Paul Volcker: A Giant of Economic Policy

Opinion Pieces>Paul Volcker: A Giant of Economic Policy

At six foot seven inches, Paul Volcker commands the attention of any room. Yet as a young man, his preschool teacher was worried about his distinct lack of self-confidence. Later in life, however, it would not be a boisterous demeanour or an air of self-confidence that Volcker would be remembered for, but rather his dogged resilience, his no-nonsense attitude and his shrewd, yet severe, approach to monetary policy that would write him into the annals of economic history.

Paul Volcker

It would be these attributes that would eventually help him to drag – almost single-handedly – the US economy out of an era marked by ballooning inflation, peaking at 14.8% in 1980 and successfully suppressed to under 3% by the time of Volcker’s fourth year as Chairman of the Federal Reserve in 1982. Volcker’s suppression of inflation was a feat that many have called an economic miracle, while others have highlighted the less positive effects of his drastic contractionary policies, including a national recession and an unemployment rate that reached double digits for the first time since the 1940s.

With a penchant for shiny suits and cheap cigars, prominent pictures of Paul Volcker are often framed in a haze of smoke. Even when testifying before Congress about the Fed’s possible involvement in foreign exchange rate manipulation, a frugal and Churchillesque Volcker would puff away on his 25-cent variety cigars, as he carefully selected the words for his statements to the court – scenes that would earn him a cult-like respect among some, including Missouri Senator Christopher Bond, who believed the wreath of smoke gave him something of a “Delphic aura”.

As the son of a municipal manager in the small town of Teaneck, New Jersey, Volcker admired his father’s pragmatic and apolitical approach to governance in managing the local municipality. He benefitted from an exceptional education that included Ivy League schools such as Princeton, Harvard and the London School of Economics, as well as the principles of no-nonsense governance that were instilled in him by his father. It was these qualities that guided him as he began his career at the Federal Reserve Bank of New York as an economist in 1952. Almost 20 years later, Volcker would be brought in by President Richard Nixon as Under Secretary of the Treasury for International Affairs, where he was integrally involved in the severing of the dollar to its direct gold convertibility – a decision that would eventually result in the collapse of the Bretton-Woods system and something that Volcker still considers “the single most important event in his career”. For most economists, however, it was Volcker’s battle against inflation for which he will forever be remembered.

At the end of Richard Nixon’s first presidential term in 1972, the US economy was booming. The stock market had experienced a prolonged bull run, the economy was growing steadily, and unemployment was close to zero. To secure another term, Nixon and the Democrats had pushed the Federal Reserve to keep interest rates as low as possible, making money cheap, lending plentiful and stimulating short-term economic growth. Between December 1971 and December 1972, money supply grew rapidly from $228 billion to $249 billion in the most liquid assets (M1) and even more steeply in less liquid assets (M2), increasing from $710 billion to $802 billion. The inflationary effect that resulted – ballooning from under 2% in 1962 to 15% in 1979 – was inevitable. Nixon, however, was not greatly concerned, stating, “We’ll take inflation if necessary, but we can’t take unemployment.” In the end, as long as his electoral base felt the immediate positive effects of his cheap-money policies, Nixon and the Democrats were happy – and for a time, it worked. But this temporary boom would be short-lived, soon to be eclipsed by a recessionary era dubbed the Great Inflation – a recession that would ultimately change the very foundations of how central banks control monetary supply and interest rates.

Nixon succeeded in his goal of winning the 1972 election, taking 49 of 50 states, but it came at a cost – the rapid devaluation of the dollar. Not long after Nixon’s re-election, industrial production began to decline, the stock market was cooling off, foreign investors were spooked by a destabilised dollar, and unemployment was steadily rising. For Keynesian economists and central bankers who had convinced themselves that they had cracked the monetary policy code – following 20 years of unwavering economic growth and stability since the 1950s – the simultaneous rise of inflation and unemployment was thoroughly perplexing.

