Can Paul Volcker Ride to the Rescue Again?
Kurt Brouwer September 30th, 2009
Paul Volcker was the Federal Reserve chairman back in the early 1980s. He had been appointed by President Jimmy Carter in 1979. His task was to squelch inflation and that he did by sharply hiking short-term interest rates. Unfortunately, the economy took a huge hit as a result of his inflation-fighting efforts, but he did kill off inflation for a generation. That feat alone gives him enormous credibility in terms of our banking and monetary system.
Now, of course, Volcker is back in the news as an economic advisor to this administration. However, they are apparently not taking his advice as this ABC News report suggests [emphasis added]:
White House adviser Paul Volcker today criticized the Obama administration’s sweeping financial regulatory reform proposals, specifically one that he warned could lead to future bailouts by designating certain firms as “too big to fail.”
In testimony prepared for a hearing Thursday morning before the House Financial Services committee, the former Federal Reserve chairman expressed doubts about the administration’s proposal to designate certain firms that pose a threat to financial stability, subject them to stricter supervision, and make them submit resolution plans in the event of failure.
“The clear implication of such designation whether officially acknowledged or not will be that such institutions, in whole or in part, will be sheltered by access to a Federal safety net in time of crisis; they will be broadly understood to be ‘too big to fail’,” Volcker said.
This designation, Volcker said, will only serve to encourage more risk-taking, thereby leading to even worse crises in the future.
“What all this amounts to is an unintended and unanticipated extension of the official ’safety net,’ an arrangement designed decades ago to protect the stability of the commercial banking system,” Volcker stated. “The obvious danger is that with the passage of time, risk-taking will be encouraged and efforts at prudential restraint will be resisted…”
…The former Fed chief also expressed opposition to the administration’s proposal to remove responsibilities other than monetary policy from the central bank…
Chairman Volcker (a shorter version):
First, let’s make banking boring again. No bank should be too big to fail. And, second, don’t mess with the Federal Reserve.
What was it like back in the early 1980s?
To see what Chairman Volcker was up against, let’s head back to those days of yesteryear — the early 1980s — and compare some key indicators to the situation back then. Here is a good chart showing key interest rates plus inflation and unemployment, then and now:
Source: Carpe Diem
I suspect you could win some bets with some of these statistics. How many folks really remember that home mortgage rates hit 18% back then? Or, that they never went below 12% from 1979 through 1985?
Double Digits in 1980-82: Inflation, Unemployment & Mortgage Rates
In the late 1970s and early 1980s we had sky-high inflation, unemployment and mortgages rates. At that time, Chairman Volcker, had to raise interest rates to unheard-of levels. These rate hikes led to a prolonged economic contraction that was the worst since the Great Depression of the 1930s. This description from Wikipedia gives a sense of how severe the reaction was [emphasis added]:
“…However, the change in policy contributed to the significant recession the U.S. economy experienced in the early 1980s, which included the highest unemployment levels since the Great Depression, and Volcker’s Fed also elicited the strongest political attacks and most wide-spread protests in the history of the Federal Reserve (unlike any protests experienced since 1922), due to the effects of the high interest rates on the construction and farming sectors, culminating in indebted farmers driving their tractors onto C Street and blockading the Eccles Building…”
The image of farmers blockading Washington D.C. with tractors is hard to imagine now, but those were tough times. The reason Volcker raised interest rates so aggressively was that inflation went wild in the late 1970s. For example, inflation hit 11.3% in 1979, 13.5% in 1980 and 10.3% in 1981 before Volcker’s harsh medicine began to kick in and inflation moderated to 6.2% in 1982.
As inflation ratcheted higher, so did home mortgages rates. Thirty-year fixed rate mortgages went up to nearly 13% in November 1979 and did not fall under 12% again until November 1985. The peak rate for mortgages was 18.45% in October 1981. 18.45%!
But, even though high interest rates began knocking down inflation, soaring rates also led to sharply higher unemployment. The unemployment rate peaked at 10.8% in December 1982. However, it had been soaring for years and it remained at 8% or higher until January of 1984. Given all this, it is not surprising that investors and consumers were very negative in that time period 1980-82.
As you can see from the chart above, there is a huge disparity between interest rates, inflation and unemployment today versus the early 1980s. It is true, that government statistics on inflation and unemployment have changed since then. Nonetheless, interest rates and inflation were much higher back then. Unemployment was probably about the same although some would argue it is higher now due to changes in the methodology of calculating unemployment.
