In a letter to the Financial Stability Oversight Council, Roosevelt Institute Senior Fellow Rob Johnson explains how banks will try to evade regulation.

Financial Stability Oversight Council

Department of the Treasury

1500 Pennsylvania Avenue, NW

Washington, DC 20512

c/o The Honorable Timothy Geithner, Chairman

Re: Docket Number FSOC-2010-0002, Financial Stability Oversight Council study on Section 619

Dear Chairman Geithner and Council Members:

I write in response to the request for public comment on the Financial Stability Oversight Council study on how to implement the Volcker Rule, embodied in section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

The previous five years has proven with ringing clarity that the health of Wall Street is not sufficient to guarantee the health of Main Street, and may in fact be detrimental to the health of the non-financial economy. Following the disastrous financial crash of 2008 and the continuing economic consequences, the recent financial reform effort should, at its core, be about putting Main Street back in the driver seat economically: making investment in the real economy rather than investment in bubble financial assets the focus of our policy incentives, restoring the health and vitality of community and regional financial networks, and getting rid of the tricks, traps, and conflicts of interest of financial engineering, at every level. The Volcker Rule is a central part of that effort.

I believed strongly that a full return to the separation between banking and securities dealing would be in the best interests of our nation. At the same time, recognizing that Congress was unlikely to go down that path, I also endorsed the work of Senators Merkley and Levin -- and their two dozen Senate co-sponsors -- who crafted a strong version of the Volcker Rule that seeks to achieve many of the same objectives. Congress adopted their framework, and it is now incumbent upon you as regulators to implement that vision.

I fully expect that Wall Street will continue to place many obstacles in the path of strong implementation, just as they sought to do so during legislative consideration. Powerful interests will undoubtedly put forward arguments as to why specific details ought to be implemented in ways that do not disturb their business models or put them at perceived disadvantages with their international counterparts. You should recognize their arguments for what they are -- distractions -- and reject them.

Quite simply, banks under the protection of taxpayer guarantees should be in the business of banking: holding deposits, making loans, and serving clients. The Merkley-Levin provisions let them remain in certain parts of securities dealing, but sets limits on what those activities can entail. You should be certain to implement those limits to the full extent of your authority and ensure that the permitted activities do not swallow the protections offered by our taxpayers.

In particular, terms like "market-making-related" and "risk-mitigating hedging" should be defined narrowly. Market making is where a firm provides liquidity to trading markets but avoids long or short exposures to the instruments being traded. The goal is to provide clients with buy and sell opportunities without incurring substantial risk. This contrasts with the goal of proprietary trading, where firms seek to accumulate financial holdings and profit from changes in the value of the held financial instruments. Similarly, hedging is where firms take a position in order to reduce a specific financial exposure created by another position or holding.

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Market participants know full well when they are marking a market in a product or hedging a position in that product, versus when they are making proprietary bets. You should dive deeply into the inner workings of financial entities and subject their trading records to close inspection. Talk directly to the traders inside and outside of these institutions who will tell you how things really work. In short, do the hard work necessary to implement the Congressional directive.

It is also critical that terms such as "trading account" and "short term" or "near term", as well as "material conflict of interest," "high risk asset" and "high risk trading strategy" be defined so as to capture the full range of risk that the Congress intended section 619 to cover. When studying how to define these terms, you should look carefully at the nature of the exposures that brought down Long-Term Capital Management in 1997, Amaranth Advisers in 2006, and the major Wall Street firms, including Bear Stearns and Lehman Brothers, in 2008. The definitions of these terms should flow from those investigations, as they were clearly the types of failures that Congress is seeking to keep out of the nation's critical financial infrastructure.

Your study should also pay close attention to the provisions governing how firms relate to private funds. I agree with Chairman Volcker that our banking system would be better off if banks did not maintain any connection channel investments into hedge funds or private equity funds. There is simply no reason why the bank needs to pool client funds into these entities to invest. But Congress chose a compromise position that permitted firms to organize and manage funds, seed funds, and maintain de minimis fund investments to "align their interests" with their clients. To achieve the intent of the Merkley-Levin Volcker Rule, these provisions should be interpreted narrowly. In particular, I urge you to do a broad survey of market participants (including major competitors of the banks) regarding precisely how large seed funds need to be. I believe most will tell you that true seed funds are quite small, in the $5 million to $20 million range. Your regulations should reflect your findings, and not permit the de minimis exception to allow $100 million revolving "seed" funds.

As to the argument that nothing should be done until the international community acts, that argument should be rejected outright. The United States remains the world's most important financial market, largely because of its reputation for integrity and security built on the back of decades of thoughtful regulation. The world needs U.S. leadership, and our foreign counterparts need you to take a strong position to counter the increasingly global reach of the banking lobby, which now conducts lobbying efforts through several industry-sponsored channels. If the giant U.S. banks have concerns regarding perceived competitive disadvantages from being unable to take the same kinds of extraordinary risks that certain of their "too big to fail" foreign peers may be permitted to continue to take (and in fact, the world seems to be converging towards the U.S. approach of tougher regulation anyway), then the better approach would be to protect U.S. depositors and taxpayers from those risks by directing the Federal Reserve to reject applications to acquire U.S. institutions by foreign firms with material exposures to the risks of proprietary trading and investments in hedge funds and private equity firms. This is well within U.S. regulators' discretion under the prudential safeguards of global trade rules.

