...against fictions and other tall tales

Sunday, 24 July 2011

The Volcker Years

Good exchanges on interesting topics deserve their rightful place in the world of economic blogging. Hence, I'm creating a direct link to the recent discussion on Paul Volcker and economic policy in the 80s that followed my last post (h/t: Goffredo, for the suggestion). No offense to Miles...

In regard to the specific discussion on whether monetary or fiscal policy was responsible for lowering the unemployment rate and solidifying the recovery in the mid-80s, I've decided to copy the following excerpt from an article by economist James Tobin:
...it was the Fed’s reversal of policy in late summer 1982 that turned the economy around. No doubt the Reagan fiscal stimuli, as they were phased in, gave a big push to aggregate demand. But the Fed nevertheless managed the recovery in 1983–1984, braking it when it seemed too fast, and relaxing the brakes when GNP growth faltered...
...Could we have had the same recovery, the same path of GNP and employment, under the much more moderate fiscal regimes of the pre-Reagan years? I think the answer is clearly “yes”; the Federal Reserve had plenty of room to lower interest rates further and faster. Would it have done so? That is more debatable. Although the Fed’s change of heart in 1982 signaled its willingness to adjust its policy to macroeconomic performance rather than to money supply targets, it is possible that residual monetarist concerns would have prevented the Fed from fully replacing fiscal stimulus absent or withdrawn.("How to think about the deficit", New York Review of Books, September 25, 1986) (my emphasis)
Although Tobin here first seems to give full credit to the Fed for the recovery, he later questions whether monetary policy alone was responsible. Most likely, Tobin concludes, it was the combination of monetary and fiscal policy that reinvigorated the economy in the 80s. A well-nuanced argument indeed.

Also, I thought it was relevant to link the following article by blogger Lord Keynes. It contains an interesting analysis on Volcker's first term at the Fed. I strongly recommend this article, as it captures my own position on the matter and highlights some key points made by (some of my favorite economists) Alfred Eichner and James Galbraith. Here's an excerpt:
What actually happened under Volcker is that his “floating” interest rate policy caused the federal funds rate to soar to 19% by June 1981, inducing two severe recessions, the first from January to July 1980, and the second from July 1981 to November 1982. This caused mass unemployment, crippled American manufacturing enterprises in the Midwest, and a Third World debt crisis (Galbraith 2009: 38), as the American recessions and high interest rates essentially caused a global recession (Eichner 1988: 548). The high interest rates in the US also lead to a damaging appreciation of the US dollar late in 1980, which hit US exporters hard (Eichner 1988: 549).

The recessions, the US demand contraction and steep fall in the price of oil (which can be seen in this graph) were the real reason US inflation fell from a peak of 14.8% in March 1980 to 4.6% in November 1982, and not because money supply growth rates were brought under control in the way imagined by monetarism or the quasi-monetarist targeting Volcker pursued.
Lord Keynes's point regarding the fall in the price of oil is in line with Warren Mosler's take on the Fed's actions in the early 80s. According to Mosler,
Volcker did not crush inflation. If anything, his rates added to business costs and unearned income long after inflation turned down. The positive supply shocks in the energy markets is what broke the back of inflation, led by the deregulation of natural gas in 1978 that did the lion's share of cutting the demand for crude for electricity generation.
Finally, I'm also including a link to Martin Feldstein's brilliant American Economic Policy in the 80s, published in 1995. The book contains excellent articles on that period, including an article and commentary by Michael Mussa, Paul Volcker and James Tobin on monetary policy in the 80s. Also, I'm linking an article by John Kenneth Galbraith on his preferred approach for dealing with inflation, one that does not rely on high interest rates.

Feldstein, Martin, American Economic Policy in the 80s(Chicago: NBER, University of Chicago Press, 1994.

Galbraith, J.K., Up from monetarism and other wishful thinking, New York Review of Books, August 13, 1981.


  1. Volcker tops the Holiday Reading list.
    Volcker for Secretary of the Treasury. Anytime. Under-Secretary of the Treasury? No one can follow Volcker there. That's where Volcker pitched camp before the war of 1979-87.

  2. Circuit, remember the anecdote: Rep. Frank Annunzio of Illinois, sputtered at the cigar-smoking Volcker during a hearing: "Your course of action is wrong. It must be wrong. There isn't anyone who says you are right." Tobon, Bob Samuelson, Mosler, Feldstein! are excellent.

