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possible that residual monetarist concerns would have prevented the Fed from fully replacing fiscal stimulus absent or withdrawn.("How to think about the deficit", New York Review of Books, September 25, 1986) (my emphasis)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.

The US should use its oil reserves to stabilize oil prices

How is the world's largest economy and oil consumer to cope with the current oil supply disruptions resulting from the turmoil in the Middle East? This question is especially important to consider given the significant amount of uncertainty surrounding OPEC's current spare oil production capacity. As a result, reporters and commentators are asking whether the US should tap into its oil reserves to supplement the global supply of crude oil and mitigate the risks associated with unknown oil prices and supplies moving forward.

Would it be a good idea for the US government to use some of its strategic oil reserves? Given the uncertainty regarding the additional spare capacity and the substantial risks associated with higher oil prices moving forward, it would indeed be wise for the US to sell in the market some of the oil it has accumulated in its strategic petroleum reserve (SPR). Not doing so could jeopardize the recently revitalized recovery. More precisely, tapping into the SPR would reduce the risk that the global economy derails into another recession, and it would ensure that the price of oil and its derivatives remain stable until the events in the Middle East subside.

In his book The Keynes Solution (New York: Palgrave, 2009), post-keynesian economist Paul Davidson explains the benefits of using such a policy when the risk of commodity inflation looms. According to Davidson,

...commodity price inflation occurs whenever there is a sudden and unforeseen change in demand or available supply for delivery in the near future [and] can be avoided easily by an institution that is not motivated by self-interest but instead wants to protect society from inflationary pressures. Preventing commodity price inflation requires the government to maintain an inventory of the commodity as a buffer stock to prevent changes in demand and/or supply from inducing significant price movements. A buffer stock is nothing more than some commodity shelf inventory that can be moved into and out of the market to buffer the market from disorderly price disruptions by offsetting previously unforeseen changes in demand or supply as they occur. (p. 69)

Currently, the SPR has a capacity of over 725 million barrels of oil that can be drawn down at a rate of 4.4 million barrels a day. These amounts are more than sufficient to cover the shortage of approximately 1.5 million barrels a day caused by the disruptions in Libyan oil supplies. In fact, it would not even be necessary for the US to replace all of the oil affected by the shortage, as half of that amount would probably be sufficient to return the price of oil to a more reasonable level that is consistent with current growth trends.

Of course, such a strategy would only be temporary since there is no reason to believe that the supply disruptions will be permanent. In 1990 and 1991, during Desert Storm, the US sold some of its reserves to stabilize prices for short periods with great success. The result was that the price of crude oil remained quite stable during that period. A similar strategy should be followed today. The uncertainty surrounding OPEC's oil production capacity represents at this time simply too great a risk to the US and other world economies, including China, a country that stands to be severely affected by any future slowdown in the US and Europe.

From a legal standpoint, the US is fully authorized to use the SPR at this time. In accordance with the Energy Policy and Conservation Act, the SPR can be drawn down if the increase in the price of oil is "likely to cause a major adverse impact on the economy".

On a final note, it is worth mentioning that this policy would actually be profitable to the US government given that the oil would be sold at the ongoing market price. According to the US Department of Energy, the average price paid for the oil in the reserves was $29.76 per gallon.

Saudi vs. Libyan Oil Production

So how do Libya and Saudi Arabia compare in terms of oil production? Based on recent media headlines, it sounds as though Saudi oil production wouldn't suffice if it became necessary for the Saudis to step in to make up for any possible reduction in the oil supply caused by the geopolitical problems in Libya. But looking at the data, we notice the two countries don't really compare.

According to the US Energy Information Administration, Libya currently only supplies about 1.7 million barrels a day whereas the Saudis supply over 8.5 million barrels daily (see charts 1 and 2). Also, in regard to production capacity, we see the Saudis could supply up to 12 million barrels a day (chart 3). With such a large unused capacity, the Saudis could very well fill the gap potentially created by a shortage in Libya. Thus, it seems unlikely that the world's oil supply will be highly and permanently affected by the current events in the Middle East.

Chart 1

Chart 2

Chart 3