Twain v. Volcker

Paul Volcker is a big man, 6 feet 7 inches tall.  He is also a great man — truly great.  Appointed chairman of the Federal Reserve Board in 1979 after his predecessor, the unfortunate G. William Miller, obviously out of his depth, had to be replaced to avoid a collapse of confidence in the dollar.  A consensus quickly formed that only one man, Paul Volcker, then President of the New York Federal Reserve Bank, could restore the confidence of the nation and the rest of the world in the US monetary system.  Facing double-digit inflation, Volcker immediately took the steps needed to bring inflation down, raising interest rates and slowing monetary expansion, precipitating a recession in the process, a recession intensified by rapidly rising oil prices in the wake of the Iranian Revolution that brought the Ayatollah Khomeini to power.  However, the year was 1980, and Jimmy Carter, desperately seeking reelection, demanded a relaxation of monetary policy, forcing Volcker to subordinate monetary policy to Carter’s political requirements.  After Carter lost the election anyway, Ronald Reagan, who had pledged to bring inflation under control, gave Volcker a blank check to do whatever was necessary to reduce — but not eliminate — inflation.  And so he did, but it wasn’t pretty.  Interest rates skyrocketed to the highest levels in US history, unemployment rising above 10 percent for the first time since the Great Depression.  But Volcker, notwithstanding almost universal condemnation, held fast, and in the end gained vindication for his courageous anti-inflation stance.  In the annals of central banking, there are few, if any, figures that loom any larger than Paul Volcker.

So when Paul Volcker writes a column in the New York Times, warning against any increase in the Fed’s inflation target as a means of hastening our painfully slow recovery (if we can even call it that) from the Little Depression of 2008-09, his opinion cannot be dismissed lightly.

There is great and understandable disappointment about high unemployment and the absence of a robust economy, and even concern about the possibility of a renewed downturn. There is also a sense of desperation that both monetary and fiscal policy have almost exhausted their potential, given the size of the fiscal deficits and the already extremely low level of interest rates.

So now we are beginning to hear murmurings about the possible invigorating effects of “just a little inflation.” Perhaps 4 or 5 percent a year would be just the thing to deal with the overhang of debt and encourage the “animal spirits” of business, or so the argument goes.

It’s not yet a full-throated chorus. But remarkably, at least one member of the Fed’s policy making committee recently departed from the price-stability script.

The siren song is both alluring and predictable. Economic circumstances and the limitations on orthodox policies are indeed frustrating. After all, if 1 or 2 percent inflation is O.K. and has not raised inflationary expectations — as the Fed and most central banks believe — why not 3 or 4 or even more? Let’s try to get business to jump the gun and invest now in the expectation of higher prices later, and raise housing prices (presumably commodities and gold, too) and maybe wages will follow. If the dollar is weakened, that’s a good thing; it might even help close the trade deficit. And of course, as soon as the economy expands sufficiently, we will promptly return to price stability.

Well, good luck.

Some mathematical models spawned in academic seminars might support this scenario. But all of our economic history says it won’t work that way. I thought we learned that lesson in the 1970s. That’s when the word stagflation was invented to describe a truly ugly combination of rising inflation and stunted growth.

Well, I am not ashamed to admit to being somewhat overawed and intimidated by Paul Volcker.  So I am going to call on Mark Twain to respond to Mr. Volcker on my behalf.  “We should be careful,” Mr. Twain observes, “to get out of an experience all the wisdom that is in it — not like the cat that sits on a hot stove lid. She will never sit down on a hot lid again — and that is well; but also she will never sit down on a cold one anymore.“

What Mark Twain meant was that history alone can’t teach us anything.  To learn anything from history, we need a theory to explain why history worked out as it did.  The cat doesn’t have a theory, so she learns the wrong lesson:  don’t sit down on a stove lid.  But, with the benefit of a theory, we know that the lesson that the cat ought to have learned was:  don’t sit down on a hot stove lid.

