Volcker: Little Evidence Financial Innovation Has Helped Economy

Tall Paul is my hero. I would go further than he did in a speech in Sussex. The case can made that financial innovation of the OTC derivatives variety, which has mushroomed from 1992 onward, has been at best a wealth transfer device from the real economy to the financial economy, and has probably exacted a net cost on society as a whole.

As much as that notion might seem intuitively obvious to many readers of this blog, it would take a fair bit of certain to be impossible data gathering to demonstrate it. The beauty of OTC markets is that the information one would need resides with the dealers. They have no reason to give it up, and the regulators haven’t been and continue not to be too keen to go after it. And we are talking such a long period of time that many of the records are long gone.

But the remarkable bit isn’t that Volcker said what he said; he’s made it clear that he takes a dim view of the nonsense that the industry has chosen to wrap in the mantle of innovation. It’s that the listeners were stunned. This is yet another proof of industry narcissism: the complete and utter inability to recognize and take responsibility for the damage it has wrought.

From the Telegraph (hat tip reader Albert):

The former US Federal Reserve chairman told an audience that included some of the world’s most senior financiers that their industry’s “single most important” contribution in the last 25 years has been automatic telling machines, which he said had at least proved “useful”.

Echoing FSA chairman Lord Turner’s comments that banks are “socially useless”, Mr Volcker told delegates who had been discussing how to rebuild the financial system to “wake up”. He said credit default swaps and collateralised debt obligations had taken the economy “right to the brink of disaster” and added that the economy had grown at “greater rates of speed” during the 1960s without such products.

When one stunned audience member suggested that Mr Volcker did not really mean bond markets and securitisations had contributed “nothing at all”, he replied: “You can innovate as much as you like, but do it within a structure that doesn’t put the whole economy at risk.”

He said he agreed with George Soros, the billionaire investor, who said investment banks must stick to serving clients and “proprietary trading should be pushed out of investment banks and to hedge funds where they belong…If you fail, fail. I’m not going to help you. Your stock is gone, creditors are at risk, but no one else is affected.”

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  1. Peter T

    Tell, why was Volcker ever replaced by Greenspan? It seems that we would have had less financial “innovation” and less risk taking, and less profit for the banksters.

    1. Yves Smith Post author

      My guess is that Volcker was a Carter appointee. Second reason might be Greenspan’s membership in the cult of Ayn Rand.

      1. Andrew Bissell

        I know it’s fun to tie Greenspan the Price Fixer to Ayn Rand any chance you get, but do you really think that association had anything to do with his appointment? Were a lot of other members of the “Collective” given top posts in the Reagan administration?

        The answer (no) probably has a lot to do with the fact that most of the others weren’t willing to compromise and betray their principles to pursue power and Washington social climbing like Greenspan did.

    2. Albatross

      And tell us why Volcker is still out of loop given how dire economy is still at brink of disaster?..

    3. freedom24

      Volcker’s departure from the Fed came after years of political antagonism with the Reagan administration (particularly from then Chief of Staff Jim Baker) about the public perception and electoral impact of austere monetary policy.

      Impressive consistency of Tall Paul’s image as a selfless public servant with America’s long-term prosperity at heart. That has and will continue to make him a very dangerous figure in the otherwise self-interested, narrow-minded circles of Washington politics.

      For more see http://www.freedom24.org/rationalpost/2009/12/10/volcker-vs-greenspan/

  2. charles

    Derivatives are harmful because they are a strong enabler of the real cause of financial instability : maturity transformation outside of the Central Bank. For all his handwaving, Volker did NOTHING to steer Central Banking in that direction during his tenure, simply because he is as blind to the root of the problem as his predecessor or his successor.

    Bond market and Securitization are not by themselves what “put the whole economy at risk” (quite the contrary actually, as it matches liabilities and assets maturity !). What is toxic is the bank-enabled short term lending on the back of these assets (and others), either through on balance sheet (repo, commercial paper) or off balance sheet (derivative) instruments.

    1. Yves Smith Post author


      Empirical evidence does not support your view. There was a notable absence of financial crises from the Depression to the sovereign bond crisis at the very end of the 1970s.

      1. charles

        …and Paul Volcker was Chairman of the Fed between 1979 and 1987, right when the fun started (stock index futures appeared in 1982). Two months after the end of his tenure, black monday happened. I don’t like Greenspan, but he couldn’t create the condition of the krach by himself in only two months !

        and, by the way, exiting from Gold convertibility and instituting price controls counts for me as a financial crisis.

      2. Andrew Bissell

        There was the 1970 Penn Central debacle in there. It’s hard to say how far-reaching the damage would have been without the federal loan guarantees. Kind of a dry run for the “kick the can down the road” bailout mentality.

        At any rate a post-depression lull in the number of financial crises isn’t really surprising or solid evidence that there was an especially good set of policies in place at the time. It takes time for people to lever themselves back into trouble again.

