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True Leader, Volcker



June 09, 2010 – Comments (10)

I like this piece by Volcker

He questions that the financial sector takes 40% of all corporate profits.  He puts forth what ought to have happened to truly justify such a stellar rise in profits:

Can the truly enormous rise in the use of derivatives, complicated options, and highly structured financial instruments really have made a parallel contribution to economic efficiency? If so, does analysis of economic growth and productivity over the past decade or so indicate visible acceleration of growth or benefits flowing down to the average American worker who even before the crisis had enjoyed no increase in real income? 

We can all answer this question as monolithic NO.  Indeed, we've seen quite the opposite.  It has been a long time since there was such a gross rape of society by an industry, and perhaps this is the largest and most vile rape of society.

10 Comments – Post Your Own

#1) On June 09, 2010 at 10:11 AM, JakilaTheHun (99.92) wrote:

Good piece by Volcker, as always.

However, my biggest question is whether this was created by market forces out of control or whether governmental subsidies created the situation.  

While I am not in the "End the Fed" camp (the altnerative is much worse), I do believe Alan Greenspan played a significant role in creating the financial crisis the more I examine things.  Low interest rates seem to benefit bankers at the expense of other capitalists.   This is because it's a 'low-risk' environment for the bankers.  Evidence seems to suggest that central banks that use inflation targeting (and use inflation rates as 2% - 5% as a guide) fare better economically than those using the US/Japan model. 

Also, Fannie Mae, Freddie Mac, and all the home buying incentives passed by Congress over the years have also helped the banks. 

We seemed to have our biggest real growth from the mid-80s to the late 90's; which also largely coincided with a long period of moderate interest rates. 

Then, you have the implied subsidy of TBTF, which is one of the thing Volcker attacks the most.  I'm increasingly of the opinion that the answer is not to 'break up' the big banks, but to make the FDIC require disproportionately higher payments from banks with certain high-risk characteristics typical of TBTF banks.  Sheila Bair has taken steps in that direction, but I think we need to go much further.  If you force the banks to pay FDIC in proportion to the risk they create, that will automatically create market pressures that promote smaller banks.  


One final thing to consider --- perhaps some of this trend isn't our fault.  China's currency peg has had a lot of negative side affects and I believe we have failed to note a lot of these.  For the US, it has helped undermine manufacturing here and push us towards a more service-oriented economy.  It has also artificially increased the purchasing power of the Dollar (which is one reason why the US govt pays such low interest rates), and has benefited bankers more than anyone else.  


So in sum, I think there might be a whole host of issues that have led to the US banking industry creating such a ridiculously large proportion of American corporate profits.

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#2) On June 09, 2010 at 10:15 AM, dwot (28.86) wrote:

 More from the article:

A few days ago, I spent a little time in Ireland. It’s a small country, with few resources and, to put it mildly, a troubled history. In the last twenty years, it took a great leap forward, escaping from its economic lethargy and its internal conflicts. Responding to the potential of free and open markets and the stable European currency, standards of living have bounded higher, close to the general European level. Instead of emigration, there has been an influx of workers from abroad.

But now Ireland has been caught up in its own speculative excesses and financial deficits, culminating in a sharp economic decline. There is a lot of grumbling, about banks in particular. But I came away with another impression. The people I spoke to had an understanding that the boom had gotten out of hand. There seems to me a determination to do something about the situation, reflected not just in the words of the political leaders but in support for action among the public. And there is a sense of what is at stake, that the gains they made in recent years have been placed in jeopardy. The urgent need to get back on a sustainable budgetary and economic track is well understood.

It is interesting, when I talk to people from my generation, say 35 to 50 age group,  I see the strongest sense of financial responsibility towards governance.  Who likes taxes, but I can sit with people in this age group and we aren't cheering the tax reductions.  We have already paid back way more in taxes then we got and we don't want a repeat.  I get frustrated to no end with people in the 10 year plus older age group.  They have it better then any demographic group before or after and all they do is whine, and blame people who followed the same steps they followed who have far less success as there is a deficiency in them.

