When I was growing up as a teenager in America, Paul Volcker was a household name. He was a giant of a man in every way, confidently directing the American economy as chairman of the Federal Reserve and, at 6 feet 7 inches tall, towering over the two presidents he served, Jimmy Carter and then Ronald Reagan.

Volcker mostly did a good job. His policy of sharply raising interest rates upset a lot of people at the time, but it tamed inflation and led to the long years of economic expansion that began in the 1980s under the Reagan presidency.

The reason that this is more than just a history lesson is that Volcker is back. At 82, he is Chairman of President Obama's Economic Recovery Advisory Board and once again helping to steer the nation's financial course.

This time, unfortunately, Volcker is getting it badly wrong. His plan to interfere with the structure of America's largest investment banks, by severely restricting the types of business they can do, is profoundly misguided.

In a capitalistic market, there are winners and losers. Sometimes, those who lose try to impose changes to the system that would do more harm than good.

The temptation is to jump in with regulation or legislation that will solve "every" problem and mitigate "every" risk. The result is often legislation that is well intentioned but ill-conceived.

The best example of this is the Sarbanes Oxley Act of 2002 — feel-good legislation that did nothing to address the underlying problems of corporate governance it was intended to address, but cost (and still costs) investors billions and is a thorn in America's side.

Volcker's plan also smacks of populism. It may be emotionally satisfying to bash the banks, given the huge responsibility they bear for creating the global financial crisis that began in 2007, but it should not be done just for the sake of getting a "political monkey" off the president's back.

Wrong priorities

The Volcker plan, approved by Obama, does exactly that. It completely fails to address the problems that caused the financial crisis and distracts the government and the public from the actions that do need to be taken to restore the country to economic health.

Volcker wants to ban America's largest investment banks from three types of activity: 1) trading with their own money, 2) operating private equity funds and 3) running hedge funds.

He and Obama say this will ensure that no bank can be so large that its failure might bring down the entire financial system.

This policy is difficult to understand because it was not those activities that caused the financial crisis. Instead the main culprit was the trading of trillions of dollars of complex over the counter derivatives that few people understood.

This was done mostly with clients' money, not the banks' own capital, and it was carried out by many types of investors, not just hedge funds. Private equity had nothing to do with it at all.

Volcker's plan would achieve very little except disperse the activities it addresses across a larger number of institutions, making them harder to keep track of and regulate. This would reduce the transparency of the financial markets and encourage a proliferation of smaller financial firms, some of which might choose to base themselves outside the United States or any other reputable financial jurisdiction and thus escape regulation altogether. The plan in any case looks unworkable. It could prevent banks carrying out a number of useful activities, such as market making, in which they put their own money on the line in the interests of clients.

Key areas

The Obama administration should instead focus on two key areas of financial and economic policy. First, it should impose stronger regulation of derivatives trading, chiefly by bringing more of them on to exchanges.

An exchange shines the bright light of transparency and can provide a central clearing house that significantly reduces the risk that one party failing will create stress to the entire system.

This would greatly reduce the risk that another fin-ancial crisis will strike. It would also have the virtue of reducing spreads, so that derivatives trading could no longer be a source of easy money for the banks at the expense of their clients.

To his credit the Treasury Secretary, Tim Geithner is working with the Securities and Exchange Commission to push for greater regulation of derivatives. It is unclear whether they will succeed, partly because of strong opposition from banks that do not want this major source of revenue to diminish.

The government's other priority should be to focus on economic expansion, so that America can grow its way out of trouble. This requires measured public spending and thoughtful policy around business and consumer taxes. Businesses hire and consumers spend; good tax policy does much to encourage both.

This common sense approach to economics is something that Ronald Reagan, Volcker's former boss, understood well in the 1980s. Volcker would do well to pass on some of that wisdom to Obama.

It is sometimes said in jest of Volcker, because of his great height, that he is "too big to fail". We must hope that now he is back near the seat of power, America's financial policies will indeed be successful.

 

The columnist is Chief Executive, Nasdaq Dubai.