, therefore, naturally applies to Smith: that when there is a multitude of dishonest buyers and sellers in a perfect market, the market is not only imperfect but the invisible hand produces a systemic crisis. The feedback loop can be either negative or positive vis-à-vis social welfare.
In a simple model of the financial sector, in principle, there can be one bank and one government. Are they both too big to fail? If they are, and one government for a country, since the birth of the nation-state, is a Hobson’s choice, then why is there a systemic crisis in what is otherwise a perfect market that is the U.S financial sector? There is no shortage in the United States of thrifts, credit unions, community banks and other small commercial banks? The issue, therefore, is not how many firms exist in a market. It is, according to Smith himself, how honestly and responsibly the firms conduct their business both in relation to each other and in relation to the consumer. Smith argues that honesty and responsibility are in their best interest because without it they will be deprived of a market.
If the butchers and bakers of Adam Smith and his day’s equivalent of today’s community banks woke up one day and decided to collude, and the monarch running the empire wanted to bail them out by bringing in quality meat, bread and gold from elsewhere in the empire each time they fail for poor business practices, do Smith’s business folks have any incentive to be honest? This is precisely the predicament of American capitalism today.
Honesty and responsibility cannot be legislated. It applies to both economics and politics. The American founders had little faith in power and government. So, they had deliberately constructed a system of government that was inherently weak so as not to become tyrannical even if it is a government of, for and by the people. Honesty in American governance is a structural outcome by design because the interests of the constantly warring branches are such that they are expected to keep each other honest. Should that fail, the First Amendment provides the safety net. When all of these fail, America is also not immune to tyranny, just as the Weimar Republic was not either.
The United States of America is currently in the throes of the tyranny of capitalism, in a society where money has coopted both the government and the First Amendment. To correct it, tweaking the number of firms and separating what they do in the financial markets cannot alone solve the problem. What has not been done as a conscious matter but more as a matter of political evolution in the United States is the role of government regulation: the substance of the laws that Congress writes.
The administration of justice by the third branch of government was seen by the founders, besides the checks and balances between legislation and execution, as the principal regulator. The ability of the Congress to regulate outside the courts itself could be litigated. Justice, in economic terms, is the original pure public good for which the Congress appropriates tax revenues. Any regulation outside of it naturally results in more government.
In reforming government, therefore, the question that the government must be asking itself is whether the United States must formally commit itself to treating government regulation in the interest of the general welfare of the country as a pure public good. If so, tax revenues must be appropriated only for the purposes of enforcing the laws in all areas of the marketplace beyond the only two pure public goods of national defense and foreign affairs. All else, besides a social safety net, would be provisioned by the private markets and regulated appropriately by the government to ensure equity.
The principal responsibility of the government is to enable a well-functioning marketplace under law. Now, the question for financial reform becomes one of writing the law efficiently so that the desired outcome of system stability can be achieved at the least cost to the tax payer to provide the most benefit to the society. Therefore, what must be the substance of the reform legislation and how would that impact both private financial institutions and the existing government regulatory agencies? Questions such as these by definition cannot be answered by political contributors and financial industry lobbyists who currently produce government legislation in the backrooms of the Congress.
In answering these questions, I do not think there is a need for the Volcker Rule which cannot separate risky banking from relatively riskless commercial banking without also severely and gratuitously constraining financial innovation in the process (the derivatives market which had caused the current crisis in housing), but it is necessary to fix the marketplace for risk to ensure that risk premia correspond better to the underlying risk. If doing so is working for the consumers, it must work for the financial markets’ participants because risky behaviors on the part of the financial markets had caused consumer failure, not vice versa.
That the marketplace for risk had failed has been the cause of the current crisis for sometime.