I exclude under 35 because I have seen a trend in this group to live for the day.  The way I see it, they saw their older brothers and sisters work their asses off and gain little and they simply did not see the point.  I am not saying all, but the hard times in Vancouver started in the early 80s and there simply hasn't been enough good jobs to go around since.  Sure some did well, but too many found themselves disillusioned at how hard they worked towards what they thought would secure a decent future to end up grossly under employed.  Also, taxes headed down by the time this group was working.  The highest tax bracket was 54.9% in the 80s and 90s.  It was at 45% for this group.


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#3) On June 09, 2010 at 10:49 AM, Dobbes (< 20) wrote:

I'm afraid you misread what Volcker wrote.  Your words:

He questions that the financial sector takes 40% of all corporate profits.


Does the past profitability of and the value added by the financial industry really now justify profits amounting to as much as 35 to 40 percent of all profits by all US corporations?

Volcker's assertion is correct (how could financials take profits from other corporations?), that financials represent a large portion of our economy.

But how the sector got so large isn't any sort of nefarious conspiracy.  The financial sector is such a large component of the economy because of the leverage they are allowed to employ.  Fractional reserve banking is a prime example.  So, yes the sector becomes outsized, but its because they have better profitability than other corporations.

As for the efficacy of derivatives, I must disagree wtih Volcker.  CDOs and mortgage securitization allowed home ownership to soar, making his misguided assertion that the average Joe had seen no benefits from derivatives (misguided because derivatives are primarily products for businesses wishing to manage risk and as such they are the primary beneficiaries, not average Joes), untrue in any regard.  

As for the rape of society, I find that superlative at best.  Derivatives are not inherently evil, and for the most part during the crisis, they did their job.  Some brave souls took outright positions with them and reaped the benefits of unhedged exposure or fell on their faces as derivatives reliably and successfully transferred wealth in accordance with movements in underlying assets.  It isn't the derivatives themselves that crashed those underlying assets.  In the case of real estate it was high foreclosure rates from a soft economy -but people forget that and rush to scapegoat the math-laden financial instrument they don't understand.

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#4) On June 09, 2010 at 11:18 AM, russiangambit (28.69) wrote:

> But how the sector got so large isn't any sort of nefarious conspiracy.  The financial sector is such a large component of the economy because of the leverage they are allowed to employ.  Fractional reserve banking is a prime example.  So, yes the sector becomes outsized, but its because they have better profitability than other corporations.

This is one of very sore points with me. I think US financial industry is too big. It provides little value but skims profits from everything. I agree that they got this way through legal means.

But what it also means is that US  policies are such that it is profitable to be in finance and reselling various stuff, but not at all profitable to actually produce or develop anything. This is how financial industry got so large - because US policies are favorable to it. They emploey little real capital, it is all out there in the virtual world. Whoile industries that require hard labor and equipment are at disadvantage in the US. But the whole weconomy cannot consist only of financiers, doctors, laywers and retialers can it? It needs to be able to produce something that is real, not just virtual. 


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#5) On June 09, 2010 at 1:17 PM, brycecovert (< 20) wrote:

Volcker has done a lot for the financial reform debate, especially on derivatives. The only problem is that derivatives are really complicated. I think spinning them off is a really good idea--we don't need to ensure banks' risks with tax payer money. But derivatives will still happen, and they have a lot of inherent risk, so we should use clearing houses, right? Well it's more complicated than that. Check out this article for an explanation:

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#6) On June 09, 2010 at 3:24 PM, binve (< 20) wrote:

Thanks dwot, good post.

I have written many times that financials are the cancer of the economy.

Financials are not, at their core, bad businesses (at least financials of 30-40 years ago). They do perform a very vital role of facilitating the dispersion of resources. It it not productive, so there is a loss of efficiency, but there is an overall economic good that comes out of it.

But today, financials (investement / shadow banks in particular) comprise a disproportionate size of the economy to the amount of economic usefulness they perform. This non-productive garbage has to be cleaned out, just like cancer. This is precisely why I call financials the cancer of the economy. They are a huge drain that transfers the economy's money (the wealth of the productive part of society), largely between each other, collecting fees for their "work".

On top of that, throw in the corruption and blatant fraud that is associated with most of these debt instruments, they should be illegal, and really are when you consider the spirit of the law. The letter of the law, of course, gets bent all the time to suit.

