Studies clearly demonstrate that countries secure enormous economic benefits when control over the supply of money is firewalled from the political process. Long-term price stability (or rather long-term minimal inflation to avoid the Irving Fisher fear of deflation) provides the keystone for economic growth under conditions of laissez-faire capitalism. Politicians, however, only rarely share such a goal. For price stability removes from the political market-place the short-term advantage of a seigniorage tax, that simultaneously floods their coffers with federal revenues and reduces the real value of the public debt. The political pressure is always to inflate above the minimal rate.
The Federal Reserve Board, in principle, is firewalled from the political process, is mandated to pursue the goal of price stability appropriately defined. The Chairman of the Board, by tradition and through agenda control, dominates the behavior of the Fed. In the first 100 years of the Board’s existence, however, with only a single exception, the Fed chairmen have proved to be normal human beings, who succumb to the pressures of politics, and the adulation or hatred of the general public, by oiling the monetary wheels too generously.
The cost of such personal weakness, such a failure to honor their oaths of office, has been high, as the run-up to the Great Depression, the stagflation of the 1970s, and the run-up to 2008 clearly show. When monetary policy has been disastrously too tight, as was the case throughout the period 1929 to 1932, the reason was not deliberate policy but an absence of leadership, indeed an absence of any policy whatsoever.
At this moment in time, monetary policy in the United States is critically important for the future of the United States economy. Under the successive chairmanships of Alan Greenspan and Ben Bernanke, between 2001 and January 2010, the Fed has performed far from well, fueling a monetary furnace that spilled over into stock market and housing market bubbles, that burst as soon as monetary sanity was restored, followed by a dangerous policy of balance sheet debasement as the Fed has correctly flooded the money supply, but foolishly by a process of purchasing, not Treasury Notes, but largely worthless toxic mortgage securities as a means of creating a second, politically-desired bubble in the housing market.
The medium-term risk is significant inflation, with the Fed handicapped by a lack of valuable assets to sell back to the public as a means of mopping up an excessive supply of money, once the income velocity of circulation of money returns to normal levels. Ben Bernanke, sadly, is a well-meaning chairman who, nevertheless, has been center-stage throughout this ill-fated sequence of events.
In the history of the Fed, one chairman alone towers above the rest as super-hero, stalwart in pursuit of his mandate, incorruptible in his defense of Fed independence against powerful pressures from the White House and the US Congress, to say nothing of the construction and farming industry special interests that clogged up C Street, NW and blockaded the Eccles Building with stalled tractors and other such vehicles in an attempt to intimidate him into monetary expansion.
That man is Paul Volcker, the 12th Chairman of the Federal Reserve (August 6, 1979 – August 11, 1987), who almost single-handledly pulled the United States economy out from a decade-long stagflation and who paved the way for some 17 years of The Great Moderation.
Volcker honored his oath of office from his first day in office, asserting that his policy was to remove the curse of high inflationary-expectations from the United States economy. For the most part, his statement was dismissed as hyperbole, which was unfortunate because that error of judgment exacerbated the depth of the economic downturn that his policies created. The federal funds rate had averaged 11.2 per cent in 1979. It was increased to a peak of 20 per cent in June 1981. The prime rate rose to 21.5 per cent in June 1981, the 30-year mortgage rate to 18.5 per cent and the 48-month car loan rate to 17.4 per cent.
The impact on economic activity was pronounced, with unemployment peaking at 10.8 per cent in December 1982 and remaining above 8 per cent until January 1984, an election year. Volcker came up for renewal in 1983, and under most circumstances, he would have been political toast. Fortunately for the country, another super-hero was in high office, and President Reagan burned up significant political capital to ensure that Paul Volcker (a registered Democrat) was re-appointed to a second term. Volcker repaid his debt to Reagan by correctly refusing ever to meet with him, either in the White House or at the Federal Reserve, to discuss monetary policy. Paul Volcker knew exactly the true nature of good policy with respect to the money supply. That was his job, not the President’s.
By mid-1983, inflation had been squeezed out of the system, as the inflation rate dropped dramatically to 3.2 per cent on an annualized basis. Ronald Reagan was re-elected by a landslide into a second term of office in November 1984, not least because Paul Volcker had put inflation back into its cage.
Should President Obama learn from history, remove his support for Bernanke’s second term, and throw his full political weight behind the Lion of the Fed, promoting a newly-minted Paul Volcker candidacy? Evidently, that should be a tempting prospect for a beleaguered president. I shall address that question directly, not least from a public choice perspective, in tomorrow’s column.