Paul Volcker is a practical man.  That was one of his great strengths as a central banker, but it can also be a weakness when his practical instinct leads him to take an overly simplified – dare I say, simplistic – view of a complicated economic disorder.  Mr. Volcker knows from experience how terribly difficult it is to eradicate, or even reduce, inflationary expectations after they have become embedded in the psychological fabric of an economy.  Lacking a theory of how inflation might be an essential element of a recovery from a recession in which profit and demand expectations have become deeply pessimistic, Mr. Volcker assumes that every inflation is of exactly the same type as the one with which he had to contend in the early 1980s.  Like the cat, he thinks that every lid is hot.

Well, that wasn’t quite fair.  Mr. Volcker is not like the cat.  He acknowledges that there may be “mathematical models spawned in academic seminars” in which inflation could be essential, or at least very conducive, to a recovery.  But, as a practical man, he cannot bring himself to take seriously the esoteric mathematical models supporting such a scenario.  The condescending reference to mathematical models and academic seminars, however, betrays Mr. Volcker’s own anti-theoretical bias, because one doesn’t need a mathematical model to see how inflation could promote recovery.  That conclusion is a straightforward implication of straightforward macroeconomics that has been understood for at least a century.  The question is whether we should take the risk that if we use inflation to get a recovery going, we will become hopelessly hooked on inflation, like someone experimenting with drugs becoming addicted after his first fix, or the risk that our slow, faltering recovery is really a reflection of deep structural problems immune to the stimulus of inflation.

Furthermore, Mr. Volcker’s view of economic history seems to be focused almost exclusively on the 1970s, which is understandable, but not necessarily practical.  It would also be worth paying attention to March 1933, when FDR, taking office with an economy seemingly unable to recover from the Great Depression, prices having fallen 30% or more since 1929, suspended the gold standard and announced a goal of restoring the US price level to where it had been in 1926.  By devaluing the dollar, Roosevelt produced a rapid rise in prices (wholesale price rose 14 percent from April to July 1933), triggering the fastest recovery in US history, industrial output increasing by over 70% from April to July while the Dow Jones average nearly doubled.

So, yes, Mr. Volcker, history shows that inflation can produce a recovery.  Maybe we need to learn from it.


12 Responses to “Twain v. Volcker”

  1. 1 Steve September 21, 2011 at 1:27 pm

    Great commentary, but overly kind and too deferential to Volcker.


  2. 2 Benjamin Cole September 21, 2011 at 1:58 pm

    Terrific blogging.

    On Volcker, it may also be the case of a general, or baseball team manager, recalling the glories of his improbable and greatest campaign. Hard to unlearn lessons of one’s singular triumphs, against prevailing sentiments. And where there are eternal truths —hard work and digging in leads to victory—they may become confused with other fleeting realities.

    Man, oh man, we do not needed tight money in 1980, and we do not need it now. There is a good case to be made we are in deflation already.

    And ask Volcker about Japan. The yen has doubled in value in the last two decades. Yet Japan is under-performing every other major industrial society, and that’s saying quite a bit.


  3. 3 Benjamin Cole September 21, 2011 at 1:58 pm

    PS I meant to write we needed tight money in 1980 and do not need it now.


  4. 4 jm September 22, 2011 at 12:24 am

    What makes you think Japan is under-performing? I’ve been closely associated with Japan for most of the last four decades, and read and speak the language. Having drifted away from Japan-related work since 2000, I was just there on my first visit since then, in June. Everywhere I went, prosperity was obvious. Railway stations, the trains themselves, buses, roads, hotels, restaurants, retail malls, the home of ex-in-law’s I visited, the assisted living facility where my ex-mother-in-law resides — not only were all in an excellent state of repair, much had been extensively renovated or newly constructed since 2000. The quality of life appears very significantly improved.

    It appears that the Japanese put their efforts in the 2000s into making the nation a better place to live, and have done quite well at it.