In the world of simplified Keynesian economics, rising inflation was tolerable since it was seen as a direct result of rising demand – with more market demand pushing up the price of goods and services. This increased demand would theoretically allow companies to expand to meet the market’s needs, allowing them to hire more workers and consequently, decreasing the unemployment rate. In this framework, inflation had always been linked to a healthy, growing economy and therefore was not considered overly concerning, as it would always self-correct as demand decreased and unemployment increased. Until the 1970s, these economists had never experienced the phenomenon of stagflation – the simultaneous rise of inflation and slowdown of the economy. At this point, the very fundamentals of the economics that underpinned central banking had to be reconsidered.

With inflation continuing to rise, the Federal Reserve had run out of ideas on how to curb accelerating price increases. To exacerbate the situation, during the late 1970s, multiple supply shocks – from within and from outside of the US – put extra pressure on the economy, causing the inflation rate to rise even further. By 1979, in the wake of almost a decade of poor monetary policy under the Nixon regime, Paul Volcker was brought in as the Chairman of the Federal Reserve by President Jimmy Carter to save the US economy from runaway inflation. Taking office on August 6, 1979, it took Volcker just over three years to correct a complex problem that today’s economists believe had been building for 15 years. But despite saving America from itself, Paul Volcker was not generally a popular figure, as the average American homeowner naturally blamed Volcker for a rise in their interest payments.

As soon as he stepped into the position of Chairman of the Federal Reserve, Volcker had a clear plan – he needed to increase interest rates to combat inflation. In just a two-year period, the federal funds rate was ratcheted up from 11.2% in 1979, when Volcker took control, to almost double that in 1981, peaking at a rate of 20%. But this extreme measure did not come without criticism and consequence. With the prime rate rising to almost 22% in 1982, a tough period of belt tightening beset the US economy, with many industries having to lay off workers in what became a recession marked by an unemployment rate of over 10% – the highest rate in the post-war era. With such high interest rates, companies were reluctant to borrow money from banks and aggregate investment in new equipment and stock slowed drastically, pushing the US into a new recession.

Volcker’s tight monetary policy, and the subsequent economic recession, attracted much criticism. Not since its inception had the Federal Reserve been under such intense pressure from the public, as the economic consequences could be directly linked to the decisions of the new Fed Chair. In the early 1980s, there were widespread protests and a continuous barrage of attacks on the Fed, culminating in a protest by struggling farmers who drove their tractors into the heart of Washington, D.C., to blockade the route to the Eccles Building that houses the Board of Governors for the Federal Reserve. But despite the fury of the nation and extreme political pressure, Volcker persisted with his policies.

In the midst of the recession that he had caused, with trust in the Fed at an all-time low and with even his colleagues beginning to doubt the extremity of the policies he was implementing, Volcker displayed unique self-belief and a particular stubbornness of character. As detailed in his co-authored autobiography, Keeping At It: The Quest for Sound Money and Good Governance (2018), in a secret meeting with Ronald Reagan in the White House library – a location known to have no recording devices – the President asked Volcker, via the Chief of Staff James Baker, not to raise interest rates before the election of 1984. In the history of the Fed, much political pressure has been applied to it by various governments, both Democrat and Republican, yet legally, the Fed must stand independent of the government. Any government’s attempt to influence the decisions of the Fed is thus deemed illegal and, as history would show, Volcker stuck to his guns, not allowing the president to intervene in monetary policy.

Today, many economists still argue about whether Volcker’s extreme policy was necessary. What is undeniable, however, is that he succeeded in breaking the back of inflation. The reining in of this inflationary effect was critical, not only in terms of the danger to the US economy, but also in terms of the knock-on effect a destabilised dollar would have had on the global financial system. And whilst Volcker’s stubborn, yet principled and pragmatic approach, may not have been glamourous or popular at the time, it certainly has not been forgotten. In 2009, his position as an esteemed economist and policymaker was reaffirmed when Barack Obama appointed Volcker, at the age of 81, to chair the President’s Economic Recovery Advisory Board. Through this forum, Volcker’s old-fashioned approach to solving real economic problems using simple, yet often painful, means has been preserved and championed in the approval of the Volcker Rule in 2013. As implemented under the wider scope of the Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly known as Dodd- Frank, the Volcker Rule sensibly prohibits proprietary trading by commercial banks, making it unlawful for these financial institutions to take speculative trading risks with depositors’ money.  

This article is from the Monocle Quarterly Journal, A Short History of Banking. Visit our "Journals" section to read the full issue.