The inflation fighter himself, Paul Volcker knows government safety nets. And stogies.

The inflation fighter of the 1970s and 80s, former Federal Reserve Chairman Paul Volcker, wants to make sure banks don’t take the economy to the brink of destruction yet again. Said Volcker:

If banking institutions are given protection by the taxpayers — I may not live long enough to see the next crisis — but my soul is going to come back to haunt you.

Let’s hope so. The “Volcker Rule” is an attempt to restrict banks from making speculative investments that do not benefit their customers, and limit the ability of the largest banks to use borrowed money to fund expansion plans. Similarly, President Obama has proposed to restrict proprietary trading by banks and get them out of the hedge fund business.

A man who worked during the presidencies of Jimmy Carter and Ronald Reagan, Volcker now heads the Economic Recovery Advisory Board for Obama. Volcker’s vast experience, and knowledge, makes him far wiser than many of the relatively green people in the White House. Volcker knows the federal government has provided safety nets to the financial sector for decades.

Take the Savings and Loan crisis of the 1980s and early 90s. The Federal Savings and Loan Insurance Corporation, which insured depositors’ money, became insolvent. In 1989, Congress and the president agreed on a taxpayer-financed bailout measure known as the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA). This act provided $50 billion to close failed S&Ls, totally changed the regulatory apparatus for savings institutions, and imposed new portfolio constraints. A new government agency called the Resolution Trust Corporation (RTC) was set up to liquidate insolvent institutions. In March 1990, another $78,000 million was pumped into the RTC. But estimates of the total cost of the S&L cleanup continued to mount, topping the $200,000 million mark.

If you didn’t think there was a wink and a nod relationship between large banks and the feds, the “Volcker Rule” should serve as an acknowledgment. Because lending and credit is so crucial to the economy, financial institutions know the government will backstop them during an industry crisis.

We’ve seen dumbfounded bank CEOs on Capitol Hill, or in media interviews, during this most recent financial crisis, the worst since the Great Depression. When asked why they made such risky decisions, and why the entire industry followed lock step, their response is always about the same. Said one fictional banker:

Well, I don’t really know. I suppose we just wanted to remain competitive and really didn’t think about the dire consequences of such risk-taking. We’re working to make sure it doesn’t happen again.

Right. Most of us pass this type of behavior off as greed, and one way capitalism can fail. But in-between the lines, I see smart financial minds who knew full well the path was unsustainable. Greed can consume the new mortgage broker. But the CEO, generally quite experienced, is responsible for the long-run consequences of organizational actions. They knew the taxpayer would catch them if their risky bets ever led to bank insolvency. It’s a win-win for banks: make investments with huge potential returns, in large volume, while being protected from the downside. This is moral hazard, and Volcker knows it all too well.

Unfortunately, major bank conglomerations are fighting against some practical, sensible regulations to curb risk-taking. As a result, the “Volcker Rule” may need to be watered down to pass through the Senate.

The financial system is far from healthy as banks are still weighed down by toxic debt. The last thing we need is for banks, that were bailed out by taxpayer funds, to make high-risk investments that do not benefit their customers, or use money from the discount window to expand; all while the taxpayer safety net remains securely fastened underneath.

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More Articles About the Financial Meltdown:

The Financial Crisis – Part 1: Is Deregulation to Blame? Well, Kinda…

The Financial Crisis – Part 2: The Rest of the Story

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