Back in 1999,> when Paul Volcker was lecturing at New York University s business school, he asked students to raise their hands if they expected stock prices to rise at least 10 percent a year over the next decade. Every hand shot up, Volcker recalls. Not long afterward, naturally, the tech bubble burst: The actual return for that period is zero!
At this, the 6-foot-7 Volcker erupts in laughter. The words I told you so are unspoken. And one can forgive the former Federal Reserve chairman a little smugness. During his long career, Volcker has often been a lone voice arguing against Wall Street s excesses. But his vision of stricter regulation has come back into vogue since the financial system imploded. This summer he watched from the audience as President Obama signed a reform bill that included a version of the Volcker rule, which curbs banks ability to take big risks with their own capital. Since then Volcker has stayed visible on the media circuit, warning regulators against growing lenient as they work out the fine print. Obviously, he deadpans, they weren t too diligent before the crisis.
Of course, Volcker has been grappling with financial messes for more than four decades. Most famously, after becoming chairman of the Fed in 1979, he pursued policies that eventually tamed soaring inflation even as he earned enemies by raising interest rates. He was unenthusiastic about the Reagan-era trend toward financial deregulation, and in 1987, Reagan replaced him with Alan Greenspan. Still, his ability to keep a seat at the table under Democratic and Republican administrations remains a rare talent. Volcker, who s now chairing Obama s economic-recovery advisory board, has strong convictions but manages not to be wildly political, notes William Donaldson, the former Securities and Exchange Commission chairman.
The question now is how he ll use his influence to help rebuild the financial system a job Volcker, 83, says has just begun. Unlike many economists (including Fed chief Ben Bernanke), he doesn t see deflation as a looming threat to investors; he also thinks China won t soon dethrone the U.S. as the world s top economy. But he foresees plenty of other problems including the effects of government deficits, which could crush bondholders. We have to figure out how society deals with this, he says.
When SmartMoney caught up with him at his office in New York s Rockefeller Center, Volcker was in good spirits, looking forward to a fishing trip. But even a good mood for Volcker is grumpy by others standards. In feisty fashion, he offered his solutions for getting the economy back on track.
SmartMoney: You aren t overly concerned by deflation.
Paul Volcker: No, I am not. It s a difficult balancing question now. We are way below full employment. The immediate outlook is for extremely sluggish growth. It s not the time to take strongly restrictive measures. But we do have to do so over time, or eventually we will be up to our necks in red ink. That s the lesson, not just for the federal government but for state governments as well.
SM: And right now government agencies are expanding. The economist Friedrich Hayek warns of tyranny when the government controls economic decision making.
PV: Obviously, government should get more involved in the regulatory side than we have been in the last two decades. The government has a role in health care we just had a big political fight about it. I don t think people are ready to give up Social Security, Medicare or defense.
SM: Weigh in on the debate.
PV: I m not in favor of big government by and large. I picked up Hayek s The Road to Serfdom the other day, and it seemed less relevant than in 1945 [when it was published]. He wrote at a time when communism was a prime threat and socialism an existential ideal. We still have too much government interference, but we don t have the communist bear looming down on us.
SM: But you do share the concern that real growth does not usually come from social programs?
PV: Yes, growth comes from productivity and innovation, and hopefully, jobs will follow.
SM: And how do we get those?
PV: From the magic of the marketplace. What your Mr. Hayek writes about.
SM: How should we address the rising red ink?
PV: Spending restraint. If that doesn t do it, a tax increase. Better to do it by spending restraint.
SM: Are you concerned about whether other governments will continue buying our debt?
PV: Yes, eventually it s a concern. But we are still the largest and strongest economy. Surveying the prospects of Europe and Japan, we are still in a relatively stronger position than those countries.
SM: But it s a matter of time before China surpasses us.
PV: If they keep growing so rapidly, eventually they will have a higher GDP. It s still some time off. But in per capita income, innovation and the openness of markets, they have a long way to go.
SM: So we re okay?
PV: Saying we are okay is a little too casual. A lot of the current budgetary problem is tied up in retirement benefits. Social Security reform should have been on the program this year it s a solvable problem, but we have to solve it.
PV: You can make quite tolerable adjustments. Maybe we have to raise the retirement age. There could be some change in the complicated formula they use to determine payments. But few people would notice these changes. And I don t think they will adjust the payments to people in the lowest economic bracket.
SM: Your view on the financial-reform bill? It s hundreds of pages long, with a lot left up to regulators.
PV: We need the rulemakers to do a thorough job in writing the regulations from the Dodd-Frank bill, as well as to press for tough-minded candidates to fill key supervisory positions.
SM: People say the Volcker rule is so diluted, it is hardly worth having at all.
PV: Proprietary trading is prohibited. The rule applies to what banks can put in hedge funds they re allowed to invest only up to 3 percent of their capital. I m satisfied but would have preferred they prohibited investment in hedge funds entirely. It s a big step forward.
SM: Banks are talking about combining customer accounts with these trading accounts to get around the rules.
PV: Something the regulators will have to keep an eye on.
SM: Why can t banks just build business by offering great customer service?
PV: I think they get tempted. You don t understand that they like to make millions of dollars personally? Of course, the central service is providing credit responsibly. Banking can certainly be a profitable good business without engaging some of the extreme activities for which they were known recently.
SM: Has this been a victory for you?
PV: It s been a victory for the American people.
SM: What s missing?
PV: We are going to have to reconstruct the whole mortgage market that s a challenge for next year and the year following. The mortgage market now is almost a wholly owned subsidiary of the U.S. government. It s clear Fannie Mae and Freddie Mac need to go. I d like to see the private sector more involved, as well as stricter underwriting standards.
SM: Now that the reform bill is behind us, do you plan to take a step back?
PV: Only to steady my feet midriver for a particularly long cast. There are still a lot of challenges before this country that I think about when the fish aren t biting.