VIEWPOINTS : Will the Challenge to Paul Volcker Provide Economic Benefits? : Recent Events Threaten Fed’s Policy Victories

Lawrence H. Summers is professor of economics at Harvard University and a research associate of the National Bureau of Economic Research

At the Federal Reserve Board, it is the best of times and the worst of times. Largely as the result of shrewd and courageous monetary policy decisions, the inflation rate has declined from double digits to levels not seen since the early 1960s. At the same time, the economy is now well into its fourth year of reasonably robust expansion. In the wake of sharply declining oil prices, many observers are coming to expect a long period of non-inflationary real growth. But just at its moment of triumph, the Fed is afflicted with unprecedented dissension. Members of the board of governors recently appointed by an enormously popular President Reagan have frontally challenged the authority of formidable Fed Chairman Paul A. Volcker and demanded more-expansionary policies.

The current strife at the Federal Reserve between the President’s recent appointees and Volcker raises profound questions about the determination of monetary policy in a democratic society.

If war is too important to be left to generals, why is not monetary policy too important to be left to central bankers? Should we have a monetary policy that is determined by popularly elected officials rather than an elite appointed board of governors? Should the Federal Reserve, like the Congress, follow the election returns?

The answer to all these questions is no. An understanding of the reasons why makes it clear why the latest challenge to Chairman Volcker so seriously threatens the Federal Reserve’s hard-won triumphs of recent years.


The genius of our Constitution lies in its recognition of the need for checks and balances to prevent transient popular passions from being translated into unwise long-run policies. Especially in areas where temptation is great--and where the benefits might be immediate and tangible while the costs would be delayed and difficult to perceive--the framers recognized the need to provide policy-makers with a measure of political independence.

Monetary policy is an area where it is especially important to take the long view. Overly easy money is an ever-present source of temptation. The benefits--more credit at lower interest rates and economic expansion--come quickly. The costs, increased inflation and reduced economic stability, arrive only slowly. Politicians and their loyal retainers will inevitably find it hard to resist the temptation of easy monetary policy, especially as elections draw near.

The best way to avoid temptation is to place the day-to-day control of monetary policy in the hands of independent experts who can take the long view in balancing credit availability and inflation risks.

When price and wage-setters know that price increases will not be accommodated by money creation, restraint is more likely. Political leaders as well as the citizenry are better off if an independent body can take the responsibility when necessary, but unpleasant actions to control inflation must be taken. As former Fed Chairman William McChesney Martin once suggested, the role of the Fed is to remove the punch just when the party is getting good. It is perhaps no accident that most nations, not just the United States, provide for a significant degree of central bank autonomy.


The Federal Reserve’s recent great success in bringing down inflation is the direct result of its independence. It is inconceivable that elected officials would have undertaken the harsh policies that were necessary to bring inflation under control. And it is unlikely that they would have tolerated the consequences of these policies without the ability to shift blame to the Federal Reserve. The concentration of power in the hands of a widely respected chairman whose commitment to combatting inflation was not in doubt played an important role in establishing the credibility necessary to bring down the inflation rate.

It is ironic that after the impressive achievements of the last few years, Volcker’s policies are now coming under such intense fire from within the board of governors. The pressure from Volcker’s supply-side critics for more expansionary policies threatens to undermine the credibility and independence necessary if we are to continue to enjoy growth and price stability.

The spectacle of internal bickering at this moment of singular success raises doubts about the Federal Reserve’s future ability to resist inflationary pressures.

The consistent stand of recent Reagan appointees for more expansionary policies and the knowledge that more appointments will soon follow inevitably raises concerns about the future independence of the Federal Reserve from political pressures. Market participants watch closely for any sign of weakness in the resolve to fight inflation and so signs of reductions in the Federal Reserve’s commitment to fight inflation will quickly be translated into higher prices.


Even leaving aside their impact on the key long-run issues of independence and credibility, pressures for expansion are unwarranted at the present time. Interest rates have tumbled as has the dollar; the stock market has soared. The economy continues to grow at a significant clip. The basic money supply has grown at a rapid rate over the last year. By no standard is monetary policy now restrictive.

The only argument to be made for further expansion is that inflation is now at very low levels and more money is always better. It was just such arguments that led to premature declarations of victory in the early and mid-1970s just before rapid run-ups in the inflation rate.

As long as the economy continues to grow, there is little to gain and a great deal to lose from more expansionary policies. Monetary policy is very important, much too important to be entrusted to supply-side ideologues. We can only hope that Chairman Volcker will be able to continue the monetary policies that have been so successful over the last few years.