SEX AND CENTRAL BANKING
Ajit Chaudhuri, February 2013
'The only useful banking innovation was the invention of the ATM': Paul Volcker
Allow me to meander through three unconnected events before getting to Paul Volcker, inflation and bank regulation, which this paper is actually about.
One of the events that a fellowship at the London School of Economics (LSE) entitled you to gatecrash back in 2001 was the annual meeting of the UK-Germany Economic and Commercial Cooperation Society (or some such thing). I had imbibed too much wine with my lunch while there, and was therefore not prepared for what followed – a long and excruciatingly detailed talk on macro-economic policy by the then President of the Bundesbank, Ernst Welteke. When the torture finally ended, I mentioned to the others on my table that there should be a ban on central bankers speaking after lunch. They concurred, but also said that there was something comforting about Herr Welteke’s boringness – that the very qualities suitable for a person charged with the monetary policy of a nation were those that made for dull oratory. It seems a natural law that central bankers have the effect of chloroform on others. At a subsequent seminar at LSE, another speaker was discussing the cultural barriers to European integration and gave the example of Germany and Italy. To Germans, he said, Italy is a place one only goes to on holiday. And to Germans, all Italian men are gigolos – because that is their experience while they are on holiday. Germans, therefore, cannot conjure up an image of an Italian central banker – a huge barrier to discussions on formation of a European central bank with shared responsibilities and rotating leadership.
On a rare TV-watching foray away from sports channels, I came across a discussion on the slowing Indian economy and possible courses of action. The speakers, purporting to speak in the public interest, were castigating the government for being held hostage by the RBI’s (India’s central bank) refusal to lower interest rates. It was unusual to observe such unanimity on TV!
I recently read a biography of Steve Jobs (‘Steve Jobs’ by Walter Isaacson, Simon and Schuster, 2011), and this had me thinking about the concept of ‘greatness’ again. Is it the preserve of the rich and charismatic, of those who have built something from nothing, who have changed the way we do things, who have seen something others did not, or who have fought and won wars? What is the scope for those who have lived rather more ordinary lives, who have preserved and prevented rather than created or destroyed, who have not wowed the world with products and thoughts? Are only the former worthy of our awe? Or can the dull post-lunch speakers too aspire to greatness?
The financial collapse of 2008 soiled many reputations – within the financial industry, and among those entrusted to keep it in check. It also enhanced a few, and a man called Paul Volcker’s was one of these. This note attempts to make a case for Volcker to be considered ‘great’ – despite him being gawky in appearance (he’s over 2 meters tall), only comfortably well off (rather than obscenely rich) and, yawn, yawn, a central banker to the core.
Volcker’s achievements can be described through three episodes.
The first was his time in the Treasury Department (1969-1974), when he oversaw the abandonment of the post-1945 Bretton Woods arrangements that pegged the value of the dollar to gold, and of other currencies to the dollar at fixed exchange rates. As the Vietnam War escalated, demand in the US grew without accompanying increases in productivity, resulting in rising prices and, because of the inability to devalue the currency, uncompetitive exports. As investors began fleeing to other currencies, the US decided in August 1971 to end the dollar’s peg to gold and to usher in an era of flexible exchange rates. Volcker was entrusted with ensuring an orderly transition. Thanks to a combination of negotiation and coordination, the Bretton Woods arrangements were dismantled without sparking off a full-blown financial crisis. The relevance of this episode is still significant in the light of the Euro-zone’s struggles to cope with the havoc of maintaining fixed exchange rates.
The second was his war on inflation as Chair of the Federal Reserve Bank (or the Fed, the US’s central bank). In the 1970s, inflation was the bane of the US’s economy (12 percent in August 1979, a month after Volcker took over). Inflationary expectations had deeply set in, and had set off a ‘wage-price spiral’ – in plain English, wage negotiations that assumed 5-7 percent inflation and resulted in 7-9 percent wage increases, in turn causing prices to rise still further. Volcker designed a new Fed policy of explicitly slowing growth of money supply (rather than a central bank’s normal method of raising interest rates directly), forcing the US economy to slip into recession and its associated problem of unemployment (which peaked at 10.8 percent in late 1982). He stuck to his guns despite withering criticism from the US Congress and industry, and stayed the course until inflation climbed down. He then cut interest rates and made it easier to borrow money. Unemployment fell rapidly, and conservative economists (including Milton Friedman) warned of overheating and an imminent return to inflation. But Volcker saw the Fed’s worst failure as one of waiting too long to tighten monetary policy during the expansion, not of loosening too much during recession. History proved him right – a record breaking expansion followed, and inflation never returned.
