FLORENCE – Former Federal Reserve Board Chairman Paul Volcker provided the central inspiration for President Barack Obama’s proposal for overhauling banking. Without question the most successful central banker of the twentieth century, Volcker was an early and persistent voice warning of the problems of what he called "the bright new financial system.”

But Volcker has also been a prominent critic of the dangers of currency volatility. What is the link between nostalgia for a simplified and less risky banking sector and the wish to reintroduce a currency system that also seems a relic of the past?

There was already much discussion about reviving 1930’s-style regulation of banks before Obama’s dramatic and combative announcement on January 21.

The proposals for what is now called the "Volcker rule,” which would ban proprietary trading and prevent banks from "owning, investing in, or sponsoring” hedge funds or private equity funds, is an updated version of the Glass-Steagall Act, the law enacted in the United States in 1933 to separate investment banking from commercial banking.

The drive in the 1930’s to restrict banking activities occurred in many countries. In Belgium, where the first universal banks had been established in the early nineteenth century, investment and commercial banking were also separated. Italian banks were banned from holding securities in industrial corporations.

The argument of the 1930’s was cast less in terms of banks that were "too big to fail” than as a response to the faulty advice that banks had offered their clients.

Investment banks had sold shares and bonds (especially for foreign corporations and governments) to their retail customers, offloaded their own risk, and created a large revenue stream of fees for themselves.

Then, as now, many people demanded some punishment for the banks and bankers. But they also wanted banks to direct more resources to financing domestic investments and industry. The bank reforms generally did punish the bankers, but they were not successful in promoting new bank lending.

Today’s discussion focuses less on the danger that banks pose to their customers than on the risks they create for taxpayers. Proprietary trading was justified not because it created large profits for banks (it did), but because it was supposed to create markets and provide liquidity for rarely traded instruments.

The banks themselves established what in effect were their own substitute markets, which allowed their customers and themselves to price instruments that would otherwise have been impossible to value.

The huge profits were supposed to be the reward for the provision of a public service.

Such large banks are needed because small players alone cannot make a market. Big banks are also major players in international currency markets, and accumulate major foreign-exchange positions both between their subsidiaries and on a consolidated basis.

If modern banks are too big and too dangerous because they are too vulnerable, the most obvious way to make them safer is to demand higher capital requirements.

Historically, that was the course advocated in most international discussions. But, unfortunately, the most obvious way for banks to increase their capital ratios is to curtail their lending. In an economic downturn, that is the last thing that businesses need or want.

The new answer to the dilemma is to legislate what sorts of activity should be cut out completely. The hope is that refocusing financial activities in this way will revive other types of lending.

In the 1930’s, the control of banks went hand in hand with the control of capital movements and in the end with the fixing of exchange rates.

The alternative of continued capital movements, facilitated by major financial institutions, and flexible exchange rates was set out by a few economists, notably the Austrian Gottfried Haberler, but found no political resonance.

In celebrating the conclusion of the 1944 Bretton Woods agreement, which created the post-war world’s financial architecture, US Treasury Secretary Henry Morgenthau’s used his closing address to the conference to call for a more effective banking system that provided more money on cheaper terms: "The effect would be …to drive only the usurious money lenders from the temple of international finance.”

After the collapse of the Bretton Woods exchange-rate regime in the early 1970’s, it was widely supposed that a flexible currency system would bring more stability.

But, whereas we only recently learned that financial behemoths create financial instability, foreign-exchange markets for a long time were characterized by volatility and uncertainty.

These markets needed the big banks to act as stabilizers and take the other side of bets. When large banks are unable to play this role, and are forced to retrench, the likelihood of market volatility increases.

The continuation of the current crisis is likely to produce more foreign-exchange crises, as governments’ creditworthiness and the position of their banks go hand in hand. In 1992, during the crisis that rocked the European Monetary System, France’s finance minister, Michel Sapin, spoke in parliament about how the French Revolution had used the guillotine on speculators. 

Could we go back to 1944, when the lessons of the 1930’s were drawn at an international level, and fix exchange rates once more?

That would run counter to almost every argument of modern economics, but, at a moment when we are looking to the past for financial solutions, it is no longer unthinkable.

Harold James is Professor of History and International Affairs at Princeton University and Marie Curie Professor of History at the European University Institute, Florence. His most recent book is The Creation and Destruction of Value: The Globalization Cycle.

Copyright: Project Syndicate, 2010.