Is the "Volcker Rule" More than a Marketing Slogan?

At the broadest level, Thursday's announcement from the White House was encouraging—for the first time the president endorsed potential new constraints on the scale and scope of our largest banks and said he was ready for "a fight." After a long, tough argument Paul Volcker appeared to have finally persuaded President Obama that the unconditional bailouts of 2008–09 planted the seeds for another major economic crisis.

But how deep does this conversion go? On the "deep" side is the signal implicit in the fact that Volcker stood behind the president while Tim Geithner was further from the podium than any Treasury secretary in living memory. Where you stand at major White House announcements is never an accident.

Increasingly, however, there are very real indications that the conversion is either superficial (on the economic side of the White House) or entirely a marketing ploy (on the political side). Here are the five top reasons to worry.

1. Secretary Geithner's spin on the "Volcker Rule," Thursday night on the Lehrer NewsHour, is in direct contradiction to what the president said. At first, it seemed that Geithner was just off message. Now it is more likely that he is (still) the message.
2. The White House background briefing on Thursday morning gave listeners the strong impression that these new proposals would freeze the size of our largest banks "as is." Again, this is strongly at odds with what the president said and seemed—at the time—to indicate insufficient preparation and message drift. But who is really drifting now, the aides or the president?
3. At the heart of the substance of the "Volcker Rule," if the idea is literally to freeze the banks at or close to their current size, this makes no sense at all. Why would anyone regard 20 years of reckless expansion, a massive global crisis, and the most generous bailout in recorded history as the recipe for creating "right-sized" banks?  There is absolutely no evidence, for example, that the increase in bank scale since the mid-1990s has brought anything other than huge social costs—in terms of direct financial rescues, the fiscal stimulus needed to prevent another Great Depression, and millions of lost jobs. On reflection, perhaps the president really still doesn't get this.
4. Since Thursday, the White House has gone all out for the reconfirmation of Ben Bernanke, whereas gently backing away from him—or at least not being so enthusiastic—would have sent a clearer signal that the president is truly prepared to be tough on big banks and their supporters. Unless Bernanke unexpectedly changes his stripes, his reappointment at this time gives up a major hostage to fortune—and to those Democrats and Republicans opposing serious financial reform.
5. As the White House begins to campaign for the November midterms, how will they answer the question: What exactly did they "change" relative to what any other potential administration would have done in the face of a financial crisis? How will they counter anyone who claims, citing Rahm Emanuel, that: "The crisis is over, and we wasted it."? No answer is yet in sight.

The Geithner strategy of being overly nice to the megabanks was not good economics and has proven impossible to sell politically—the popular hostility to his approach is just common sense prevailing over technical mumbo jumbo.

But selling incoherent mush with a mixed message and cross-eyed messengers could be even worse.

Also posted on Simon Johnson's blog, Baseline Scenario. The following were previously posted:

Paul Krugman for the Fed

January 23, 2010

The case for Ben Bernanke's reappointment was weak to start with, weakened with his hearings, and is now held together by string and some phone calls from the White House. Bernanke is an airline pilot who pulled off a miraculous landing, but didn't do his preflight checks and doesn't show any sign of being more careful in the future—thank him if you want, but why would you fly with him again (or the airline that keeps him on)?

The support for Bernanke in the Senate hangs by a thread—with Harry Reid providing a message of support, albeit lukewarm, after the markets close. The White House is telling people that if Bernanke is not reconfirmed there will be chaos in the markets and the economic recovery will be derailed. This is incorrect.

The danger here is uncertainty—the markets fear a prolonged policy vacuum. Fortunately, there is a way to address this. Ben Bernanke should withdraw and the president should nominate Paul Krugman to take his place.

Paul Krugman is an expert on monetary policy—he wrote the classic paper on balance of payments crises (and probably could have gotten the Nobel Prize just for that), his work on Japan in the 1990s shaped everyone's thinking of how to handle potential deflation, and his assessment of the crisis and needed response in fall 2008 was right on the money.

Krugman is known to many academics as a trade theorist and as a pioneering modeler of growth with increasing returns. But just because Keynes wrote eloquently on Indian currency reform that did not prevent him from also understanding what had gone wrong with the world economy—and how to substantially fix it.

Krugman also has exactly the paper trail that you would like to see from any potential Fed chair. He has written pointedly and with complete clarity about all the leading policy issues of the day.

