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.
