STATEMENT OF PAUL A. VOLCKER
BEFORE THE JOINT ECONOMIC COMMITTEE
WASHINGTON, DC FEBRUARY 26, 2009
Madame Chairwoman and Members of the Joint Economic Committee:
It is no secret that we are living in a difficult time for the economy, with unprecedented complexities,
complications and risks for financial markets and financial institutions. You have entitled this hearing “Restoring the Economy: Strategies for Short-term and Long-term change”.
I appreciate the invitation to address those issues, but I am sure you understand that any brief statement may elicit as many questions as answers. In the circumstances, I will proceed by making a few points that I consider highly relevant in the effort to achieve recovery, greater stability, and protection against a future financial crisis. We must not again leave the markets so vulnerable that a breakdown will again threaten the national and world economies.
1. My first point is to emphasize an essential longer-term reality.
The present crisis grew out a serious andunsustainable imbalance in the United States and world
economies. Specifically, over recent years, until theoutset of the recession, Americans spent more than ourcountry produced or was capable of producing at fullemployment. That spending, reflected in exceptionally highlevels of consumption generally and in housing inparticular, was made possible by a high level of imports, acollapse in personal savings, and large trade and currentaccount deficits. The consequence was the nation becamedependent on borrowing abroad hundreds of billions ofdollars a year.
For a while it was all quite comfortable. Imports fromChina and elsewhere satisfied our strong consumption proclivities without inflationary pressures. China, Japanand other countries were eager to export and willing toacquire and hold trillions of U.S. dollars, keeping ourcurrency strong and helping to keep our interest rates low.
The trouble was it could not last. The process came tobe dependent upon an enormous build-up of domestic as well as international debt, facilitated by the low interest rates and sense of “easy money”. The bulk of that debt came to be mortgage-related. It was supported by the strong increase in housing prices, giving the illusion of wealthcreation. When housing prices leveled off and then declined, the weakest mortgages – so-called subprime – cameunder pressure, and the highly engineered over-extended financial structure began to unravel. As the financialcrisis broadened, the recession was triggered.
I repeat that story because the first and most fundamental lesson of the crisis is that future policy should be alert to, and take appropriate measures to dealwith, persistent and ultimately destabilizing economic imbalances. I realize that is a large and continuing challenge of international as well as domestic proportions, but it is the essence of prudent economic management.
2. Secondly, I turn to the problem in financialmarkets. The rising debt, particularly mortgage credit, wasfacilitated and extended by the modern alchemy of financial
engineering. Mathematic techniques that have developed inan effort to diffuse and limit risk turned out in practiceto magnify and obscure risks, partly because, in all theircomplexity and opacity, transparency was lost. Riskmanagement failed. At the same time, highly aggressivecompensation practices encouraged risk taking in the faceof misunderstood and sometimes almost incomprehensible debtinstruments.
As we look ahead, the obvious lesson is the need formore disciplined financial management generally and betterrisk management in particular. Plainly, review and reformof compensation practices are particularly difficultmatters that defy rigid specification.
3. As the financial crisis evolved, weaknesses inaccounting, credit rating agencies and other marketpractices were exposed. “Fair value” accounting rules were inconsistentlyapplied and have contributed to downward spiralingvaluations in illiquid markets. Credit rating agenciesfailed to analyze collective debt obligations withsufficient vigor. Clearance, settlement and collateralarrangements for obscure derivative contracts createduncertainty and need clarification.
These are all highly technical issues, not readilydealt with by legislation. They do need to be resolved aspart of a comprehensive reform process.
4. More directly of governmental concern are thelapses in financial regulation and supervision thatpermitted institutional weaknesses to fester, failed toidentify exceptional risks and deal adequately withconflicts of interest, and did not expose large personalscandals after warnings.
This area will require, and I’m sure will receive, close attention by the Administration and the Congress inthe period ahead. I will be surprised if you do not conclude that substantial changes will need to be made inthe administrative structures for oversight of thefinancial system.
Taken together, the need for change is both obvious
and wide ranging. In approaching the challenge, I do urge
that all these matters be considered in the context of a
considered judgment about the appropriate role and
functioning of the financial system in the years ahead.
At the most general level, I am certain we all would
like to see a “diverse, competitive, predominantly
privately owned and managed institutions and markets, able
to efficiently and flexibly meet the needs of global,
national and local businesses, governments, and
Those words are taken directly from a recent report of
the Group of 30 setting out a Framework for Financial
Stability. It points up the challenge of making those broad
generalities a strong and lasting operational reality. I
chaired that effort and naturally recommend it to you.
The Report makes some eighteen broad recommendations,
touching upon most of the points I enumerated earlier. One
area it does not cover are specific proposals for
restructuring the agencies responsible for regulation and
supervision. I believe judgment and legislation in that
area should logically follow and not proceed judgment about
the overall design of the financial system.
The G-30 Report recognizes what I believe is common
ground among most analysts. Specifically, all banking
organizations should come with the framework of an official
safety net, with the natural corollary of regulation and
supervision. It is also recognized that a few of the banks
(and possibly some other financial organizations) will be
so large, and their operations so intertwined in complex
relationships with other institutions, as to entail
“systemic risk”. In other words, the functioning of the
financial system as a whole could be jeopardized in the
event of a sudden and disorderly failure. Consequently,
those institutions should be subjected to particularly high
international standards directed toward maintaining their
safety and soundness.
Taken together these banking organizations should be
predominantly “relationship-oriented”, providing essential
financial services to individuals, businesses of all sizes,
and governments. To help assure their stability and
continuity and limit potential conflicts of interest,
strong restrictions on risk-prone capital market activities
– e.g. hedge funds, equity funds, and proprietary trading
– would be enforced.
At the same time, trading and transaction-oriented
financial institutions operating primarily in capital
markets could be less intensively regulated, although
stronger registration and reporting requirements would be
appropriate. In instances where the institutions are so
large or otherwise so complex as to be “systemically”
relevant, capital, leveraging and liquidity requirements
would be imposed.
Implicit in this approach is the need for strong
cooperation and coordination among national authorities and
regulators. Some approaches – accounting standards,
capital and liquidity requirements, and registration and
reporting procedures – should be internationally agreed and
consistent in application to minimize regulatory arbitrage
and any tendency by particular countries or financial
centers to seek competitive advantage by tolerating laxity
All this will take time if the necessary consensus is
to be achieved and a comprehensive rather than a piece-meal
approach is taken. I also recognize that a coherent vision
of the future should help guide the emergency responses to
the present crisis and, even more important, the steps
taken as the truly extraordinary measures now in place are
relaxed and ended.
Let that debate proceed. I will, of course, welcome
the opportunity to participate in your deliberations.