Perhaps that explains why Alan Blinder, a leading Keynesian Democrat, who was appointed by President Bill Clinton as vice-chairman of the Federal Reserve Board during the early Greenspan era, minimized Volcker's accomplishments. In a retrospective on the twenty-fifth anniversary of October 1979, Blinder praises Volcker as a “highly principled and determined inflation hawk,” but trivializes his lessons for monetary policy. “Paul Volcker retaught [
sic
] the world something it seemed to have forgotten at the time: that tight monetary policy can bring inflation down at substantial, but not devastating cost.”
19
Blinder, a successful textbook author, skimps in his appraisal. The decline in economic activity between 1979 and 1982 was severe, as he implies, but the disinflation came with much less unemployment than anyone had expected.
20
Volcker disappointed the pessimists, which included just about everyone in the economics profession, because he tamed what was called an intractable inflation. Nothing displeases a dismal scientist more than favorable outcomes.
But Volcker's more important contribution came after 1983, during the economic upturn, a time when gains against inflation had been squandered in the past. He avoided Keynesian sins of remaining too
easy for too long and of focusing on economic growth until excess capacity had disappeared. He established the practical wisdom of preemptive restraint, raising real interest rates before inflationary psychology reignited excessive spending, and furthered the goal of price stability.
21
Volcker conquered inflation without controlling the money supply and without monetarist approval.
22
Milton Friedman and Allan Meltzer, two leading monetarists, gave the Federal Reserve failing grades on controlling monetary aggregates between October 1979 and August 1982, when Volcker tried.
23
Friedman said, “There was no monetarist experiment and there was never an intent for a monetarist experiment.”
24
He is right. Meltzer added that “the inflation rate was brought down too fast” and this created “pressure [since 1984] to ⦠reflate.”
25
It did not.
Volcker succeeded, despite Keynesian and monetarist disapproval, by allowing real interest rates to fluctuate more freely than ever before, to rise and fall like shock absorbers to smooth bumps in the economic terrain. High real interest rates curtail spending when inflation threatens, and low real rates boost expenditures when recession emerges. Between 1979 and 1982 the money supply served as a crutch for Volcker, supporting the case for unprecedented high real interest rates, but after that, discretion ruled. Volcker's record gave license to Alan Greenspan to continue preemptive interest rate adjustments to control inflation, which he did.
26
Years later, when Greenspan's reputation as Fed chairman had reached its height, he said, “We owe a tremendous debt of gratitude to Chairman Volcker and the Federal Open Market Committee for ⦠restoring the public's faith in our nation's currency ⦠Maintaining an environment of stability is simpler than restoring the public's faith in the soundness of our currency.”
27
It was a nice compliment, but Greenspan had missed something big.
George W. Ball, an undersecretary of state in the Kennedy-Johnson administration, who had also served as U.S. ambassador to the United Nations, wrote to Volcker in mid-1984.
28
“Some day you will receive the recognition you deserve for halting and reversing the inflationary curve. To accomplish that purely by the use of the monetary instrument with
no help from the fiscal side is a tour de force for which you will be long remembered.”
Ball ends with a rhetorical question: “How about an equestrian statue in front of the Federal Reserve Building? It would have to be at least a Clydesdale.” No such display currently exists, but the former diplomat confirmed why Volcker's sculpture belongs at the entrance to Fed headquarters on Constitution Avenue, even though Ball understates his accomplishment.
Milton Friedman's popular phrase “Inflation is always and everywhere a monetary phenomenon” obscures the link between fiscal policy and inflation that Friedman himself diagnosed.
29
Alan Greenspan shares that view, which is no surprise, since Arthur Burns taught both men and drilled that wisdom into all his students. Greenspan recalls: “Burns loved to provoke disagreements among his graduate students. One day ⦠he went around the room asking âWhat causes inflation?' None of us could give him ⦠[a satisfactory] answer ⦠Burns puffed on his pipe, then took it out of his mouth and declared, âExcess government spending causes inflation!' ”
30
Burns blamed budget deficits in the United States for his poor record on inflation, but Volcker taught the world that a determined central bank can dominate fiscal policy, even without gold as the anchor.
