http://www.financialstability.gov/docs/regs/FinalReport_web.pdf
40. Leverage enhances profits when prices rise but can lead to bankruptcy when prices decline. For example, suppose a family with $100,000 in savings pays that amount for a home a few miles outside of Cleveland or Dallas. A drop of $20,000 in the price of the house means a 20 percent loss on the $100,000 investment, but they still have a net worth of $80,000 and can enjoy the benefits of living close to downtown. A family with only $10,000 to begin with could also buy the same house but would have to borrow the remaining $90,000 to complete the purchase. After this leveraged transaction, the identical $20,000 price decline would turn the family’s net worth from plus $10,000 to minus $10,000—the house is worth only $80,000, but they still owe $90,000. The price decline might even force the family to vacate the premises. Leverage can cause bankruptcy when asset prices decline.
41. Prohibiting Certain High Risk Investment Activities by Banks and Bank Holding Companies, p. 22.
42. Ibid., p. 21.
43. Ibid., p. 22.
44. See Markus Brunnermeier, “Deciphering the Liquidity and Credit Crunch of 2007–2008,” Journal of Economic Perspectives 23, no. 1 (Winter 2009): 80–81. “In hindsight, it is clear that one distorting force leading to the popularity of structured investment vehicles was regulatory and ratings arbitrage. The Basel I Accord (an international agreement that sets guidelines for bank regulation) required that banks hold capital of at least 8 percent of the loans on their balance sheets; this capital requirement (called a ‘capital charge’) was much lower for contractual credit lines.”
45. See “Citigroup Says It Will Absorb SIV Assets,” MarketWatch, December 13, 2007, available at www.marketwatch.com/story/citi-plans-to-absorb-49-billion-in-siv-assets-onto-balance-sheet.
46. This quote and the following quotes by Senator Johanns and Volcker come from Prohibiting Certain High Risk Investment Activities by Banks and Bank Holding Companies, pp. 26–28.
47. For a detailed argument against the power of the Volcker Rule to prevent a crisis, and for arguments in favor of more capital, see Lawrence J. White, “The Gramm-Leach-Bliley Act of 1999: A Bridge Too Far? Or Not Far Enough?” Suffolk University Law Review 43 (2009–2010): 937–56.
48. Sorkin, Too Big to Fail, tells the Lehman story well.
49. See “Dollar Hits Two-Year Low vs. Yen; Subprime-Battered Investors Pull Back from ‘Carry Trade,’ ” Wall Street Journal, November 13, 2007, p. C2. Also see “Yen Gets Lift from Turmoil in the Market; Strength Amid Distress Reveals Investor Caution as Carry Trades Unwind,” Wall Street Journal, January 24, 2008, p. C1.
50. Prohibiting Certain High Risk Investment Activities by Banks and Bank Holding Companies, p. 36.
51. Shelby had asked “what constitutes excessive growth” at the largest financial firms? And Volcker gave the pornography answer. See ibid., p. 14.
52. This quote and the remaining quotes in the chapter are from ibid., p. 37.
18. The Rule
1. Guardian, London, February 3, 2010, p. 22.
2. The article is entitled “On the Nature of Trading: Do Speculators Leave Footprints?” Journal of Portfolio Management 29, no. 4 (July 2003): 64–70. It was written in connection with my work as an expert witness in a legal dispute over a corporate takeover. The court case was Consolidated Edison, Inc. v. Northeast Utilities. I was retained by Shearman & Sterling on behalf of Consolidated Edison to provide deposition testimony and an expert report analyzing the nature of customer-based trading versus speculation. I applied that analysis to the behavior of the Northeast Utilities energy trading subsidiary in connection with Con Edison’s bid to terminate its takeover of Northeast.
3. I traded on the New York Futures Exchange, the COMEX, and the New York Mercantile Exchange as a scalper, or market maker, and wrote a paper describing that activity entitled “Marketmaker Behavior in an Auction Market: An Analysis of Scalpers in Futures Markets,” Journal of Finance 39, no. 4 (September 1984): 937–54. I traded for a hedge fund called Odyssey Partners, run by Jack Nash and Leon Levy, from 1988 through 1996.
4. The letter, entitled “Congress Should Implement the Volcker Rule for Banks,” was signed by W. Michael Blumenthal, Nicholas Brady, Paul O’Neill, George Shultz, and John Snow, and appeared in Letters to the Editor, Wall Street Journal, February 22, 2010, p. A18.
