Perhaps he will be remembered best as a visionary—for his ability to see beyond the conventional wisdom of his time
The world recently lost a titan among central bankers. On 8 December, Paul Volcker passed away at the age of 92. He was most famous for his stint as chairman of the board of governors of the US Federal Reserve System from August 1979 to August 1987. These eight years saw Volcker’s tight money policy slay the dragon of inflation, and put the US back onto a low-inflation, high-growth trajectory. Appointed by President Jimmy Carter, his battle against inflation, with high policy interest rates as the chief weapon, was waged mostly under President Ronald Reagan.
The Fed’s policy operated in tandem with Reagan’s “supply side"-driven tax cuts and increased military spending, and so the combination seemed like a paradoxical mix of monetary tightening and fiscal loosening, which went against conventional Keynesian theory that fiscal and monetary policy should pull in the same direction. Interestingly, the Volcker-Reagan policy mix had been anticipated and advocated by economist Robert Mundell, and his former student, Arthur Laffer.
Thus, Mundell and Laffer argued, the combination of tight money and loose fiscal policy could simultaneously help the US achieve both internal and external balance—that is, full employment and low inflation at home, and a balance of payments equilibrium. This Mundell-Laffer policy mix, as put into practice by Volcker and Reagan, helped catapult the US back onto a low-inflation and high-growth trajectory. The balance of payments equilibrium did not come so easily, partly given the dollar’s role as a global reserve currency, but that is a tale for another time.
The abiding lesson of Volcker’s time as Fed chairman is that disinflation is costly, which is why it is best to avoid getting into a “stagflation" trap (economic stagnation combined with high inflation) to begin with. In contrast to the then fashionable “new classical" school of economics, which argued that a period of disinflation fully anticipated by the public could be virtually costless, the Volcker disinflation proved very costly, with a sharp recession induced by the high interest rate policy, followed by a relatively rapid recovery back to higher growth with low inflation.
Volcker’s approach had reach beyond the US. In Canada, for example, John Crow, a hawkish central bank governor who was in office from 1987 to 1994, used high interest rates to get Canada out of its low-growth, high-inflation trap, which proved to be similarly costly—and not just economically. Much like Carter lost to Reagan in the 1980 US election, in part because of the short-term economic costs imposed on the economy by the Volcker disinflation, the Canadian government of Conservative Prime Minister Brian Mulroney, which had appointed Crow, suffered its most crushing defeat in history in 1983. Mulroney had already resigned, but the Conservatives still crashed home with only two seats, after having ruled from a majority position for two terms.
It is worth noting that while he was most certainly a believer in US-style free-enterprise capitalism, Volcker—unlike his successor, Alan Greenspan—was no doctrinaire libertarian. Thus, while Greenspan was reading the libertarian writer Ayn Rand and arguing that financial markets could regulate themselves, Volcker came to believe that unregulated, or insufficiently regulated, financial markets could run amok and lead to crises; indeed, that was his view after the global financial crisis. Thus, in a later avatar, Volcker pushed for a regulation limiting certain kinds of speculative investments that banks could make. This was inserted into the Dodd-Frank Act of 2010 and became known as the “Volcker rule".
Volcker’s role in financial re-regulation occurred under the then President Barack Obama, but since the ascension of President Donald Trump, much of the bite of the Volcker rule and other elements of re-invigorated financial regulation have been loosened, as its compliance costs on banks is believed to be too high. Whether this has set up the US financial system for future crises remains an open question, but it is clear what Volcker’s view would be.
Apart from his outsized role in the economic history of the last part of the last century, Volcker was a colourful character, of a type little seen in today’s more sanitized world, and seemed almost out of a 1930s American novel by the likes of celebrated crime writer Raymond Chandler. Thus, he was famously frugal, and dressed in cheap, ill-fitting, and rumpled-off-the-rack suits. He was a chain smoker of cigars, but, unlike some other well-known economists, preferred the cheap drugstore variety. He was often seen in his office emitting words of wisdom while suffused in “a haze of nickel cigar smoke", as Chandler would have put it.
On a more personal note, I had the privilege of meeting Volcker only once. This was at an 85th birthday celebration for Mundell at an Italian restaurant on Manhattan’s Upper West Side in New York City in 2017. Volcker, then 90, gave a warm and personal birthday toast to his great friend Mundell.
Perhaps Volcker’s most lasting legacy will be as a visionary who was able to see beyond the conventional wisdom of his time. That is how he tamed inflation and restored growth when others thought the task impossible. And, unlike many central bankers who hew to the dogma of inflation targeting by national central banks and flexible exchange rates, Volcker thought in terms of the whole system. In a quote Mundell often repeated, Volcker had said: “A global economy requires a global currency."