Volcker Had Glory but Not the Power to Curb Inflation

The hyperbolic rhetoric used to describe the role of Paul A. Volcker at the Federal Reserve Board--Czar of the American Money Supply, the Man Who Cured Inflation--shouldn’t be confused with reality. Being chairman of the Fed “ain’t what it used to be,” and “what it used to be” wasn’t ever the way it often is portrayed in the financial press.

Legally, the Federal Reserve is in charge of determining the American money supply. But with the development of a world capital market, “the American money supply” has ceased to exist.

The reality is a world money supply of which the dollar is only one part.

Clout Has Waned

One can do business in the United States using West German marks, Japanese yen or any other convertible currency. One can borrow Eurodollars in London that are not subject to the controls of the Fed. You and I can do a deal in the Bahamas without either of us being there.

Real interest rates are more affected by Japanese decisions about whether to lend in American capital markets than they are by the actions of the Federal Reserve chairman.

Rather than being the czar of the American money supply, the Fed chairman is at best a leader of a team of central bankers who determine the world’s money supply. But the chairman of the Fed is not at his best.

With the United States having become the world’s largest net debtor nation, it is not at all clear that the Fed chairman is first among equals.

The first among equals, if he chooses so to be, is the central banker who represents the nation that is the world’s largest net lender, and that is Japan. As all of us have learned in our own personal dealings, borrowers always hold a subsidiary position to lenders.

Moreover, given a little-known quirk in American banking regulations, the Fed chairman is not even the leader of the American team in determining the world’s money supply. By law, the Treasury determines all American decisions to manage the money supply by buying and selling currencies. The Fed is merely the operating arm of the Treasury when it comes to international maneuvers.

Lost Its Importance

The Treasury also conducts all international financial negotiations. Internationally, the Fed has no independent powers of action. It must follow the instructions of the Treasury and ultimately the policies of the President.

Yet the power to buy or sell currencies is the power to control the number of dollars issued by the Fed. If the Treasury orders the Fed to sell dollars, the world’s supply of dollars increases. If the Treasury orders the Fed to buy dollars, the world’s supply of dollars contracts.

Because of the importance of international capital markets, the Fed essentially has lost its importance. It retains the legal ability to control the domestic money supply, but there is no domestic money supply that can be isolated from the international money supply. The regulations remain, but what is to be regulated has disappeared.

Even in the past, the Fed’s independent powers were limited. The Fed has preserved its legal independence from the executive arm of the President by never using its independence when an incumbent Administration knew what it wanted and was determined to get what it wanted.

The Fed’s only independence comes when the Administration doesn’t know what it wants. When the Carter Administration wanted restrictions on credit cards in 1980, it got them even though the Fed did not agree with the action.

Occasionally, the President and the Fed chairman have played out an elaborate charade where the President pretends to be opposed to some Federal Reserve policy so that it can take the political blame for what the President knows must be done. President Lyndon B. Johnson played out such charades several times during the Vietnam War. But I am aware of no instance in post-World War II history where the Fed chairman ever defied a determined President. If they ever did, they wouldn’t long have their jobs and the Fed wouldn’t long be independent.

Despite the rhetoric and praise, Volcker did not cure inflation. The rate of inflation fell because the prices of energy and farm products started to fall and because the Reagan Administration was willing to tolerate a very severe recession in 1981-82 that forced labor to accept much lower wage gains.

In 1980, the price of energy rose 31% in the consumer price index; in 1986 it fell 13%. In 1980, the price of food rose 12%; in 1986 it fell 5%. None of this was caused by anything done at the Federal Reserve. Put a 31% increase in energy prices and a 12% increase in food prices back into the economy and no one doubts that inflation would be back up to double-digit levels.

It is not clear whether Volcker jumped or was pushed off the bridge of the Fed, but to go down in history as the man who “cured” inflation, there never was a better time to jump.

With a falling dollar and a stagnant world economy, the United States can cure its balance of payments problems only by having inflation. The price of imports must go up to the point that Americans cease buying $170 billion of imports. Toyotas must be priced like Mercedes and Mercedes must be priced like MX missiles.

The best that the Fed can hope to do is to keep import prices from spreading to domestic wages or prices. Expected inflation rates for 1987 are more than double those measured in 1986, and 1988 is expected to be still worse. When it comes to curing inflation, Volcker has been more lucky than smart, but then there is nothing quite so good as good luck to make one look like a genius.