Fed Chairman Powell Repeating Volcker’s Tight Money Mistake! Volcker Did Not Reduce Inflation, Only Caused Exploding Budget and Trade Deficits.
It is a total myth that Paul Volcker’s tight money in the early 1980’s “slayed the dragon of inflation”. Incredibly, that myth survives to this day, as Fed Chairman Powell and much of Wall Street have recently praised Volcker’s approach to fighting inflation. That myth is the result of bafflingly flawed logic and disregard for the facts. Rigorous logic and attention to the facts lead to the conclusion that just as spiking oil prices worldwide (from $12 a barrel to $42) caused a massive cost-push inflation in the late 1970’s/early 1980’s, stabilizing oil prices due to free market forces caused the eventual decline in inflation. In other words, the sharp rise and fall in inflation had all to do with oil prices, and nothing to do with monetary policy. It would be absurd to claim that soaring world oil prices in the late 1970’s and early 1980’s were due to a loose American monetary policy, rather than to a sudden major reduction in OPEC oil production following the arrival of Ayatollah Khomeini in Iran and the subsequent breakout of the Iran-Iraq War.
Similarly, the first energy crisis of 1973 was caused by OPEC’s nationalization of its oil and the consequent price decontrol, leading to world oil prices jumping from $2 a barrel to $12 overnight. Oil being a very important cost factor, the knock-on effects led to a jump in inflation, leading to the new phenomenon of “stagflation”, a combination of inflation and economic decline. It should be obvious that the jump in world oil prices had nothing to do with U.S. monetary policy, and that a restrictive monetary policy response was totally inappropriate and counterproductive. In fact, since the jump in oil prices was not due to increased oil consumption but to sudden price decontrol, the correct policy response would have been to stimulate investment in non-OPEC oil production and in energy efficiency. High interest rates would clearly hinder such investments, making them more expensive to finance and requiring a higher return on investment threshold.
The reason the Federal Reserve and the economics profession failed to properly understand the oil induced inflation and “stagflation” following the 1973–74 and 1979–80 energy crises, is that the elementary distinction between cost-push and demand-pull inflation was forgotten. That distinction was forgotten because historically most inflation had been of the demand-pull variety, i.e., due to a booming economy with excess aggregate demand. Clearly, a tighter monetary policy is logical when there is demand-pull inflation, but it is nonsensical and counterproductive when there is cost-push inflation. The proper policy response to cost-push inflation is to address the reasons why costs are rising, not to reduce consumer demand and cause a recession.
Today’s global inflation spike is of the “cost-push” variety. It is clearly not due to a jump in American consumer demand, but to global supply-chain disruptions due to the Covid pandemic, subsequently aggravated by Russia’s invasion of Ukraine and the consequent reduction of Russian oil and gas supplies in the West for political reasons. The statistical correlation is perfect. Just as American monetary policy has not been the cause of our domestic inflation, it cannot be the solution. Tightening monetary policy will do nothing to resolve global supply-chain disruptions or spiking oil prices; it will only serve to significantly slow economic growth, increase unemployment and our budget deficits, and give us our third bout of “stagflation”.
It is important to understand that Volcker’s tight money had very deleterious effects, apart from doing nothing to reduce inflation. Not only did high interest rates slow investments in domestic oil production and energy efficiency/conservation, they served to explode American public and private indebtedness. Our budget deficits soared not only for cyclical reasons (lower tax revenues and higher social outlays) due to the recession worsened by tight money. They also soared as federal interest expense skyrocketed: maturing Treasury debt with 7% coupons was rolled over into new Treasury debt with 16% coupons, piling on to newly issued Treasury bonds with historically high coupons. Thanks to Volcker, the fed funds rate reached 21% in 1983–84, while inflation was below 10%, meaning that the real overnight interest rate (with no future inflation risk!) was an absurd 10%+. Not only did those absurdly high nominal and real interest rates cause our public and private debt to surge, they caused the dollar exchange rate to double, leading to record trade deficits and high unemployment.
Unfortunately, Fed Chairman Powell has now embraced a Volcker-like response to the current cost-push inflation, and he will uselessly cause a recession. He is hiking the fed funds rate and reducing the Fed balance sheet (quantitative tightening), both measures being totally inappropriate. Illogically, he is focusing on year-to-year CPI inflation numbers, instead of month-to-month numbers which accurately indicate current inflation. In fact, inflation is already quickly subsiding in tandem with diminishing supply-chain problems and lower oil prices.
