“Wake Up, Gentlemen”

[This post originally appeared at The Baseline Scenario on December 15, 2009. It is reproduced here in its entirety with the kind permission of the author.]

The guiding myth underpinning the reconstruction of our dangerous banking system is: Financial innovation as-we-know-it is valuable and must be preserved. Anyone opposed to this approach is a populist, with or without a pitchfork.

Single-handedly, Paul Volcker has exploded this myth. Responding to a Wall Street insiders‘ Future of Finance “report“, he was quoted in the WSJ yesterday as saying: “Wake up gentlemen. I can only say that your response is inadequate.”

Volcker has three main points, with which we whole-heartedly agree:

1. “[Financial engineering] moves around the rents in the financial system, but not only this, as it seems to have vastly increased them.”
2. “I have found very little evidence that vast amounts of innovation in financial markets in recent years have had a visible effect on the productivity of the economy”

and most important:

3. “I am probably going to win in the end”.

Volcker wants tough constraints on banks and their activities, separating the payments system – which must be protected and therefore tightly regulated – from other “extraneous” functions, which includes trading and managing money.

This is entirely reasonable – although we can surely argue about details, including whether a very large “regulated” bank would be able to escape the limits placed on its behavior and whether a very large “trading” bank could (without running the payments system) still cause massive damage.

But how can Mr. Volcker possibly prevail? Even President Obama was reduced, yesterday, to asking the banks nicely to lend more to small business – against which Jamie Dimon will presumably respond that such firms either (a) are not creditworthy (so give us a subsidy if you want such loans) or (b) don’t want to borrow (so give them a subsidy). (Some of the bankers, it seems, didn’t even try hard to attend – they just called it in.)

The reason for Volcker’s confidence in his victory is simple - he is moving the consensus. It’s not radicals against reasonable bankers. It’s the dean of American banking, with a bigger and better reputation than any other economic policymaker alive – and with a lot of people at his back – saying, very simply: Enough.

He says it plainly, he increasingly says it publicly, and he now says it often. He waited, on the sidelines, for his moment. And this is it.

Paul Volcker wants to stop the financial system before it blows up again. And when he persuades you – and people like you – he will win. You can help – tell everyone you know to read what Paul Volcker is saying and to pass it on.

By Simon Johnson