On the 8thof December, Paul Volcker passed away. He is not a very well-known figure by the general public and outside economic and political discussion circles. These are some of the injustices that sometimes occur throughout History. Some people are forever remembered just for having an extroverted character, while they actually did nothing relevant for humanity and its development. Others, as is the case of Paul Volcker, changed History and made life easier for everybody by promoting economic stability, but sadly, are not so well-known by the general public. That’s the main reason and incentive for today’s post. To allow people to briefly discover Paul Volcker’s legacy and his important contributions to today’s monetary system.
Paul Volcker’s fight against American inflation started in 1979, with annual inflation standing at 12%, something unbelievable nowadays in developed countries, which are struggling to even reach the 2% inflation goal established by central banks. Reading articles from the main economic newspapers of the time, you’ll find pretty similar reactions to Volcker’s first press conference as head of the Federal Reserve, after being designated to that position by Jimmy Carter. Nearly all economic journalists and analysts at the time thought that Volcker’s measures were drastic and disproportionate. It was typical for central banks to control interest rates, which tend to be identified as the “price of money”, and manage monetary policy with that tool, but Volcker changed everything. The Fed President innovated and decided that from then onwards, the Fed would make a strong emphasis in moderately managing monetary supply, and through it, to control interest rates indirectly. So basically, he flipped the equation around. Instead of trying to change the supply of money by manipulating interest rates, he decided to manage the monetary mass, and afterwards, to allow interest rates to adapt to it.
The head of the Fed knew that a short economic downturn would come if he contracted money supply and allowed interest rates to skyrocket. But he also knew it was vital for the economy in the long run to stabilise inflation and reduce consumption expectations and behaviours at the time, as people who didn’t have the possibility to guard themselves from double-digit inflationary trends by buying gold, real estate or assets, decided to use the entirety of their wages for consumption; as money per se at the time devaluated terribly fast. Interest rates rose to 20% (federal rate), being the highest in American History, which at first shrunk the American economy into a short-term recession, which lasted just until 1983, but wasn’t insignificant, with unemployment standing at 10.8% in 1982, before slashing inflation rates in 1983, when it went spiralling down to 4%.
There’s a Hayekian idea that Volcker almost made his. Hayek believed that inflation could reduce unemployment just in one way: by cutting real wages, which made Volcker see high inflation and depression as synonyms. At the time (1980s) the prevailing idea was that inflation could be a national drama, as it destroyed societies by making savings redundant and purchasing power inexistent. This is one of the main reasons why Volcker didn’t believe in gradualism and small interest rate increases. We need to bear in mind, that when he arrived at the Fed, inflation rates had been around 5% for most of the 70s decade. Volcker found confrontation from consumers, farmers and small enterprises mostly, but he was a resilient and determined man, and he knew that inflationary stability would bring greater growth and development in the near future. And it happened that way.
After a couple of bad years, in 1983, the economy grew (Real GDP growth) by 7.9%, not going below 2.74% until 1989, and not registering annual negative economic growth until the Great Recession of 2008 started. Friedman’s theories were empirically demonstrated through Volcker’s mandate, as what needed to be done to increase economic growth was supposedly to reduce inflation, closing the gap as much as possible between nominal GDP growth and real GDP growth. As we have seen, this gap was successfully diminished, with real GDP growth suffering during a couple of years, but after then, growing at incredibly high rates- just as inflation vanished-. This situation is a clear empirical demonstration of Friedman’s “Natural rate Hypothesis”. As inflation was lowered, money velocity also contracted, just as Friedman predicted, due to a much tighter monetary policy which prevented lavish consumption, which can be easily deducted also from the basic formula M*V=P*Q, being M the Money supply, V the money velocity, P the price level and Q the real GDP level.
Volcker also fought for a crucial thing in free-market systems: independent central banking. It is well-known that Volcker was heavily pressured during the months previous to Ronald Reagan’s 1984 presidential campaign. He was asked by very important members of the GOP to abstain from rising interest rates along those months, to prevent hampering economic expansions, which was a very effective electoral weapon. One of the things I love the most from what I’ve read about Volcker is that he was very consistent with his ideas, being a firm defender of budgetary equilibrium and fiscal responsibility. This was demonstrated when in 1981, he decided not to give his support to Reagan’s famous tax cuts, unless they were accompanied by a contraction in spending of almost the same level, mainly to prevent having to fight against a rampant deficit, which finally occurred.
On top of it, we should highlight that Volcker was not an ideologized or politicized person at all. He believed in his economic principles and work methods, but not in some kind of ideological program which should be accomplished by the Fed. As I’ve commented before, he believed in a strictly independent Fed. His political neutrality and professionalism have been empirically demonstrated several times, as he was a firm defender of the Glass-Steagall act since 1933, later on he worked under pressure during Reagan’s Administration, and finally he became part of Obama’s economic advisory team, which you may probably remember because of the 2010 legislation that restricted flexibility on the use of customer deposits by banks for various investment purposes, which was called “Volcker Rule”.
Politicians and central bankers nowadays should follow Volcker’s spirit and values. I’m of course not saying that they should imitate his policies, as we are living a completely different economic and political time, with a rapidly changing socioeconomic atmosphere with severe spillovers on politics, with populist parties on surge. Precisely to prevent that, Volcker’s values should be applied. Central bankers should try to be impermeable to individual political demands, as when Donald Trump has repeatedly asked Jerome Powell to lower interest rates massively, just for the sake of some extra growth before the 2020 Presidential Elections. It’s crucial for central banks and regulatory institutions to be independent from the government. Following those principles, we’ll be able to have a stable economic and political environment. We should remember Volcker.