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September 30, 2006

Volcker, Corrigan, McDonough and Geithner - Part II
by Doug Noland

Gerald Corrigan: "If every time I called a meeting, to bring together at 33 Liberty Street (NY Fed offices) a bunch of chief executive officers of financial institutions, that had been defined as intervention, I would've made Attila the Hun look like a pacifist."

Gerald Corrigan: "I really think that - in all due respect Heidi - it is not the way I think at all. I think what the Fed did and Bill, Peter Fisher, and Dino Post, who is here, and Alan & Company in Washington, all were supportive of that. What they did was provide, essentially, a setting within which a broad cross section of leaders from the private sector were able to sit down in the presence of each other, with no black smoke or white smoke going out the chimney at Liberty Street, and sort out what they collectively thought was in their best interest and in the best public interest to stabilize what potentially could have been a very, very, very nasty situation. And I think that's all for the credit of the Federal Reserve and I think it's also to the credit of the tradition of Liberty Street, if I can put it that way.

Now, as to the second part of your question, did what you call 'intervention' bring with it some kind of a moral hazard problem? I think that was the spirit of your question. And, again, I can just say that that risk is always there, but it seems to me that in that particular case on the private sector some $3.5 billion worth of checks that afternoon, that's a pretty powerful antidote to moral hazard. So, the answer to your second question, in my judgment, would be no. I think that that was one of many examples where, in my judgment, the Fed unambiguously did the right thing in the interest of the well-being of the system."

William McDonough: "Can I add a footnote to that. I think it's very important that one realize what all of the Presidents of the Fed have done, when you had that kind of a meeting. I'll just give you my own introductory spiel, which was, 'I'm the public servant. The psychic income of serving the nation as a patriot is mine. You all are responsible for your shareholders. And you have to decide whether what may well be in the public interest is in the interest of your shareholders. Because I want to make it very clear that whatever you do has to be for that reason. The Federal Reserve owes you nothing; the government of the United States owes you nothing; and I owe you nothing. There's nothing but a private sector solution for a private sector problem.' That's it. And that is a spiel that I gave every time I had the kind of meeting to which Gerry refers, and it's one that I think is absolutely essential. Private sector people are paid by their shareholders to represent their shareholders. They're not paid to be patriots. It's nice if they're patriots, but what they should be doing in making the kind of decision to recapitalize Long-Term Capital Management, was because they thought their shareholders were better off to recapitalize it than to let it fail and have a real question about what damage it would do to them."

Gerald Corrigan: "I agree with that too, but I also believe the major financial institutions also have the responsibility for the well-being of the system. It's not just the shareholders."

Paul Volcker: "Well, in the interest of truth in speaking, I recall that I expressed certain reservations about that particular operation at the time. And I hold steadfast to my reservations about that particular operation, at that particular time, for a variety of reasons, which I could exculpate at length, but maybe I will refrain from doing so. Let me say, quite simply, that this was not an institution that was considered to be in the normal ambit of Federal Reserve supervision and oversight at the time. It is not an institution that by law had access to Federal Reserve facilities. Now, technically, the Federal Reserve provided no money in this case - is quite clear. But it did provide a convenient meeting room, which implied a certain degree of moral suasion, I think, in the process. Whether this was justified for this particular institution, at this particular time, I must take a little exception to something Gerry said - that this was a broad section of [financial] leaders. I think this was 13 investment banks who were heavily..."

William McDonough: "Seventeen institutions, most of them were commercial banks."

Paul Volcker: "Oh, Merrill Lynch - the big ones, just take the big ones here; Merrill Lynch, Goldman Sachs, Salomon, on and on and on."

William McDonough: "Salomon... at that time was part of Citigroup."

Paul Volcker: "Were the major - the major drivers of this rescue, as I recall it. The one commercial bank that I was involved with didn't like the idea and went ahead with great reluctance."

Gerald Corrigan: "Bankers Trust?"

