Paul A. Volcker

English

Research Papers in Economics

AP ERSPECTIVE ON FINANCIAL CRISES
Paul A. Volcker*
I think my role is supposed to be to provide perspective. When I
listen to this discussion, I am struck by how little things have changed. I
also confess, as age advances, to a little skepticism and last night, and
again today, George Willis has kept coming to mind. He was a wonderful
senior civil servant in the U.S. Treasury Department when I arrived there
as a callow youth in the 1960s and early 1970s. George Willis was in
charge of the international ﬁnance area; he was the last survivor, at least
in the U.S. Treasury, of Bretton Woods, so he dated back to real monetary
negotiations. He used to carry Mr. White’s bags, I guess, at the Bretton
Woods Conference, and he was a very dominant inﬂuence at Treasury.
Not many people in the U.S. Treasury knew anything about international
ﬁnance in those days.
Willis was a rather skeptical fellow. You may recall that in 1971 a
sizable international crisis occurred, right at the heart of the international
monetary system. In fact, I thought it was the biggest crisis in 50 years.
(One of the characteristics of the international system is that about every
10 years, we have the biggest crisis in 50 years, which tells us that
something is amiss.) But we had a big international negotiation then, the
C-20, where Robert Solomon was one of the leaders, and where we
debated all these arcane issues of international ﬁnance. I had to lead the
American delegation, and we used to have conferences in my ofﬁce and
consider this alternative and that alternative. Eventually the discussion
would get around to George. “What do you think, George?” And George
would say, “It won’t work!” Finally, you got frustrated about this, so you
*Henry Kaufman Visiting Professor, Stern School of Business, New York University.started out with George, and asked, “George, what will work?” And the
answer came back, “Nothing!”
I want to explain to you why that response is still relevant today. I
might add ﬁrst that two concrete results of that old C-20 were the Interim
Committee (this was 25 years ago, but it is still called the Interim
Committee) and the Development Committee (you still need some
development, I guess). Anyway, let me make a few points.
As Jerry Corrigan has already said, if you expect the results of all
these efforts to be the end of international ﬁnancial crises, you are wrong.
International ﬁnancial crises, I might even say domestic ﬁnancial crises,
are built into the human genome. When we map the whole thing, we will
ﬁnd something there called greed and something called fear and some-
thing called hubris. That is all you need to produce international ﬁnancial
crises in the future. I have not seen anything to raise any doubts about
that.
Now, let me explain why I am skeptical about some of the answers
that have been presented in the name of architecture. If I were to confess,
I think that I have more respect for architecture than Jerry Corrigan, but
I do think most of these proposed changes belong in the area of interior
decoration rather than architecture.
The outline for this conference stated that “misguided national
policies produce harmful spillovers.” That statement could have just as
appropriately read, “national policies produce harmful spillovers,” be-
cause good national policies can also produce harmful spillovers. The
better a national policy is perceived to be in the emerging countries,
obviously the more capital they will attract. The increased capital they
attract will be an endorsement of the fact that the policies are good, so the
country will attract still more capital until you get a bubble of the kind we
are interested in. Then it all unravels, and everybody looking back says
you must have had bad policies.
I made the mistake of accepting an invitation to go to Indonesia in
the middle of that crisis, when the IMF was on its ﬁrst iteration of
repairing its ﬁrst program. For the ﬁrst time I read the IMF and World
Bank appraisals of Indonesia, which were then about nine months old,
issued shortly before the Thai crisis. I also read their program for
Indonesia, incorporated in the letter of intent. I tell you, no red-blooded
American investor reading either the Thai report or the Indonesian report
or the World Bank or the IMF material would not have wanted to invest
in both of those countries in June of 1997. Those countries had had 8
percent rates of growth for 20 years, they had price stability, they had
budgetary discipline. That was all the ﬁrst and second paragraphs of
these reports said.
Now, to be fair, if you read on the reports also said, well, maybe
