Paul Volcker

Paul A. Volcker is widely recognized as the most powerful and effective central banker in U.S. history. As board chair of the Federal Reserve System (or the U.S. central bank, commonly called "the Fed") from August of 1979 to August of 1987, Volcker manipulated bank interest rates and the national money supply in an effort to end the double-digit inflation that plagued the nation during the late 1970s. The cost of Volcker's determined anti-inflation campaign was the deep economic recession of 1981 and 1982--the biggest such contraction since the Great Depression of the 1930s--which led to widespread business failures and high unemployment, making the Fed chair an unpopular figure among many Americans. But critics have indicated that Volcker's policies also contributed to the unprecedentedly long economic expansion with low inflation that followed, an apparently remarkable achievement in light of the growing trade and federal budget deficits, the unstable dollar, and volatile financial markets that defined this period. Considered a masterful economic psychologist as well as an adroit monetary technician, Volcker is credited with a remarkable talent for predicting the complex economic reactions to sudden shifts in monetary policy. His 1978 book The Rediscovery of the Business Cycle presents some of his observations on economic policy.

Volcker's early career prepared him to assume the nation's top monetary policy post. As undersecretary of the treasury for monetary affairs during the early 1970s, Volcker played a leading role in designing and executing the momentous shift from fixed to floating international exchange rates initiated by President Richard M. Nixon's administration. The erosion of international confidence in the dollar under the inflationary pressures of the Vietnam War forced the United States to withdraw the dollar as the world's stable benchmark currency. Volcker was given the difficult and delicate task of negotiating major devaluations of the dollar in 1971 and 1973 with the United States's principal economic partners in Europe and Japan. His success earned him international respect that would serve him well later in his career.

In 1975, after teaching for a year at Princeton University, Volcker was appointed president of the New York Federal Reserve Bank. The most important of the twelve regional branches of the Federal Reserve System, the New York Fed lends hundreds of millions of dollars every day to New York's big private banks to cover temporary shortages in their reserve requirements; it also operates the Open Market Desk, where the central bank buys and sells U.S. Treasury securities on the open market. The New York Fed chief sits with four of the other regional bank presidents and the central bank's board of governors on the Federal Open Market Committee, which sets the nation's broad monetary policy.

The Federal Reserve System was created by Congress in 1913 to protect banks from failure by requiring them to keep a portion of their deposits in reserve to cover any temporary cash shortages. In addition, the central bank was intended to stabilize and unify the nation's monetary system, a system which, at that time, was a virtual hodgepodge of metal coinage issued by the U.S. Mint and paper bank notes backed by private regional banks. These bank notes would become worthless if the issuing bank failed. The Federal Reserve System was organized as a privately owned but publicly controlled central monetary authority that would provide member banks with a common bank note, lend them funds to ensure that their reserves met their demand deposits, and oversee a rate of monetary expansion intended to keep the currency stable.

In 1935 President Franklin Delano Roosevelt restructured the Fed to give it broad regulatory authority over the nation's banks. Historically, the Fed has used two principal methods to regulate the nation's money supply. One of these is to manipulate short-term interest rates by raising and lowering the discount rate at which it lends money to its member banks and by adjusting the quantity of money that it lends to them. A higher discount rate or a tight Fed lending policy is reflected in higher bank lending rates, which discourage general borrowing and consequently tend to reduce the amount of money in circulation. Lower bank interest rates act in contrary fashion. The Federal Reserve System also controls the money supply directly by buying and selling U.S. Government securities. To create money, the Fed buys treasury bonds and other securities from banks and bond dealers and pays for them with a credit convertible into cash. To take money out of circulation, the central bank sells its bond holdings for cash and holds this cash in its reserves; any major withdrawal of money from the private economy generally raises bank interest rates, or the price of money, as supply falls to demand.

In the late 1970s, as inflation jumped into double digits under the shock of huge price hikes by the Organization of Petroleum Exporting Countries (OPEC) oil cartel, the Fed sought unsuccessfully to bring prices under control by raising the discount rate. As explained by Nicholas von Hoffman in the New York Times, this strategy was premised on the monetarist assumption that a main cause of inflation was "too much money chasing too few goods" and that prices could be brought down if the money supply were tightened. But under chair G. William Miller, the Fed was reluctant to keep the discount rate high for any sustained period of time for fear that doing so would trigger an economic recession. The result was that inflation continued to climb while gold prices soared and the value of the dollar declined in international exchange markets.

On August 6, 1979, President Jimmy Carter called in Volcker, who still headed the New York Fed, to take over as Federal Reserve Board chair. Volcker's appointment was apparently fraught with political risks, as the new chair favored a tight money policy that might cause a downturn in the economy and damage the president's reelection prospects. According to critics, few economic experts in Washington anticipated the extent to which Volcker would stand behind his professed policies. In October, the new central banker virtually forced the Fed's board of governors to take an unprecedented step: abandon short-term interest rate manipulation as a major inflation fighting weapon in favor of clamping down directly on the money supply by selling treasury bonds. The new policy would allow the market to set commercial bank lending rates and the Fed would no longer intervene to stabilize rates for the sake of economic growth. Several critics noted Volcker's later acknowledgment that he adopted this dramatic new initiative less out of any doctrinal monetarist conviction than a pragmatic objective of braking inflationary expectations in the public psychology.