In that period, the Federal Reserve had to fight pervasive inflation and the only means available was to raise interest rates. As a result of higher interest rates, bond yields soared and bond values plummeted. Higher interest rates hurt the real estate market and values fell. Higher rates also hurt the stock market.
Inflation is not a huge problem now as it was throughout the 1970s and early 1980s. For example, inflation averaged nearly 8% per year for the entire decade of the 1970s. And, it began accelerating into double digits for the period 1979-81. Clearly, that was a huge threat.
Is deflation underway?
Today, we have two competing issues: current deflationary trends and likely future inflation influences (see Pimco Warns of Deflation To Come).
Right now, the government is more concerned with deflation than inflation as this report from the Congressional Budget Office indicates. The CBO made this statement in the summary section of its recent report on the President’s Budget [emphasis added]:
…For the next two years, CBO anticipates that economic output will average about 7 percent below its potential-the output that would be produced if the economy’s resources were fully employed. That shortfall is comparable with the one that occurred during the recession of 1981 and 1982 and will persist for significantly longer-making the current recession the most severe since World War II. In CBO’s forecast, the unemployment rate peaks at 9.4 percent in late 2009 and early 2010 and remains above 7.0 percent through the end of 2011. With a large and sustained output gap, inflation is expected to be very low during the next several years…
The CBO estimates that inflation will be very low for ‘the next several years’ due to the output gap mentioned in the quotation above. That is, if global GDP is 7% below potential then there should not be a lot of pressure on pricing until the output gap is closed.
Will Paul Volcker’s voice be heeded?
However, even though inflation is not a pressing problem today, there are plenty of serious concerns we have about the integrity of the banking system and many other factors. Paul Volcker’s wisdom and experience are badly needed now and I hope the administration heeds it.
Unfortunately, I’m afraid that — so far — his recommendations are not getting the hearing they deserve.
Did you enjoy this article?
[…] Read more here: Can Paul Volcker Ride to the Rescue Again? […]
[…] Read more here: Can Paul Volcker Ride to the Rescue Again? […]
It took immense courage to do what Volcker did in 1980. I recall 20%+ passbook savings rates, looking out of my NYC apartment window at the local Citibank branch’s window signs. Since then Fed chairmen seem to have been more concerned with getting on the ‘A list’ of dinner invitees than doing the right thing for the country. Courage is nowhere in sight - just a desire to be reappointed.
The ‘too big to fail’ designation is a perfect example. Oh! to be the CEO of one of those institutions - simply impossible to lose.
The Carpe Diem chart exemplifies one of my pet peeves: comparisons between the early 1980s and our own time. There seems to be so many people haunted by the era of stagflation that they think anything else pales by comparison. In my opinion stagflation is for economic sissies. Debt is inflated away. All you have to do is raise interest rates through the roof, watch unemployment soar and eventually inflation falls to sane levels. It’s a situation easily solved by a take no prisoners inflation hawk monetary policy. The real problem is a liquidity trap (our own time) when monetary policy becomes impotent. The danger is asset deflation leading to further deleveraging. The solution depends on a discretionary fiscal stimlus that in turn depends on (@#$%^&*) politicians. This is a time for hardy economic souls.
Mark–I agree that it is different this time. However, I don’t agree that the inflation problem was ‘a situation easily solved’ back then. Bonds lost well over 50% of their market value, unemployment soared, interest rates soared. Can you imagine a meeting of the FOMC in which the Fed Chairman presented a program of raising short-term interest rates to 20%? Can you imagine an environment in which home mortgage rates hit 18%? Whoa.
However, your concern about asset deflation is on point. Deflation is far scarier than inflation at this point. And, the solutions are geopolitical in nature. Unfortunately, when we need politicians to do something of critical importance, we are all in trouble.
What’s your prognosis?
Kurt,
My prognosis? I don’t expect you to agree with everything I am about to say but for what it is worth this is my opinion.
I’ve found this particular recent IMF analysis of the medium-term effects of financial crises in advanced, emerging, and developing economies over the past 40 years to be very interesting:
http://www.imf.org/external/pubs/ft/weo/2009/02/pdf/c4.pdf
I took the following from the IMF report:
1) Following a financial crisis the effectiveness of monetary policy is usually greatly impaired (as in a liquidity trap).