5. Brady (1988–1993), O’Neill (2001–2002), Shultz (1972–1974), and Snow (2003–2006) served in Republican administrations; Blumenthal (1977–1979) served in a Democratic administration.
6. Milton Friedman was born on July 31, 1912, and died on November 16, 2006.
7. See Bloomberg news report “Ex–Treasury Secretary Brady Running with ‘Volcker,’” at www.nj.com/business/index.ssf/2010/08/ex-treasury_secretary_brady_ru.html.
8. Letter dated May 19, 2010, Personal Papers of Paul Volcker.
9. New York Times, July 11, 2010, p. BU1.
10. See John Cassidy, “The Volcker Rule,” New Yorker, July 26, 2010, p. 25.
11. A copy of the 849-page bill, Public Law 111-203–July 21, 2010, is available at the online Government Printing Office with the following specific address: www.gpo.gov/fdsys/pkg/PLAW-11publ203/pdf/PLAW-111publ203.pdf.
12. Public Law 111-203—July 21, 2010, 124 Stat. 1620.
13. Ibid., 124 Stat. 1621.
14. Ibid., 124 Stat. 1394. Section 111 of the Dodd-Frank Act established the Financial Stability Oversight Council (124 Stat 1392).
15. The council consists of ten voting members and five nonvoting members. The voting members are the secretary of the treasury; the chairman of the Board of Governors of the Federal Reserve System; the comptroller of the currency; the director of the Bureau of Consumer Financial Protection; the chairman of the Securities and Exchange Commission; the chairman of the Federal Deposit Insurance Corporation; the chairman of the Commodity Futures Trading Commission; the director of the Federal Housing Finance Agency; the chairman of the National Credit Union Administration Board; and an independent member with insurance expertise who is appointed by the president and confirmed by the Senate for a six-year term. The nonvoting members, who serve in an advisory capacity, are the director of the Office of Financial Research; the director of the Federal Insurance Office; a state insurance commissioner designated by the state insurance commissioners; a state banking supervisor designated by the state banking supervisors; and a state securities commissioner (or officer performing like functions) designated by the state securities commissioners.
16. See FSOC 2011 Annual Report, available at www.treasury.gov/initiatives/fsoc/Pages/annual-report.aspx, esp. p. 127.
17. See Cassidy, “The Volcker Rule,” for a detailed account of the negotiations.
18. See “Banks Dodge a Bullet as Congress Dilutes Rules,” Bloomberg, June 25, 2010.
19. See WSJ.com, February 3, 2010, 9:16 P.M.
20. Volcker’s letter is addressed to Timothy Geithner as chairman of the FSOC, and is dated October 29, 2010. His footnote reads, “I understand that NYU Professor William Silber, who has served as expert witness in cases requiring identification of, and distinctions between, ‘proprietary’ and ‘market-making’ activity, is providing FSOC with relevant analysis.” My letter to committee chairman Timothy Geithner, dated November 2, 2010, included the following: “The methodology outlined in my paper can be applied to the ban on proprietary trading contained in Section 619 of the Dodd-Frank Act but it should not be viewed as a substitute for a comprehensive approach to implementing the Volcker Rule. In conversations with some of the staff at Treasury I have suggested that you instruct regulators to adapt the practical skills of managers in financial firms whose job it is to distinguish between speculation and market making. For example, during the years I spent as a trader on a number of futures exchanges I was impressed by the ability of my clearing firm to monitor each of their traders’ risk exposure and to impose different capital requirements depending on whether the trader was a market maker or a specula
tor. The manager at the clearing firm looked at the sequence of a trader’s transactions, the rate of inventory turnover, end-of-day positions, and then supplemented those numerical facts with surprise visits to the trading floor to see what a suspected ‘closet speculator’ was actually doing. I think that regulators monitoring the implementation of the Volcker Rule ban on speculation should arm themselves with a variety of methodologies, including the analysis outlined in ‘Do Speculators Leave Footprints?’ They should establish the same type of multi-dimensional approach that the IRS uses to identify tax evasion, including face-to-face audits where that is indicated.”
21. See “Wall St. Faces Specter of Lost Trading Units,” New York Times, August 6, 2010, p. B1.
22. See “Morgan Stanley Team to Exit in Fallout from Volcker Rule,” Wall Street Journal, January 11, 2011, p. C1.
23. See “Wall St. Faces Specter of Lost Trading Units,” New York Times, August 6, 2010, p. B1.
24. See “With Big Banks Forced to Exit, Look for Speculators to Step In,” Wall Street Journal, September 7, 2010, p. C10.
