“You are not going to be very happy with my response,” PAUL VOLCKER began, when he was asked to address ideas for reforming financial services at last week’s Wall Street Journal Future of Finance Initiative in the UK. Volcker, who was chairman of the Federal Reserve under Presidents Carter and Reagan and serves on the Economic Recovery Advisory Board of President Obama (right), said that financial instruments like Credit Default Swaps provide no benefit to the overall economy. An excerpt:
I heard an awful lot of particulars here that I agree with to some degree, but my overall impression is that you have not come anywhere near close enough to responding with necessary vigor or structural changes to the crisis that we have had. If it is really true that financial weaknesses brought us to the brink of a great depression which would have ended your livelihood and destroyed a lot of the global economy then let me explain.
You concluded with financial services executives showing cultural sensitivity and responsible leadership — well I have been around the financial markets for 60 years and how many responsible financial leaders have we heard speaking against the huge compensation practices? Every day I hear financial leaders saying that they are necessary and desirable, they are wonderful and they are God’s work. Has there been one financial leader to stand out and say that maybe this is excessive and that maybe we should get together privately to think about some restraint?
I hear about these wonderful innovations in the financial markets and they sure as hell need a lot of innovation. I can tell you of two — Credit Default Swaps and CDOs — which took us right to the brink of disaster: were they wonderful innovations that we want to create more of? You want boards of directors to be informed about all of these innovative new products and to understand them but I do not know what boards of directors you are talking about. I have been on boards of directors and the chances that they are going to understand these products that you are dishing out or that you are going to want to explain it to them, quite frankly, is nil.
I mean wake up, gentlemen — I can only say that your response is inadequate. I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy, just one shred of information.
A few years ago I happened to be at a conference of business people, not financial people, and I was making a presentation. The conference was being addressed by a very vigorous young investment banker from London who was explaining to all these older executives how their companies would be dust if they did not realize the joys of financial innovation and financial engineering, and that they had better get with it.
I was listening to this and I found myself sitting next to one of the inventors of financial engineering who I did not know, but I knew who he was and that he had won a Nobel Prize, and I nudged him and asked what all the financial engineering does for the economy and what it does for productivity. Much to my surprise he leaned over and whispered in my ear that it does nothing. I asked him what it did do and he said that it moves around the rents in the financial system and besides that it was a lot of intellectual fun.
Now, I have no doubts that it moves around the rents in the financial system, but not only this as it seems to have vastly increased them. How do I respond to a Congressman who asks if the financial sector in the United States is so important that it generates 40% of all the profits in the country, 40% after all of the bonuses and pay? Is it really a true reflection on the financial sector that it rose from two-and-a-half percent of value added according to GDP numbers to six-and-a-half percent in the last decade? Is that a reflection of all your financial innovation or is it just a reflection of how much you pay?
What about the effect on our economies [taking] all our best young talent? In Britain, I was just talking to a high-tech company about the immense attraction to go into finance when both Britain and the United States are suffering from a basic inability to produce things competitively.
Is it a result of financial innovation that we should be really worried about excessive regulation, which I am against?
The most important financial innovation that I have seen the past 20 years is the automatic teller machine, that really helps people and prevents visits to the bank and it is a real convenience. How many other innovations can you tell me of that have been as important to the individual as the automatic teller machine, which is more of a mechanical innovation than a financial one?
I have found very little evidence that vast amounts of innovation in financial markets in recent years has had a visible effect on the productivity of the economy, maybe you can show me that I am wrong. All I know is that the economy was rising very nicely in the 1950s and 1960s without all of these innovations. Indeed, it was quite good in the 1980s without Credit Default Swaps or CDOs. I do not know if something happened that suddenly made these innovations essential for growth. In fact, we had greater speed of growth in the 1960s and more importantly it did not put the whole economy at risk of collapse.