Paul Volcker: "I agree with that. Even when it was a commercial banking operation it didn't like it. But, you know, there are things I don't know about it - whether there were other solutions on the table. I thought it perfectly possible these people would get rescued and they'd go out and make another mutual fund or investment fund, in which they did."

Question (John Authers): "At what point is it appropriate for the New York Fed to come in and clean up the industry's act for it [Credit derivatives] and what are the main steps that need to be taken to clean up the credit derivatives [market]?"

Gerald Corrigan: "Let me try to briefly put this issue in a little bit of context. And I'm sure some people in this room know that it was an industry group that I was chairman of that in a very real way put the spotlight on this whole collection of issues related to the integrity of the infrastructure supporting the operation of the OTC derivatives market in credit derivatives in particular. And I'm not going to go into the details except to say that when we were putting that industry report together in May of 2005, I have to confess that I myself, was taken aback if not shocked when I discovered - I still kick myself that I didn't discover this problem earlier - but when I discovered the severity of the problems with the, again, potential implication that in the face of those problems, if for other reasons, we had some major financial disturbance, the condition of the infrastructure supporting those markets would have, without a doubt, in my judgment, made an extremely difficult situation all the more difficult..."

Question (Terri Thompson): "I'd like to discuss a little bit about communications. Walter Bagehot for whom the (Columbia University's) Knight-Bagehot program was named, was a real proponent of clear, precise, concise writing for journalists... How important is effective communications to the Fed? How has communications changed over the years and requirements changed over the years and do you believe that the markets and the media misread remarks made by the Fed Chairman and bank president and if so, why?"

Gerald Corrigan: "I'm going to give this one to the master (Paul Volcker), but I have to say just one quick thought... To me, the suggestion or train of thought - the idea - that Central Banks can and should telegraph in advance every single time it's going to change the Federal Funds rate or whatever the operational policy target might be - it just seems to me to be very short-sighted at the extreme - I will use the extreme deliberately. One could make a case that what you're doing if you adopt that position as kind of the rule of the day or the month or the year, is you're basically turning over the responsibility for monetary policy to the financial markets. That just doesn't seem to me to be very good idea."

Paul Volcker: "Well, in this area of communication, I always thought the high point of my career was once when I was testifying before the Congress in the Humphrey Hawkins [framework] and the headline in the Wall Street Journal was 'Federal Reserve Tightens.' The headline in New York Times was 'Federal Reserve Eases.' And all I was trying to do was explain the complexity of the real world. And people read into what you say, what they think. In that particular case, I'm sure there were some monetarists who thought - I don't remember which side they were on - they thought we were tightening or easing and some interest rate people who thought the opposite.

So, it was what they read into the testimony, not what was said. But, I do think that actions speak louder than words, and the words should as little as possible confuse things. It's almost gotten to the point where I don't know that we need all this apparatus of open market operations anymore. The chairman can go out and say, 'We raised the Federal Funds rate by a quarter percent today.' The market says, 'Yes, sir,' and up it goes or down it goes, and the rest of you can go to sleep. I think that's going a little too far in making the objectives clear, because the market ought to make up its own mind once in a while. And eventually they will, but I - how much they need to be spoon- fed, so to speak. But, I don't know, I'm in the old school, so."

Question (Heidi Miller): "I was really struck: a number of you - the guardians of the economy or economic policy - you talked about monitoring markets in a way that would be good for market practices or the broader economy. And yet, somebody also used the term 'normal ambit of supervision' and it strikes me in a world where non-bank financial institutions are increasingly involved in creating derivative instruments and trading those instruments - where capital moves and indeed, some great creativity takes place in London as much as it does in New York - that the role of the supervisor has been, in fact, diluted a little bit. And, so, I was wondering if you could address the issue of whether the Fed's supervision is sufficient in a world where other entrants are evolving and creating change in the economy?"

