How Paul Volcker became a practical monetarist

A bit of history I only recently learned.

I recently read Inside the Economist’s Mind, which is a collection of interviews by famous economists of even-more-famous economists. The book was edited by Paul Samuelson and William Barnett, and even has its own blog– talk about niche blogging!

One of the most interesting for me was an interview conducted in April 2000 by Perry Mehrling of Paul Volcker. Volcker chaired the Federal Reserve from August 1979 through August 1987, during which period the U.S. inflation rate was brought down from 12% to 4%. The Volcker regime has sometimes been characterized as one in which the traditional notion of interest-rate targeting was replaced by a focus on controlling the growth of the money supply, as a consequence of which interest rates were initially allowed to reach unprecedented high levels:



Data source:FRED
ff_volcker.gif



In the interview, Volcker explained to Mehrling how he became a “practical monetarist” primarily in order to cultivate the necessary intellectual and political support for allowing interest rates to get so high:

It always seemed to me that there is a kind of commonsense view that inflation is too much money chasing too few goods. You could oversimplify it and say that inflation is just a monetary phenomenon. There are decades, hundreds of years, of economic thinking relating the money supply to inflation, and people to some extent have that in their bones. So I think we could explain what we had to do to stop inflation better that way than simply by saying that we’ve got to raise interest rates. It was also true that we had no other good benchmark for how much to raise interest rates in the midst of a volatile inflationary situation.

Paul Volcker
volcker.jpg

At least as important was the idea to discipline ourselves. People in the Federal Reserve don’t like to raise interest rates. So the danger is you’re always too little too late. I think that would apply to the current situation [April 2000]. So, when inflation really had the upper hand, it was, I think, very important to put something out there so you could discipline yourself. For that kind of a commitment, you’ve got to know what’s at stake, and it does make some broad sense if you have that much inflation [pp. 178-179].

Volcker related that the critical decisions came in February 1980:

What really propelled me to make the change was when we raised the discount rate for the second time, when I was first down there. The vote was 4-3. I thought it was a reasonably strong move and we’d get a favorable reaction in the market, but we didn’t. The response was, “Well, gee, the Federal Reserve is behind the curve anyway, the vote was 4-3, and that’s the last increase of the discount rate we’ll see.” So the market reacted very badly, which surprised me. I guess I was a little naive. I remember very clearly, I didn’t bend over backwards to try to twist the arms of the three people who voted the other way. I knew I had four votes. If we had to increase the discount rate again, we’d have another 4-3 vote. But that’s not the way the market read it. Then I realized that we had this credibility problem worse than I thought. That got me off and really thinking operationally about the other approach [basing policy on target growth for the monetary aggregates]. But when it was sprung on them, everybody was very much in favor, even those who were voting against the increases in interest rates [pp. 178-179].

The rest, as they say, is history. But, if you can become a practical monetarist as a technical expedient to achieve your short-run objective, you can drop the intellectual baggage just as easily when being a monetarist no longer seems to be all that practical:

Then in October [1982], or whenever it was, the money supply (by some measures) was increasing again rather rapidly. We had a tough explanation to make, but I thought we had come to the point that we were getting boxed in by money supply data that was, in any event, strongly distorted by regulatory changes and bank behavior. We came to the conclusion that it was not very reliable to put so much weight on the money supply any more, so we backed off that approach [p. 183].

It really wasn’t a matter of choosing sides in the debates between academic economists about how to bring inflation down. Instead, it was simply whether the Fed had the will to stick with the program until inflation was brought under control. Volcker proved to be the man for the job.


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10 thoughts on “How Paul Volcker became a practical monetarist

  1. Nickson

    One need not go to such extravagant lengths as quoting a behaviorist to put the point that “will to stick with the program” is analytically vacuous. “Will” (“will-power”, etc.), like “chance” is only a fancy way of saying “Ich weiss nicht”. (Bentham made a similar point in Anarchical Fallacies, in commenting something like: “when a man wants something but can’t think of a good reason, he says he has a ‘right’ to it.”) But I do trifle, as none should disagree that to go beyond the superficial “Volcker’s will to stick” would have cost you more research or trouble than profit in insight.

