Former Federal Reserve System Chairman Paul Volcker
calls for action on the U.S. credit crisis, the economy and inflation

"The mother of all financial crises" is how former Federal Reserve System Chairman Paul Volcker described the current situation in the United States.

"What we've been seeing is a really wrenching reversal of exuberance that only a few years ago sent stock markets and then residential values through the roof to precarious levels," said Volcker, the first-day keynote speaker at CME Group's Global Financial Leadership Conference. "It's not uncharacteristic of financial markets to move from exuberance to fear, from greed to fear - and it's the fear that's driving values today."

Volcker knows a crisis when he sees one. He identified inflation as the nation's number-one problem during the 1979 Senate Banking Committee hearing that confirmed him as Federal Reserve chairman. That year the Consumer Price Index rose 13.3 percent. Volcker achieved a relatively speedy decline in infl ation by tightening the money supply and raising interest rates, despite concerns about a recession and high unemployment. The consumer price index increased just 3.8 percent in 1982 and 4.4 percent in 1987, the year Volcker stepped down as Federal Reserve chairman. He is now serving as an economic advisor to U.S. presidential candidate Barack Obama.

HOW DID WE GET HERE?

Volcker believes that today's situation was triggered by the very complexity that fueled strong economic growth over the past 25 years - a level of prosperity comparable to the boom years of the 1950s and 1960s.

Twenty-five years ago, banks were the dominant operators in the credit markets, with about a 60 percent market share in the United States and much more in other countries. Today, banks have just 30 percent of the credit market. Compared with 25 years ago, a much higher percentage of real estate credit and other loans are securitized and sold to non-bank financial institutions promptly after origination.

Before the financial crisis began in mid- 2007, this arbitrage appeared to spread credit risk, encourage pricing consistency and improve market efficiency. The increasingly obvious bad news is that a lender did not need to be as concerned about creditworthiness if a loan was not staying on its books. Furthermore, secondary market purchasers may not have been able to assess credit or maturity risk accurately, despite internal due diligence or credit agency ratings.

"Instead of spreading the risk, in some ways today's market seems to have concentrated risk,' Volcker said. "Its very complexity has made the system more opaque, not more transparent. When the crisis broke, enormous uncertainty unraveled mutual trust among market participants and contributed to the market breakdown. We have a failed financial structure."

When the excesses of the subprime mortgage were exposed, doubts about financial values spread and painful adjustments were forced on the U.S. economy, said Volcker in an April 2008 speech to the Economic Club of New York. At that time he stated, "Financial crises have been a recurrent feature of free and open capital markets, not least in the United States. Those past 40 years of relative tranquility were the exception, not the norm. Any return to heavily regulated, bankdominated, nationally insulated markets is pure nostalgia, not possible in this world of sophisticated fi nancial techniques made possible by the wonders of electronic technology."

WHERE DO WE GO FROM HERE?

Daily and even hourly headlines attest to the rapidly unfolding nature of the U.S. credit crisis. Some of this was not a complete surprise. For example, editorial writers have expressed anxiety for years if not decades about Fannie Mae and Freddie Mac. These agencies were created by the U.S. government in part to finance affordable housing, and are able to borrow at rates lower than their competitors. It is not altogether a surprise that we are now being asked to make good on this implied U.S. government backing.

It is the blue-chip names in the headlines that are truly astonishing. A year or even six months ago, who would have predicted the demise of Bear Stearns or Lehman Brothers? Or the fact that Goldman Sachs and Morgan Stanley would voluntarily transform themselves into Federal Reserve-regulated bank holding companies?

"Our failed financial structure has been held together in recent months only by really, truly extraordinary official actions, actions without any precedent and going right to the edge of their legal responsibilities," said Volcker. While he characterizes those actions by the Federal Reserve and Treasury Department as "necessary," Volcker has called for clarification of the Fed's role as both regulator and lender of last resort. Among his concerns is that the Fed may be perceived to favor particular institutions or politically sensitive constituencies when exercising its sweeping emergency powers.

To restore market confidence and a sense of reasonable valuations, Volcker also suggests that the government establish a temporary entity with broader powers than currently given to the Fed and Treasury. Precedents include the Resolution Trust Corp. in the early 1990s after the savings and loan crisis, and the Reconstruction Finance Corp. during the Great Depression in the 1930s. In this vein, the U.S. Treasury-administered Troubled Asset Relief Program (TARP) went into effect in early October. TARP has authority to buy residential and commercial mortgage loans, credit card securitizations, auto loans and other financial assets for which there is no current market.

Volcker is not the only one calling for action, as today's pendulum swings from less regulation to more regulation. In recent years, the rationale was that heavy-handed regulations would damage the competitive position of financial institutions operating in international markets. Today, the loudest calls are for more regulation to address the systemic failures that led to today's crisis.

"In the long run, we have to rebuild a stronger system, a system that's innovative, competitive, but also more secure - a system better able to stand on its own feet without the expectation of official support," concluded Volcker.

DON'T FORGET ABOUT INFLATION

Not reassuringly, Volcker sees numerous similarities between today's situation and the early 1970s. In both cases, he cites the fear of a recession, skyrocketing oil prices, fast-rising commodity prices and a weak dollar. Any move by the Federal Reserve to cut short-term interest rates and increase credit at its reserve banks to address the credit crisis could exacerbate inflationary pressures and further weaken the U.S. dollar.

"I think we have the opportunity to get the inflation rate back at a very low level that we like to see," Volcker added. "The other side of that coin is that the typical wage earner is losing real income right now, with the inflation rate up... I expect a higher level of unemployment and very slow growth at best. The pressure will be to keep costs down and keep wages down."

However, the credit crisis itself will affect prices, as demand drops for everything from houses to luxury goods. In this financial crisis, both individuals and businesses are finding it more difficult to borrow and are likely to worry about too much debt. Lower U.S. demand already has led to a dramatic decline in the price of oil, which reached a high of more than $147.00 a barrel in mid-July before touching a seven-month low of $91.54 a barrel in mid-September 2008. Volcker noted that our economy can make up for somewhat slower domestic consumption by ramping up exports - which comprise a much larger share of the U.S. economy than the housing industry as a whole.

"The real economy - the economy apart from the financial and housing markets - so far has not been severely impacted," said Volcker. "It is a tribute to the relatively good shape of most companies that actually produce things."

Back to Fall 2008 Issue Home