06 February 2010

Volcker Rule: They Shoot Horses, Don't They?

If the Volcker Rule were posited as a panacea, much of the criticism that has been leveled by the bank lobbyists and their congressmen, and sincere critics who were surprised by its ungainly introduction into the reform deliberations, would be correct. However, I do not think it was, but I could be wrong.

Because a cure for heart disease does not also cure diabetes does not impugn its effectiveness in curing heart disease. And if the patient has both heart disease and diabetes, one might expect a variety of remedies used in careful combination.

What the Volcker Rule would have accomplished is to take the gamblers away from the new “discount window” of Fed and Treasury subsidized programs. It would have also put a serious dent in the ‘Too Big Too Fail’ meme, although it alone was not enough to do that, as it lacked some teeth. But it opened the door to a debate that is not occurring.

What exactly is the role of the financial system, and what needs to be done to regulate it, and help it to perform some utility to society's greater functions? Is the relationship between the financial sector and the productive economy out of balance?

I want to stress this. Any proposal that has not been hammered upon by multiple minds, and tempered with the objections and observations of many perspectives, is likely to be premature, needing much work. By its method of introduction, I fear that the reconsideration of the relationship between the FIRE sector and the productive economy is now off the table.

People seem to be making assumptions about what the Volcker Rule would and would not include. For example, there is reference to the 'shadow banking system' that is something relatively new, the intersection of investment banking and mortgage origination. Does anyone really believe that Volcker would object if mortgage origination and similar long term loans were relegated to the commercial banks and the GSE's? I think not.

For me, the 800 pound gorilla is who obtains access to the discount window and Treasury guarantee programs, and who can be a primary dealer for the Fed. I would say that a company that is not a bank cannot. It is as simple as that. And this is what Wall Street hates so much about anything like Glass-Steagall or the Volcker Rule. They want to be able to tap the Fed's balance sheet, and still maintain their aggressive leverage.

There is a reason that the banks engaged in a decades long effort, costing hundreds of millions in lobbying payments of various sorts, to overturn Glass-Steagall. To ignore that reality is to fall into the trap of the financial engineering distortion that is crippling the Western world. The bankers wanted to broaden their portfolio to intertwine their higher risk efforts with the public trust, as insurance against the occasional setback to even the best laid plans.

Relatively simple systems are more resilient and robust; needlessly complex systems are doomed to increase in complexity to the point of failure without accomplishing anything except more complexity.

The trade offs are always there, and a good system contains a mix of both.

Perhaps the new ‘reform legislation’ will be effective, but I doubt it quite a bit almost to the point of certainty. It will be hailed as an 'evolutionary effort' but will contain loopholes large enough to drive a CEO's bonus through. . If it does nothing to separate self interested, higher risk speculation from the trough of the Fed's balance sheet, it will institutionalize moral hazard, which has probably been the goal of the banks all along.

If the reform legislation relies on firms erecting 'chinese walls' within their firms, and regulators being able to sort out various types of regulated and unregulated activity within a firm, then it is my opinion that it is anathema to sound financial management, and doomed to failure. The problem is fraud, and deception, and regulatory capture. The rules must be as clear, simple, and difficult to cheat as is possible.

And then we will see the return of the financial pundits, suggesting this tweak, and that tweak, this addition to close that loophole, and if only we had made this change. Its a good game really, because it ensure a steady flow of funds from the bank lobby to the Congress, and full employment for financial engineers who can engage in endless argument about the relative merits of the latest tweak.

And the zombie banks will continue to drain the life from the real economy, not in dramatic bailouts, but in a steady stream of slow debilitation. But they will be able to pay enormous salaries and bonuses to their captains and lieutenants, by gaming nearly every financial instrument and market in the world.

This is what will doom the West to a stagflation that will mimic the long Japanese decline, their lost decades. It may not ultimately be resolved without social disorder.

The people are still too easily lulled by jargon and reassurance, and the econorati still believe in financial engineering. If only we put a clever tweak here, and an easy rule change there, things will be fine again. That is why allowing engineers to fix their own 'big system' problems is almost always doomed to failure, because they are too intellectually fascinated with their own creation, and cannot see it in the stark light of objectivity and its function as part of the whole.

How will we fix this? How will we accomplish that? Well, perhaps one can look at how those functions were addressed before the system started to go off kilter, say around 1990, and find an answer there. But that drives the financial engineering crew batty, because it sounds antithetical to Progress. It might stifle innovation.

Well, one might as well say that if they stop getting drunk and engaging in random sex, they will also not wake up next to so many new and interesting people. The point is, you do not have to engage in high risk behaviour to accomplish personal and institutional growth. And there is a role for stifling some things, so that only the good can thrive. It is a basic principle of what used to be called conservatism before it was co-opted by the neo-cons. We have to keep first principles in mind even as we change the specifics.

Was the real economy served better by subprime mortgage collateralization and the growth of an unregulated shadow banking system? Ask the average person, and the answer is clear. But the question is never put that way. To a financial engineer, it is the system itself that matters, and not its primary application, to serve the real economy.

The objective of reform would ideally be more than merely preventing the next collapse of the same sort. It would involve giving the middle class a fighting chance to recover itself and prosper again. And that would involve shrinking the portfolio of the Wall Street banks, and expanding the function and stability or regional and local banking. Already the elite are softening up that hope, of a middle class recovery, by forecasting years of underemployment and decline as an inevitability.

The title of this blog does not refer to the Volcker Rule, which was dead out of the gate by its method of introduction into the process, late and fleshless, and quite possibly by intent to stifle debate. It refers to the public, the poor horses that will be beaten senseless by the FIRE sector over the next ten years for their diversion and entertainment. Am I wrong?

So time to move on, to assess what will be coming out of Washington by way of reform. But I have little hope that there will be anything in it that does not serve about ten corporate institutions well, and a financial elite, to the disadvantage of the rest of the world in the form of distorted markets, institutionalized fraud, and the seignorage of the currency reserves.

Would that I am wrong, I doubt it very, very much.