Volcker blames recession on trade imbalances

Paul Volcker, former chairman of the Federal Reserve and an economic adviser to President Obama, told a congressional committee Wednesday that massive trade-related imbalances in the U.S. economy were the source of the financial crisis that has produced an ugly recession.

Mr. Volcker then urged Congress to enact long-term financial-market reforms by increasing regulation of large financial institutions that could undermine the entire economy if they failed.

Some banks are not only “too big to fail,” Mr. Volcker said. Some are “too big to exist.”

Senate Banking, Housing and Urban Affairs Committee Chairman Christopher J. Dodd, Connecticut Democrat, asked Mr. Volcker to assess the source of risk in the current crisis.

“Go back to the imbalances in the economy,” Mr. Volcker replied. “The United States has been consuming more than it has been producing for many years.”

The result was a collapse in personal and government savings and an explosion of the trade deficit. America’s lack of savings was replaced by a flood of financial capital from abroad. Those inflows generated low long-term interest rates, which helped home prices to soar.

“When housing prices stopped rising, the fragility of the financial system was exposed,” Mr. Volcker said.

Mr. Volcker testified on behalf of the Group of 30, which includes financial experts from private and public sectors around the world.

Citing a recent G30 report, Mr. Volcker called for greater transparency and the registration of large hedge funds with a national regulator, which should have authority to establish standards for capital, liquidity and risk management.

Noting that Europeans were more concerned about regulating hedge funds than U.S. officials were, Mr. Volcker said it was imperative that a regulatory framework be applied consistently from country to country.

He criticized the public-private hybrid form of government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac.

“GSEs, with the connivance of Congress, were considered something special [that] would be protected, rightly or wrongly,” even though there was no explicit taxpayer guarantee, Mr. Volcker told the committee.

“We should not have that kind of hybrid institution in the future,” he said. If the government wants to support the mortgage market, it should do so directly, he said.

Very large banking institutions whose deposits are protected by the government should not engage in highly risky activities, Mr. Volcker said. When banks participate in the packaging and sale of collective debt instruments, such as mortgage-backed securities, the banks should retain a meaningful part of the credit risk on their own balance sheets, he said.

Noting that financial regulation can affect monetary policy, Mr. Volcker recommended that the Fed and other central banks play a role in supervising systemic risk.