Sunday, December 14, 2008

Paul Volcker's Harsh Economic Medicine

Paul Volcker, former Chairman, U.S. Federal Reserve Bank

Paul Volcker speaks in a voice not quite up to the challenge of transiting his imposing frame. It is the voice of a man with nothing to prove: a leader chosen by acclamation when the Vandals have stood at the Gate.

Schooled at Princeton, Harvard and the London School of Economics in liberal arts, political economy and government, Mr. Volcker began his career as a summer research assistant at the Federal Reserve Bank of New York in 1949 and 1950. He returned twice, first as a research economist, then as President in 1975. By then he had already served two stints at Chase Manhattan (first as a research economist, later as vice president and director of forward planning), two stints at the US Treasury during the Kennedy and Nixon administrations, and a senior fellowship at the Woodrow Wilson School of Public and International Affairs at Princeton University.

President Carter, burdened by a deepening economic malaise with inflation running at 13.3%, appointed Volcker to a four-year term as Chairman of the US Federal Reserve Bank in August, 1979. Chairman Volcker immediately set about restricting the growth in the money supply, intent on getting inflation under control.

Ronald Reagan defeated Carter for the US Presidency in 1980, pledging to rebuild the military and restore confidence in the US economy. His economic plan rested on the postulate of USC economist Arthur Laffer that under special circumstances lowering the income tax rate might increase tax revenue by stimulating growth. Reagan's budget featured a massive tax cut concentrated in the upper income brackets. It also included a net increase in government spending, with defense spending increases overtaking the much publicized cuts in other budgets.

While Volcker was encouraged by members of the Reagan administration to continue to restrict monetary growth, he publicly worried in 1981 about the consequences of simultaneously pursuing restrictive monetary policy and expansionary fiscal policy:

I know that in concept a case can be made that restraint on money and credit alone, sustained long enough and strong enough, could control inflation and thus lay the ground for renewed growth. But is that a realistic, believable and tolerable course if other instruments of policy and opinion are running counter to our purposes? Will the sustainability of the policy be credible if the costs in growth and employment seem excessive? And the costs fall unfairly on the industry and elements of the population most dependent on credit?**

He had concisely laid bare the inherent contradiction in the policies of the Reagan team: supply side theory was to be crushed by a predictable monetarist outcome. When the excess demand for money set off by the unprecedented budget deficit was not accommodated by the Federal Reserve, interest rates spiked (spectacularly), inducing the recession of 1981-82.

Volcker seems to have set the terms for the harmonization of monetary and fiscal policy that ensued in 1982. Volcker began to loosen his grip on the money supply just as Reagan put through a major tax increase to check increases in the federal deficit, taking back 1/3 of the value of the 1981 tax cut. Reagan again raised taxes in 1983 and 1984, enacting a major increase in taxes to fund Social Security, increasing taxes on gasoline, and closing certain business tax loopholes.

Many remember Reagan's tough stands against the strike of the air traffic controllers in 1981 and his unrelenting escalation of the arms race that contributed to the virtual bankruptcy of the Soviet Union. Nonetheless, in large part the economic success achieved during Reagan's second term was due to his willingness to follow the advice of his equally resolute Fed chief. By forcing Treasury Secretary Don Regan to finance the arms race with higher taxes, Volcker burst the inflationary bubble and set the stage for two more decades of prosperity. When President Reagan reappointed Volcker in 1983 the rate of inflation was 3.2%.

Perhaps Obama is looking to the doctor of the 1980 economy to administer some bitter medicine early in his own first term.

*To view his Oct. 9, 2009 interview with Charlie Rose in its entirety and other clips featuring Paul Volcker, see the Charlie Rose website.

**Secrets of the Temple: How the Federal Reserve Runs the Country, by William Greider (Simon & Schuster, 1989), pp.358-359

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