Posted by: Dirk | June 29, 2008

Inside Volcker’s Mind: on market functioning

The following is an excerpt from an interview with Paul Volcker in 2000, Chairman of the Board of Governors of the Federal Reserve System ’79-’87, reprinted in Samuelson and Barnett’s excellent collection of interviews Inside the Economist’s Mind, p. 188-89:

Volcker: How we get the advantages of an open competitive flexible financial system and deal with its proclivity toward volatility and crisis has been an unsolved problem, one that has preoccupied me. I’ll tell you the Federal Reserve paid a lot more attention to banking regulation when I was there than it had before. Maybe I didn’t do a good enough job, but the problem is chronic. […]

I’m very skeptical of the effort of the banks to develop so-called “modern” risk management approaches based on some theoretical modelling by mathematicians who never saw a financial market. All of this is summed up in the “value at risk” concept, which I think is borrowed from statistical and mathematical theory. The whole concept rests on the idea of normal distribution curves, but there ain’t no normal distribution when it comes to financial crisis, I think. They tend to run to extremes. The banks want to run a risk management system based upon the idea that we have a normal distribution of outcomes but, as has been demonstrated by the Asian and the LTCM crises, there are lots of problems there. […]

I think that the market has no sense of what a sustainable equilibrium is now, but I don’t think it’s beyond imagination that it could be given a sense of reasonable equilibrium, because there is enough to economic theorizing that there is some equilibrium out there. And it’s better to stay reasonable close than to wander way away from it.

Mehrling: So markets don’t manage themselves, and also bankers don’t manage themselves given the greed, fear, and hubris combination.

Volcker: This is true. Also bureaucrats left unchecked probably don’t manage themselves either.

Given that the interview is from 2000, this looks pretty good right now. There are more interesting parts in the interview with Volcker, on expectations, a world currency and central bank independence. Also, people like Modigliani and Friedman make interesting contributions. This is great stuff (especially for PhDs that are loaded up with theoretical and empirical stuff, but lack some history). Recommended!

Paul Volcker is not the only one to note that things have changed in macroeconomics. Axel Leijonhufvud, who also has his share of experience, makes the same point in his paper The Long Swings in Economic Understanding (pdf):

To the older generation, macropolicy was stabilization policy. To the present generation, it has become the art of constraining governments. If the older was uncritical in trusting the power of government to do good, the present one has a distinctly cynical view of representative democracy.

Macroeconomics seems to be very interesting these days.

UPDATE (30/06/2008): I just read Alan Blinder’s piece Two Bubbles, Two Paths at the NY Times. He also regrets that what Volcker apparently knew was lost with Greenspan:

As long as the central bank is also a bank supervisor and a regulator, it is extraordinarily well placed to observe and understand bank lending practices — much better positioned than almost anyone else. Beyond merely knowing more, part of a bank supervisor’s job is to make sure that banks don’t engage in unsafe and unsound lending, and to scowl at or discipline them if they do. We know that America’s bank regulators fell down on the job as the housing-mortgage bubble inflated. But that was a failure of bank supervision, not of monetary policy.


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