Timothy Geithner: "An interesting, complicated question. I think we have ample authority today to satisfy the objectives we've been given for supervision/regulation. I do think, though, that there's been enough change in the financial system over the last two decades or so, that we have to be prepared occasionally to reassess whether we've got the broad balance right. Whether this overall framework we have of supervision regulation - where we have capital base supervision over a diminished and smaller share of the system as a whole - works in delivering the balance between efficiency and stability that's so important. That's a judgment that we've just got to be prepared to look at over time. I don't think you can look at the balance today and say it's clearly wrong, it's clearly inadequate. But we may come to the point in the future that we're going to have to revisit both the scope and the design of that basic framework."

Paul Volcker: "I think this a big, big issue in terms of the changes in the market which get back a little bit to the intervention with Long-Term Capital Management. I have always been a great defender of the proposition that the Federal Reserve should be the leading regulator and supervisor of banks. There are other agencies involved, but when push comes to shove - because of lender of last resort position. In other words, the Federal Reserve has a special responsibility. And once you controlled the banking system, that was enough, and the rest of the market ought to go on its own.

Well, that was fine when commercial banks were 60% or 70% of the financial system and we're a long, long ways from that and in fact, what we still call the big commercial banks, aren't commercial banks anymore. That's kind of a subsidiary operation and they all want to become investment managers and investment banks and insurance companies and all sorts of things. Which really raises the question of whether what we have in law is the traditional supervisory distribution of authority, is really relevant. Now, we make-do for the reasons that Tim suggested: by the momentum of history and authority and moral suasion and all the rest and demonstrated again with Long-Term Capital Management.

But as one who has violently defended the role of the Federal Reserve - the rather unique role of the Federal Reserve in this area - I think it's time that that gets reviewed. And if that is, in fact the case, maybe the law does have to be changed to reflect that a little more clearly, with all the complications that that will involve. Where do you go? What seems to be fashionable these days - go with the British initiative and say all the regulation ought to be stuck in some other agency, somewhat removed from the Central Bank? I guess eventually, we're going to have to face up with it sooner or later."

William McDonough: "I think that the likelihood is that probably in the fairly distant future, the Congress of the United States and the President of the day will have to decide that the present system of the Federal Reserve supervising directly, only banks, and the securities firms are sort of regulated by the SEC and the hedge funds are more or less not regulated by anybody - that that is a situation which can work, but it invariably demands now that the Federal Reserve interest itself in institutions other then the banks more then it had to in the past.

That's why Paul Volcker and I have a little difference of opinion in LTCM. It's that issue alone. But whether you had something less dramatic - the lead up to 12/31/99 - would the computers work or not work. Well, frankly it didn't make a whole lot of difference whether it was a bank's computers that didn't work or Goldman Sachs' computers that didn't work. It still would have been a problem and the Federal Reserve would have had to be in the middle of it, if only supplying liquidity through the banking system to the market in general.

It's a situation like many things in America that works almost despite the design, which is very much inherited from the past. And one would hope that we won't wait until a crisis that is truly a mess for the Congress and the President to look at the structural issues and decide to put in place a supervisory system that is more appropriate for the day. I would be very much opposed to a supervisory system of the kind that the United Kingdom has in which, by and large, the Bank of England just isn't involved. I can't imagine a regulatory system in the United States in which it would not be better if the Federal Reserve had a very powerful and important position."

Question (John Authers): "I'd like quickly to ask one other question on monetary policy. How important - traditionally when you think of monetary policies as being led by inflation, the control of inflation - how important are assets prices and asset prices beyond the inflation statistics in monetary policy and how should - how important should they be? You know, under Chairman Greenspan people had the impression at one point that he was trying to talk down the markets and at other points that he was injecting liquidity to help the stock market. And now we've got great fears in the housing markets and whether or not that will have knock-on effects on the economy. So, I guess, that's the question I'd be interested in asking everybody, to what extent do asset price bubbles and asset prices beyond those in the inflation statistics matter to the formation of monetary policy?"

