On 6 October 2010, attendees at Canadian Economic Forum had the opportunity to hear from Paul Volcker, a man described as perhaps the greatest Fed Chairman of the 20th century. Anna Savelyeva provides this report for readers of The Analyst.

Paul Volcker was chairman of the U.S. Federal Reserve from August 1979 to August 1987, under Presidents Jimmy Carter and Ronald Reagan. He is currently the chairman of President Obama’s economic recovery board. During his tenure with the Fed., Mr. Volcker demonstrated that tough policies can be implemented in difficult times amidst strong political pressure and results be achieved in a very short period of time. The session included a Q and A with Don Drummond, senior vice president and chief economist at TD Bank Financial Group.

Shifting world geopolitics

Mr. Volcker asserted that the shifting world will affect global geopolitics and the place of the U.S. in the international arena. It is not only the U.S., but the entire developed world, with the exception of Australia and Canada, that is not doing very well. The fragile economic world is dependent upon support from the emerging countries, which are looking terrific from the standpoint of measuring their growth. It is not just China with near 10 percent growth year after year, it is India, South Korea, Taiwan, Brazil, and even some Eastern European countries. This is unusual: emerging world economies growing much faster than the developed world with ‘poor’ countries lending to the ‘rich’ countries.

“It is not in any textbook, it is not anyone’s expectation. Rather, it is a reflection of the real imbalances in the world economy that need to be corrected and this is what any economic crisis is all about.”

Industrial sectors

Mr. Volcker believes there is no major sector in the American economy that holds much promise for delivering expansionary momentum. He explained that this is very unlike an ordinary recession. It is very difficult to find a sector in the American economy that has any spark to it, which makes it hard to get out of this recession (which was created by over consumption). An increase in exports as well as manufacturing is much needed; however, this change will take years to materialize.

The U.S. economy

The developed world is facing serious unemployment problems and everything else that is the result thereof. While the financial crisis may be a big part of the cause of this recession, there is an underlying problem of disequilibrium in the world economy. U.S. consumption increased dramatically with almost no increase in real income. On top of that, it was so easy to borrow, which created a great boom and later a massive bubble in the housing industry. With no savings and a lot of borrowing, the high level of consumption could not be maintained forever. The United States, the centre of the world political system, the centre of the world economy, has been living year after year on heavily borrowed funds. Interest rates stayed low, which served to further fuel the housing bubble. America’s financial engineers took short-term debt and converted it into powering the consumer boom.

U.S. versus China

Meanwhile, there was a complementary problem in Asia, particularly in China:

“China loved to produce. They were delighted to export to the United States to support our consumption. And for a while they were equally delighted to take dollars in payment and invest them into U.S. Treasury Bills.”

U.S. consumption had been running at about 70 percent of sluggishly growing GDP and it became the biggest part of the economy. On the other hand, Chinese consumption was 35 percent of their rapidly developing GDP, which is exactly a half of what America’s is in relation to the size of the economy. They became dependent upon foreign capital. Greece, Spain, Portugal, Ireland and the U.K. are all overextended as well. China is not a leader yet, but they are surely trying to get there. Now China is looking around the world for a better way to deploy their savings than U.S. Treasury Bills at 0.25 percent.

“What a contrast to the world 20-30 years ago. The U.S. used to be a super power, a leader with no competition. China was struggling as [it] emerged from the cultural revolution. They looked to others for assistance, for advice. They do not ask us anymore and this is symbolic of the change that we have, which has implications internationally.”

Sub-prime mortgages and the CDS market

At their peak in 2007, sub-prime mortgages had grown into a giant U.S.$1.5 trillion segment in only three to four years. No other financial phenomenon of this size took hold so rapidly (and on such a weak structure). The other important instrument was the Credit Default Swap (CDS), which was invented in early 1990s. However, the CDS market only started to make serious headway in 2003. By the end of 2007, CDSs outstanding amounted to U.S.$62.2 trillion, which was backed by only about U.S.$6 trillion dollars in collateral.

These two instruments were not helpful in terms of two fundamental functions of financial markets, namely to transform our savings, do it efficiently and into the most productive sector of the economy. Financial markets have become enormously profitable in the past 10 years, but Paul Volcker believes they were not efficiently channeling the savings of Americans into the most productive uses.

“We were channeling Chinese savings into our sub-prime mortgages, but that could not last forever. Sooner or later we could not count on borrowing any more, nor could China count on selling us their excess capital.”

The way forward

Paul Volcker supposes that it will take years to fully exit this recession, which was caused by a breakdown in the financial system. In order to repair the damage large adjustments will have to be made. Big increases in American exports will help close the fiscal deficit. Mr. Volcker still believes in the power of confidence and describes the great challenge for political leadership.

“We must maintain confidence in our own stability and the ability to see this through. Exceptional political leadership is needed to explain to people how we will get out of this recession. We are still the most productive and we can bring our capacity in the line with the rest of the world.”

Banking reform

A high concentration ratio in the banking industry worked in favour of Canada during the financial crisis. Canadian banks avoided many problems, partly because proprietary trading activities were not as significant as in the U.S. and also because they have very profitable retail businesses. Mr. Volcker does not necessarily agree that the U.S. should implement a similar policy, but he argued that if a single bank has 10 percent of all the financial assets in the U.S., it is simply too big to manage. Further, the problem with these banks being too big is that they get into proprietary trading and other speculative activities.

“The people who ran these activities did not recognize any fiduciary relationship with a customer, were very aggressive and very highly paid”.

Financial system reforms

Mr. Volcker ended by commenting on the financial system reforms. Regulatory change requires structural change, otherwise there will be problems. In particular, Mr. Volcker mentioned credit default swaps, stressing the importance of clearing procedures through organized exchanges, which will provide a greater degree of certainty as to what will happen in the event of failure. The second equally important area in structural regulation is those institutions that are too big to fail. The key lies with a speedy bankruptcy process, thereby minimizing the impact on financial markets. Big banks that are the most complicated, most important, and which cannot be replaced right away, must be protected and appropriately regulated. However, he emphasized the distinction between commercial banks that provide an essential service for people and institutions, involved in proprietary trading or hedge fund activities:

“Commercial banks ought to have a safety net. There should be no taxpayers’ money in proprietary trading.”