News this morning of the passing of Paul Volcker, the chairman of the Federal Reserve during the key period from 1979 – 1987 when inflation was wrung out of the American economy, a painful though necessary move whose long-run benefits we are still experiencing today. The Reuters obituary notice today says:
Volcker was appointed Fed chairman by a Democratic president, Jimmy Carter, and then reappointed by a Republican, Ronald Reagan. He was only a few months into the job when on Oct. 6, 1979, he announced a 1-point rise in the discount interest rate to an all-time high of 12 percent.
Other borrowing costs followed and the prime rate climbed to a record 20.5 percent by May 1981. Unemployment rose to 11 percent and the country was steeped in economic malaise. Yet between 1980 and 1983, inflation fell from nearly 15 percent to less than 3 percent.
Volcker’s inflation-slaying action spurred massive protests, with farmers blockading the Fed’s headquarters with tractors, and builders famously mailing him a wooden 2×4 to show their lumber was no longer needed. One U.S. senator demanded that he take his “boot off the neck of the economy.”
One of the curious things about Volcker is that he was controversial both on the right and the left. In recent years he threw in with Obama and the class warfare of the left over income inequality, but in general the left hates him much more than the right ever did, because Volcker was in instrument in the dreaded “neoliberal” project to shore up finance capitalism. One lefty critic today tweeted that “Volcker’s job was to break the New Deal domestically so U.S. bankers could maintain their power abroad. And that’s what he did.”
For what it’s work, here is part of my account of Volcker and Reagan from my book:
Here, before leaving this confusing and difficult subject, we must outline the last major piece of the economic picture of the early 1980s. Monetary restraint was one of the four pillars of Reaganomics (the other three being tax cuts, spending restraint, and de-regulation). Reagan’s economic strategy called for a gradual reduction in monetary growth to bring inflation down slowly over the next three years. But neither the president nor Congress controls monetary policy of course; it is the domain of the independent Federal Reserve. The Fed’s “independence” does not exist in a complete political vacuum, however. Fed chairman, Paul Volcker recognized this, commenting candidly that “No central bank can—or should, in my judgment—conduct policies for long that are out of keeping with basic, continuing objectives of the political system.”
In other words, Reagan needed the Fed’s cooperation for the economic plan to work. There had been rumors and recommendations following the election that Reagan might try to replace Volcker (a Democrat) before his current term expired in 1983, or that Reagan should meet with Volcker and reach a public agreement that the Fed would commit to a steady policy of slow but predictable monetary growth. Time magazine commented that “Reagan is unlikely to follow that advice, mainly because he knows that the independent Federal Reserve would never agree to such restrictions on its freedom.” Sure enough, in the opening weeks of his administration Reagan had said that “We fully recognize the independence of the Federal Reserve System, and will do nothing to interfere with or undermine that independence.” Reagan understood this as a matter of principle, but he had also roughed up Volcker in his typically understated fashion.
Reagan had his first meeting with Volcker over lunch on his third day in the Oval Office. Reagan opened the lunch with a question that must have nearly knocked Volcker out of his chair: Why do we need a Federal Reserve anyway? Martin Anderson, who had prepared a memorandum for Reagan briefing him for the meeting, recalls Reagan’s words as follows: “I was wondering if you could help me with a question that’s often put to me. I’ve had several letters from people who raise the question of why we need a Federal Reserve at all. They seem to feel that it is the Fed that causes much of our monetary problems and that we would be better off if we abolished it. Why do we need the Federal Reserve?” Had Volcker been chewing on one of his trademark cigars, Anderson thought, he would have swallowed it.
Reagan was invoking here the idea of “free banking,” which he probably learned about from his reading of conservative and libertarian periodicals such as The Freeman. “Free banking” is essentially the system of privately-issued competitive currencies in a system without a central bank. Was Reagan just trying to make small talk or expressing curiosity about Volcker’s opinion, or was he sending a subtle signal that he could make a world of trouble for the Fed if it didn’t mesh with Reagan’s policies? Reagan had already expressed some sympathy for the gold standard, which would severely circumscribe the role of the Fed if adopted. Now Reagan was hinting that he could consider going far beyond this. To orthodox Keynesian economists, if tax cuts were “voodoo economics” and the gold standard a medieval superstition, the idea of “free banking” ranked somewhere below leechcraft.
