It’s Not True That Volcker Whipped Inflation!

A Myth Debunked.

Andrew Ross Sorkin’s October 23, 2018 New York Times Dealbook article, He Whipped Inflation. He’s Still Punching. consists of his recent interview with Paul Volcker, the chairman of the Federal Reserve from 1979 to 1987. The title affirms the mistaken mainstream belief that Volcker “slew the dragon of high inflation” of the early 1980’s with an extremely restrictive monetary policy, which drove real and nominal interest rates to record highs. That mistaken belief reflects the flawed understanding of inflation by mainstream economists, which has unfortunately influenced monetary policy for decades worldwide, leading to unnecessarily long and deep recessions, as well as to exploding public and private indebtedness.

The logic behind the belief that Volcker’s extremely tight money brought down the high inflation of the early 1980’s rests on the flawed assumption that there is only one strain of inflation, “demand-pull inflation”. But there is a second, distinct variety of inflation, i.e., “cost-push inflation”, having completely different causes and requiring completely different economic policy responses. “Demand-pull” inflation, the most common variety of inflation, is due to excess aggregate demand, the situation of “too much money chasing too few goods”, corresponding to a booming economy with high capacity utilization and low unemployment. “Cost-push” inflation, a historically rare variety of inflation, is instead due to increased costs of production and distribution having nothing to do with excess aggregate demand. Those increased costs are transmitted by companies to consumer prices in an attempt to protect shrinking profit margins, even when such price increases result in fewer sales.

The high inflation of the early 1980’s during Volcker’s term was of the “cost-push” variety, due to the sudden quadrupling of oil prices between 1979 and 1980 (consequent to Iran’s substantially reduced oil production for political reasons with the return of Ayatollah Khomeini, and soon thereafter to the outbreak of the Iran-Iraq war, which greatly reduced the oil production of both countries). Oil being a very important cost component in production and distribution, the giant increase in its price substantially drove up costs, which then caused retail prices to jump as a knock-on effect. Since “cost-push” inflation has nothing to do with excess aggregate demand, a tight money therapy of high interest rates, whose effect is to reduce consumer borrowing and consumption, is totally inappropriate. In the early 1980’s the economy was weak due to insufficient consumer demand, and the sky-high high interest rates engineered by Volcker turned an economic slowdown into a severe recession, without reducing the price of oil. The unusual simultaneous occurrence of recession and high inflation had only been experienced once before, and a new term was coined, “stagflation”. That was during the first energy crisis in 1973–74 which also produced high inflation, as oil prices rocketed from $2 a barrel to $12 subsequent to a temporary OPEC oil export embargo and the expropriation of Western oil company assets in OPEC countries, terminating the unofficial “oil price controls” imposed for decades on the producers of Middle East oil by the West to benefit its consumers.

What brought down inflation, finally, was not Volcker’s extremely tight monetary policy, but stabilizing oil prices between 1981 and 1984 followed by a 50% drop in oil prices in 1985, both entirely due to free market, supply-demand forces in the energy sector, not to the Fed’s monetary policy which was actually counterproductive and retarded the drop in oil prices. High oil prices spurred energy efficiency measures and related investments, a shift to alternative energy sources, and to rising oil production outside of OPEC, all of which eventually led to stabilizing and then much lower oil prices. High interest rates made financing those energy related investments much more expensive and effectively braked them to a significant degree.

Mainstream economists who insist that monetary policy was the cause of double digit inflation and then its fall, inexplicably ignore that oil price variations from 1973 to 1987 perfectly correlate with the consumer inflation index, whereas money supply figures do not at all, statistical proof that monetary policy had nothing to do with the high inflation of the mid 1970’s and early 1980’s, and little to do with the drop in inflation.

What is also generally ignored is that Volcker’s extremely restrictive monetary policy (with the fed funds rate reaching 22% and long-term Treasury bond yields reaching 16% in 1984 while the CPI was under 8%) singlehandedly caused the budget deficits to explode from 1979 onwards, as 1) borrowing costs skyrocketed for newly issued Treasuries financing current deficits and the replacement of maturing Treasuries with low coupons; and 2) as a deep recession reduced tax receipts. Furthermore, with U.S. Treasuries offering by far the highest real and nominal interest rates among the major industrialized nations, the dollar exchange rate doubled, seriously reducing the global competitiveness of many American companies. The result was an extraordinary jump in our trade deficits during the 1980’s. (Contrary to mainstream belief, our budget deficits were not the cause of either high inflation, high interest rates, an overvalued dollar exchange rate, or of our trade deficits. Apart from proper logic, the lack of statistical correlation proves that the conventional economic wisdom regarding the effects of budget deficits is mistaken.)

A proper monetary policy response to the oil crisis “cost-push” inflation would have been implementing a “neutral” monetary policy, with a monthly targeting of the fed funds rate at the 6-month trailing CPI average. Interest rates would have never exceeded 10%, the recessions of 1974–75 and 1981–82 would have been much shorter and less deep, the budget deficits and trade deficits much smaller. And oil prices and inflation would have fallen more quickly. Conventional, mainstream economists still do not understand that, just as they don’t understand that the U.S. is not, and has never been, dependent on foreign capital to finance its budget deficits, as explained in my Wall Street Journal article No Addiction to Foreign Capital (May 3, 1985), and as the Fed’s $3 trillion of ‘Quantitative Easing’ financing between 2010 and 2013 should have made very clear. If the Fed was able to finance three years of our budget deficits all by itself through QE, why would we ever need Japan or China or any other nation to finance our budget deficits? We have QE by the Fed, whenever necessary.

One more point: there is no need for the Fed to sell off its large holdings of Treasury securities, as mainstream economists believe. The Fed can hold on to all its Treasury securities until they expire at maturity. That means the $3 trillion of Treasury debt held by the Fed through QE purchases would simply evaporate in thin air as it matures. And there would be no consequent increase in inflation since the money represented by those securities has already been in circulation for various years, with inflation remaining at historic lows. Any future “demand-pull” inflation will derive from new (additional) dollars in circulation, not from the dollars injected through QE between 2010 and 2013. The correct policy response would then be to tighten monetary policy or to raise taxes temporarily.

© Edward Sonnino 2018

October 25, 2018

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Edward Sonnino

Born and raised in New York City. Best course in college: history of art. Profession: economic forecaster and portfolio manager. Fluent in French and Italian.