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Friday, October 10, 2008

Volcker On the Essential Problem

Former Federal Reserve Chairman Paul Volcker appeared on the October 9 edition of Charlie Rose to comment on the international aspect of the ongoing financial crisis. During a larger point about one particular tactical decision involving banks in Britain and Ireland, Volcker actually identified the root problem facing any of the worldwide efforts to mitigate the problem.

He stated that one of the events that led to the realization among central bankers that more coordination was necessary was the decision by the government of Ireland to protect ALL bank deposits. This had the desired affect with depositors within Ireland, calming their fears and reducing withdrawals, but it induced panic with banks in England who worried about depositors transferring balances out of British banks into Irish banks.

That really epitomizes the entire worldwide problem in a nutshell. Think of the entire globalized world economy as a giant baking pan – a square mile in size – filled with one inch of water. The amount of water in the pan CAN go up over time with enough productivity across the world but competitive forces make it difficult for the depth of water in the pan to build up in any one corner without eventually spreading out to the rest of the pan. Now picture that pan sitting on top of a bar stool instead of the ground then imagine trying to pick up and MOVE that baking pan to the ground without temporarily causing all the water to slosh wildly from side to side or corner to corner or slosh over the side and leave the pan.

That’s the fundamental task facing central bankers across the world. In order to stabilize the banking system, each economy has to coordinate with the others to help move their corner of the pan at exactly the same time. The amount of leverage in all of the economies throughout the world is so great that any temporary imbalance in perceived risk or opportunity causes investors to rush towards the same corner or away from the same corner simultaneously.

Using that visual analogy, it seems unlikely that the central bankers of the world -- all operating with different political motivations and perceptions and different economic and financial biases -- will be able to repeatedly reach compatible tactical decisions on a moment’s notice over the coming months to allow the financial pan to be safely lowered to terra firma. More importantly, it requires participating economies and institutions to temporarily suspend their competitive instincts because any action that would normally "win" depositors or investors to their side could trigger a panic somewhere else and still collapse the entire system.

So let's review...

1) a massive worldwide problem
2) the solution requires frequent, perfect coordination among dozens of parties
3) the solution is ENDANGERED by forces normally thought to be good in markets

Yea. This will end nicely.