25. See Michael Lewis, “Wall Street Proprietary Trading Under Cover,” Bloomberg Opinion, October 27, 2010, 4:48 P.M.
26. Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds, Financial Stability Oversight Council, January 2011, p. 4, at www.treasury.gov/initiatives/Documents/Volcker%20sec%,20%,20619%,20study%,20final%,201%,2018%,2011%,20rg.pdf.
27. For a complete list of the metrics see ibid., pp. 39–43.
28. Ibid., p. 44.
29. Prohibiting Certain High Risk Investment Activities by Banks and Bank Holding Companies, p. 37.
30. See page 2 of Volcker’s letter addressed to Timothy Geithner as chairman of the FSOC, dated October 29, 2010.
31. Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds, p. 3.
32. Ibid., pp. 35–36.
33. See “Volcker Rule May Work Even If Vague,” New York Times, January 21, 2011, p. B1.
34. “Volcker Rule Should Require Sign-off by Bank CEOs, Panel Says,” Bloomberg, January 19, 2011, available at www.bloomberg.com/news/2011-01-19/volcker-rule-should-require-bank-ceos-to-certify-compliance-panel-says.html.
35. Ibid.
36. See “Volcker Rule May Work Even If Vague,” p. B1.
37. Paul Volcker, Mais Lecture, Cass Business School, London, July 14, 2011.
19. Trust
1. The Wall Street Journal ran an op-ed piece by Lewis Lehrman on August 15, 2011, the fortieth anniversary of the suspension of dollar convertibility, entitled “The Nixon Shock Heard ’Round the World.” The facts are mostly right, with one big exception. Lehrman writes (Wall Street Journal, August 15, 2011, p. A13), “At least one Camp David participant, Paul Volcker, regretted what transpired that weekend.” The suspension of convertibility was, in fact, Volcker’s idea (see chapter 3), and he does not think it was a mistake.
2. See chapter 2 on the gold cover. The requirement that the Federal Reserve hold gold certificates against bank reserves was removed in 1965, and the requirement against Federal Reserve notes was eliminated in 1968.
3. This inscription appears on the face of every Federal Reserve note. Check your pocket.
4. See Friedman’s testimony in “Gold Cover,” Hearings Before the Committee on Banking and Currency, U.S. Senate, 90th Congress, 2nd Sess., February 1, 1968, p. 152.
5. Irving Fisher was a professor of economics at Yale University from 1898 until 1935. His most important books include The Rate of Interest (Macmillan, 1907), The Purchasing Power of Money (Macmillan, 1911), and The Making of Index Numbers (Houghton Mifflin, 1922). In Money Mischief (New York: Harcourt Brace, 1994), p. 37, Milton Friedman calls Fisher “the greatest economist the United States has ever produced.”
6. The quotes in this paragraph are from Friedman, Money Mischief, pp. 252 and 254.
7. For a general discussion on the origins of the Great Inflation, see Allan Meltzer, “Origins of the Great Inflation,” and Christina Romer, “Commentary,” in Reflections on Monetary Policy 25 Years After October 1979, Federal Reserve Bank of St. Louis 87, no. 2, part 2 (March/April 2005).
8. See chapter 14 for the discussion of the passage of the Gramm-Rudman-Hollings amendment to balance the budget.
9. Federal Reserve press release available at www.federalreserve.gov/newsevents/press/monetary/20110809a.htm.
10. PIPAV.
11. Paul Volcker, “A Little Inflation Can Be a Dangerous Thing,” New York Times, September 19, 2011, p. A27.
12. According to Federal Reserve chairman Ben Bernanke, “Even after economic conditions have returned to normal, the nation faces a sizable structural budget gap. Both the Congressional Budget Office and the Committee for a Responsible Federal Budget project that the budget deficit will be almost 5 percent of GDP in fiscal year 2015, assuming that current budget policies are extended and the economy is then close to full employment.” See “Fiscal Sustainability,” Remarks by Ben S. Bernanke, Annual Conference of the Committee for a Responsible Federal Budget, Washington, DC, June 14, 2011, p. 1, available at www.federalreserve.gov/newsevents/speech/2011speech.htm.
13. Paul Volcker, “A Little Inflation Can Be a Dangerous Thing,” New York Times, September 19, 2011, p. A27.
14. See WSJ.com, October 19, 2011, 10:27 A.M.
15. See “Fiscal Sustainability,” Remarks by Ben S. Bernanke, Annual Conference of the Committee for a Responsible Federal Budget, Washington, DC, June 14, 2011, available at www.federalreserve.gov/newsevents/speech/2011speech.htm.