31
Robert Lucas, the Nobel Laureate from the University of Chicago and a Volcker cheerleader, doubted the Federal Reserve's clout, saying, “It is not within the abilities of any central bank to make things work out right” when the government spends on a sustained basis more than it receives in taxes.
32
Volcker proved otherwise by refusing to accommodate increases in government debt as the economy expanded after 1983. He avoided monetizing the deficit through purchases of government bonds and instead forced the Reagan budget deficits to battle corporate borrowing for investor funds. The resulting increase in real interest rates pressured Congress to enact the Gramm-Rudman-Hollings bill to tame the budget. Volcker never pushed Gramm-Rudman, but he admitted to Senator John Heinz that “an inevitable consequence” of his monetary policy might be the crisis atmosphere leading to that draconian legislation.
33
Volcker's veiled script had been anticipated by the Nobel Laureate Thomas Sargent, who had been a consultant to the Federal Reserve
Bank of Minneapolis. Sargent had written in mid-1983 that the Fed could succeed by “foreclosing the possibility of ever monetizing the deficit [and forcing] ⦠the government ⦠to promise higher and higher real interest rates on its ever-increasing debt. This force would eventually, and probably quite soon, create irresistible pressures to balance the budget.”
34
Gramm-Rudman's commitment to budgetary balance succeeded in lowering interest rates even though it needed help fixing the deficit. Congress had learned a painful lesson on Volcker's knee: that fiscal irresponsibility provoked crippling interest rates. Investors at home and abroad bought U.S. Treasury securities because they believed that America would no longer tolerate reckless deficit spending.
Alan Greenspan echoed Volcker on the deficit at his own confirmation hearings: “Over the long run ⦠there is just no way that you can finance ever-increasing central Government deficits without ultimately ⦠[driving] interest rates sharply higher.”
35
He added, “There is no question in my mind that ⦠[the deficit] is the most important economic policy variable.”
Congress responded to the shortcomings of Gramm-Rudman with the Budget Enforcement Act of 1990, which successfully pared the deficit until a budget surplus emerged (by surprise) in 1998.
36
Soon after, when President Bill Clinton met with Greenspan to discuss a fourth term as Fed chairman, the president said, “I have to congratulate you. You've done a great job in a period when there was no rulebook to look to.”
37
Greenspan gave a politically correct response: “Mr. President, I couldn't have done it without what you did on deficit reduction. If you had not turned the fiscal situation around, we couldn't have had the kind of monetary policy we've had.”
Volcker laid the foundation for restoring fiscal integrity in America and in the process anchored inflationary expectations to sound monetary policy. The years of economic stability that followed came as no accident. The so-called Great Moderationâlow and stable inflation without severe recessionsâbegan in mid-1984, when Volcker gathered his second wind, and it lasted a generation.
38
But he thought it would end badlyâwhich it did.
On Tuesday, February 2, 2010, Paul Volcker arrived at the Dirksen Senate Office Building to testify before the Senate Banking Committee on the rule that bore his name, courtesy of President Obama. Volcker had proposed a regulation that would allow commercial banks to trade securities to serve customers but prevent the type of reckless transactions accompanying the World Financial Crisis that began in 2007.
1
The Volcker Rule would permit commercial banks to buy and sell securities with clients but prohibit high-risk speculation either directly or by the banks' owning hedge funds. It was a noble idea that displeased the bankers.
Volcker had had less than ten days to prepare his remarks after Obama's announcement on January 21, 2010, supporting his initiative, but he had testified in Congress more than forty times since his departure from the Fed in 1987 and had not lost his touch. He was still a commanding presence at age eighty-two, as tall as during his Princeton basketball days, despite carrying extra inches around the midsection, with a slight loss of hearing his main infirmity.