  5. 5 freebird September 22, 2011 at 7:05 am

    Speaking of Japan, on my last business trip there I came down with a bad cold and went to our company’s medical center– and was promptly given antibiotics.

    Also on interpreting history, while the sequence of events may not be in doubt, sometimes it’s tricky to distinguish between cause, corollary, and consequence. Mean reversion does not always require intervention.


  6. 6 David Pearson September 22, 2011 at 9:43 am


    As you point out, one of Volker’s main points is that inflation expectations, once unanchored, are not easily fixed. To this point, stimulus proponents usually reply, “we have a symmetric target”. That is, inflation would not be allowed to overshoot, so the risk of unanchoring is quite low. Here is where the practitioner has something to contribute over the academic. Volker has been in that hot seat, and I think he understands just how asymmetric such a target might be. He likely would prefer that we not find discover that later.

    BTW, a minor point: profit expectations are far from “deeply pessimistic”. We have just experienced a peak in profits-to-gdp, and the consensus forecast of S&P earnings for next year, while falling, still shows decent growth.


  7. 7 Philo September 22, 2011 at 6:05 pm

    “. . . dare I say ‘simplistic’ . . .”? Yes, you already showed that you dare! You said ‘overly simplified’ (you should have said ‘oversimplified’), and this means the same as ‘simplistic’.


  8. 8 David Glasner September 22, 2011 at 9:04 pm

    Steve and Ben, Thanks for the kudos. As for my deference to Volcker, I genuinely do admire him, but I must admit that I was laying it on a bit thick for effect. Perhaps that was not the best rhetorical strategy, but that’s they way it came out.

    Ben and JM, My limited knowledge of Japan suggests that they had a decent, but not great, recovery in the aughts, especially not great given the depth of recession in the 90s. So I think it’s a half-empty, half-full situation.

    freebird, What is the point about antibiotics?

    David, I think one advantage of level targeting is that there is some short-run flexibility to overshoot but there is a commitment to compensate for overshooting.

    About pessimistic profit expectations, my view is that the current level of output is highly profitable, but everyone is afraid to expand output beyond current levels because they don’t think that they will be able to sell the extra output except by deep price discounts.

    Philo, The Oxford English Dictionary defines “simplistic” as “of the nature of or characterized by extreme, excessive, or misleading simplicity.” That sounds to me like a step beyond either “overly simplified” or “oversimplified.” But you may be right that I was getting slightly carried away.


  9. 9 Will September 23, 2011 at 12:06 am

    Wow. I wish I could have written this.

    Of course, the debate on the desirability of inflation is wholly academic. Among the untutored, Volcker’s position passes for common sense. This means that any inflation will not come from public policy. We nobodies need to start counterfeiting like mad! We don’t even need to spend it ourselves, just leave it around. Alternately, we could get the North Koreans to do it (or the Iranians or the Cubans, or whoever).


  10. 10 David Glasner September 24, 2011 at 7:42 pm

    Will, writing is like any skill, you get better at it by doing it a lot and by working to improve. That probably goes for counterfeiting, too, but I would encourage you to work on the former not the latter.


  11. 11 acroteria September 27, 2011 at 4:10 pm

    “About pessimistic profit expectations, my view is that the current level of output is highly profitable, but everyone is afraid to expand output beyond current levels because they don’t think that they will be able to sell the extra output except by deep price discounts.”
    – David, I respect this opinion and don’t disagree with it. I would simply qualify it, “[for many] the current level of output is highly profitable [but, for them, increased output could be a value judgement of diminishing returns vs volume; without the additional security of a meaningful upward trend. For others, depending on their sector of the economy and market, the situation may be quite different and they may be adding to the unsurity of the situation.
    – I suspect this is where you would have gone with the comment if it were more closely central to your blog post.


  12. 12 David Glasner October 2, 2011 at 9:28 am

    acroteria, Thanks for your comment. I think that we are indeed looking at things in a similar way.


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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