  2. DickF

    So, when inflation really had the upper hand, it was, I think, very important to put something out there so you could discipline yourself. For that kind of a commitment, you’ve got to know what’s at stake, and it does make some broad sense if you have that much inflation [pp. 178-179].
    Volker knew much was at stake but he did not understand either the problem or the solution.
    Then in October [1982], or whenever it was, the money supply (by some measures) was increasing again rather rapidly. We had a tough explanation to make, but I thought we had come to the point that we were getting boxed in by money supply data that was, in any event, strongly distorted by regulatory changes and bank behavior. We came to the conclusion that it was not very reliable to put so much weight on the money supply any more, so we backed off that approach [p. 183].
    In his second comment Volker virtually admits that he had no idea initially what was happening, but he still will not admit the truth, even though he seems to know it in his heart of heart.
    Volker and the FED moved to a hyper monetarism in 1980 with the intent of controlling down the Nixon, Ford, Carter 1970s hyper-inflation, but what Volker missed is something he expresses clearly: inflation is too much money chasing too few goods. Volker only saw one side.
    The Reagan tax cuts were beginning to increase production and so goods were beginning to flow into the market. Volker and crew only saw the money side of the hyper-inflation, but were blind to the supply side probably because of their Keynesian demand side foundation to their economics. Now the FEDs hyper-monetarism did bring down inflation, but it also brought the economy crashing down around our heads in the deflationary recession of 1981-82. There were supply siders at the time warning Volker that his hyper-monetarism would bring on a deflationary recession, but as can be seen from his comments, he was committed to the monetarist idea even if it killed the economy, come hell or high water.
    It is funny that he pretends to not be sure that it was 1982 when the money supply began to increase again but I think that is a defense mechanism on his part. He is in a state of denial as to what brought us out of the recession because he cant admit that his monetarism was wrong and supply side was right. Volker and the FED were forced to abandon his hyper-monetarism because it was spreading deflation through the whole world especially in creating the Mexican Peso crisis. In 1982 Volker was forced to abandon his monetarism and pump dollars back into the system through Mexico to support the Peso. The result is that the deflationary crisis caused by the FED hyper-monetarism was reversed.
    Finally the money supply and product supply began to return to equilibrium and the economy began to function effectively, and as is noted by Volker and as has been noted by other economists, the FED abandoned monetarism for an inflation targeting regime. Now if we could only get them to abandon their useless and destructive interest rate system.

  3. patrick

    DickF
    Perhaps the more important point to all this, is simple; a private bank controls this countries money supply. Why don’t you ask them to abandon their entire useless system so the people can go back to printing their own money? That’s the real problem.

  4. William A. Barnett

    More about that Volcker interview seems to have just appeared in the Brazilian financial newspaper, Valor Economico (which means “Economic Value”). A major cover story about that book, ITEM, appeared last Thursday (February 9, 2007). It includes original artwork and photographs acquired by the newspaper. In addition to the cover story by the newspaper’s editor, the article includes commentaries by five Brazilian economists. The color photographs alone are worth seeing. Although I cannot read Portuguese, I’d guess from the large photograph of Volcker that there is discussion about that interview.

  5. DickF

    …so the people can go back to printing their own money? That’s the real problem.
    Patrick,
    I am not sure what you are proposing here. Can you give me some help?

  6. dryfly

    The Reagon tax cuts did little for the economy as for the most part, the 80’s were inferior to the 70’s(a non PC statement, but trust, me, living in the midwest in the 80’s, it was as a hard landing in 1987 than 1977) except for a investment view, which is the real legacy of the 80’s.
    Now that investment has come to a end……………..

  7. Valuethinker

    dryfly
    I think what killed the Midwest was the Exchange Rate. The dollar and the pound were almost 1 for 1 in September 2005.
    The US Midwest was unusually dependent on exports (farm products) and unusually sensitive to imports (manufacturing competition). It was also highly unionised (and hence inflexible cost bases).
    No sooner had the US emerged from the early 80s recession, than the soaring dollar squeezed the midwestern economy– I remember a cover story about blue collar workers who had lost their jobs in Newsweek (or Time?).
    Yes the Plaza Agreement engineered a big fall in the dollar after that, but the damage had been done.
    Those high wage union jobs never came back.

  8. DickF

    Valuethinker,
    Thanks. Right on point.
    The deflation of the dollar not only caused problems with farming and manufacturing it drove down the price of oil and created a real crisis in oil production, an oil depression in Texas.
    What many miss is that high oil prices are often caused by a prior monetary deflation that drives the price of oil down so that productions is marginally profitable and producers are forced out of business. When the FED finally realizes it is creating deflation it then creates inflation in a destructive effort to correct its error. The economy takes off and the demand for oil jumps dramatically. The oil companies cannot keep up with demand so oil prices go through the ceiling. Much of the reason for the current high oil prices was the FED driven deflation of the mid-1990s and then their inflation after 2000.
    It is too bad we can’t sue the FED for whiplash.

  9. DickF

    Yes the Plaza Agreement engineered a big fall in the dollar after that, but the damage had been done.
    Valuethinker,
    I stumbled on this presentation this morning and thought of your post.
    http://www.aae.wisc.edu/aae319/319week7/img020.gif
    It made me laugh. The Plaza Agreement creates the G5 in February 1985 to coordinate the fall of the US$. only two years later there is the Louvre Accord in February 1987 to stop the fall of the US$. If you will remember October 1987 Greenspan and Jim Baker engineered Black Monday. It amazes me that people still believe that the FED is keeping the currency stable.

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