12/10/2013 02:52 pm ET Updated Feb 09, 2014

Structural Stagnation, Bubbles, and the Volcker Rule

In much recent economic discourse, it has been suggested that we suffer from structural stagnation. That is, some underlying misalignment in resource allocation or distribution is preventing the macro economy from achieving its potential in terms of job growth, GDP growth, labor force participation, productivity, and full employment -- not just in recessions, but in recoveries as well.

It's a position I've held for a long time, largely emanating from work on slack labor markets, stagnant incomes, growing inequality, and -- the topic of this post -- financial market instability.

It's pretty hard to miss the shampoo cycle -- bubble, bust, repeat -- that has characterized the last few business cycles in the American, and more recently, European and even Scandinavian economies. It's also the case that choice economists since Adam (Smith, of course) have recognized this proclivity towards financial market instability, including Keynes and most notably, in terms of the depth of his analysis, Hy Minsky.

Most recently, financial bubbles propped up demand in the 1990s ( and 2000s (housing). Thus far in the current expansion that began in 2009Q3, financial markets and corporate profitability have far outpaced the rest of the economy. Real GDP is up 10 percent over the expansion and the real value of the S&P 500 is up 70 percent. Real median household income is down 4 percent.

I'm not saying we're in another financial bubble, though no less than Robert Shiller recently raised that concern. But I'm decidedly saying that unless we enact and enforce tough financial market regulation, that's where we're headed.

It is in that regard that I'm very glad to see what looks like a tougher-than-expected Volcker rule coming out of the implementation phase of Dodd-Frank financial reform. This rule is designed to restrict proprietary trading, where federally insured banks trade their own books, thus putting taxpayers at risk. Like I said, it won't work if we don't enforce it -- regulators can sleep even at the best switch -- and there are still parts that need to be fleshed out. But here's why it's looking pretty good.

As I recall from my White House days, crafting the Volcker rule was a big challenge, because banks can have legitimate business in trades between customers that involve the bank's own capital. What makes a trade "proprietary" -- meaning the bank is trading its own book for its own profits -- is not the clearest of lines.

But as Mike Konczal points out there are a number of ways to make this distinction, and the new rule looks fairly tough in that regard. For example, a key question for the rule's effectiveness is, how tight is its definition of hedging? A broad definition, like: "banks can hedge against risk to their capital" -- would quite clearly allow disastrous proprietary trades like that of the "London Whale," the JP Morgan trade that cost the bank $6 billion last year.

Konczal notes:

If the Volcker Rule couldn't have stopped the London Whale trade, it's fairly useless as a piece of reform...Treasury Secretary Jack Lew has also explicitly said in recent remarks that 'the [Volcker] rule prohibits risky trading bets like the 'London Whale' that are masked as risk-mitigating hedges.'

Today's reporting says that the rule:

... includes new wording aimed at the sort of risk-taking responsible for [JP's loss]. The bank contended it was trading to hedge its broader risks, but in fact it built a sprawling speculative position that spun out of control.

To prevent such blowups, according to the version of the rule reviewed by The Times, it will require banks to identify the exact risk that is being hedged. The risks, the rule said, must be "specific, identifiable" rather than theoretical and broad.

Konczal notes another way -- a sort of a market test -- to evaluate whether the rule is adequately distinguishing between legitimate financial services on behalf of the banks' customers versus trading its book: simply observe what they're doing and whom they're hiring. If they're spending more time and resources on client services than gambling on derivatives, regulators should be able to pick that up fairly easily, and visa versa. What you want to see here is the type of personnel from JP's London Whale office moving from banks over to actual hedge funds.

Let's be careful not to overstate the rule's toughness. According to the Times, "... banks can build up positions [acquire securities] to meet 'the reasonably expected near-term demands of clients, customers or counterparties.' Banks and regulators may clash over what is 'reasonably expected,' and the rule leaves it largely up to banks to monitor their own trading."

That sounds less than air-tight, but it's typical of such regulations. One could make a case that's why we're always stuck in the shampoo cycle, but blurred lines are the nature of the beast in this space.

Which means that at the end of the day, it's going to be up to the regulators and their agencies to make this work, and that caveat goes all the way to the top. It is not a coincidence that Alan Greenspan, the Federal Reserve chair during the last two economy-crashing bubbles, maintained that financial markets were "self-correcting." It's thus hopeful in this regard that in her confirmation hearing, the likely next Fed chair, Janet Yellen, said, for the first time as far as I'm aware, that it was in fact the job of the Fed to identify and deflate bubbles before they last waste upon the land. Treasury Secretary Jack Lew, as noted above, is also an important player here and from what I've seen, he's genuinely interested in effective financial reform.

So, with caveats that it's far from perfect, it's only one piece of "fin reg," and the lobbyists are working tirelessly as we speak to gut it, the Volcker rule looks good... better, frankly, than I expected. It has the capacity to help dampen, if not break, the cycle. But only if we're vigilant in its implementation.

This post originally appeared at Jared Bernstein's On The Economy blog.