Lastly, I urge you to be aggressive in your inclusion of nonbank financial companies for supervision by the Board, and therefore, coverage by the Volcker Rule. The weakness of Glass-Steagall was its failure to keep up with the shadow banking system. The Merkley-Levin Volcker Rule properly corrects that oversight by subjecting nonbank financial companies supervised by the Board to significantly higher capital charges for their proprietary trading and fund investments. These capital charges accommodate the diversity of financial firms that could pose a risk to U.S. financial stability, but can only do their job if vigorously applied and if the right firms are covered.

If the financial reforms of 2010 are to keep the U.S. out of another financial crisis and recession, you as regulators must not be unduly influenced by the smooth talking bankers who lobby you on a daily basis. Conduct your study on implementing section 619 with an eye on keeping our nation's banks out of the business of gambling, and back in the business of serving clients and the real economy.

Sincerely,

Robert A. Johnson

Director of Global Finance, Roosevelt Institute

Author Mark Weisbrot examines Kenneth Rogoff's arguments in favor of deficit cutting, but doesn't find anything convincing. Read the full article:

No Convincing Economic Arguments Against Further Stimulus Spending

By Mark Weisbrot

This article originally appeared on The Guardian.

In much of the world, including the United States and Europe, a debate is taking place about whether the government's first responsibility should be to reduce unemployment -- which is at elevated levels -- or to reduce government deficits and debt. Many of the arguments for deficit reduction are simplistic, based on ignorance, or ideologically-based. For example, there are inappropriate comparisons of government to household debt, a fixation on absolute numbers without any comparison to national income, or just right-wing opposition to government in general. Although these are the most commonly propagated views on television and through the media, it is worth taking a moment to examine the (ostensibly) more sophisticated and economics-based arguments and see whether they hold water.

Kenneth Rogoff is Professor of Economics at Harvard University and a former Chief Economist at the International Monetary Fund (IMF). This week he responded to some of the pro-stimulus arguments:

"Some portray Japan, with nearly a 200 per cent government debt to income ratio, as a poster child for extremely indebted countries with low interest rates. Japan's 'success', of course, has a lot to do with its government's ability to sell debt domestically. How the country will handle its finances as saving by retirees shrinks and as its labour force rapidly shrinks, remains to be seen."

Some background: Japan has a gross debt-to-GDP ratio of about 227 percent of GDP. This is more than three times the level of the United States. But more than 100 percentage points (of GDP) of this debt is owed to the Japanese central bank. This means that the interest payments on this debt go to the government of Japan, so there is no interest burden added by this part of the debt. In fact, Japan's net interest payments are less than 2 percent of GDP, which is a modest amount.

It also means something else that most of the economists in this debate are not eager to talk about: it means that Japan has financed nearly half of its public debt by creating money. In other words, instead of the government borrowing money from investors, the central bank created money and lent it to the government. In the popular imagination, this creation of trillions of dollars (in yen) to finance government deficits has to cause serious inflation. However, the Japanese experience has been the opposite: over the last 20 years, Japan's consumer price index has risen about 5 percent -- that's the 20-year total, not annual inflation.

Rogoff is correct to say that the domestic ownership of Japan's debt is key to its success. But this is just an additional argument for the United States, or Europe, to finance deficit spending through money creation at this time. Such financing is by definition domestic ownership -- i.e. ownership by the central bank. In the Eurozone, the European Central Bank (ECB) would have to agree to refund the interest payments on the debt to the borrowing countries, so as to duplicate what Japan (and the United States) has done with its own central bank.

Of course, Japan's debt that is held by the public is also held mostly by domestic investors. So this part of Rogoff's argument is really making the case for avoiding the chronic trade deficits that the United States has run for decades. It is the overvalued dollar, and the resulting trade deficits, that drive foreign borrowing in the United States.

As for the warnings about what might happen when savings and the labor force shrink, we have heard this rhetoric for decades from deficit hawks in the United States and Europe. Suffice it to say that there are many options open to rich countries should they ever face the problem of a "labor shortage." But unfortunately our problem for the foreseeable future is the opposite. It is a shortage of jobs, not labor.

Rogoff cites his own work, with Carmen Reinhart, in arguing that debt-to-GDP ratios of more than 100 percent are "above the threshold where growth might be affected." But their paper really doesn't show much at all, especially for economies like the United States and the Eurozone that can borrow in their own currencies. Countries that end up with debt greater than 100 percent of GDP are likely to have other problems that got them there. As others have also noted, without controlling for these other factors -- which this paper decidedly does not do -- there is no way of establishing causality. In fact, the authors do not even control for changes in population growth, since they look only at GDP growth rather than per capita GDP.

Rogoff adds another self-defeating argument: "Importantly, governments that emphasize long-term fiscal sustainability are likely to have an easier time inducing their central banks to maintain highly supportive monetary conditions."

In other words, he is saying that central banks might react to expansionary fiscal policy in the present situation by tightening monetary policy. But this just means that the central bank should be subordinated to national economic policy, instead of the other way around. He is taking for granted that central banks must be "independent." But as experience has demonstrated -- e.g. the U.S. Federal Reserve somehow missed the two biggest asset bubbles in world history -- this doesn't necessarily mean independent of Wall Street, it means independent of the public interest. So yes, a government that wants to use expansionary fiscal policy will need the cooperation of its central bank. And should have it.

Rogoff argues that "anemic growth with sustained high unemployment is par for the course in post-financial-crisis recoveries." Par for whose course? If past governments made stupid mistakes and/or didn't care about condemning a generation of low-income young people to years of unemployment, does that mean we should do the same? At the end of the day, Rogoff provides no convincing economic argument why either the United States or Europe cannot, or should not, finance the necessary stimulus until unemployment approaches more normal levels.

Rob Johnson is a Senior Fellow and the Director of the Project on Global Finance at the Roosevelt Institute.