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Who was this central banker?
Believe it or not, the central banker in question is the allegedly great former Fed Chairman Paul Volcker. Can someone remind me again why he is considered a great Fed Chairman? Can someone clue me in as to why this is the man the Obama administration turns to for economic credibility?
The Volcker myth is that he was the slayer of inflation in the early 1980s and that set the stage for the economic recovery of the 1980s. Democrats especially want to believe this narrative because more than anything they don’t want to give any credit to Ronald Reagan, but to believe that, one has to believe that someone who obviously had no clue how to run monetary policy in his first three years suddenly figured it out in the following five. I don’t think so.
Volcker was sworn in by Jimmy Carter in August of 1979 as Chairman of the Federal Reserve and almost immediately shifted the Fed to targeting the monetary aggregates rather than the fed funds rate. This disastrous experiment with monetarism is what drove gold to $850 by February 1980. Monetarism as practiced by Volcker was concerned exclusively with maintaining a constant growth rate of the supply of dollars but ignored the demand side of the equation. The rise in the price of gold in the first six months of Volcker’s term shows why demand has to be considered. The demand for dollars collapsed under monetarism because while the monetary aggregates were fairly stable and predictable, other economic variables such as interest rates were suddenly much more volatile. With Volcker determined to keep the supply of dollars steadily expanding, the value collapsed.
So what happened in 1980 to change the equation? Did Volcker suddenly recognize that the demand for dollars had changed and change policy in response? Why did gold peak and then start a steady decline that caused it to fall to $400 by the middle of 1981? Unfortunately for those who want to promote Volcker’s monetary sainthood, the drop in gold prices can only be partially attributed to Volcker. The dollar rallied and gold prices fell because there was a change in the demand for dollars which Volcker promptly ignored. Why did the demand for dollars change? Quite simply, Ronald Reagan. The price of gold fell during the whole of 1980 as it became more apparent that Reagan, running on a tax cut platform, would win the election. Tax cuts increase the demand for dollars as liquidity is needed to accomodate the increased economic activity. Economic growth is inherently deflationary so to prevent deflation, growth policies require an increase in money supply. Volcker obviously didn’t understand this and didn’t accomodate the demand for liquidity.
The result of Volcker’s ignorance of the demand for money was one of the worst recessions in our history, the notorious double dip of 1981-82. The first half of the recession can be laid directly at Volcker’s doorstep since he maintained a deflationary monetary policy in the face of Reagan’s initial tax cuts. The second half can be blamed on him too since he lobbied for and convinced Congress to pass tax increases in 1982. Volcker didn’t stop the deflation until he was forced to by the Mexican debt crisis that hit in August of 1982. By the way, Jude Wanniski, Art Laffer and Robert Mundell all tried to convince Volcker to ease policy prior to that but to no effect. Volcker only finally eased to protect the banking system which his deflationary policies had put in danger.
Paul Volcker is given credit for slaying the inflation monster but that is true only if you prefer deflation. It was Reagan’s supply side policies that ended the inflation of the late 70s by increasing the demand for money and the supply of goods in the economy. Volcker was merely lucky that he occupied the office of the Chairman of the Federal Reserve at the time. Even then he managed to create one of the worst recessions of the 20th century by refusing to accomodate the liquidity demands associated with the Reagan tax cuts. The Mexican debt crisis finally forced Volcker to abandon his flirtation with monetarism, but for the balance of his term dollar volatility continued to wreak havoc on the US economy. He never did get policy right; if he had, the Reagan boom would have been even better than it was.
I bring all this up because it has become commonly accepted today that Paul Volcker is some kind of elder economic statesman who deserves our reverence. He was trotted out by the Obama team during the campaign to give his candidacy a stamp of approval from someone allegedly knowledgeable about economic affairs. Considering the actual history of his performance on the main stage of the US economy, it’s a good thing he wasn’t given a more prominent position once the administration was in office. Unfortunately, now that the Obama team has taken some hits for its economic policy, Volcker is being wheeled out again. He should be retired permanently instead; he’s done enough damage.
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