It may be difficult for anybody born after, say 1960, to appreciate the extent to which inflationary expectations became embedded in society in the 1960s and 1970s; and even more difficult, perhaps, to understand how inflation came to be widely seen as unavoidable. It was true that some conservatives inveighed against its dangers, weighty editorials in the more solemn newspapers thundered about its evils, and a small band of unorthodox monetary economists led by Milton Friedman called for monetary policy to be used to fight it. It is true, then as now, that Germany (referring at the time to West Germany) was allergic to inflation, but, then as now, this was attributed to German experience between the first and second world wars – an experience that need not be heeded by others. So these voices were drowned by the dominant view – to risk inflation was necessary in the effort to maintain full employment.
Fiscal policy should be used to maintain demand so as to eliminate any ‘spare capacity’. This was defined ambitiously. In the UK, for example, any action that might raise unemployment above 3%, even temporarily, was considered unacceptable. Students were taught that monetary policy had, at best, an uncertain effect, and that any impact it might have would be through suppressing interest-sensitive components of demand, such as capital investment, which would be a ‘bad thing’. Monetary policy was used, if at all, to defend the fixed exchange rate to the US dollar.
Before its breakdown in 1971, the fixed-exchange rate regime agreed at Bretton Woods checked these latent pressures towards more rapid inflation taking hold, at least in a majority of industrial countries; but the United States did not feel the same degree of constraint to maintain the fixed dollar price of gold, though this was the hub of the system. Indeed, the general neglect of monetary policy meant that very few observers or officials attributed the strains in the system, as shown in the growing US payments deficit, occasional bouts of dollar weakness and flare-ups in the gold market, to an excessively expansionary monetary policy. William Martin, chairman of the Federal Reserve from 1951 to January 1970, was viewed as a conservative central banker pursuing prudent policies – did he not coin the famous aphorism about the job of central bankers being to ‘take away the punchbowl’?
In 1969, when Paul Volcker, aged 42, was appointed under-secretary for monetary affairs at the US Treasury, his first big job, the global monetary structure was perhaps already beyond repair. It was threatened not only by the rise in US costs and prices, notably budgetary pressures arising from the Vietnam war, but also from its own internal contradictions – its dependence on a national currency to serve as the basis for international liquidity as diagnosed by the economist Robert Triffin. Politically, French president Charles de Gaulle’s call for a return to gold in 1965 was widely seen, at least in Europe, as delivering a death sentence. Volcker rejected the options favoured by many Europeans, of raising the price of gold, on two grounds: first, it would reward speculators, inflaming speculative frenzy further; second, it would require the approval of the US Congress. This would, in Volcker’s view, not be forthcoming as it would be seen, politically, as an unacceptable devaluation of the dollar. Volcker also formed the view that the role of gold in the system should be reduced.
Quickly, Volcker came to the view that a revaluation of other major currencies against the dollar would be needed to correct the US’s growing payments deficit. However, he also believed in a fixed exchange rate system. Thus he proposed to President Richard Nixon what he called a ‘cold-blooded’ suspension of gold convertibility – an action deliberately taken to force other countries to revalue. He hoped this would lead to agreement on a new set of fixed exchange rates. (The legal advice he received was that suspension of convertibility would not require Congressional approval even though it was a far more radical action than changing the gold price). This led to the Camp David Meeting of August 1971, followed by Nixon’s announcement suspending convertibility. What Volcker could not foresee or control was the way Nixon and Treasury secretary John Connally would present the action, along with an import surcharge, as an exercise in triumphant unilateralism. Connally set the tone when he famously told a European delegation that “the dollar is our currency, but your problem” – a statement that has echoed down the decades since.
From this angle, the rest of Volcker’s career can be interpreted as a series of noble efforts to repair the damage done by this act of monetary euthanasia.
The fight to restore order
On September 30, 1979 in Belgrade, Yugoslavia, Central Banking founder Robert Pringle was standing with a few colleagues at a reception to mark the opening of the 1979 International Monetary Fund (IMF) annual meeting, when a large figure loomed above them – it is Paul Volcker, the newly appointed chairman of the Federal Reserve. They have picked up rumours that he would be leaving early to return to Washington. Someone asks whether it is true. So far as Pringle recalls, he replied, looking away, “Well, I have things to do….”. He left the next day.