Selected Bibliography
Books, Articles, Reports
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Anderson, Harry, and Rich Thomas. 1983. “Voting for Volcker to Stay.” Newsweek, June 20, p. 53.
Anderson, Martin. 1990. Revolution: The Reagan Legacy. Stanford, CA: Hoover Institution Press, Stanford University.
Arrow, Kenneth. 1963. “Uncertainly and the Welfare Economics of Medical Care.” American Economic Review 43, no. 5 (December): 941–73.
Barro, Robert. 1982. “United States Inflation and the Choice of Monetary Standard.” In Robert Hall, ed. Inflation: Causes and Effects. Chicago: University of Chicago Press, pp. 99–110.
———. 1989. “The Ricardian Approach to Budget Deficits.” Journal of Economic Perspectives 3, no. 2 (Spring): 37–54.
Bell, Geoffrey. 1973. The Euro-Dollar Market and the International Financial System. New York: John Wiley.
Bernanke, Ben S. 2004. “The Great Moderation.” Remarks at the Meetings of the Eastern Economic Association, February 20, 2004. Available at fraser.stlouisfed.org/historicaldocs/1191/download/64784/bernanke_20040220.pdf.
———. 2010. “Paul Volcker,” Time, April 29, 2010. Available at www.time.com/time/specials/packages/article/0,28804,1984685_1984745_1984803,00.html.
———. 2011. “Fiscal Sustainability.” Remarks at the Annual Conference of the Committee for a Responsible Federal Budget. Washington, DC, June 14, 2011. Available at www.federalreserve.gov/newsevents/speech/2011speech.htm.
Bernstein, Peter L. 2000. The Power of Gold: The History of an Obsession. New York: John Wiley.
Blinder, Alan. 2005. “Panel Discussion I: What Have We Learned Since October 1979?” Reflections on Monetary Policy 25 Years After October 1979, Federal Reserve Bank of St. Louis 87, no. 2, part 2 (March/April).
Board of Governors of the Federal Reserve System. 1963. Federal Reserve System: Purposes and Functions. 5th ed. Washington, DC: Board of Governors of the Federal Reserve System.
———. 2005. Federal Reserve System: Purposes and Functions. 9th ed. Washington, DC: Board of Governors of the Federal Reserve System.
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———. Various dates. Press Releases. Washington, DC: Board of Governors of the Federal Reserve System.
Bordo, Michael D., and Athanasios Orphanides (eds.) (forthcoming). The Great Inflation. Chicago: University of Chicago Press.
Boughton, James. 1998. “Harry Dexter White and the International Monetary Fund.” Finance and Development 35, no. 3 (September).
Bremner, Robert P. 2004. Chairman of the Fed: William McChesney Martin Jr. and the Creation of the Modern American Financial System. New Haven, CT: Yale University Press.
Brunnermeier, Markus. 2009. “Deciphering the Liquidity and Credit Crunch of 2007–2008.” Journal of Economic Perspectives 23, no. 1 (Winter): 77–100.
Burns, Arthur F. 1979. The Anguish of Central Banking. Belgrade, Yugoslavia: The 1979 Per Jacobsson Lecture. Available at www.perjacobsson.org/lectures/1979.pdf.
———. 2010. Inside the Nixon Administration: The Secret Diary of Arthur Burns, 1969–1974. Robert H. Ferrell, ed. Lawrence: University Press of Kansas.
Carter, Jimmy. 2010. White House Diary. New York: Farrar, Straus and Giroux.
Cassidy, John. 2010. “The Volcker Rule.” New Yorker 86, no. 21, July 26.
Chernow, Ron. 1990. The House of Morgan: An American Banking Dynasty and the Rise of Modern Finance. New York: Atlantic Monthly Press.
Clarida, Richard, Jordi Gali, and Mark Gertler. 2000. “Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory.” Quarterly Journal of Economics 115, no. 1 (February): 147–180.
Cohan, William D. 2009. House of Cards: A Tale of Hubris and Wretched Excess on Wall Street. New York: Doubleday.
Connally, John B. 1993. In History’s Shadow: An American Odyssey. New York: Hyperion.
Coombs, Charles A. 1976. The Arena of International Finance. New York: John Wiley.
Council of Economic Advisers. Various dates. Annual Report. Washington, DC.
———. Various dates. Economic Report of the President. Washington, DC.
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