Structural Stagnation, Bubbles, and the Volcker Rule

December 10th, 2013 at 1:38 pm

In much recent economic discourse, it has been suggested that we suffer from structural stagnation.  That is, some underlying misalignment in resource allocation or distribution is preventing the macro economy from achieving its potential in terms of job growth, GDP growth, labor force participation, productivity, and full employment—not just in recessions, but in recoveries as well.

It’s a position I’ve held for a long time, largely emanating from work on slack labor markets, stagnant incomes, growing inequality, and—the topic of this post—financial market instability.

It’s pretty hard to miss the shampoo cycle—bubble, bust, repeat—that has characterized the last few business cycles in the American, and more recently, European and even Scandinavian economies.  It’s also the case that choice economists since Adam (Smith, of course) have recognized this proclivity towards financial market instability, including Keynes and most notably, in terms of the depth of his analysis, Hy Minsky.

Most recently, financial bubbles propped up demand in the 1990s (dot.com) and 2000s (housing).  Thus far in the current expansion that began in 2009Q3, financial markets and corporate profitability have far outpaced the rest of the economy.  Real GDP is up 10% over the expansion and the real value of the S&P 500 is up 70%.  Real median household income is down 4%.

I’m not saying we’re in another financial bubble, though no less than Robert Shiller recently raised that concern.  But I’m decidedly saying that unless we enact and enforce tough financial market regulation, that’s where we’re headed.

It is in that regard that I’m very glad to see what looks like a tougher-than-expected Volcker rule coming out of the implementation phase of Dodd-Frank financial reform.  This rule is designed to restrict proprietary trading, where federally insured banks trade their own books, thus putting taxpayers at risk.  Like I said, it won’t work if we don’t enforce it—regulators can sleep even at the best switch—and there are still parts that need to be fleshed out.  But here’s why it’s looking pretty good.

As I recall from my White House days, crafting the Volcker rule was a big challenge, because banks can have legitimate business in trades between customers that involve the bank’s own capital.  What makes a trade “proprietary”–meaning the bank is trading its own book for its own profits–is not the clearest of lines.

But as Mike Konczal points out there are a number of ways to make this distinction, and the new rule looks fairly tough in that regard.  For example, a key question for the rule’s effectiveness is how tight is its definition of hedging? A broad definition, like: “banks can hedge against risk to their capital”—would quite clearly allow disastrous proprietary trades like that of the “London Whale,” the JP Morgan trade that cost the bank $6 billion last year.

Konczal notes: “If the Volcker Rule couldn’t have stopped the London Whale trade, it’s fairly useless as a piece of reform…Treasury Secretary Jack Lew has also explicitly said in recent remarks that ‘the [Volcker] rule prohibits risky trading bets like the ‘London Whale’ that are masked as risk-mitigating hedges.’”

Today’s reporting says that the rule:

…includes new wording aimed at the sort of risk-taking responsible for [JP’s loss].  The bank contended it was trading to hedge its broader risks, but in fact it built a sprawling speculative position that spun out of control.

To prevent such blowups, according to the version of the rule reviewed by The Times, it will require banks to identify the exact risk that is being hedged. The risks, the rule said, must be “specific, identifiable” rather than theoretical and broad.

Konczal notes another way—a sort of a market test—to evaluate whether the rule is adequately distinguishing between legitimate financial services on behalf of the banks’ customers versus trading its book: simply observe what they’re doing and whom they’re hiring.  If they’re spending more time and resources on client services than gambling on derivatives, regulators should be able to pick that up fairly easily, and visa versa.  What you want to see here is the type of personnel from JP’s London Whale office moving from banks over to actual hedge funds.

Let’s be careful not to overstate the rule’s toughness.  According to the Times, “…banks can build up positions [acquire securities] to meet “the reasonably expected near-term demands of clients, customers or counterparties.” Banks and regulators may clash over what is “reasonably expected,” and the rule leaves it largely up to banks to monitor their own trading.”

That sounds less than air-tight, but it’s typical of such regulations.  One could make a case that’s why we’re always stuck in the shampoo cycle, but blurred lines are the nature of the beast in this space.

Which means that at the end of the day, it’s going to be up to the regulators and their agencies to make this work, and that caveat goes all the way to the top.  It is not a coincidence that Alan Greenspan, the Federal Reserve chair during the last two economy-crashing bubbles, maintained that financial markets were “self-correcting.”  It’s thus hopeful in this regard that in her confirmation hearing, the likely next Fed chair, Janet Yellen, said, for the first time as far as I’m aware, that it was in fact the job of the Fed to identify and deflate bubbles before they last waste upon the land.  Treasury Secretary Jack Lew, as noted above, is also an important player here and from what I’ve seen, he’s genuinely interested in effective financial reform.

