Vale Volcker

By George P. Brockway, originally published June 1, 1987

A COUPLE OF years ago, Mayor Edward I. Koch was asked who was responsible for pulling New York City back
from the brink of bankruptcy. In one of his formerly frequent bright moments, he replied. Well, I suppose someone
has to get the credit, and it might as well be me.
It is worth remembering that New York had been pushed to the brink by Walter B. Wriston s Citibank,David
Rockefellers Chase, Donald T. Regans Merrill Lynch, and the rest, because in their self-advertised wisdom they
thought it safer to lend our money to Argentina, Brazil and Mexico. Well, I suppose someone should get the credit for
the mess our banks and the debtor nations are in, and it might as well be them.
But they dont deserve all the credit. They should share it with Paul A. Volcker, for they couldnt have raised the
interest rate to usurious heights without his help. That may not be a nice thing to say about a man who is now retiring
from government after many years of undoubtedly self-sacrificing service. Unhappily; I have some even less nice
things to say. I say them not only in sorrow but also in anger, because people have been hurt-have had their lives
ruined-by the lordly mistakes of this big man, and because his smaller successor as chairman of the Federal Reserve
Board, Alan Greenspan, is apparently ready to keep making most of the same mistakes (besides, when the wind is
north-northwest, declaring his devotion to Ayn Rand and longing for the gold standard).
Lets briefly examine the Volcker record in five areas- (1) inflation, (2) general welfare, (3) economic output, (4)
foreign trade, and (5) the deficit and then look more closely at his underlying theory. Volcker is admittedly not singlehandedly responsible for the bad things-or the good things, if any-that can be pointed to in each case. He had a lot of
help from Ronald Reagan, from legions of people who were sure they were doing what the President would have
wanted had he been paying attention, and -yes- from you and me. Nevertheless, even if Paul VoIcker wasnt, as the
commentators liked to say, the second most powerful man in the world, he is, as they also say, a legend in his own
time. Its really what he stands for that I will [be] talking about.
1. Inflation. There is no doubt that VoIckers present fame is based on his claim to have been the tamer of the
inflation dragon. He took office at the Fed in October 1979 and immediately began his attack. What really happened?
From that December through December 1986, the Consumer Price Index (CPI) rose 51.06 per cent in constant
dollars. In comparison, the increase from 1972 through 1979 was considerably greater, 73.50 per cent, but from 1964
through 1972 it was considerably less, 34.88 per cent. And if we go back to the bad old days of Harry S. Truman, we
find that the increase from 1948 (following the jump when wartime controls were suddenly ended) through 1952 was
only 10.26 per cent. On the record, VoIcker, the great inflation tamer, turns out not to have been all that great.
2. General Welfare. VoIcker never made a secret of the fact that his program was going to hurt. That may have
been, as Ring Lardner would have said, one of its charms. Again using constant dollars, we find that from 1964
through 1972 the median family income increased 25.46 per cent; from 1972 through 1979 it increased 1.56 per cent;
but in the VoIcker years, from 1979 through 1985 (the latestEconomic Report of the President doesnt have 1986
figures for this), the median income fell 4.56 per cent. Given that more families had multiple wage earners in 1985
than earlier, the drop in family income was even steeper.
The fate of the poor was much more dramatic. The number of our fellow Americans living in poverty actually declined
32.13 per cent from 1964 through 1972; it held unchanged from 1972 through 1979; but it jumped 26.81 per cent in
the Volcker years.
On October 19, 1979, shortly after taking office, Volcker proclaimed, The standard of living of the average American
has to decline. He made it happen.
3. Economic Output. Volckers rationale for hurting people was that inflation would thus be controlled, and the
rationale for controlling inflation was that prosperity depended on it. As we have seen, inflation was only slightly
restrained; perhaps it will be said that is why the recovery has been so lackluster.