Volcker's monetary clampdown had a powerful effect, shooting the short-term prime rate (the rate at which commercial banks lend money to customers worthy of credit) up to 21.5 percent by December of 1980; it remained in that range for months, sharply depressing the economy. Long-time interest rates also rose to their highest levels in this century. Farmers found themselves unable to borrow against their crops, and tight credit contributed to thousands of business failures in 1981 and 1982, throwing five million more Americans out of work and raising the national unemployment rate to a postdepression high of almost 10 percent. Popular resentment against Volcker and the Fed grew proportionately: car dealers and building contractors, for example, reportedly mailed the central banker thousands of car keys and two-by-four planks to symbolize unsold cars and unbuilt homes. The public furor eventually prompted the federal government to give Volcker Secret Service protection.

Despite the unanticipated depth of the 1981 to 1982 recession, Volcker held his tight money course, convinced that the ultimate benefits of reducing inflation justified even a period of mass unemployment. Observers noted that the publicly cool and unflappable central banker skillfully defended his policy before Congress and the Reagan administration while acknowledging its unpopularity. The Fed's job was to "take away the punch bowl when the party was just getting good," he remarked to a Newsweek reporter, quoting his predecessor William McChesney Martin, Jr. But Volcker's no-nonsense demeanor and frugal lifestyle helped mitigate public resentment toward him to some degree. The Federal Reserve System chair's rumpled, shiny suits and twenty-cent cigars became part of Washington lore and contributed to his relatively high visibility in a traditionally low- profile post. Critics point out that among his government colleagues, Volcker earned a reputation as a formidable bureaucratic infighter and talented consensus builder who never used his towering six-foot seven-inch frame and booming bass voice to bully or intimidate his opponents.

After a year of sharp economic contraction, Volcker loosened the money supply in mid-1982. While the annual rate of inflation in the United States had been driven down to about four percent, the Fed's tight money policy had also helped to plunge western European economies into recession and trigger the Third World debt crisis. When high interest rates forced Mexico to default on its foreign debt payments in August of 1982, Volcker contributed to a crucial package of new public and private credits designed to bail out the country. In the United States the flood of new money quickly brought interest rates down and, by the end of the year, put the economy back on the road to growth. In light of falling oil prices, Volcker voiced a belief that inflation could be kept under control by increasing labor productivity and allowing wages to rise faster than prices.

Volcker's success as an inflation fighter and his popularity on Wall Street encouraged President Reagan to appoint him to a second term as chair of the Federal Reserve System in August of 1983. As the economy grew in the mid-1980s, Volcker confronted a number of new challenges to the country's monetary and financial stability. Low inflation and interest rates and the Reagan administration's permissive regulatory philosophy encouraged a speculative corporate takeover boom in the financial markets that complicated monetary calculations. The budget deficit created by both the Reagan administration's tax cuts and huge increase in military spending obliged the treasury to raise interest rates on U.S. bonds in an effort to attract additional--principally foreign--investors. These new investors drove up demand for the dollar, strengthening its value in relation to other currencies and raising the cost of U.S. exports, thereby worsening the American trade deficit. U.S. economic policymakers were then faced with a dilemma: taking measures to weaken the dollar and reduce the trade gap might drive foreign investors out of U.S. debt financing, since the value of their investment would fall in terms of their own currencies. To keep these investors, interest rates would then have to be raised further, threatening economic growth. On the other hand, doing nothing about the trade deficit undermined domestic production and reduced tax revenues, thus adding to the budget deficit.

Volcker's support of immediate budget deficit reduction caused some conflict with President Reagan's economic advisers, who argued that future economic growth primed by tax cuts would furnish the revenues to finance the accumulated deficit. As noted by Eric Gelman in Newsweek and in an article for The Economist, Volcker also clashed with Reagan administration policymakers--principally treasury secretary Donald T. Regan--over the Fed's monetary policy in 1984 and 1985. During this time the central bank tightened the money supply and dampened economic growth to throttle alleged inflationary pressures. Finally, the issue of bank deregulation became a major source of contention between Volcker and Reagan officials during the Fed chief's final years in office. Volcker consistently opposed a Reagan-backed campaign that would allow commercial banks to branch out into other financial services, such as underwriting insurance and trading stocks. In another bank regulatory matter, described by John M. Berry in the Washington Post, the Fed chair helped engineer a commercial bank bailout of the insolvent Continental Illinois National Bank and Trust Company in 1984, believing that to allow the bank to fail--as some free-market economists counseled--would endanger the nation's financial system.

Volcker's cautious approach to economic growth and bank deregulation contributed to President Reagan's decision in 1987 not to reappoint him for a third term as central banker. As documented by Los Angeles Times staff writers Tom Furlong and Jesus Sanchez, the financial community lamented Volcker's departure but applauded his replacement, Alan Greenspan, an economist who also held tough inflation fighting views. Since leaving public office, Volcker has continued to speak out forcefully on the need to take a more aggressive approach to the problems of the Third World debt and the U.S. budget deficit.