Sunday, 22 February 2009

Future inflation - the thin end of the wedge

During a speech last week that was given by Paul Volcker, at Columbia University, the veteran central banker made some astute observations regarding the nature of the current economic/financial crisis and pointed towards a dual model for banking in the future. If you have the time to watch the speech it is worth it but here are some of the more salient points.
  • He discussed the notion that the exculpatory arguments now being given by many in the financial engineering community, that they were not to blame for the debacle that has arisen from their overly complex structured instruments because they were simply obeying orders from above. Volcker’s rejoinder to this was to cite the bogus Nuremberg Defense case presented by SS officers who claimed they were just following orders emanating from the Fuhrerbunker.

  • The obsessive predilection by banks for the originate and distribute model that accompanied the proliferation of securitized instruments during the last several years has brought with it an alarming breakdown in the customer relationship and retention culture that is vital to commercial banking.

  • The relaxation of the segregation between high risk/investment banking and the more routine matters of deposit taking, payment clearances and granting of commercial credits allowed the inherent dissonance, and opportunity for abuse, in the classical Principal/Agent conflict to return in a major way to the manner in which the large supermarket banks operated. In particular the credit ratings agencies were hopelessly compromised in this respect.

  • His final point, and the one which is perhaps the most important, was to contrast the role that a central bank is now being required to play in the current crisis with the more traditional role of a central bank which, he suggested, is to ensure price stability. There was an implied warning that the current mindset of throwing everything including the kitchen sink into a desperate effort to reflate the economy was also encouraging the view amongst some close to the current Federal Reserve that tolerating a little bit of inflation down the road is not such a bad thing.

  • Volcker who earned his credentials for taming rampant inflation in the late 1970's and early 80's has just cause to be alarmed. As he said towards the end of his speech there is a tendency for a little bit of inflation to turn into a lot of inflation, and going on record with such a reminder was perhaps the most useful part of his speech.



  • The speech was short on jargon and delivered in a calm manner with just a hint of irony and could unfortunately be easily overlooked by the glib, fast talking financial technocrats who presently hold sway in Washington. But one is reminded of the remark sometimes made about the judgments of bright young entrepreneurs and their cadre of advisers - it is always good to have some grey hair on the board - notwithstanding the fact that Mr. Volcker has very little even of that.

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