LONDON (Reuters Breakingviews) - Last week’s obituaries for Paul Volcker were effusive, lavishly praising the former chairman of the U.S. Federal Reserve for breaking inflation in the early 1980s and for criticising the behaviour of banks after the 2009 recession. The enthusiasm may be excessive.
Start with inflation. When Volcker took up the top monetary policy post in August 1979, the annual rate of consumer price inflation had risen from 6.6% to 11.8% in the two preceding years. The highest monthly rate was 14.6%, reported for April 1980.
By then, Volcker was boldly pushing up policy interest rates high enough to drag the economy into recession, the only way to break the curse of inflationary expectations. Or so the story goes.
There can be no doubt about the correlation. The federal funds rate moved from 10.9% in August 1979 to 17.6% the following April, and up to 19.1% in January 1981, with three months in single digits in between. The annual inflation rate fell quickly from its April peak, hovering around 10% for most of 1981. The subsequent decline was precipitate, down to below 3% by mid-1983.
Correlation, though, does not demonstrate causality. There are two good reasons to wonder just how much credit Volcker’s toughness deserves.
First, the American performance does not stand out. Inflation fell almost everywhere in the early 1980s. Between 1980 and 1983, International Monetary Fund data shows the annual rate dropped from 7.8% to 1.9% in Japan, 16.8% to 5.2% in the UK, and 5.4% to 3.3% in traditionally inflation-shy Germany. Even in Italy, where union agreements were particularly inflation-friendly, the rate fell from 21.8% to 14.7%.
Central bank policies may deserve some credit for the turn, but cross-border monetary coordination was much less prevalent then than now. The price of oil, which was the same around the world, is a more obvious candidate for the multinational downward trend in inflation.
In the decade before Volcker took the helm at the Fed, the annual average price of a barrel of crude had risen from $3.35 to $26.50 in nominal terms. Then it got worse, thanks largely to the tensions leading up to the Iran-Iraq war. The price spurted up to a monthly average $39.50 in April 1980, according to the Macrotrends data website.
But the oil price tide then turned, with crude down 15% in nominal terms over the next two years – or 27%, taking the still-high U.S. inflation rate into account. Cheaper energy may have a greater economic and psychological effect on inflationary momentum than higher borrowing costs.
The second reason to take anti-inflation credit away from Volcker is that central banks have been unable to control the inflation rate ever since the financial crisis, despite policies which have been at least as stimulating as Volcker’s were contractionary. That long failure suggests that the best available understanding of the dynamics of inflation is not very good.
Inflation is generated, or not, by interactions among economic shocks, consumer and employer psychology, demographics, fiscal policy and, yes, monetary policy. Volcker’s contribution to the disinflationary turn is less clear than the effect of his ultra-high rates on the economy. A recession in 1980, widely blamed on Volcker’s anti-inflationary rate squeeze, left the U.S. economy the same size in 1982 as in 1980.
While Volcker may have pushed unnecessarily hard against inflation, his battle against excesses in the financial sector looks half-hearted. The eponymous Volcker Rule, which limited proprietary trading by banks, came very late in the day after the 2008-9 financial crisis.
When he had more power to change practices, Volcker seemed much less concerned with financial malpractice. In 1984, the Fed boss presided over what was then the largest U.S. bank rescue ever, of Continental Illinois. Volcker’s insistence that no depositors or bondholders should lose any money helped popularise the phrase “too big to fail”. Arguably, this ultimate government umbrella helped encourage banks in the enthusiastic risk-taking which led eventually to the 2008-9 financial crisis.
Volcker left the government service in 1987, long before the worst pre-crisis excesses started. Still, in 1993, he presided over a blue-ribbon panel on banks’ use of derivatives. In the introduction to the final report he declared that “systemic risks are not appreciably aggravated” by these new instruments. That proved to be a far too optimistic judgement of the core instrument of contemporary financial speculation.
Volcker was already something of a celebrity when he gave this all-clear. Such fame, which has endured past his death on Dec. 8, was unprecedented for a modern central banker. The man himself was, by all accounts, a dedicated and conscientious regulator, and his later work was sincere. The most he can be blamed for is excessive dedication to the conventional wisdom of his time.
Still, rather than looking for another Volcker, politicians and economists would do well to search for greater wisdom. Volcker’s herograms would have been merited if it was clearly his courageous actions which broke the back of inflation, or if his prophetic voice had rated against the risks of financial excess. The evidence suggests a more cautious judgement.
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