The third was his championing of a ban on proprietary lending (when a firm trades financial instruments with its own money, rather than its customers’ money, so as to make a profit for itself) by commercial banks – now called the ‘Volcker Rule’. His reasoning was that commercial banks (where citizens keep their savings) are backed by deposit insurance and can borrow money from the Fed at a discount in a crisis, and this enables their access to cheap capital. Proprietary lending therefore involves using a state subsidy to make risky investments that leave the taxpayer on the hook if they fail – a sort of ‘heads I win, tails you lose’ situation. It also invariably puts banks in direct conflict with their clients. Volcker’s critics contend that the rule is untenable because commercial banks have to compete with entities (hedge funds, money market funds, international banks, etc.) that are not subject to these restrictions. There was furious lobbying to remove it – yet each time the rule looked in jeopardy some development would validate Volcker’s logic, such as news of Goldman Sachs knowingly shorting investments it was selling to its clients, or JP Morgan Chase losing billions on a single proprietary investment.
Indians have another cause to remember Volcker – he investigated the UN’s oil for food racket in Iraq that brought down our then foreign minister, Natwar Singh. Interestingly, our politician-bureaucracy mafia didn’t resort to their usual shenanigans in the report’s aftermath; gang-up, counter-accuse the investigator of racist bias, obfuscate by questioning the motivation, basis, methodology or numbers, etc. (the stunts being pulled on the Comptroller and Auditor General today). Volcker’s reputation and methodological rigour were impeccable and irreproachable – the @##&@# simply
shut up and resigned.
Great careers offer lessons to others, and Volcker’s is no exception.
To policy makers, the critical lessons are that of projecting confidence and credibility, and of articulating clear frameworks to resolve crises. Volcker understood that a government had to establish credibility in order to give policy makers the flexibility to act. In both the gold and inflation crises, it was the failure of authorities to make credible promises that invited speculative attacks by investors betting that the government would back down. In the 1980s, once people believed that Volcker was willing to administer the most painful medicines, and to keep at it until prices stopped ballooning, he earned the flexibility to bring inflation down to normal levels. Policy reversals undermine credibility and make rescue much more difficult – a lesson proved relevant by Europe’s chaotic response to its sovereign debt crisis. And also, serious crises cannot be tamed solely by improvised disaster control by well-intentioned officials – it takes explicit frameworks, that leave people in no doubt what the government will do when things go wrong. A benefit of a preference for frameworks over emergency meetings is, according to Milton Friedman, that it puts an end to the ‘occasional crisis – that produces frantic scurrying of high government officials from capital to capital’.
Volcker was tough on regulatory oversight. He believed that free markets are unable to govern themselves, that they can function only if people trust the system, and that conflict of interest and creative accounting are dangerous precisely because they destroy public trust. He said that bankers, like everyone else, would try to take advantage of a system that lacks oversight – and many so-called financial innovations are actually ways for firms to get around regulations or to avoid taxes, thus providing little benefit to consumers or to the economy. He articulated the need for clear and direct oversight of banks’ behaviour, saying that ‘commercial bankers understand when a bank examiner gives them a green light to lend. They also understand a red light, whether they like it or not, but most ignore the cautionary yellow.’
My own key take from Paul Volcker is his contention that honour is the most important thing a person has (he remembers that, in his earlier days in government, no banker worried more about his bonus than his reputation), and that public service is the most important thing a person can do – despite the modest pay and the considerable tribulations of government work.
To those of you still here, I would like to return to my question in page 1 of this note – can a man such as this be considered great? I am not sure I make a convincing case – there is something ‘unsexy’ about interest rates, financial regulation, and a career spent ensuring that the small guys sleep at night.
Further reading for those interested:
Goolsbee, Austan; The Volcker Way: Lessons from the Last Great Hero of Modern Finance; Foreign Affairs; January/February 2013
Silbur, William; Volcker: The Triumph of Persistence; Bloomsbury Press; 2012