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Paul Volcker’s Principles Must Endure

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Paul Volcker’s Principles Must Endure

December 10, 2019

Former Federal Reserve Chairman Paul Volcker passed away this week at age 92. Volcker will always be remembered as the man who acted, singlehandedly, to end America’s “Great Inflation” of the 1970s. When he arrived at the Federal Reserve Board in August 1979, inflation as measured by annual changes in the consumer price index was running at 12%. When he left in August 1987, inflation was down to just 4%.

These numbers highlight, most vividly, Volcker’s immediate achievements as a policymaker. Even more importantly, however, Volcker set the stage for a much longer period of economic growth and prosperity, supported by monetary policies that have kept inflation low and stable for more than three decades following his term as Fed chairman. Volcker accomplished this goal by articulating, clearly and consistently, three basic principles that seemed radical at the time but are now widely accepted. These basic principles lie at the heart of Federal Reserve strategy, even today, and must not be forgotten.

Volcker emphasized his three principles from the very start. He outlined them in detail, less than a month after taking charge at the Fed, in his testimony before Congress on Sept. 5, 1979.

Volcker’s first principle states that, no matter what else may be happening to the U.S. economy, the rate of inflation remains under the Fed’s control. In his testimony, Volcker explains that rising inflation like that experienced during the 1970s cannot be blamed on non-monetary factors, such as rising food and energy prices, alone. To the contrary, these increases in the prices of individual goods cannot translate into a broader increase in all goods and services—that is, an increase in inflation—unless Federal Reserve policy allows them to.

Volcker’s first principle thereby restates in practical terms Milton Friedman’s famous dictum that “inflation is always and everywhere a monetary phenomenon.” This point seems obvious today. But, as Federal Reserve economist Edward Nelson documents in his careful research, throughout the 1970s, U.S. policymakers—not just at the Federal Reserve but also in Congress and at the White House—routinely attributed inflation to “cost-push” factors such as rising commodity prices and union wage demands that, in their view, monetary policy was powerless to resist. Thus, as Robert Hetzel and Joshua Hendrickson explain in much greater detail, Volcker’s first principle led to a profound reorientation of Federal Reserve policy. Before Volcker, the Fed’s passivity allowed individual price and wage movements to spiral into persistent movements in inflation. After Volcker, the Fed assumed responsibility for controlling inflation, no matter what.

Volcker’s second principle emphasizes that inflation imposes significant costs on both businesses and consumers. His September 1979 testimony describes explicitly some of these costs. Inflation, Volcker pointed out, interacts with accounting systems and the tax code in complex ways that erode the profitability of capital investments and discourage businesses from taking a long-run view. Later work by Martin Feldstein confirmed that inflation imposes some of its largest costs precisely through this channel. At the same time, inflation encourages consumers to allocate resources to privately lucrative but socially wasteful activities that protect the value of their savings from the corrosive effects of inflation but fail to add to the economy’s productive capacity. My own research with Michael Dotsey demonstrates that these effects can cumulate to be quite damaging. In making these points first, before anyone else, Volcker built a political consensus favoring low and stable inflation, which remains in place today.

Volcker’s third principle relates importantly to the Phillips curve: the association between higher rates of inflation and lower rates of unemployment that sometimes appears in the U.S. data. In making these points, Volcker once again cast in the most practical of terms implications of the “rational expectations” approach to macroeconomics developed much more abstractly by Robert Lucas and Finn Kydland and Edward Prescott. Like those Nobel Prize-winning economists, Volcker acknowledged the statistical regularity, but objected strongly to the view that the Phillips curve offers the Fed a trade-off between inflation and unemployment that it can exploit through its monetary policy decisions. To support his view, Volcker pointed out in his testimony that, by allowing inflation to rise throughout the 1970s, the Fed never succeeded in lowering unemployment. Instead, unemployment followed inflation’s trend, by rising and becoming more volatile, throughout that miserable decade. Volcker’s view of the Phillips curve, revolutionary at the time, received further validation as unemployment reversed course and trended steadily downward, even as his successors at the Fed succeeded at keeping inflation low and stable.

Today, Volcker’s three principles are “hard-wired” into Federal Reserve policy, through the Federal Open Market Committee’s “Statement on Longer-Run Goals and Monetary Policy Strategy,” renewed annually since 2012. Volcker’s first two points, implying that the Fed can and should actively target low inflation, is reflected in the Statement’s assertion that “the inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation . . . at the rate of 2 percent.” Meanwhile, Volcker’s view of the Phillips curve reappears when the Statement acknowledges that the Fed’s dual statutory objectives of stabilizing inflation and unemployment are “generally complementary” and not the source of painful trade-off.

By combining his three principles into its Statement, therefore, the Federal Reserve affirms that maintaining the environment of price stability that Volcker restored is the single biggest contribution that monetary policy can make to American economic prosperity. The sad event of Volcker’s passing, however, reminds us that the basic principles he espoused were not always widely accepted and may be forgotten, especially as collective memory of the 1970s continues to fade. Paul Volcker’s legacy consists, above all, in a set of ideas that must endure.

Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.

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