Paul Volcker: "Well, the question is the importance of asset bubbles, I take it, and what the Federal Reserve should do. I would approach an answer to that question by a parable, not exactly a parable, but - there's a lot discussion about what went wrong in Japan in the last 15 years. And somehow with the consumer price index declining by 1% a year or being stable for five years and then declining by 1% a year for the next five years - and the common lore is named 'deflation.' I don't know how that's deflation, exactly. We live in a peculiar world where 3% inflation is stability, but a half a percent decline in the price index is deflation. So, I'm not quite up with modern nomenclatures here.

But what I do sense is the trouble in Japan was not by all odds primarily that the price index was declining by half a percent a year, but the fact that both the real estate market and the stock market declined by 75% from the peak of the late 1980s and particularly within the context of the Japanese financial system, which was very heavily dependent upon real estate prices. And, in fact, the bank's heavily dependent upon stock prices as well, created a great drag on economic activity for a while. So, if you accept that proposition as a reasonable interpretation of reality, you would say the problem was in retrospect, the bubble. And why was that permitted to proceed as long as it did and as far as it did without an earlier reaction in monetary policy.

In fact, there was a reaction eventually that came too late and exacerbated the decline. A lot involves, you know, whether in prospect or retrospect, a very difficult judgment. And nobody wants to intervene in every wiggle or every potential excess in the markets, for sure. And how do you reconcile that desire to stay out of these markets with the recognition that when apparent risk of a bubble and a reaction becomes great enough so that it's worth taking a little risk through, I would say general measures, to deal with it."

Gerald Corrigan: "I'll answer it with my own questions and answers, rather than your questions and my answers. The first question I would say is...should central banks, in any way, target asset price bubbles - whether it's in housing or stock prices or whatever. And the answer to that question, to me, is no. I have no reservations, but there's another question, though. The other question is, are there circumstances in which emerging conditions in the form of asset price bubbles, might well warrant a tilt in monetary policy? In other words, to err on the side of maybe being a little bit more firm rather than a little bit more easy. My answer to that question is yes. There are circumstances in which I think that would be quite appropriate, but circumstances are not a cookbook or a rule book."

William McDonough: "Let me add, very much in agreement with Gerry. I think that the policy instruments available to the Federal Reserve do not lend themselves to aiming right at an asset bubble. If you take the period between a certain remark about 'irrational exuberance' and the market correcting, there was about three and a half years. During that time, certainly it looked as if stock prices were rather heady, but it also looked as if in order to actually attack the asset prices, the cost would be to tank the real economy. You can do some leaning - I agree very much with Gerry in that regard - you can have monetary policy be a little firmer than it might otherwise be or a little more accommodative than it otherwise might be, but I don't think there's anyway in the world in which it would be justified for the Central Bank to say, well, the equity market's higher then we'd like it to be, the stock market is - the housing market is higher then we'd like it to be - so let's really put in a very firm monetary policy and slow down the economy, create a lot of unemployment. That simply is not what the laws of the United States say that the Federal Reserve should be doing. Leaning against it, as Gerry suggests, I think is very appropriate, but a direct attack on asset prices - I just don't think we have the tools and the use of the tools would be very detrimental to the well-being of our people."

Question (John Brademas): "My question is, what have you to say about the impact on the future of the American economy of the rising deficits in the government of the United States? And what, if anything, can the Federal Reserve do about them?"

Gerald Corrigan: "First of all, you're asking what the Federal Reserve should be doing about this? The answer basically is nothing. People in the Federal Reserve can go out and give speeches and all that, but this is not a Federal Reserve problem. And I think the future of the Federal Reserve, which is Mr. Geithner and his associates and Mr. Bernanke and his associates, that the most important thing that the Federal Reserve has got to do is keep a steady hand on the helm and not let monetary policy perpetuate this problem.

But on the larger question - and you know this perhaps better than anybody in this room - what we need to get even the beginnings of a solution to this problem is a return of a genuine spirit of bipartisanship within the political mechanism in Washington, both in the Congress and the executive branch. And I don't know where you are on that, but as I look at things, at least right now, I must say I do not see a wave of bipartisanship standing around the corner or waiting to join the party."

Back to Part I

Doug Noland
The Credit Bubble Bulletin
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