Time to restore some sanity to the financial system (Paul Volcker, via Simon Johnson)

Despite important differences on particular points, most serious analysts would now agree that many of the roots of the great economic crash of 2008 and the world-wide economic recession through which we're still struggling lie in the long-term consequences of decades of unwise, reckless, and irresponsible deregulation driven by a toxic combination of market-utopian ideological delirium and straightforward political corruption. One area in which this especially true is the financial sector. Finance capitalism was unleashed, ran wild, swallowed up too much of the economy, and then brought down the house when it crashed (and had to be rescued).

Back in April 2009 the indispensable Paul Krugman wrote a column that zeroed in on these developments as a crucial factor that helped to produce the economic crash and explained why "Making Banking Boring" (again) would have to be a key part of any long-term solution. Anyone who hasn't read that column yet should do so. Some highlights:

Thirty-plus years ago, when I was a graduate student in economics, only the least ambitious of my classmates sought careers in the financial world. Even then, investment banks paid more than teaching or public service — but not that much more, and anyway, everyone knew that banking was, well, boring.

In the years that followed, of course, banking became anything but boring. Wheeling and dealing flourished, and pay scales in finance shot up, drawing in many of the nation’s best and brightest young people (O.K., I’m not so sure about the “best” part). And we were assured that our supersized financial sector was the key to prosperity.

Instead, however, finance turned into the monster that ate the world economy. [....]

Before 1930, banking was an exciting industry featuring a number of larger-than-life figures, who built giant financial empires (some of which later turned out to have been based on fraud). This highflying finance sector presided over a rapid increase in debt: Household debt as a percentage of G.D.P. almost doubled between World War I and 1929.

During this first era of high finance, bankers were, on average, paid much more than their counterparts in other industries. But finance lost its glamour when the banking system collapsed during the Great Depression.

The banking industry that emerged from that collapse was tightly regulated, far less colorful than it had been before the Depression, and far less lucrative for those who ran it. Banking became boring, partly because bankers were so conservative about lending: Household debt, which had fallen sharply as a percentage of G.D.P. during the Depression and World War II, stayed far below pre-1930s levels.

Strange to say, this era of boring banking was also an era of spectacular economic progress for most Americans.

People who get their economic 'common sense' from purveyors of simplistic pro-business & market-fundamentalist propaganda (including the Wall Street Journal editorial page, right-wing think tanks, standard political clichés, and too many economics courses) should stop to re-read that last sentence and to ponder its significance.

After 1980, however, as the political winds shifted, many of the regulations on banks were lifted — and banking became exciting again. Debt began rising rapidly, eventually reaching just about the same level relative to G.D.P. as in 1929. And the financial industry exploded in size. By the middle of this decade, it accounted for a third of corporate profits. [....]

Only a few people warned that this supercharged financial system might come to a bad end. [....] And the meltdown came.

Much of the seeming success of the financial industry has now been revealed as an illusion. (Citigroup stock has lost more than 90 percent of its value since Mr. Weill congratulated himself.) Worse yet, the collapse of the financial house of cards has wreaked havoc with the rest of the economy, with world trade and industrial output actually falling faster than they did in the Great Depression. And the catastrophe has led to calls for much more regulation of the financial industry.

But my sense is that policy makers are still thinking mainly about rearranging the boxes on the bank supervisory organization chart. They’re not at all ready to do what needs to be done — which is to make banking boring again.

Part of the problem is that boring banking would mean poorer bankers, and the financial industry still has a lot of friends in high places. But it’s also a matter of ideology: Despite everything that has happened, most people in positions of power still associate fancy finance with economic progress.

Can they be persuaded otherwise? Will we find the will to pursue serious financial reform? If not, the current crisis won’t be a one-time event; it will be the shape of things to come.

Over the past year and a half, an increasing number of analysts have been making similar points, arguing in particular that we need to break free from the ideological illusions that automatically "associate fancy finance with economic progress." I may return to some of them soon.

In the meantime ... another important voice has weighed in with the same message: none other than former Federal Reserve Chairman Paul Volcker. Volcker cannot easily be dismissed as some sort of ignorant Luddite, economic populist, left-liberal ideologue, or anti-market radical. As Chairman of the Fed in Reagan's first term, he was the one who broke the dynamic of inflation with a deliberately harsh policy of monetary contraction that pushed the economy into deep recession, inflicted severe economic pain across the society, and sent the US unemployment rate to its highest levels since the Great Depression. Furthermore, over the course of his career, even people who have disagreed strongly with Volcker have never been able to question his intelligence and integrity.

So here is Volcker's latest intervention into the debate over what went wrong with the financial system and how to fix it, as reported by Simon Johnson, former chief economist for the International Monetary Fund:

Volcker, legendary former chairman of the Federal Reserve Board with much more experience of Wall Street than any current policymaker, was blunt: We need to break up our biggest banks and return to the basic split of activities that existed under the Glass-Steagall Act of 1933 – a highly regulated (and somewhat boring) set of banks to run the payments system, and a completely separate set of financial entities to help firms raise capital (and to trade securities).

This proposal is not just at odds with the regulatory reform legislation then (and now) working its way through Congress; Volcker is basically saying that what the administration has proposed and what Congress looks likely to enact in early 2010 is essentially — bunk.

Speaking to a group of senior finance executives, as reported in the Wall Street Journal on Monday, Volcker made his point even more forcefully. There is no benefit to running our financial system in its current fashion, with high risks (for society) and high returns (for top bankers). Most of financial innovation, in his view, is not just worthless to society – it is downright dangerous to our broader economic health.

Volcker only makes substantive public statements when he feels important issues are at stake. He also knows exactly how to influence policy – he has not been welcomed in the front door (controlled by the people who have daily meetings with the President), so he’s going round the back, aiming at shifting mainstream views about what are “safe” banks. Many smart technocrats listen carefully to what he has to say. [....]

Not only is this contrast – high unemployment vs. bankers’ bonuses – annoying and unfair, it is also not good economics. Bankers are, in effect, being rewarded for taking the risks that created the global crisis and led to massive job losses. And they are being implicitly encouraged to do the same thing again. [....]

Read the whole thing HERE ... and also this & this.

--Jeff Weintraub

P.S. And for a recent WSJ interview with Volcker dealing with these themes, see here.