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 have taught 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. In 2011, 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, and/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. It is not enough, in this view, 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, the market mechanism is not enough; government, according to Volker, should have stepped in after the financial crisis of '08 to make sure the downsizing was adequate even if the market and the banks' CEOs were just fine with the status quo. Essentially, the message at the time was that the market mechanism itself is insufficient to obviate systemic risk. At the same time, Volcker wanted 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” was 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, or least resistance, from the standpoint of democratic accountability. Therefore, from both the standpoint of economics and political theory, the private sphere should be clearly distinguished from the public sphere 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 had powerful defenders on Capitol Hill and at the White House in 2011. Extracting the two mortgage guarantors from the housing market would have been an up-hill battle. Concentrated private power of American banks can make use of the U.S. Government's many access-points, moreover, in order to stave off unwanted proposed 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 have tended to take the rather-obvious positions of such vested interests at face value and accord them validity. Well ok, the conventional wisdom probably concluded, 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 had an immediate effect in relegating the banks' position in the public debate as well as in Congressional offices.
Interestingly, Volcker simultaneously disavowed relying exclusively on the market mechanism (e.g., regulating to minimize systemic risk) and advocated keeping any government involvement in the market from mixing with the profit motive. In other words, he opposed distortions on that motive even as he was not laissez-faire. Because he was fine with a role for the government in the housing market as long as the public sector involvement would 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 did not line up with the "purists" on either side. Even as he was for financial regulation, such as the Volcker Rule, he wanted to stress the importance of an "arm’s length distance" between business and government in a market, even that of banking. Theoretically, 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, such as "socialism," "deregulation," and the "free market."
Gretchen Morgenson, “How Mr. Volcker Would Fix It,” The New York Times, October 22, 2011.