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#7) On June 09, 2010 at 6:39 PM, ryanalexanderson (< 20) wrote:

> I'm afraid you misread what Volcker wrote.  Your words: He questions that the financial sector takes 40% of all corporate profits.

I don't think most of us read that as "took directly from corporations". Perhaps "takes in" is a slight modification that makes it clearer. 

> As for the efficacy of derivatives, I must disagree wtih Volcker.  CDOs and mortgage securitization allowed home ownership to soar...

This isn't really an advantage. Cheap credit and securitization pushed up prices of houses to unreasonable valuations; people then proceeded to throw 80-90% of their net worth into a single overpriced asset. They'd be better off with a well-diversified portfolio. 

> Derivatives are not inherently evil, and for the most part during the crisis, they did their job. 

No, they're not evil. They're just very, very dangerous. And when a trader has nothing to lose but his job, and millions to gain on a correct derivatives bet, he/she will make these bets. If he wins, good for him - if he doesn't, the public bails out his institution. Since derivatives aren't regulated, we can't see these bets until bailout time. 

So, no, they're not "evil". Just a hidden weapon with which individual traders can hold the public to ransom. It's like giving tactical nukes to petty criminals. 

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#8) On June 09, 2010 at 9:09 PM, Entrepreneur58 (37.73) wrote:

Biggest mistake by any modern era president was Reagan firing Volker and putting Greenspan in his place.  Boy, will we be paying the price for that move for a long, long time.

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#9) On June 10, 2010 at 12:01 AM, AbstractMotion (< 20) wrote:

I agree that the growth of the banking sector and the credit bubble in general are not coincidental.  I do not believe that structured finance as a whole has really brought any real benefits to the real economy, there's a whole wealth of evidence that it was simply a great way for banks to earn huge underwriting fees for constantly repackaging one set of debt instruments 10 times over.  They might have allowed higher rates of home ownership, but ultimately a huge amount of that was on a purely speculative basis for both the borrower and the investor at the other end of the transaction.

It's tough to pin down where it all began.  The growth of the banking sector got a significant boost under Reagan, but I find it hard to blame him for a crisis 20 years later as other people very actively kicked the can down the road long after he left office.  Greenspan was unarguably an abject failure as a regulator and really served a central role as an enabler for ridiculous risk taking by the shadow banking industry.  GW Bush was an inept leader in general, he gutted a lot of the regulatory agencies either directly (SEC) or indirectly (FBI).  Personally I think Bill Clinton also holds a hell of a lot of blame for a lot of this mess too.  He signed on to the repeal of Glass-Stegal, signed the CFMA into law, voted in NAFTA and lobbied hard to get the WTO established.  The economy didn't explode under Bill Clinton's watch, but he unarguably had a very large role in the expansion of the banking sector, GSEs, keeping derivatives unregulated and moving the US towards a service based economy.  I really view a lot of this current crisis and the long term slump in employment we're likely to see to be a relic of his national policy.  The framework for this disaster had been in place for years, but there was no catalyst for it until Greenspan floored interest rates to historic lows for a prolonged period of time.

I also agree with the sentiment that bank profits are a direct result of the leverage they tend to employ, Charlie Munger had a great quote about how there are a lot of idiots in banking who get paid a lot of money to exploit very narrow spreads and it's quite true.  But leverage in itself is a large part of the problem, the same leverage that allows for those massive profits also exacerbates the severity of losses that occur from bad investments and allowed for relatively small changes in assets (relative to an institution's size) to completely bankrupt and ruin a company.  Nassim Taleb has some the best commenty on that very issue, and I'd highly recommend reading his books.

I'm also beginning to become more skeptical of the repo market as a whole and it's involvement in finance as it played an extremely large role in both Lehman and Bear Stearns but have largely escaped the same kind of public scrutiny that the CDO and CDS markets have in this crisis.  That said one of my favorite investments right now (NLY) also makes extensive use of repo agreements.  Still the repo market as a whole allowed for both the hiding of bad assets (Lehman) and virtually overnight bankruptcy (Bear Stearns).  I'm unsure of how the currently proposed financial regulation will deal with this issue (if it will at all), but it's definitely one that needs to be addressed.


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#10) On June 10, 2010 at 6:47 AM, dwot (28.86) wrote:

Paulson/Geithner committed fraud?

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