Little did reporters know he was already planning the biggest change of Fed policy since World War II. A few days later, the Federal Reserve announced that it would in future let short-term interest rates fluctuate much more widely to focus on controlling monetary aggregates. This was a change that monetarist economists had been urging on the Fed for several years. The question was, would the Fed stick with it? And would politicians and the public give Fed officials the backing they needed?
Volcker set an example of leadership in action that ushered in a new era, not only for central banking, but also for the US and for the world economy
It took an agonisingly long time to work. Inflation peaked at 13.5% only in 1981. To Volcker’s dismay, long-term bond yields continued to rise. But the Federal Open Markets Committee (FOMC) stuck to its guns and, despite the opposition of some groups, public opinion remained broadly supportive, as was the incoming president, Ronald Reagan. In the process, Volcker set an example of leadership in action that ushered in a new era, not only for central banking, but also for the US and for the world economy. The Volcker Fed defeated defeatism. The assumption that high inflation just had to be accepted, for fear of something worse, was triumphantly shown to be false. This set the agenda for a new generation of central bankers. As Volcker himself said in an interview in Central Banking, August 1999, Vol X No 1: “The relative independence and standing of central banks in recent years has stemmed from the success of a few central banks in combating inflation at a time when the inflationary process seemed deep-seated and almost inevitable.”
By his demonstration of the practical success of such a policy, Volcker had a crucial influence on the global movement towards central bank independence – while always insisting on its limits.
Persistence in face of adversity
Some economists emphasise the costs. Even Alan Blinder, later himself a vice-chair of the Fed, commented that Paul Volcker showed that “tight monetary policy can bring inflation down at substantial, but not devastating, cost”.1
This does not give due weight to the major achievement, which was to prove that inflation could be beaten at a time when this was widely regarded as not politically feasible. Moreover, the recession brought much less unemployment than had been expected. It is true that the sudden policy switch had other unintended, adverse effects – including triggering the developing countries’ debt crisis of the 1980s. But by the time Volcker instituted the new monetary policy, these costs were already built in the system – the real costs had been incurred by the misallocation of resources during the long inflationary build-up in the 1970s, as well as the negative real interest rates that accompanied it and the explosion of cross-border lending and borrowing by developing countries.
In short, it was precisely his persistence with a controversial monetary policy that eventually brought long-term rates down and laid the basis for 20 years of non-inflationary growth. But it took time – and courage. In May 1981, the FOMC raised rates to 14% – six months into a major recession. Meanwhile, monetary policy was set on a collision course with Reagan’s expansionary fiscal policy. Nominal rates reached 14% at the beginning of 1982, and real rates also were forced up, a full two years after the start of the new policy. But then the fall in long rates started, and, with an interruption in 1984, that decline has continued pretty much ever since. Inflation, meanwhile, fell to 3% as early as 1985.
In a recent biography, William Silber develops a related theme – that Volcker can take credit for persuading Congress to institute a regime of greater US fiscal responsibility. This was evidenced by the passage of the Gramm-Rudman-Hollings balanced budget legislation of 1985 and 1987, described by senator Phil Gramm as "the first binding constraint imposed on federal spending”. Its spending caps have become part of every subsequent budget round. This, argues Silber, was the result of the Fed’s refusal to monetise the budget deficit in 1984–85.2
At a time when controlling public sector deficits are again a priority in most countries, this showed how central banks can get involved when such deficits threaten price stability.
Another key characteristic of Volcker’s approach is his respect for, and ability to reach out to, policy-makers and informed opinion-leaders outside the US. Ever since the early 1970s, he has been a familiar figure on the international circuit, making numerous friends around the world. Moreover, he has always taken international factors and repercussions into account when framing his policy positions. YV Reddy, former governor of the Reserve Bank of India, recalls how Volcker spoke at length about his views on global development and his support for tight monetary policy measures to contain inflation and strict prudential norms for restraining excessive credit growth in India at a dinner in Mumbai. “His articulation lent support to my efforts by strengthening public opinion in my favour – his credibility in the world of money, finance as well as the government in India also, was evident to me at that time,” says Reddy.