There is no question where he stands, for example, on "too-big-to-fail" financial institutions: he's opposed and would push for fundamental financial reform and tough oversight.

Big banks, without doubt, would be appalled. But the "Greenspan fallacy" was always that no one else could do his job and even considering an alternative would be destabilizing. Look at the mess that got us into.

What the markets really care about is what the Fed does with regard to both interest rates and regulation. What we need is a Fed chair who can be trusted to nurture the recovery—find me the business person who is opposed to that—without allowing too-big-to-fail institutions to remain so big and so dangerous that they can destabilize the system.

And don't think that Krugman can't raise interest rates if he really sees inflation coming—even if the danger, for example, is not picked up by conventional measures. He is tough minded, not afraid to take stands long before they are fashionable, and confident that others will soon come to their senses.

Would he be a "populist" choice? Absolutely not. He would be a popular choice, no doubt, but he is also many technocrats' favorite thinker and a person whose credentials and proven policy opinions speak for themselves. No one would question the independence of the Fed with him at the helm.

Would Krugman be opposed by the Republicans? Yes, potentially. And there could be quite a fight in the Senate—entirely of the Republicans' making. But if they oppose his appointment—despite his qualifications and in the face of our weak economy—what signal would that send about their priorities?

The president said on Thursday he is (finally) willing to fight the big banks. He's an effective fighter and, with enough support, he can win. But is any part of his agenda at this point really advanced by winning the reappointment of Ben Bernanke?

Secretary Geithner Needs to Get With the Program

January 22, 2010

The details of the new White House banking policy are somewhat vague and in places borderline incoherent—e.g., what exactly does "The president's proposal will place broader limits on the excessive growth of the market share of liabilities at the largest financial firms…" mean (from point 2 in yesterday's short and poorly edited statement)?

And the size restrictions currently in pencil on the back of an envelope near the president's desk are almost certainly too lenient; the goal should not be a return to the status quo of 2007 or thereabouts—the clock must be rolled back much further and "too big to fail" completely removed from the financial map.

But the general principle behind our "Volcker Rule" is clear. Here's what President Obama said, "Banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers."

Whatever you think of that notion or the exact wording, this clearly implies that banks will get smaller. Secretary Geithner apparently does not get this (transcript).

There are two possibilities given that Tim Geithner is a smart person with a great deal of relevant media experience—he did not misspeak.

1. Geithner is not on board with the policy shift. This would be understandable, as it directly repudiates what he has worked hard to achieve over the past year.
2. Geithner does agree with the obvious interpretation—provided by the president—of the Volcker Rule and associated principles. As an expert, he is certainly entitled to his own view, but this is beyond awkward.

President Obama said, quite plainly, "So if these folks [the big banks] want a fight, it's a fight I'm ready to have." He cannot fight this issue and these people effectively if his Treasury secretary is not on board.

If the Democrats go at this fundamental shift in policy in a half-hearted manner or with mixed messages, they will be hammered so badly in November that the Massachusetts special election will feel like a victory in comparison.

Kindly ask Secretary Geithner to appear on all the weekend news shows with a convincing "clarification."

Questions that Ben Bernanke Must Now Answer

January 21, 2010

Ben Bernanke's reconfirmation as chair of the Federal Reserve is in disarray. With President Obama having launched, on Thursday morning, a major new initiative to rein in the power of—and danger posed by—our leading banks, key senators rightly begin to wonder: Where does Ben Bernanke stand on the central issue of the day?

There are three specific questions that Bernanke must answer, in some convincing detail, if he is to shore up his weakening cause in the Senate.

1. Does he support the president's proposed emphasis on limiting the scope and scale of big banks?
2. With regard to the key detail, is it his view that the size of big banks can be capped "as is" or—more reasonably—should we require these banks to contract or divest so as to return to the profile of system risk that prevailed say 15 or 20 years ago?
3. If Congress cannot act in the short term, because of opposition from Republicans and some Democrats, does he see the Fed's role as taking the initiative in this arena—or will he wait passively for the legislature to act?

As running hard against the "too-big-to-fail" banks is now a major theme of 2010 and beyond for the Democrats, how can any Democratic senators feel comfortable voting for Ben Bernanke unless they know exactly what his position is on all of these points?

And given what we know about Bernanke's record and positions relative to these questions, absent new information it is not a surprise to see his support dwindling.