As reported in today’s Wall Street Journal, Paul Volcker, who is a former Fed Chairman and current adviser to President Obama, challenged bankers to produce a “shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy.” Yet some of these innovative financial products brought the economy to “the brink of disaster.” Profits in banking are being restored in part by playing financial brinkmanship once again.
How can this be? Volcker focuses in on public policies that back excessive risk taking by bankers. They and their stockholders garner the profits, but, through bailouts and government guarantees, manage to socialize the losses. That process is what economists call moral hazard.
He questions whether improved regulation can resolve the problems without serious structural change. He repeats his longstanding policy of separating traditional commercial banking from what has been aptly termed casino banking. Casino banks must not be protected by the government.
Here is my suggestion for a start. Hedge funds can serve a very useful function in the economy. But banks taking insured deposits should not be permitted to operate hedge funds in their institutions. Most proprietary trading by banks amounts to an in-house hedge fund. Separate the activity from banking.