there are some structural weaknesses in the banking system and a few
problems here and there. I must say I was also struck by all the people
A PERSPECTIVE ON FINANCIAL CRISES 265advising Thailand who were so conﬁdent that the Thai exchange rate was
overvalued by 15 percent. When I asked them about the dollar/yen rate
they said, “I do not have the vaguest idea what the exchange rate is.”
How can we be so sure about the Thai rate, and yet have no opinion at all
about our own exchange rate?
I do not think that just following good policies will solve the
problems, at least for the interim. I think the problems go beyond that.
What about strong banks, strong supervision? Bob Eisenbeis and Jerry
Corrigan already referred to this. What happened in the United States?
The United States has the image of strong banks and strong supervision.
I have been a supervisor in the United States for more of my life than I
would like to remember, and I tell you the state of Texas keeps coming to
mind.
The state of Texas in 1980 undoubtedly had the strongest collection
of the most proﬁtable banks in the United States, in the best part of the
country. Five or six years later, they were all bust, all of them except one
that had been bought by another American bank. Something went on
there. It was in the early 1990s that the biggest bank in the United States
was, I would judge, within three months of federal intervention, before
the situation fortunately turned around. If it had not been for substantial
supervisory oversight and action by management, the bank probably
would not have remained an independent institution. That is in this
decade!
There is an inherent problem here. I hear discussion goes on in Basle
about letting banks judge their own credits and capital requirements. But
we have seen the dangers of the banks setting their own capital
requirements. We have a dilemma. If you go in and set a tough capital
requirement in this day and age, the U.S. banking system is no longer the
principal ﬁnancial market. The market will go elsewhere. Recently, the
U.S. government and others demanded that emerging countries toughen
banking standards, insist on transparency, and limit bailouts. Then, right
at home, we found it necessary to conduct an ofﬁcial sponsorship of the
bailout of the most unsupervised, unregulated, non-transparent, ﬁnancial
organization in the United States, because of concern that its failure was
going to bring down the whole of the supervised, open, American
banking system.
About transparency and auditing, all I will say is that in my entire
experience as a bank supervisor, I have never seen a private bank audit
that gave any warning whatsoever of a failing bank. Now, maybe some
of you know of one, and I would be glad to hear from you afterward.
Think about that audit report that the Penn Square Bank in Tulsa,
Oklahoma, got some two months before the bank collapsed. You could
not have a much worse bank than Penn Square, I will tell you. But they
had a nice, clean, well-audited statement. Does anybody here really think
that it is not possible to have a bubble in the U.S. stock exchange? I am not
266 Paul A. Volckerspeaking about the current situation, of course, I am just talking theoret-
ically.
With all the best accounting, disclosure, whatever, human emotions
are involved. The problem is up here in the head, it is not what you read.
The one piece of information everybody had about these emerging
countries was that they did not have very much information. Did that
stop anyone? And incidentally, marking to market, which Henry Kauf-
man already mentioned, can be a great recipe for accelerating crises.
Now in my view, all these arguments about what the IMF should do
suggest a certain myopia. Are they lending too much? Are they lending
too little? Are they providing too much surveillance? Too little surveil-
lance? Are they too intrusive? Not intrusive enough? There are no good
answers to those questions, in my view, except case by case, which has
been suggested. The common theme I am trying to stress is that there is
a broad systemic problem here that people have not been willing to face
up to. The problem has been touched upon in these conversations, but I
do not think we have faced it very squarely.
I think we are seeing a real crisis of global ﬁnancial capitalism. It
reﬂects the clash of two elements. One is globalization itself, all the
technology you know about better than I. I cannot even get on the
Internet. But a friend told me that he was in Heathrow Airport in these
little booths where you make telephone calls, and an attractive young
woman in the next one pulls in her laptop and does—whatever you do on
