Volcker: U.S. imbalances underpin financial crisis

By Pedro Nicolaci da Costa and Burton Frierson

NEW YORK (Reuters) - Financial crises do not happen in a vacuum and the current U.S. banking debacle is linked to imbalances in an economy that favored spending at the expense of saving, Paul Volcker, the former Federal Reserve chairman, said on Wednesday.

The U.S. economy is on the verge of recession as a persistent housing slump drags down the banking sector, pushing up unemployment.

Volcker said a propensity to consume more than it produces is what got the United States into this sort of trouble.

"Financial crises usually don't come along unless there are other underlying problems in the economy," Volcker said at an event sponsored by the Harvard Club. "You can't go on forever spending more than you're producing. You have to rely on unorthodox finance to sustain it."

Volcker, who as Fed chairman during the 1980s raised interest rates to historic highs in an effort to rein in double-digit inflation, said policy-makers should be leery of inflating their way out of crises.

He argued that investors had become too reliant on mathematical models that the current troubles suggest were terribly unreliable.

"There's a fascination with a lot of risk management tools that this situation has demonstrably proved are false," said Volcker.

He added that Treasury Secretary Henry Paulson's plan to expand the Fed's regulatory authority to include investment banks, proposed after the recent Fed-funded bailout of Bear Stearns by JPMorgan Chase, provides a useful longer-term framework but does not address the more immediate problems.