Chairman of the Economic Recovery Advisory Board Paul Volcker argues that, in order to minimize the risks of financial institutions' moral hazard, banks must be "free to fail" and prohibited from proprietary trading, running hedge funds, and engaging in potentially risky activities.
Some five years ago, at a conference of the Stanford Institute for Economic Policy Research, I lamented that “the growing imbalances, disequilibria, risks” were giving rise to “circumstances as dangerous and intractable” as any I could recall—intractable not just because of the combination of complicated issues, but because there seemed to be “so little willingness or capacity to do much about it.”
Part of the story is familiar. In the United States, savings practically disappeared as consumption rose far above past relationships to national production. That consumption was satisfied by rapidly growing imports from China and elsewhere in Asia at remarkably cheap prices, helping to keep inflation well subdued. The resulting seemingly inexorable increase in our current account deficit was easily financed by an equally large flow of short-term funds from abroad at exceptionally low interest rates. In fact, money was so easily available that it supported what became a bubble in housing, with rising home prices reinforcing a sense of prosperity and high consumption.
It was not so much that the imbalances were hidden or unknown. In particular, the Chinese surpluses and American deficits were widely thought to be unsustainable. But for the time being, the world economy was growing strongly. China in particular was mainly interested in developing its industry by encouraging exports, and the United States was not prepared to balance its national budget or to restrain the consumption and housing boom.
At the time, I suggested that the most likely result would not be well- thought-out and complementary policy actions. Rather, sooner or later, the necessary changes would be forced by a financial crisis.