a laptop—for 20 minutes! And he got curious as to how she was so busy
on this thing for 20 minutes in Heathrow. Eventually, she got out and
apparently she could not refrain from saying, with a little smile, “I just
made $25,000.” Now when you are operating on the Internet, making
$25,000 between planes in Heathrow Airport, you know something of
signiﬁcance is going on.
The ability to move money around the world rapidly is well known.
There has not been enough emphasis on the other element in the crisis.
We live in an asymmetric world. As Jerry Corrigan mentioned, and
Henry Kaufman mentioned earlier, we are dealing with very small
economies. BankBoston, a $70 billion bank, just merged again because it
apparently thinks it is too small. Yet it is bigger than most of the banking
systems in these small economies. The more attractive they are, the more
small countries are bound to be overwhelmed by free capital movements,
no matter how strong they are to start with. You know, you put $30
billion of external capital into a total ﬁnancial system of $100 billion, and
you have a problem. A banking system that was strong to start with will
not be strong after such an inﬂux of capital.
The inherent vulnerability of smaller countries to this kind of capital
ﬂow is a real problem, no matter how good the economic policies, no
matter how good their banking system, no matter how good their
accounting system. What are we going to do about it?
A PERSPECTIVE ON FINANCIAL CRISES 267Well, we can see a natural market response going on and it has very
little to do with the debate here and elsewhere. Countries want to get
bigger, they want to get more diversiﬁed. Obviously, a country faces
certain constraints in that respect. But its economic system can in effect
get bigger and more diversiﬁed by linking onto somebody else’s. That is
what has happened in Argentina. Argentina used to have its own banks;
now almost all its big banks are owned and controlled by foreigners. The
same thing is going on in lesser degree in Mexico. Korea has never felt
good about opening to foreign banks, especially to Japan, but now they
are beginning. It will be true in Thailand, it will be true in Indonesia, and
soon people will have enough conﬁdence in those countries to buy their
banks, and the countries will be willing sellers. They are in a jam and they
understand the only way they can get stability and strength is by joining
to something that is big and diversiﬁed. The same thing is going on in the
nonﬁnancial world. I think that is all ﬁne, and economically it is correct,
if we are going to have a good recovery from this crisis.
Let’s consider what is at stake. These are countries that have been
growing by 6 to 8 percent a year, as far back as my memory goes. They
have only opened up their economies and particularly their ﬁnancial
systems in this decade. They opened up, and ﬁve years later they fell ﬂat on
their backs. Maybe it is all a temporary phenomenon; that is what we all
hope. But we had better make it a temporary phenomenon or we are in real
trouble, which brings me back to the exchange rate question and this talk of
two-corner solutions.
I think there must be a third corner here someplace, but basically I
am in favor of straight lines. I think the idea of a small country freely
ﬂoating its exchange rate is unworkable. It does not happen in practice;
they do not have the markets, they do not have the strong institutions,
they do not have the size and depth. Then people say, “Well, it is a corner,
but it is a modiﬁed corner. I know they have to manage it a little bit.” In
fact, the strong instinct is to ﬁx.
The exchange rate is a multilateral phenomenon. There are a lot of
sides to it. You cannot ﬂoat and have other people ﬁxed. We cannot ﬁx
and have other people ﬂoat. There has to be some coherence in the
system. I do not think there is any coherence in the system now, and these
people in the Asian countries are not going to be able to pick a sensible
exchange rate. Conceptually, it is easy to think of Mexico with a ﬁxed
dollar rate because so much of its trade is with the United States. But
what do you do if you are in Thailand or Indonesia? A third of your trade
is with Japan and 30 percent is with the United States and 25 percent is
with Europe and 10 percent is with each other: You have nothing obvious
to ﬁx to. All in all, I believe we have a systemic problem with the
exchange rate system, and that is where I disagree with my friend Jerry
Corrigan and where I will conclude.
268 Paul A. Volcker

Perspective on financial crises

http://www.bostonfed.org/economic/conf/conf43/264p.pdf

Perspective on financial crises

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