Op-ed Spotlight: Paul Volcker Explains, Evaluates Financial Reform Proposals

The chairman of the Economic Recovery Advisory Board waxes eloquent on the purpose of economics

Paul Volcker, chairman of the Economic Recovery Advisory Board, has bared his heart regarding proposed financial regulation in The New York Review of Books. He covers a lot of ground, from the decidedly wonky discussion of the "vast 'shadow banking system'" and "too big to fail" to the ever-present matter of the national deficit. Here are some of the more interesting bits for the layperson:

WHERE WE STAND NOW

Any thoughts--any longings--that participants in the financial community might have had that conditions were returning to normal (implicitly promising the return of high compensation) should by now be shattered. We are left with some very large questions: questions of understanding what happened, questions of what to do about it, and ultimately, questions of political possibilities. The way those questions are answered will determine whether, in the end, the financial crisis has, in fact, forced the changes in thinking and in policies needed to restore a well-functioning financial system and better-balanced growing economies.

THE PURPOSE OF ECONOMICS

The Stanford Institute prize announcement sets out a simple proposition I suspect we all would support: "Economics is fundamentally about efficiently allocating resources so as to maximize the welfare of individuals."

THE QUESTIONS WE NEED TO CONSIDER

Has the contribution of the modern world of finance to economic growth become so critical as to support remuneration to its participants beyond any earlier experience and expectations? Does the past profitability of and the value added by the financial industry really now justify profits amounting to as much as 35 to 40 percent of all profits by all US corporations? Can the truly enormous rise in the use of derivatives, complicated options, and highly structured financial instruments really have made a parallel contribution to economic efficiency? If so, does analysis of economic growth and productivity over the past decade or so indicate visible acceleration of growth or benefits flowing down to the average American worker who even before the crisis had enjoyed no increase in real income?

WHERE THE FINANCIAL WORLD WENT WRONG

One basic flaw running through much of the recent financial innovation is that thinking embedded in mathematics and physics could be directly adapted to markets ... [F]inancial markets are not driven by changes in natural forces but by human phenomena, with all their implications for herd behavior, for wide swings in emotion, and for political intervention and uncertainties.

ON THE CURRENT FINANCIAL BILL

There are some parts of that bill that I would prefer to see changed, redrafted, or eliminated in the negotiations to reconcile it with the House bill during the coming weeks. This is particularly true in clarifying the limits on proprietary activity of commercial banks, including trading in derivatives. However, I do think that taken as a whole the bill does incorporate basic approaches that can and should be part of our international consensus ... None of these reforms will assure crisis-free financial markets in the years ahead. The point is to keep the inevitable excesses and points of strain manageable, to reduce their scale and frequency, and in the process more effectively contribute to the efficient allocation of our financial resources.

THE NEED FOR 'POLITICAL CONSENSUS' MORE BROADLY

Restoring our fiscal position, dealing with Social Security and health care obligations in a responsible way, sorting out a reasonable approach toward limiting carbon omissions, and producing domestic energy without unacceptable environmental risks all take time. We’d better get started. That will require a greater sense of common purpose and political consensus than has been evident in Washington or the country at large.