– December 15, 2019
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Paul Volcker, who served as chairman of the Federal Reserve from 1979 to 1987, passed away this week at the age of 92. He is widely credited with ushering in a new era in Federal Reserve policy making, where much more attention is given to controlling inflation.

When President Carter appointed Volcker to the Fed, inflation was approaching double digits for the second time in less than a decade. Arthur Burns, who began his tenure as Fed chair in 1970 when inflation was around 4.90 percent, saw inflation rise to 11.51 percent in 1974 Q4, fall to 5.13 percent by 1976 Q4, and begin climbing again thereafter. Inflation rose from around 6.43 to 8.52 percent during G. William Miller’s brief tenure from 1978 to 1979.

Before Volcker, Fed chairs occasionally denied their ability to control inflation. Arthur Burns referred to cost-push inflation (in contrast to the demand-pull inflation caused by faster money growth). “The rules of economics are not working in quite the same way as they used to,” he told Congress in 1971.

There were dissenting views, to be sure. But, for most of the 1970s, they were coming from outside the Fed. Milton Friedman, for example, called Burns out at the December 1971 American Economic Association annual meeting. It was not cost-push inflation, Friedman claimed, but “erratic and destabilizing monetary policy [that] has largely resulted from the acceptance of erroneous economic theories.”

Volker changed that. He acknowledged that the Fed could bring down inflation and then set a course to do just that. Moreover, he did so with great resolve.

Engineering a disinflation is a costly proposition. The central bank must cut the growth rate of money to bring down inflation. However, cutting the growth rate of money also tends to fool producers into thinking there has been a decrease in the relative demand for their products. As a result, they produce fewer goods and services — which often means laying off workers — until they realize the error and adjust their prices down accordingly.

The underproduction problem can be mitigated, to some extent, by credibly announcing the policy in advance. If producers reduce their inflation expectations in line with the policy, they will not be fooled into underproducing.

But that is easier said than done. It is difficult to credibly announce a policy in normal times. Most folks just don’t pay that much attention to — or understand — monetary policy. It is harder still when the central bank has failed to live up to expectations in the past, since even those who do pay attention and understand how monetary policy works are unlikely to believe the Fed will do what it says it will. Hence, even when such measures are called for, cutting the growth rate of money virtually guarantees a recession. 

Volcker’s disinflation was no exception. Real GDP growth fell from 6.51 percent in 1979 Q1 to −1.62 percent in 1980 Q3 and remained low through 1983 Q1. Unemployment shot up, from 5.7 percent in 1979 Q2 to 7.7 percent in 1980 Q3; by 1982 Q4, it had reached 10.7 percent. Home builders around the country pleaded for cheap credit by sending two-by-fours to the Marriner Eccles building in D.C.

But Volcker didn’t relent. Inflation came down and stayed down. Indeed, the public came to believe the Fed chair was willing to do whatever it takes to keep inflation low and steady. For every ounce of institutional credibility Burns had lost, Volcker gained a pound.

William J. Luther

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William J. Luther is the Director of AIER’s Sound Money Project and an Assistant Professor of Economics at Florida Atlantic University. His research focuses primarily on questions of currency acceptance. He has published articles in leading scholarly journals, including Journal of Economic Behavior & Organization, Economic Inquiry, Journal of Institutional Economics, Public Choice, and Quarterly Review of Economics and Finance. His popular works have appeared in The Economist, Forbes, and U.S. News & World Report. He has been cited by major media outlets, including NPR, VICE News, Al Jazeera, The Christian Science Monitor, and New Scientist. Luther earned his M.A. and Ph.D. in Economics at George Mason University and his B.A. in Economics at Capital University. He was an AIER Summer Fellowship Program participant in 2010 and 2011. William J. Luther on Facebook.
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