So, with caveats that it’s far from perfect, it’s only one piece of “fin reg,” and the lobbyists are working tirelessly as we speak to gut it, the Volcker rule looks good…better, frankly, than I expected.  It has the capacity to help dampen, if not break, the cycle.  But only if we’re vigilant in its implementation.

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7 comments in reply to "Structural Stagnation, Bubbles, and the Volcker Rule"

  1. smith says:

    “Structural Stagnation” is an imaginary ill conceived of by liberals to explain their ineptitude in the face of traditional business cycle economics punctuated by the most severe economic contraction since the great depression.

    Boom and bust is nothing new. Certainly the volatility of 19th century was greater than the 20th, and the Great Depression much worse than the Great Recession.

    Stagnation? No. I would refer to this graph as Exhibit A:
    http://www.nytimes.com/imagepages/2012/12/12/opinion/global/12iht-edbrynjolfsson12.html
    from this article:
    http://www.nytimes.com/2012/12/12/opinion/global/jobs-productivity-and-the-great-decoupling.html

    Draw a line (use a straight edge, any piece of paper held up to the computer screen) from 1960 to 2008, have it cross a little under the peaks and over the valleys and you’ll find the statistically valid smoothing yields straight steady growth, with a little more volatility since 1995 thanks to deregulated financial markets and banks run amok. Meanwhile GDP accelerates from the 1990s, but I’d argue due to income inflation. Millionaire Smith sells consulting for $100,000 to millionare Jones. GDP goes up. Millionaire Jones then buys consulting from Smith, and so on. Plus software and websites and MS Word reports are frictionless, adding to GDP in a way factory production can’t.

    The only thing stagnating is wages because of policy weakening unions, exempt status of office workers, and growth of labor participation. Who says we need to keep two full time wage earner families if it’s being driven strictly by financial need?

    Likewise android talk is nonsense
    http://faculty-web.at.northwestern.edu/economics/gordon../Is%20US%20Economic%20Growth%20Over.pdf
    http://krugman.blogs.nytimes.com/2013/12/07/gordon-versus-the-androids/

    Secular stagnation is a harmful distraction from the business at hand, getting the economy going in traditional ways, government stimulus, reining in banks, taxing the rich, restoring the 40 hour work week, phasing in 35 hours and 4 week vacations, early childhood education, free higher education the G.I. Bill without the war, no wasteful destruction and dying required.

    Secular stagnation? Don’t talk foolish!


  2. Perplexed says:

    Dean Baker had a post discussing many of the same issues a couple of days ago in relation to the enormous subsidies the government provides to these TBTF’s. http://www.cepr.net/index.php/blogs/beat-the-press/too-big-to-fail-and-the-economic-crisis

    My comment to his post applies here as well:
    “‘This is a question of whether they think Jack Lew or his successors will simply wave good bye if J.P. Morgan, Goldman Sachs, or one of the other megabanks goes under.’

    The $83 billion subsidy only covers the risk reduction to investors; the “insurance” provided by other potential victims of these institutions is provide free of charge. No one covers the costs that the failure of one of these companies imposes on other victims. The fallout from the mismanagement of one these mega-banks cascades across of millions of other economic actors, none of whom would be protected by these “reforms.” Even if “Lew or his successors will simply wave good bye,” (lets take a vote on what anyone with a clue really believes the probability of that actually happening is), the “uninsured” losses to others would be enormous. What would the losses be to other asset holders? To other companies in the economy as demand collapses? To the government as the safety net expenses skyrocket? And, as usual, the largest losses will be suffered by the unemployed who will lose their entire incomes with the safety net covering little but a tiny portion of their losses, and no coverage for the rest of it. These are the people taking on the TBTF risk, with $0 in compensation for the insurance they provide. We wouldn’t even allow a contractor to repair a bridge without providing adequate proof of insurance to cover any damage they might do to public assets or to individuals they might cause injury to, yet we provide this coverage for free to banks and then listen to them tell us they should be allowed to concentrate this risk into any form that best benefits them?

    Its past time for a ‘free market’ solution. Insist they provide proof of insurance for ALL of the damage they might cause by their high leverage, increased size & possible impact, and then let them grow to whatever size they can buy insurance for (and make sure the insurers have adequate capital to cover the losses). Why is it the public’s responsibility to manage the risks of these ‘private’ businesses and provide free insurance to them in the event they get it wrong? If the public is taking on and managing the risks, the public should be owning the stock and making the decisions. If the public is bearing the risk, they should be compensated, at the ‘market rate.’