Volcker needn’t have worried about such a radical prospect, but with Washington rife with rumors that Volcker had little regard for Reaganomics, Reagan had subtly reinforced that Volcker needed to restrain his public remarks. Between the election and inauguration, Volcker had made several public comments that suggested skepticism of Reagan’s supply-side prescriptions. “Let us not be beguiled into thinking there are quick and painless solutions,” he told a New York audience, and that “the likelihood of a squeeze is apparent.” After Reagan took office, he became more circumspect.
He had good reason to be, aside from any implicit threat from Reagan. The Fed had been highly erratic over the past decade, and remained inconsistent so far under Volcker’s brief tenure. Volcker abruptly adopted an explicit tight money policy in the fall of 1979 in an effort to combat inflation, but during the second half of 1980 the money supply grew at its fastest rate in history. Milton Friedman and other monetarists thought it was a blatant play to help Jimmy Carter win the election.
Despite the intent to get money supply growth back under control after the election, it was evident by the late summer of 1981 that Volcker was not succeeding in putting monetary growth on a gradual, three-year downward glide path. Instead, monetary growth surged in the spring of 1981, sparking fears of resumed inflation. Then, in the summer, the Fed “slammed on the breaks,” with monetary growth now coming in below the bottom end of the Fed’s own target range. The Reagan economic plan had hoped for monetary growth of about 6 percent in 1981, but during the second half of 1981 monetary growth was about zero. The nation’s credit markets were now confronted with the kind of “tight money” conditions that nearly always presaged a recession.
What was the Fed up to? Volcker and the Fed staff remained resolutely mum, much to the frustration and irritation of the Reagan administration. The informed speculation then and now is that after the tax cuts passed, Volcker believed the Fed would have only a short window of opportunity to strangle inflation through tight money before the political pressure became overwhelming for the Fed to ease. William Niskanen wrote: “My judgment is that Volcker believed that the consensus for monetary restraint was temporary and that the American political system would not tolerate the slow, steady reduction in money growth recommended by the initial Reagan guidance. He may have wanted to reduce inflation as rapidly as possible, despite the temporary adverse effects on the economy and the destruction of the consensus for sustained restraint.”
Volcker knew that the Fed had its own credibility problems. Fortune magazine summarized the situation: “The central bank’s performance has been so awful over the last 15 years that hardly anyone believes the Fed anymore.” Volcker himself admitted as much in testimony before the Senate Budget Committee: “Americans have not seen for many years a successful fight on inflation, or balanced budgets, or so massive a tax reduction. A lot of bets on the future are still being hedged against the possibility that you, and we, will not carry through.”
Reagan himself displayed a clear grasp of this problem, explaining at a lunch with out-of-town editors how the Fed was missing its monetary targets:
We know that we have to have a consistent monetary policy that doesn’t do what we’ve done over the last few decades, of the roller coaster effect—of when unemployment gets out of hand and it looks like hard times, they flood the market with paper money. And then when that brings on inflation, then all of a sudden you pull in and tighten it down and you go the other way. This is what’s been happening. I do have one little criticism, and yet I can see how it happened. You realize that we can visit with them, but we can’t impose on them. They’re totally autonomous. But it is true, recently, that they have two lines going up, a kind of a bracket, following productivity in the country, and they are trying to keep the money supply between those two lines. It may fluctuate a little bit, but staying between those two lines. And sometime back, they fell below their bottom line in this. And then they were faced with the prospect of trying to have a stable monetary policy to help in the fight against inflation. They didn’t know how to just get back up where they should be without it looking like when on Wall Street they would look at the money supply and see this surge, they’d say, “Oh, oh, here we go again,” and start acting as if, well, it was the same old game being played.