    But my take on Volcker is look at the data and not on probable policy options and mechanisms that never got tested. It's easy to do physics when you have a telescope to check data someone else construed. There's a dictum that is usually and i think erroneously attributed to Newton (Standing on the shoulders of giants) but dates back to four centuries earlier-fella called John of salisbury (aka John the Little). Any guesses on the origins of the content of that dictum. Here's the original, could date back even further: "We are like dwarfs sitting on the shoulders of giants. We see more, and things that are more distant, than they did, not because our sight is superior or because we are taller than they, but because they raise us up, and by their great stature add to ours." Berkeley ref are unintended.

    Here are my analytical preferences:
    Coibion & Gorodnichenko:

    A very good but tricky paper: Blandshard & Simon: The Brookings Paper (2001)

    On Fed efficiency and effectiveness-Romer & Romer (2000) followed by Carlos Capistran (2006)

    Volcker is only one degree of separation from Obama-that's good. He set the rule for an anti-inflation policy that does not preclude economic expansions over the long term. Alan should thank Volcker for the footnotes.

  3. Thanks Jorge. I'll have to remember those quotes. As for this: "But my take on Volcker is look at the data and not on probable policy options and mechanisms that never got tested."

    When I look at the data, I see that the economy went through a major setback as a result of the Fed's near-20% interest rates hikes: GDP fell by 3%, industry operated at 60% of capacity, unemployment shot up to over 10%, etc (see the Mussa paper). To me, it seems likely that you'd get an extended period of recovery after such dire conditions. There was plenty of room for improvement. That the Fed accommodated for fiscal policy during the mid-80s, I'm fine with. But regarding the monetarist period, I'll stick with my initial assessment. As for my reference to Ken Galbraith, my aim wasn't simply to provide an example of an alternative set of policies that could have been used during that period, but to include the views of someone who had had experience in dealing with inflation as a wage and price administrator in the early 40s, at a time when high inflation was rampant. I should have mentioned that.

  4. I did not include Galbraith (either K or J)nor Eichner.

    I strayed with Bob Samuelson. Forensics sells.

    Pro Volcker, I could have cited Paul Samuelson (relation only to Summers)instead I prefer to refer to Tobin's reference, reviewing Mussa, to Volcker's unapologetic comments on Volcker:

    If a “credible threat” was intended in the October 1979 revolution, it was
    attenuated by the policy roller coaster in 1980, severely criticized by Mike
    Mussa in his background paper and unapologetically reviewed by Paul in his

    In all cases, a lot of masterful insights.

  5. Queue link is well-formatted, circuit. Thanks.

    I'm with Circuit on Volcker, Jorge. Mensch can also overdo it. Tad too salty on inflation. But I enjoyed you repeating Tobin's quote from his review of Mussa. Mussa paper was an X-read. Forgot that compilation. Again thanks Circuit

  6. Appreciate the nod G. Would have liked to see JKG quotes. You must have some G., esp from 1994's 'Journey...' Chaps 24 & 25. G? Best policy advice in contemporary thought.

  7. Since I own most of his works, I had to go back to JKG's 'Journey'. Lots of relevant policy advice, indeed. Skimming through the pages, I noticed the chapter where I scribbled the most is the one where Galbraith recollects memories of Johnson's Great Society initiative and poverty programs of the 60s (ch. 19). I've always been fascinated by that era in social policy-making.

  8. Yes, that was well-done. JKG wasn't always around. Busy fellow, but Pres. Johnson would put in 25hrs days. During the presidential campaign of 68, while others were roaming the country-Johnson stayed in Washington, serving the country, in his own way. Pres Obama should be calling Congress back. That would win it for him. But that takes a lot out of a man.
    Memory serves when kindled, he was probably, along with Nixon, one of the greatest of US presidents, but the war overshadowed both their legacies. Pres. Johnson's domestic policies were some of the most inspired and passionate reckonings by a president. Maybe Nixon. Johnson had good people in Treasury-Barr, Dillon, Fowler, leaned on McNamara a lot for creative thought, but no one (I mean no one) knew how to get around Congress better than LBJ. Pres Obama should be taking his holidays at the Johnson library in Austin, and read the notes. He was the greatest tactician. He could eye down anyone, but wars destroy the best in good men. At the end, he was too tired. What a legacy: CivilRA,VotingRA, Immigration, Rev. Act, he appointed Marshall to the Supreme Court! he fought the KKK. The man was a visionary. And then the Great Society. Sure he picked up Great Frontier ideas, but Medicaire and M-aid, education, anti-poverty are his contributions-but the war split the party. Nixon followed through on a lot of Johnson's legacy. Nixon was further left than many democratic presidents were. Maybe those were the times.