    ‘We the People’ have turned into ‘We the Fools,’ and, as bankers well know, Fools and their money are easily separated. Nationalize the TBTF’s and let Elizabeth Warren oversea the break-up. If we had done that to begin with, we wouldn’t still be dealing with it now…”

    The question we really need to be asking here is why is it that, in all of the government of “We the People,” there are only two Senators who are really looking for out how to protect the interests of “We the People” from those that are buying our elections and putting all of us at risk in their quest for the power to pursue profits for themselves while transferring the biggest risks to the public at large? (And why are economists providing cover for the free risk transfer?)

    “…What exactly does the public get out of 1 mega-bank that it wouldn’t get out of 100, or 1,000, banks of a manageable size and manageable risk concentration? Cheaper banking? Who’s kidding who?”

    Anyone see Bill Moyers show last Sunday? “We the people” must get back in control of “our” republic:
    http://www.ted.com/talks/lawrence_lessig_we_the_people_and_the_republic_we_must_reclaim.html The “Lesters” are taking us all down with them while we pretend it isn’t happening.


    • smith says:

      Senators Dick Durbin, Bernie Sanders, and 42 other Senators voted for against banking interests in 2009

      “And the banks — hard to believe in a time when we’re facing a banking crisis that many of the banks created — are still the most powerful lobby on Capitol Hill. And they frankly own the place,”

      “The 12 Democratic senators who crossed the aisle to vote with Republicans were Max Baucus (Montana), Michael Bennet (Colorado), Robert Byrd (West Virginia), Thomas Carper (Delaware), Byron Dorgan (North Dakota), Tim Johnson (South Dakota), Mary Landrieu (Louisiana), Blanche Lincoln (Arkansas), Ben Nelson (Nebraska), Mark Pryor (Arkansas), Arlen Specter (Pennsylvania) and Jon Tester (Montana).”

      “Many of the Democrats who sided with the financial industry in the “cram-down” vote were instrumental in blocking a proposed 15 percent cap on interest rates that credit card companies can charge. Senators Baucus, Byrd, Carper, Johnson, Landrieu, Lincoln, Ben Nelson, Specter and Tester joined with Senators Daniel Akaka (D-Hawaii), Evan Bayh (D- Indiana), Jeff Bingaman (D-New Mexico), Maria Cantwell (D-Washington), Kay Hagan (D-North Carolina), Ted Kaufman (D-Delaware), Patty Murray (D-Washington), Bill Nelson (D-Florida), Mark Pryor (D-Arkansas), Jeanne Shaheen (D-New Hampshire), Debbie Stabenow (D-Michigan) and Mark Warner (D-Virginia), in opposition to the anti-usury bill sponsored by Vermont’s Independent Sen. Bernie Sanders.”

      Just don’t count on Chuck Schumer, Hillary Clinton, or Obama to do anything. Maybe Warren runs in 2016, but how could a first term 2 year Senator defeat the Clinton? Schumer may need to be defeated to pass any reform and he’s currently blocking Durbin’s path to succeed Reid some day.


      • smith says:

        I left out the link to the source http://www.truth-out.org/archive/item/84515:study-follows-the-money-on-cramdown-vote

        The first quote is Durbin saying “they own the place”

        So the problem is maybe Blue dogs, like the old Dixiecrats, not a new problem. Coat tails of a popular leader, horsetrading and a strong economy would bring them in line. But a president who preaches compromise allows them to stray further into Republican territory. Yet ironically giving Republicans and moderate Democrats that power weakens the Democratic program so that it fails, creating a political death spiral. Facing a tough election? They have only themselves to blame.

        (most of the previous comment was just quoting the article and giving the link)


        • Perplexed says:

          Thanks for the link & “roll call” stats.

          My point was that its really only Warren and Sanders that are “shouting from the mountain tops” about how outrageous this is. The rest are “posturing” but ultimately going along the ruse. Creating the illusion of opposition without any real of chance of altering the power situation back in the direction of “We the People” where it belongs. Ultimately the existence of any real opposition is a ruse. We need to reclaim the republic if we want this, or almost anything else of importance to change.

          http://www.ted.com/talks/lawrence_lessig_we_the_people_and_the_republic_we_must_reclaim.html


  3. Dave says:

    Unfortunately, I don’t think any of these details address the negative effects from the financial markets into the real economy. These are all purely financial reforms.

    There are a lot of people on both sides of this issue that simply cannot come to grips with the negative economic effects of bubbles upon debt inequality. Financial instability and potential collapse, while important to address, is just not the core problem facing most Americans.

    If Larry Summers labels me a dumb Minnesotan for saying this, then let me label Larry Summers a dumb economist.

    If you don’t want to print that last line, fine, but please don’t censor the entire comment just for that.


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