2) GDP usually falls below trend growth for a period of three years but then resumes growing at previous trend growth (but only trend growth) for a period of another 4 years (seven years from start of crisis constituting the medium term). Thus GDP never returns to previous trend in the medium term and a gap remains.
3) The gap between between previous trend growth and current trend growth in the medium term is smaller in proportion to the temporary increase in government consumption (fiscal stimulus in the form of direct spending). Each 1% of GDP in increased government consumption in the short term results in a 1.5% smaller gap between medium term trend and the previous trend.
This has the following (back of the envelope) implications for the US over the medium term:
1) We should expect GDP growth to be less than trend (less than 2.7%?) for the next two years.
2) Our discretionary fiscal stimulus is being spent at a rate of $100 billion a quarter in the short term. But only about two thirds of this is increased government consumption. This is roughly less than 1.8% of GDP so the gap between trend growth in the medium term and the previous trend growth will be about 2.7% less than contrafactual.
3) This also has implications of the long run. The CBO estimated that the stimulus would reduce real GDP between 0.0% and 0.2% by 2019 because of “crowding out.” However, if the stimulus is essentially a fiscal “free lunch,” as the above implies (I can take you through the math, it’s actually quite amazing) this effect will be zero.
In short, the stimulus appears it will hold the new trend in GDP growth to only (only!?!?!) perhaps 8% below the previous trend growth.
I think in retrospect we should have spent more on discretionary fiscal stimulus (and probably a lot less on TARP and other measures that have little to no bang for the buck). Based on things I’ve been reading lately Romer actually wanted ARRA to be about $1.2 trillion. Sumner wanted less because he was worried about the ability of the bond markets to absorb the debt and the subsequent viability of the dollar. Rahm thought a stimulus as large as what Romer wanted would be politically infeasable, so he sided with Sumner. I think in retrospect Romer was right, Sumner was wrong (the bond markets have swallowed the new debt without even a burp) and Rahm, unfortunately, was (and remains) right.
Senate centrists (of both political parties) limited the size of the stimulus and took out a lot of the state transfers and infrastructure spending and put in a hugely expensive AMT patch which was basically useless as stimulus because it was neither timely nor effective. So it ended up not only a third smaller than what Romer wanted, it was also highly watered down.
I hear buzz that more stimulus will be considered in the spring, but the window for its effectiveness is gradually closing. By then we will be about halfway through the “short term” by IMF definition (which is probably also the approximate time that ZIRP will be in effect) and the best kind of stimulus (infrastructure) takes a lot of lead time. The future consequently looks less than bright to me.
Mark–I agree with your general point that GDP growth will not be robust–that this will not be a V-shaped recovery with above trend GDP growth for a year or two. And, I agree that we are in a liquidity trap of sorts. I believe it is due to deleveraging as businesses and individuals are saving more and paying down debt.
I think the stimulative effect of permanent tax reductions has been overlooked. In the paper Christina Romer did with her husband when she was at UC Berkeley, she rated tax cuts as being far more stimulative than government spending, if memory serves correctly. Now that she is in the administration, she is downplaying tax cuts because tax cuts are not a tool that is in favor with our present leadership.
I also think that there are some unforced errors in our policy such as the tariffs on Chinese tires and other trade protectionism, including failure to finalize trade deals with Colombia and other countries. In addition, we are just wasting money on the various auto company bailouts and Cash for Clunkers program. Unfortunately, that spending is just a deadweight loss because we have incurred debt to do it yet it does not add anything to the recovery.
Kurt,
To be technical, the Romers’ paper did not find that tax cuts were uniquely stimulative. They found by using new classification techniques that certain kinds of tax changes, tax changes they termed “exogenous,” had an effect much greater than previously estimated fiscal multipliers. (Exogenous tax changes were noncountercyclical tax changes that changed the size of the fiscal balance.) If these techniques could be applied to spending changes (this would be more difficult) Romer believes that the results would be similar (”Hyper-Keynesian” as David Romer called them).
I disagree strongly with those that feel she is has become intellectually dishonest since becoming CEA chair (such as Greg Mankiw and Richard Posner). I think, with the exception of the size of the stimulus and perhaps the inclusion of the business and individual tax incentives (some of which were obviously Obama campaign promises), the administration’s original stimulus proposal mostly reflected her thinking on the matter.
Incidentally one of the findings of the Romers’ paper was that countercyclical tax cuts had no statistically significant effect on output. That’s a major reason why I think she never considered across the board tax cuts as part of the fiscal stimulus.