Two days later, on February 4, Jerry Corrigan, Volcker's former colleague and now a managing director at investment giant Goldman Sachs, would appear before the same committee to comment on the proposed legislation. Volcker had mentored Corrigan, teaching him
fly-fishing and recommending him as president of the Federal Reserve Bank of New York, the powerful branch of the central bank located in the heart of Wall Street, where Corrigan grew the Rolodex that nurtured his new career. Corrigan had served Volcker as a loyal knight, protecting his back and defending his honor. But now their interests diverged, and Corrigan served a new master.
Goldman Sachs was an investment bank, also called a securities firm or broker-dealer, offering the full spectrum of financial services. Like some of its Wall Street peers, it had become a commercial bank holding company after Lehman Brothers, Goldman's smaller sister, declared bankruptcy on Monday, September 15, 2008.
2
The collapse of Lehman, the largest bankruptcy in U.S. history, triggered a run on banks and other financial firms reminiscent of those of the Great Depression, and forced the government to rescue a system on the verge of collapse. It was the darkest hour of the ongoing financial crisis that began on Thursday, August 9, 2007.
The crisis started when BNP Paribas, the French equivalent of Bank of America, suspended withdrawals from three of its investment funds because it could not value the mortgage-backed securities held in their portfolios. The shock of the suspension, and the suspicion that this was not an isolated event, forced the European Central Bank (ECB) and the Federal Reserve to provide unprecedented liquidity to financial institutions in Europe and America to restore market order. We know now that these loans by the ECB and the Fed could not correct the deterioration in the value of mortgages, especially on subprime credits, that came with declining home prices. The collapse of two major investment banks, Bear Stearns and Lehman Brothers, with too little capital and too much real estate exposure, followed in 2008.
3
Goldman Sachs became a commercial bank holding company immediately after September 15, 2008, because it wanted the privilege of borrowing at the discount window of the Federal Reserve Bank of New York to guard against Lehman's fate. Volcker had commented to anyone who would listen, “They're just trying to hide behind Uncle Sam's skirts ⦠How can we let Goldman Sachs profit from speculation until something goes horribly wrong, and then force the taxpayers to foot the bill.”
4
Goldman lit the fuse for the Volcker Rule, but Volcker had made
that same point almost twenty years earlier, with the following quotation from Adam Smith, the eighteenth-century Scottish philosopher who invented economics: “Though the principles of the banking trade may appear abstruse, the practice is capable of being reduced to strict rules. To depart upon any occasion from those rules, in consequence of some flattering speculation of extraordinary gain, is almost always extremely dangerous and frequently fatal to the banking company which attempts it.”
5
The Volcker Rule labeled all bank speculation unflattering.
In April 1995, more than ten years before the onset of the World Financial Crisis, Volcker foresaw the tranquil origins of the biggest financial upheaval since the 1930s. He testified before the House Banking and Financial Services Committee exploring financial reform: “It is a sheer fact of human nature that if you went along for ten or twenty years without problems, that is going to create an atmosphere in which people will go to the edge. And the regulator will not be as strict and sooner or later you will have a crisis.”
6
The Great Moderation in inflation and unemployment that began in the mid-1980s had calmed the economic atmosphere, and the congressional repeal in 1999 of the separation between commercial and investment banking sanctioned earlier Federal Reserve permissiveness in expanding bank powers.
7
Stable growth during the first few years of the twenty-first century masked fundamental risks, especially in mortgage-backed securities, and the regulatory laxity encouraged reckless speculation in housing-related investments.
8
The combination fit Volcker's script for a crisis.
But Volcker had gone even further in April 1995, describing with eerie precision the dilemma that would follow deregulation: “I will not refer to Goldman Sachs ⦠but I think it is obvious that if you had a large investment bank allied with a large [commercial] bank, the possibility of a systemic risk arising is evident ⦠It may be even evident with the investment bank alone. We are trying to keep them out of the so-called safety net now, but certainly you cannot keep them out if they are combined with a banking institution.”
9