There are currently other serious misunderstandings by many Wall Streeters. influential economists, and Federal Reserve members. For example, Thomas Barkin, president of the Richmond Fed, has warned “The experience of the ’70s showed that if you back off on inflation too soon, it comes back stronger.” (New York Times, Business section, The Digest, Joe Rennison, January 7, 2023) Mr. Barkin is mistaken because he obviously is only looking at inflation charts and not seeing the context for inflation’s rise, fall, and rise in the 1970’s, specifically the two separate major oil crises of 1973–74 and 1979–80. If you only look at inflation charts, you don’t understand the causes of the fluctuations. Inflation returned in 1979–80 not because of the Federal Reserve laxity, contrary to Barkin’s understanding, but because of the second energy crisis. It’s not that inflation is like some virus rebounding after not being sufficiently treated with antibiotics and eliminated.
Another common serious misunderstanding these days is the belief that core inflation is not directly influenced by sharply rising oil and grain prices, but only or mainly by the Fed’s monetary policy. Whereas the reality is that oil and grain prices are often the primary force pushing up core inflation. Without the Covid supply-chain disruptions and the Russian invasion of Ukraine, there would have been no increase in inflation in 2022. The inflation spike has not been due to a sudden jump in consumer demand; rather it has been due to a sudden reduction in supply. It is no coincidence that inflation has been falling rapidly in recent months in perfect tandem with sharply falling oil and gas and grain prices due to increased supply, not due to Fed tightening. Meanwhile, Covid supply-chain disruptions are being resolved, adding to supply, leading to lower prices.
It is also important to understand that President Biden has been unfairly and mistakenly accused of causing the spike in inflation through his Covid stimulus, which his critics perceive to have been excessive. Those critics fail to remember that the economy was about to plunge into a deep depression due to Covid, with the domino effect of offices and factories closing, unemployment surging, and consumption dropping, and that the only tool available to avoid economic collapse was to inject lots of dollars into the pockets of consumers. There should be no doubt that Biden saved us from depression. His critics are superficial thinkers and poor analysts.
What should alert everyone to the fact that our inflation spike was not due to the Federal Reserve is that the inflation spike happened all over the world. It is highly illogical to conclude that such simultaneous worldwide inflation was caused by the Fed. That same failure of logic occurred in the 1970’s, when inflation was blamed on the Fed and not on the two energy crises. We have a deficit of logic and critical thinking in our nation, and that needs to be corrected, the only way being a course in every single public high school on logic and critical thinking with case histories.
© Edward Sonnino 2023
Addendum:
Apart from finally understanding the difference between the two varieties of inflation requiring different policy responses, Americans must also understand the real causes of our large, record federal indebtedness. One major cause is totally avoidable recessions caused by excessively tight monetary policy and high interest rates, leading to a big cyclical drop in tax revenues and a big cyclical increase in social expenditures. Eliminate all our recessions engineered by the Fed with high interest rates since 1974, and the outstanding federal debt shrinks to very low levels.
A second major cause of our heavy federal indebtedness is the fact that due to all too many mediocre public schools with deficient curriculums, half of our citizenry is undereducated with low earnings power. A flimsy basic high school education also has negative consequences for many college graduates, whose education remains very narrow. For an economically and socially prosperous society, the following high school courses must be included in the curriculum: 1) psychology (taught in conjunction with “group therapy” and “good parenting” workshops); 2) 20th Century world history analyzed in great detail; 3) economics/finance/investing; 4) history of art/architecture/design; 5) history of music; 6) the United Nations’ Charter and its Universal Declaration of Human Rights; 7) the world history of human rights violations; 8) comparative religion studied through direct readings of the holy books; 9) logic and critical thinking; 10) ethics and empathy; 11) foreign languages and cultures; 12) introductory and Constitutional law; 13) Latin; 14) the major mistakes in economic, social, and foreign policy of the past 100 years.
If all our public schools were truly excellent, with an enlightened curriculum, strict class discipline, lots of homework, school uniforms (ties and jackets, i.e., “dress the part”), and providing individual attention to students having academic or psychological problems, we would have practically no poverty, no welfare, no violence of any kind, no addiction, no crime, no rampant dishonesty, no abusiveness. We would have very few mentally disturbed citizens, hardly any mass shootings, very few high school dropouts, and very few unwanted pregnancies/abortions. Our budget deficits would disappear. Our tax rates would drop dramatically. Capital gains and unconstitutional estate taxes would be eliminated. All our social, economic, and political problems would be solved. Our politicians would be much better educated. We would avoid very costly foreign policy mistakes. We would also undoubtedly see the wisdom of requiring all our political candidates to be truly qualified before being allowed to run. There would be specialized, very advanced graduate school programs for political candidates, ensuring that at a minimum they would each be able to list off the top of their head all the major mistakes in economic, social, and foreign policy over the past 100 years and knowledgeably discuss which would have been the correct policies. It’s all doable, it should have been done many decades ago.
© Edward Sonnino 2023
January 17, 2023