The GNP rose (in constant dollars) 32.19 per cent from 1960 through 1972; 22.38 percent from 1972 through 1979;
and only 12.30 per cent in the Volcker years. Since the working-age population increased 8.19 per cent in the last
period, and more people produce and consume more goods, the Volcker recovery has been overpraised.
4. Foreign Trade. Everyone knows that our recent performance in foreign trade has been abysmal. If the monthly
deficit on current accounts falls a point or two, it is hailed as a triumph. Everyone knows, too, that the strong dollar of
recent years has made it difficult for American industry to compete either at home or abroad. What few remember,
however, is that the strong dollar was a deliberate objective of Volckers policy, announced as early as October 17,
1979. It was supposed to stabilize international trade, and it sure made it fun to travel in Europe and to buy Volvos
and Mazdas and madras shirts in the U.S. All this naturally contributed to the trade deficit and put Americans out of
work. It also made it easier to sell American bonds-not goods but bonds-abroad. Volcker wanted the strong dollar
because it made it easier to finance the American deficit-again a way to achieve a questionable result by imposing
unquestionable hardship on millions of people.
5. The Deficit. The deficit question is a phony, and so is the problem of financing it; and I dont mean merely that it
wouldnt have seemed important if it hadnt been for the Kemp- Roth tax cuts. Volcker certainly isnt to blame for
those. He is to blame, though, for crying wolf over the deficit.
There are a few ways a national debt is like a personal debt, and one of them is that the amount of debt a nation can
bear is a function of its income. Poor people and poor countries have trouble with small debts; rich people and rich
countries can carry big debts. The United States debt is always thought enormous by knee-jerk conservatives; this
was one of Reagans arguments against Jimmy Carter. In 1979 the Federal debt held by the public (some of it, of
course, is held by government agencies, mainly Social Security) was 26.33 per cent of GNP. That was one of the
lowest ratios in years, but Reagan promised to wipe it out and Volcker strengthened the dollar to help him. By 1986
the debt had risen to 41.94 per cent of GNP. This is a lot hairier than the 1979 animal, but even so its not a real wolf.
For something like a real wolf, we can go back to 1946, the last year of World War II, when the Federal debt held by
the public was 113.62 per cent of GNP. If there is validity to the notion that a high debt/GNP ratio induces or requires
a high interest rate, the 1946 rate should have been wild. Yet in that year, three-month Treasury bills paid all of threeeighths of 1 per cent, and the prime was 1.5 per cent.
Now consider this: During the Volcker years the Federal debt held by the public increased by $1,102 billion, and the
interest paid on that debt amounted to $844 billion. Suppose the 1946 rate had been paid instead of the Volcker rate.
The interest bill would have been reduced by about $812 billion, while the debt itself would have increased only $290
billion. At the same time, the debt/GNP ratio would have fallen to 2.46 per cent-hardly anything to get excited about
(except as probably too low), and certainly below the urgent need for foreigners to invest in our bonds.
It comes down to this: Volcker allowed interest rates to soar, partly to reduce the average Americans standard of
living, and partly to encourage foreign investment in government bonds. He was successful on both counts. But if the
rates had been lower, the deficit would have been minuscule, and the foreign investors wouldnt have been needed.
High interest rates simply gave a lot of money to rich foreigners-and to rich Americans, too.
I HAVE ALREADY said that Volckers attack on the inflation dragon was not outstanding. I now make the heretical
claim that his maneuvers with the interest rates indeed caused inflation to be greater than it might have been.
First, let me make a minor observation. The inflation rate is not a figure you read off an instrument, like barometric
pressure. It is a statistical construction, and one of its factors is the interest rate. Consequently, interest rates and
inflation rates have a tendency to go up and down together. This is an arbitrary and possibly small effect, and one
that could be eliminated by slight pressure on a computer key; nonetheless, it stands as a real fact in the real world.
Second, let me make the much more important observation that speculation is vastly stimulated by volatile interest
rates. Volcker says that if the strong dollar werent available to bring in foreign money, Federal borrowing would
crowd producers out of the money market. But speculation can always crowd out production, and that is what
Volckers policy has encouraged.
There is a still more serious effect than either of these. If you are running a business and your friendly banker says he
wants 20 per cent to renew your 10 per cent loan, your first defense is to increase your prices. Moreover, the loan
isnt the only thing that bothers you, because what economists call the opportunity cost of the money you and others
have invested in your business increases as well. That is, whoever invests in your business passes up the
opportunity to make easy money by being a lender rather than a borrower; so you have to raise prices to take care of
that, too, and keep your colleagues from wanting to sell out.

A significant aspect of these increases is that they are percentages. Whats more, similar percentage increases are
being made by everyone who supplies you with raw materials or rents you office space or provides shipping services
for you. Every company below you in the production chain is adding a percentage to its prices, and you add your
percentage on top of their inflated prices, and the companies above you in the chain do the same. The result is that,
as Adam Smith observed in a little-noticed passage, prices are increased geometrically, whereas a wage increases
pushes up prices only arithmetically.
The immediate impact of an increase in interest rates, therefore, is an increase in inflation. Of course, the intended
decrease in the level of business follows sooner or later (it took Volcker almost three years to get things down to
where he wanted them). Sooner or later, people cant afford the new prices. Businesses cant sell as much as they
used to. Workers get laid off. Unions get afraid to strike. Wages are held down, and so price increases can be
relaxed. This is what Volcker frankly worked for. But true to Adam Smith, we see that when wages go down
(empirically, when any cost-including interest-goes down), prices fall only arithmetically; and if interest rates remain
high, the net pressure on prices will continue to be upward.
Even a very severe depression (and Volcker made us one) will at best slow inflation; it will not stop it as long as
interest rates remain high.
Volckers announced policy was to control the money supply (Ml) and let the interest rate take care of itself.

His theory was that a controlled money supply would raise the interest rate, and that a drop in the inflation rate would
take place. He was never able to keep M1 growth within the guidelines advocated by Milton Friedman. Its just as
well.
As the table above shows, in 1981 a minor fall in Ml growth (one of only two such occurrences in Volckers career)
was accompanied, not by a rise, but by the second largest fall in the prime rate, and followed by the largest fall in the
CPI. On the other hand, in 1985 the biggest jump in Ml was accompanied by a substantial fall in the prime and
followed by the most dramatic fall in the CPI. In general, the figures in the table can be made to support Volckers
theory only by appeals to lags and anticipations and other statistical gyrations of the sort J .B. Rhine used to
prove extrasensory perception. For true believers in the Volcker magic, when 1980s slight tightening of the money
supply was followed by a slightly lower inflation rate, that proved the theory. But when 1984s greater tightening was
followed by an increased inflation rate, that proved businessmen had expected the tightening and had moved to
offset it. Either way, Volckers theory was a winner. But such pseudo-logic can equally prove the opposite.
In short, there is no way on earth to construct a valid correlation of changes in the money supply, interest rates and
inflation rates that will support Volckers theory of what he was doing. And there is no way on earth to deny that what
he did reduced the standard of living of average Americans and forced millions more into poverty. The theory that I
(and Adam Smith) have advanced (for a somewhat fuller exposition, see my note in the Winter 1986-87 Journal of
Post Keynesian Economics) goes at least part way in showing why Volckers theory was wrong.
A case can be made for many Volcker virtues, especially in impeding somewhat the rush to deregulate banking. But
the false legend of big Paul Volcker and the dragon is one that shouldnt be told to children-or to grown-ups, either.