  9. You sure know how to make an argument. When you list all those programs like that, it reminds me of how little things have progressed in the last 30 years. Also, LBJ was tough - getting through today's Congress probably would have been a walk in the park. Obama and staff definitely should take a lesson. I'd tend to agree with you on Nixon, as well.

  10. Jorge. I agree with circuit. Yours is an amazing recollection. I was young then and didn't appreciate the courage and determination LBJ (I had forgotten the initials)showed, and paradigms Johnson was forging. You and circuit are right on Obama and staff. But I think Obama has the stuff, he just needs the push.

  11. LBJ tough. He'd make pitbulls yelp. The line that gives it away was something like this ' when i get things done i don't always please everyone' Obama, listen to the mensch.
    Good book on LBJ by Woods.
    Jorge, you're right on Nixon. Underrated ouf!

  12. Mmm . . . Nixon, all criminality aside, was nonetheless mixed. He laid the foundations of the modern quagmires in both health care and incarceration.

  13. Welcome Purple and thanks for your comment. Nixon's economic and regulatory agenda was quite remarkable for someone who was favored by conservatives. For one, he was obviously quite concerned about unemployment, which in my book is key. But also, he accomplished quite a bit on the regulatory side. Although I suspect it may have been in the works prior to the start of his Administration, the EPA was established under Nixon. I can't think of another Administration (Dem or GOP) since that time that has done more in this area. I'd be interested in hearing more about the health care and law-enforcement issues that you are referring to, as I'm not familiar with these concerns.

  14. PLG:Criminality, ouff, I’m not much on criminal jurisprudence-evidence, procedure and FRE607 etc.
    Mmmm on health care. Not my forte either, but I recall Ted Kennedy (probably best US legislator on the issue) a couple of years after Nixon’s plan regretting not having endorsed Nixon earlier. For the US, big move then. Alienated many in the GOP.
    But the man's legislation is there, not creeping through sovereign legislatures. Hey, my take.

  15. I thought this excerpt by Randall Wray might be relevant to this discussion. It provides his take on the Fed's experiment with monetarism (from Monetary Policy: An Institutionalist Approach, Levy Institute working paper 21)

    "The notion that a central bank can influence reserve and monetary aggregates had been around for quite some time, as indicated above, however, the Fed did not adopt formal monetary targets until 1970, with the express purpose of bringing down inflation by reducing money growth. Still, during most of the 1970s, the Fed explicitly adopted the fed funds rate as the operating target used to hit intermediate (monetary aggregates) targets. If the rate of growth of the money supply were above the Fed’s target, it would raise the fed funds rate target. Unfortunately, the 1970s saw “stagflation” so the Fed was continually in inflation-fighting mode. In October 1979, the new Chairman, Paul Volcker, announced a major change of policy: the Fed would henceforth use the growth rate of M1 as its intermediate target, with reserves as the operating target, while it would allow the fed funds rate to rise as high as necessary to allow achievement of this goal. (Fazzari and Minsky 1984) The Fed would calculate the total reserves consistent with its money target, then subtract existing borrowed reserves to obtain a non-borrowed reserve operating target. However, in practice, when the Fed did not provide sufficient reserves in open market operations (as it hit its non-borrowed reserve target), banks would simply turn to the discount window, causing borrowed reserves to rise (and, in turn, causing the Fed to miss its total reserve target). Because required reserves are always calculated with a lag (see Moore 1984 and Wray 1998), the Fed could not refuse to provide required reserves at the discount window, thus, it found it could not control total reserves. Further, the rate of growth of M1 exploded beyond targets in spite of consistently high interest rates that resulted from the Fed’s tight policy (the fed funds rate reached above 19% during April 1980 and hit 20% in January 1981). So the Fed found it could hit neither its reserve nor its M1 targets. The attempt to target nonborrowed reserves ended in 1982 while the attempt to hit M1 targets was abandoned in 1986. (Meulendyke 1989; Fazzari and Minsky 1984) Still, the Fed continued to announce and tried without success to hit M2 targets during the rest of the 1980s."

  16. For the record, here's an interesting discussion on Paul Volcker's time at the Fed. Courtesy of Marvin Goodfriend circa 2007. Lots of details regarding inner workings/ops during the Volcker years. See pp. 51-55. http://extras.twincities.com/pdfs/goodfriend%20in%20JEP.pdf