Paul Volcker, R.I.P.

Paul Volcker died today at age 92.  A colossus of a man both physically (at 6’7″) and professionally, it sometimes seemed to me his achievements at the Federal Reserve were eclipsed by ‘maestro’ Alan Greenspan who succeeded him in 1987.  A full recounting of his career is impossible, of course, and he did much after leaving the Fed, a job he never asked for but served when asked.

In his biography of Greenspan, The Man Who Knew, Sebastian Mallaby notes that Volcker was deeply influenced by a speech in Belgrade in September 1979, weeks after his appointment.  Arthur Burns gave the speech, a former Fed chair himself, who claimed that the independence of the Fed was over because monetary experts had too many questions to speak with one voice against political pressures.   Mallaby argues that the desire to wring inflation out of the U.S. system, characterized by the Saturday Night Special announcement that Fed policy was being fundamentally changed, was Volcker’s attempt to prove Burns wrong.  (As I was writing this, Mallaby has released a version of this point in his retrospective of Volcker today.) Thus began the long disinflation that was the achievement of Volcker’s career.

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Steve Hayward has provided an interesting excerpt from his biography of Reagan about Volcker’s reappointment in 1983.  It’s worth reminding people that conflicts at the FED, so prevalent in today’s debates about economic policy, happened then too.  The battle then, as now, turned partly on exchange rates which the Reagan administration wanted to manage through multilateral agreements including the Plaza Accord (July 1985, to manage a depreciation of the dollar versus the yen) and the Louvre Agreement (February 1987) in which then-Secretary of the Treasury James Baker had tried to push Japan and West Germany to stop the appreciation of their currencies.  He was unsuccessful.

The Board of Governors was by this time fully appointed by Reagan and had in early 1986 actually voted 4-3 to cut rates with Volcker in the minority.  Volcker was forced to go to Japan and Germany to get rate cuts there to coordinate, which weakened his position.  It is quite clear to me that this was probably the end of any chance that Volcker would stay for a third term.

As Allan Meltzer notes in his magisterial History of the Federal Reserve,

[Baker] may not have understood that a central bank that targets an exchange rate cannot control money stock growth or domestic interest rates, but Volcker did.  Volcker was reluctant to relinquish central bank independence that he had worked so diligently to restore. (p. 1191)

And it was important that this link be broken because a scant 19 months later, in October 1987, stock markets fell after interest rate increases had caused revaluation of asset prices.  Exchange rates finally relented (the deutschemark fell to 1.63 from 1.80 in the last quarter that year.)  As Meltzer recounts, this gave the FED the ability to do what it does best:  act as lender of last resort.

Markets did not function smoothly in the aftermath of the stock market decline.  There was a scramble for liquid assets.  The Federal Reserve satisfied the demand, helped markets to settle transactions, and prevented the devastating secondary effects of the 1929 stock market drop.  Economic growth resumed after a brief pause. (p. 1193)

That period was the beginning of the Greenspan Fed, but the keys had been handed to him by Volcker.  When in May 1988 candidate George H.W. Bush had declare that “there is more room for the economy to growth without unacceptable increases in inflation,” Greenspan was determined to not let Volcker’s work be undone.  They raised interest rates three months later, largely to the approval of the press and Wall Street.   It would be two more years before a mild recession largely caused by a supply shock from the Middle East, and through it all Greenspan protected the legacy of the Volcker disinflation.