Revisiting Volcker

Central Banking Psychology

As central bankers around the world struggle with the consequences of the actions taken to rescue economies from the grip of the latest bank induced recession, and as monetarists and Keynesians come to blows over who has the best prescription for the future, most need to take a step back in time and reconsider the lessons of the early eighties when the Federal Reserve, led by Paul Volcker, jump started growth not by adherence to any set of ideologies but by focussing on the psychological consequences of their actions.

What the Volcker Fed showed was that sometimes you have to upset markets, politicians, ordinary people and other economists in order to break the behavioral cycles that come to govern macroeconomic behaviour. It rather looks like we’re going to need something similar to divest investors of their belief that markets are a one way ticket to riches, courtesy of hand outs from middle class taxpayers. Let’s revisit Volcker.

Inflationary Tendencies

Living as we do at a time when central bankers are busy trying to stimulate inflation rather than depress it, it takes a bit of effort to put ourselves back in the position of the Feb in 1980, just after Paul Volcker was appointed its Chairman. At that point, however, inflation was running at over 10%, had been, more or less, for over a decade and the strain on the economy was showing.

Inflation is, roughly speaking, the rise in the price of goods and services such that the purchasing price of a currency is diminished. The downside of this is that people whose income can’t increase – or at least can’t increase as rapidly as the inflation rate – find themselves increasingly poor. In this group, sadly, are those people who choose to invest in cash deposit accounts or fixed interest bonds rather than stuff like equities or property whose value tends to eventually increase in line with inflation.

This latter effect tends to lead to people focussing on speculation rather than proper investment and value creation. As we saw in Money Illusion, wage rises tend to be devoted to cost of living increases and not to productivity improvements: although this too can be good for equity investors. Although there are some positive sides to moderate inflation the idea that high levels are bad is one of the few things that virtually all economists of all hues can agree on.

Stagflation

By the end of the 1970’s the USA found itself struggling with stubbornly high levels of inflation, with a moribund stockmarket and falling competitiveness: so called “stagflation” combining economic stagnation and rampant inflation. What was perhaps worse was that the inflation tended to jump about as the economy was hit by a series of external shocks – the Vietnam War, the oil crisis and the subsequent revolution in Iran were all major factors impacting the wider economy.

This was worse because it modified peoples’ expectations: people became worried about the possibility of future shocks causing inflation increases. Now, in reality, there are far more causes of possible shocks than actually occur so if people suddenly start reacting to the fear of future shocks rather than the reality of actual ones what you’re going to see is much, much more volatility. This idea, that human psychology can start to drive macroeconomic behaviour above and beyond the actual evidence of the markets, is persuasive and rather worrying.

Psychological Disinflation

As Goodfriend and King, in The Incredible Volcker Disinflation, set out, Volcker concerned himself as much with this psychological dimension of inflation as he did with the economic models. Here he is commenting internally in 1979:

“When I look at the past year or two I am impressed myself by an intangible: the degree to which inflationary psychology has really changed. It’s not as though we didn’t have it before, but I think that people are acting on that expectation [of continued high inflation] much more firmly than they used to. That’s important to us because it does produce, potentially and actually paradoxical reactions to policy.”

Identifying market psychology as a reason for the persistence of inflation was a far-reaching piece of analysis because it led to a significant change in the way the Fed went about its business and meant that Volcker was already positioned to take advantage of a large slice of luck: the decision of the American electorate to vote in Ronald Reagan as president.

The Failure of Gradualism

As Goodfriend and King point out, previous attempts to conquer inflation had failed and they suggest that this was an inadvertant by-product of the Fed's own inflation targeting policy measures. Whatever the cause, the impact on market psychology was pretty obvious: it was thought highly unlikely that the Fed could tighten policy sufficient to stifle inflation and then keep it tight in the face of the political pressures this would bring.

Underlying a lot of the problems was the operating procedure under which interest rates were adjusted to try to modify inflation. The Fed was committed to gradualism, to making small and well signalled changes in rates to avoid disturbing the equanimity of market participants, poor and easily shocked little darlings that they are.

This policy, Goodfriend and King suggest, may work well when inflation is low and exhibits small changes but when it changes rapidly it may actually help fuel the problem. As the IMF commented in 1975:

“The upshot has been that “gradualism” as an approach to the reduction of inflation and inflationary expectations has been too gradual – in many countries, to the point of no reduction at all”.

Monetary Shock and Awe

The centrepiece of the Volcker led reforms was to remove the commitment to gradualism, allowing the imposition of a monetary shock on the markets. The aim was to be able to adjust rates in line with changes to inflation, rather than dragging along in its wake. However, the real problem of fixing inflation may not have been economic at all, but political. As former Fed Chairman Burns recalled:

“As the Federal Reserve … kept testing and probing the limits of its freedom to undernourish the inflation, it repeatedly evoked violent criticism from both the Executive establishment and the Congress and therefore had to devote much of its energy to warding off legislation that would destroy any hope of ending inflation”.

Bloody politicians. Anyway, cometh the moment cometh the man and the man, in this case, was Ronald Reagan whose monetarist leanings perfectly complemented Volcker’s ambition even though, as Lindsey, Orphanides and Rasche argue in The Reform of October 1979, he wasn’t particularly convinced of the ability of any bunch of economists to determine anything.

With economic policy and political will aligned the Fed was able to institute and maintain an inflation dampening approach for long enough to convince people that they really meant it. And with this, the psychology changed and that changed everything. Inflation fell, remained low and helped trigger a near twenty year boom. It was economic reflexivity in action.

Pavlov Dog Markets

Fast forward thirty years and we have a different problem but one with the same overtones. Repeated economic crises have given rise to a Pavlov dog type response by central bankers: flood the world with cheap cash while maintaining gradualism in interest rates policy so as not to spook the markets. Now the markets expect this every time something goes wrong such that moral hazard is almost ingrained in people’s behaviour.

Even as we speak cheap government money designated for loans to home owners, entrepreneurs and small businesses is being funnelled to speculative and higher growth regions: a commodity boom will doubtless soon follow, with a bust somewhere around the corner. The constant ebb and flow of the markets in this way can’t continue and eventually some combination of political will and regulator foresight has to be summoned to break the current market psychology.

It can be done, Volcker did it. Just don’t underestimate how bad things will have to get before it happens again.

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