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The failings of the Volcker Rule

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On Dec. 10, federal regulators voted 5-0 to implement the Volcker Rule, a part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 that aims to prevent banks from engaging in speculative trading, and also forbids banks from owning hedge funds and private-equity funds.

The new regulation is named for former Federal Reserve Chairman Paul Volcker (1979-87), who said of its imposition, “The five banking regulatory authorities have now successfully responded to the provisions of the Dodd-Frank Act by setting out a comprehensive regulation restricting proprietary trading by commercial banks in the United States. In a long and arduous process, the agencies have dealt comprehensively with thousands of particular conceptual and practical questions raised by affected bankers, by legions of lobbyists, by other interested parties, and by the general public.”

The implications of ending such proprietary trades are complicated to say the least. It is sometimes very difficult to tell the difference between a speculative (banned) position and a hedging (acceptable) position, or between a market making (acceptable) investment and a speculative position.

The theory behind the Volcker rule is essentially that if there is going to be a safety net in the form of FDIC deposit insurance and bank bailouts, then the activities of banks must be restricted to lessen the risk of such measures being needed. The problem is that such an approach views speculation in an unduly negative light and dodges the real question of whether there should be deposit insurance or bank bailouts in the first place.

As Walter Block explains in Defending the Undefendable, speculation actually helps to stabilize a market. In times of high supply, when prices of trade goods are unusually low, speculators buy. They take some of the trade goods off the market, which causes prices to rise. As supplies drop, these stored trade goods go on the market, thus causing prices to fall. Of course, trade goods will be costly during shortages, and speculators will sell them for more than the original purchase prices. But trade goods will not be as costly as they would have been without the speculative activity.

Block also shows that the theory of speculation causing great harm is illogical. A speculator who guesses incorrectly does make a malinvestment that misdirects the market, but it harms his personal finances. Those who continually guess incorrectly are thus deprived of the capital resources that would be needed to cause great harm. For example, a banking institution that speculates incorrectly will lose its capital, alienate its customers, lose its reputation, and potentially go out of business. This is bad for every employee of the bank, just as it is bad for the general public, so market incentives work against such behavior.

Finally, Block contrasts these favorable market incentives to the incentives of government agencies, which also bear resemblance to those of speculators who are shielded by government bailouts of banks and account holders. In such cases, the market incentives which normally correct improper speculations are disallowed from performing their functions. Such actors are effectively not gambling with their own money, as banks that take sufficient losses will be bailed out at taxpayer expense. Thus there is no incentive to act responsibly, with the proper consequences for acting irresponsibly being effectively removed.

The Volcker rule, rather than restoring the natural selection of the free market so that it may eliminate the stupid from the ranks of speculators, keeps the potential for bailouts and curbs economic freedom. It will therefore fail to solve the real problems of the current financial system.

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