  3. Jami B.

    I just emailed Paul’s statements to my Representative. I asked him why he isn’t being listened to…besides the obvious….follow the money trail. We need to demand that Volcker’s ideas are the best way forward.

  4. Hugh

    The banking industry has become a casino filled with gamers who only know and live for the game. It reminds me of that classic Bob le Flambeur about a gambler so addicted that he has no life outside gambling and so obsessed that he can’t leave the tables really even for a heist he planned and is participating in.

    Bankers can not be reformed. They can only be removed (to a place preferrably with bars) where they can do no damage.

    1. Daniel

      Bankers can not be reformed. They can only be removed (to a place preferrably with bars) where they can do no damage.

      +1. The 2009 scenario, massive bonus made on top of organized trading volatility using tax-payers’ money has been a nightmare come true.

      Thanks Monsieur Obama.

  5. Costard

    Agree with Charles. Derivatives are merely instruments for the distribution of risk. This becomes a problem only if you have a system in which risk is mandated, or is divorced from reward — to wit, a system like our own. Seems we have to regulate derivatives anyway in order to save our hides, but ignoring the root cause of the problem does not make us wiser. A vibrant, adaptive economy is incompatible with socialization long-term, and we must either kill the finance sector or bankrupt the nation.

    The quote that banks are “socially useless”, from a politician no less, seems to me representative of the situation. We have a political class with zero understanding of risk. They’ve compromised the banks, they see the banks pi$$ing money away on fruitless schemes, therefore they believe banks serve no purpose. But at one time banks parsed risk, and they did a pretty good job — because they HAD to.

  6. Clampit

    There’s nothing about financial innovation that wouldn’t have been solved last year if the government had left well enough alone. (You can argue that the transition would have been painful and thus support the original case, but it would have been exactly that a transition; the equilibrium results would be a far cry than the mess we have today.) It’s inherent in business and industry to draw as many resources to your side as possible, government and the markets role are to moderate this. As others have noted, there’s nothing about the current crisis that economic, it’s political. The blind faith Americans have in Republicratic leadership will eventually be their undoing.

  7. Dave Raithel

    Footnote 45 of the Brenner piece the other day took me to this: “In the words of John Kenneth Galbraith, every new financial instrument “is, without exception, a small
    variation on an established design, one that owes its distinctive character to the … brevity of financial
    memory.” Quoted in John Plender, “Financial Innovation: Blessing or Curse?” Financial Times, 7 January

    Which let me find this: http://gulfnews.com/business/features/financial-innovation-blessing-or-curse-1.43856

    reprinting the original article. To quote more Galbraith:

    “All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets … All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment.”

    My point is not to diminish Volcker’s claims as unoriginal, but to buttress them. And though I expect nobody to have made a record, the archives will document that as much “wisdom” I find in what Volcker has been saying the last 18 months or, I also have a less sanguine recollection of his policies than does Yves Smith. But the fact is he presents a model of finance that most of us (me anyway) can understand, and behavioral economics would say that counts for something. After all, rocket scientists really are best put to use building rockets …

    So it does make one wonder: cap and trade would be sabotaged if finance could not “innovate” derivatives for that market; or in the alternative, straightforward Pigovian taxes would be the only option – other than doing nothing …

    Which then suggests that the complement to “distributing risk” is the avoidance of obligations – like minimizing externalities.

  8. M.G. in Progress - The Unbearable Lightness of Being an economist

    At http://rick.bookstaber.com/2009/11/does-financial-innovation-promote.html you get an interesting debate by Rick Bookstaber on wether Financial Innovation promote Economic Growth.
    I think that it is being made implicitly a convincing case to tax financial transactions, financial innovation and all trades which have no added value to the economy. If then negative externalities are created instead, there is a cogent case to tax financial products and innovation heavily. If you tax beer and bread, incomes and labour, why would not we tax financial products?

  9. craazyman

    I don’t know. I think even the ATM is dubious. Think about it. How many times have you on the street at 3 a.m. — thinking about just one more drink someplace. And a woman too, if you can dig one up somewhere at last call. You’re out of cash and you should go home. But it’s off to an ATM to reload — ’till 4 or 5. Now you’ve wasted the next day, and whoever you happen to meet, well, it was probably better to have met through E-Harmony. And all this because of the ATM. ha ha ha ha. Volcker never had to live through that. How would he know?

  10. Imelda Blahnik

    Who cares if it helped “the economy”? Financial innovation helped the people who matter – the banksters! Mwahahahahaha!!!!!

  11. LAS

    Volker is just a bit too hard on the financial services. There is a second great financial innovation they’ve achieved – bill paying over the internet. Oh hey, right, sorry, programmers deserve the greater credit for that.

  12. Kay4

    Why aren’t people listening to Volker, he seems right and he should be hard on the financial services seeing as they have gotten us into this mess. However what does Volker propose we do now?

  13. eh

    It was never intended to ‘help the economy’. It was intended to make money for the ‘financial innovators’. Anyone can see a good deal of any FIRE economy creates no real wealth. Good grief.

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