Ever since he was a young trainee on the trading desk of the New York Fed, Volcker has also kept close to the financial markets. He strongly supported the US policy of reducing the role of gold in the system, and does not believe the world can or should return to a gold standard, but sees the need for an adequate replacement for its disciplines. He knows that fiat money is on probation – on trial in the court of public opinion. He is able to view central banks in long-term historical perspective, as this remarkable statement from 1995 makes clear:
“It is a sobering fact that the prominence of central banks in this century has coincided with a general tendency towards more inflation, not less. If the overriding objective is price stability, we did better with the 19th century gold standard and passive central banks, with currency boards, or even with ‘free banking’. The truly unique power of a central bank, after all, is the power to create money and, ultimately, the power to create is the power to destroy.”3
Paul Volcker’s unique skill set
What are the personal characteristics qualities that enabled Volcker to achieve so much? Taking his cue from Volcker himself, Silber singles out his persistence: “I may be old but I am persistent” (Silber, page 293). Then there is his courage. These virtues run like golden strands through Volcker’s entire career. They have never been more evident than in his recent astonishing success in persuading Congress to enact the Volcker rule banning US banks from engaging in certain kinds of speculative activity, and most recently persuading US rule-makers to agree on enforcement procedures that have at least got the serious attention of the financial industry. This is a typical Volcker product. It is founded in a deeply-held, lifelong, moral conviction – in this case, that banks have a special role to play in society, which is why they have special privileges that should not be extended to non-bank financial institutions.
But convictions have no purchase on the world unless they are allied to the political, presentational and personal skills necessary to get the attention of policy-makers. They then have to be convinced, cajoled and corralled into action. Nobody else could have got the Volcker rule through Congress, outflanking the likes of Tim Geithner and Larry Summers, former Treasury secretaries, while fending off lobbying by the financial services sector with its billions of dollars and hundreds of lobbyists. Here too, Volcker’s views remain highly controversial, yet his example should again inspire central bankers who are now being tasked with wider roles in financial regulation and will need to withstand lobbying by interested parties and their hired academics.
Volcker hides an exceptionally quick mind and persuasive communication skills behind a smokescreen of hesitation and self-effacement. He would rather mutter indistinctly than say something he might regret. Try not to act in haste. Build consensus. Get key people on side. Then move decisively and stick to your policy. View public office as a precious trust. Such are the qualities that make his services in such high demand. He has taken the lead in numerous commissions and inquiries into highly delicate issues. In such cases, his unquestioned integrity has been the bedrock of his authority and hence of his ability to sort things out. He is now engaged in an effort to raise standards of public service through a body formed in 2013, the Volcker Alliance. Now aged 86, his fight for the integrity of the monetary system and of public governance continues.
Outstanding public servant
“Volcker established the standard for integrity, dedication and commitment of policy-makers,” says Gary Stern, former president of the Minneapolis Fed. While Volcker is a great public servant and champion of the art of central banking, he knows as well as anybody that success can never be taken for granted. Central bankers should never rest on their laurels. They have their place in society, but it is not divinely given. It has to be earned, and any success should be viewed as provisional. Central bankers also have much to learn from a study of Volcker’s record of achievement and his teaching. This includes his demonstration that inflation can be kept under control and that central banks can encourage fiscal discipline, which is essential for long-run price stability. They also always need to keep an eye on developments in financial markets and have the courage to stand up to lobbying by special interests.
The last words should be left to Volcker himself: "The basic responsibility of a central bank is to maintain reasonable price stability and, by extension, to concern itself with the stability of financial markets generally. In my judgment, those functions are complementary and should be doable."4
All this depends crucially, says Volcker, on credibility: "Credibility is an enormous asset. Once earned, it must not be frittered away by yielding to the notion that a ‘little inflation right now’ is a good thing to release animal spirits among entrepreneurs and to pep up investment. The implicit assumption behind that siren call must be that the inflation rate can be manipulated to reach economic objectives – up today, maybe a little more tomorrow and then pulled back on command. But all experience amply demonstrates that inflation, when deliberately started, is hard to control and reverse. Credibility is lost."
1. “Reflections on Monetary Policy 25 years after October 1979”, Federal Bank of St Louis 87, No 2, part 2, March/April 2005, quoted in Silber (2012).
2. “Volcker: The Triumph of Persistence”, by William L Silber, Bloomsbury Press, 2012.
3. Preface to “The Central Banks”, by Marjorie Deane and Robert Pringle, Penguin, 1995.
4. "The Fed & Big Banking at the Crossroads", The New York Review of Books, August 2013.